1 ALTERNATIVE COLLATERAL RISK MITIGATION CRAIG R. ENOCHS Jackson Walker L.L.P McKinney, Suite 1900 Houston, Texas JOHN LIGHTBOURN NextEra Energy Resources 700 Universe Blvd. Juno Beach, Florida International Energy Credit Association 85 th Annual Fall Conference October 11-14, 2009 Orlando, Florida

2 Credit Risk  Credit risk must be tailored to each transaction  Credit risk is not absolute, but exists on a continuum  Different points on the continuum require different risk mitigants

3 Credit Risk (cont.)  Risk levels can be influenced by many factors, including:  Nominal deal value  Tenor of the deal  Market liquidity and  Relative creditworthiness of counterparty RISK LOWHIGH Next-Day Index Gas SaleLong-Term Tolling Arrangement Guaranty?First Lien or Margining?Letter of Credit?

4 Credit Risk (cont.)  The key is to identify:  Where your specific transaction falls on the risk continuum  Which credit tool best mitigates the risks involved in the deal RISK LOWHIGH Next-Day Index Gas SaleLong-Term Tolling Arrangement Guaranty?First Lien or Margining?Letter of Credit?

5 Credit Risk (cont.)  When selecting a credit tool, bear in mind that most credit tools merely shift risk and do not eliminate it altogether  Goal is not to eliminate risk  Rather, the goal is to meet the ideal point of intersection between credit risk and the cost and time to effect the credit tool

6 Credit Risk (cont.) COST & TIME CREDIT RISK MITIGATION LowHigh Guaranty First Lien

7 Credit Risk (cont.)  May use combination of credit tools in a transaction  Different tools may be necessary to capture:  Receivable risk v. mark-to-market risk  Independent amount v. tail risk

8 Selected Credit Tools for Discussion  Guaranties  Letters of Credit  Prepayment  Master Netting Agreements  Master Agreements with Multiple Annexes  Credit Default Swaps  First Liens  Joint & Several Liability Agreement

9 I. Guaranties  Third party agrees to pay  Usually parent or affiliate  Guarantee of payment not performance  Enhances counterparty’s creditworthiness  Guarantor’s right of subrogation  Termination only releases Guarantor from future liability – not prior payment obligations

10 I. Guaranties BEFORE TERMINATION Guaranty Letter of Credit Termination Credit Protection: Guaranties v. Letters of Credit AT AND AFTER TERMINATION Guaranty Letter of CreditTermination Protected Not Protected

11 I. Guaranties (cont.)  When are Guaranties used?  A party has:  Little or no creditworthiness;  Limited liquid collateral; and  An affiliate with creditworthiness

12 I. Guaranties (cont.)  Advantages:  Liquid (but see next slide)  Simple  Common  Generally quick to negotiate and implement  For beneficiaries, potentially adds value if Guarantor and subsidiary go bankrupt  Ex: Enron corporate guaranty roughly doubled unsecured creditors’ recovery

13 I. Guaranties (cont.)  Disadvantages:  Contract obligation, not cash or property  Guarantor’s creditworthiness may subsequently deteriorate  Guarantor is required to report guaranteed obligations on its financial statements

14 I. Guaranties (cont.)  Defenses to Payment:  Generally, Guarantor has same defenses as Counterparty under trading agreement  Exceptions:  Non-payment because of discharge of counterparty’s obligations in bankruptcy  Non-payment because counterparty lacked capacity under the agreement  Any defenses expressly waived in guaranty  Suretyship defenses

15 II. Letters of Credit  Financial institution agrees to pay up to the value of the letter of credit  Second only to cash  Assigned higher value than less liquid or less certain forms of collateral  Generally short-term in nature  Ex: Common term is 30 days to 1 year

16 II. Letters of Credit (cont.)  Party posting the letter of credit is usually responsible for all related fees  Fees Associated with Letters of Credit  Monthly fee to maintain the credit facility, whether or not letter of credit is issued  Usually a percentage of total amount available under letter of credit facility  Fee when letter of credit is actually issued

17 II. Letters of Credit (cont.)  Common Limitations Imposed by Issuer:  Maximum number of letters of credit  Maximum amount outstanding  Approval of beneficiary  Approval of form

18 II. Letters of Credit (cont.)  Drawing on a Letter of Credit:  Administrative Obstacles  Compliance with drawing conditions  Default under agreement generally must be continuing  May be required to present certified statement of default  Physical presentation of letter of credit to issuing bank  Ability (or inability) to make partial and/or multiple withdrawals  Depends on express terms in letter of credit

19 II. Letters of Credit (cont.)  Multiple and partial withdrawals are preferred  If not allowed, then:  Beneficiary may draw on letter of credit only one time  Wait until the maximum amount allowed under the letter of credit is owed before drawing on the letter of credit

20 II. Letters of Credit (cont.)  Advantages:  Liquid  Simple  Commonly used  Disadvantages:  For beneficiaries, risk that issuer will become insolvent  For issuers, payment risk if called upon to perform under letter of credit  For posting party, risk of expenses to replace if called upon

21 III. Prepayment  Buyer pays Seller before delivery  Net present value of sales price  Often preferred when dealing with non- creditworthy counterparties

22 III. Prepayment (cont.)  Single v. Recurring Payment  Generally Seller prefers single payment:  Larger amount of prepayment at once  Seller is not exposed to risk if it is, in turn, purchasing long-term supply upstream  Generally Buyer prefers recurring payment:  Smaller amount of prepayment at once  Mitigates Buyer’s loss if Seller does not deliver

23 III. Prepayment (cont.)  Single Payment Structure Example: Tax-Exempt Prepaid Transaction  Municipality issues 30-year tax-exempt bonds  Bond proceeds are used to prepay a 30-year supply of commodity at a price discounted to net present value  Municipality recovers a discount to the extent of their tax exemption

24 III. Prepayment (cont.)  Recurring Payment Structure Example: Retail or Wholesale Prepaid Transaction  Buyer initially pays Seller’s anticipated accounts receivable for a set billing cycle (usually 60 days)  Buyer and Seller true up each month by invoice, and Buyer prepays for the following month

25 III. Prepayment (cont.)  Recurring Payment Structure Example: Retail or Wholesale Prepaid Transaction (cont.)  Usually no mark-to-market collateralization  Best for index deals because no mark-to- market risk if either Buyer or Seller defaults

26 III. Prepayment (cont.)  Fixed v. Variable Prepayment:  Calculation and periodic adjustments  Variable price and/or variable quantity  When using an index price, should have market disruption provisions

27 III. Prepayment (cont.)  Liquidated Damages:  If a party is entitled to liquidated damages, Buyer’s previous prepayment to Seller directly affects:  Who pays damages; and  How payment is effectively made  Two Scenarios:  Seller fails to deliver and Buyer covers  Buyer fails to receive and Seller covers

28 III. Prepayment (cont.)  Liquidated Damages (cont.)  If Seller Fails to Deliver and Buyer Covers:  General Rule:  Seller returns the prepayment amount to Buyer; plus  Positive difference (if any) in subtracting the contract price from Buyer’s cover price.  Seller also responsible for all Buyer’s costs and expenses in purchasing the commodity Seller failed to deliver.

29 III. Prepayment (cont.)  Liquidated Damages (cont.)  If Seller Fails to Deliver and Buyer Covers:  Example: Buyer prepays Seller $10/MMBtu for Gas. Seller fails to deliver the Gas.  If Buyer covers at $12/MMBtu for Gas, then Seller owes:  $10/MMBtu prepayment to Buyer; plus  $2/MMBtu difference incurred by Buyer.  Seller’s $12/MMBtu payment (plus costs and expenses) keeps Buyer whole for Seller’s failure to perform.

30 III. Prepayment (cont.) Seller Seller Fails to Deliver and Buyer Covers at $12/MMBtu: Buyer (i) $10/MMBtu Prepayment 3 rd Party Seller (ii) Gas(ii) $12/MMBtu (iii) $12/MMBtu (i)Buyer prepays Seller $10/MMBtu, and Seller fails to deliver Gas (ii)Buyer covers by purchasing Gas from 3 rd Party Seller at $12/MMBtu (iii)Seller pays $12/MMBtu to Buyer $10/MMBtu original prepayment, PLUS $2/MMBtu additional cover cost

31 III. Prepayment (cont.)  Liquidated Damages (cont.)  If Seller Fails to Deliver and Buyer Covers:  Example: Buyer prepays Seller $10/MMBtu for Gas. Seller fails to deliver the Gas.  If Buyer covers at $5/MMBtu for Gas, then Seller owes:  $10/MMBtu prepayment to Buyer.  Seller’s breach resulted in a cost savings to Buyer (e.g., Buyer paid only $5/MMBtu instead of $10/MMBtu).  However, Seller must return Buyer’s entire prepayment and pay any additional cover costs or expenses incurred by Buyer.

32 III. Prepayment (cont.) Seller Seller Fails to Deliver and Buyer Covers at $5/MMBtu: Buyer (i) $10/MMBtu Prepayment 3 rd Party Seller (ii) Gas(ii) $5/MMBtu (iii) $10/MMBtu (i)Buyer prepays Seller $10/MMBtu, and Seller fails to deliver Gas (ii)Buyer covers by purchasing Gas from 3 rd Party Seller at $5/MMBtu (iii)Seller pays $10/MMBtu to Buyer $10/MMBtu original prepayment Buyer keeps $5/MMBtu cost savings resulting from Seller’s breach

33 III. Prepayment (cont.)  Liquidated Damages (cont.)  If Buyer Fails to Receive and Seller Covers:  General Rule:  Seller returns the prepayment amount to Buyer; minus  Positive difference (if any) in subtracting Seller’s resale price from the contract price.  Seller also can deduct its cover costs and expenses from the amount it returns to Buyer.

34 III. Prepayment (cont.)  Liquidated Damages (cont.)  If Buyer Fails to Receive and Seller Covers:  Example: Buyer prepays Seller $10/MMBtu for Gas. Buyer fails to receive the Gas.  If Seller covers at $7/MMBtu for Gas, then Seller returns:  $10/MMBtu prepayment to Buyer; minus  $3/MMBtu difference incurred by Seller.  By returning only $7/MMBtu of Buyer’s original $10/MMBtu prepayment, Seller is kept whole.  Seller also can deduct any of its cover costs and expenses from the amount returned to Buyer.

35 III. Prepayment (cont.) Seller Buyer Fails to Receive and Seller Covers at $7/MMBtu: Buyer (i) $10/MMBtu Prepayment 3 rd Party Buyer (ii) Gas(ii) $7/MMBtu (iii) $7/MMBtu (i)Buyer prepays Seller $10/MMBtu, and Buyer fails to receive Gas (ii)Seller covers by selling Gas to 3 rd Party Buyer at $7/MMBtu (iii)Seller pays $7/MMBtu to Buyer $10/MMBtu original prepayment, MINUS $3/MMBtu difference between $10 contract price and $7 resale price

36 III. Prepayment (cont.)  Liquidated Damages (cont.)  If Buyer Fails to Receive and Seller Covers:  Example: Buyer prepays Seller $10/MMBtu for Gas. Buyer fails to receive the Gas.  If Seller covers at $12/MMBtu for Gas, then Seller returns:  $10/MMBtu prepayment to Buyer.  Seller keeps the $12/MMBtu cover payment, including the $2/MMBtu profit resulting from Buyer’s breach.  Seller can deduct any of its cover costs and expenses from the amount it returns to Buyer.

37 III. Prepayment (cont.) Seller Buyer Fails to Receive and Seller Covers at $12/MMBtu: Buyer (i) $10/MMBtu Prepayment 3 rd Party Buyer (ii) Gas(ii) $12/MMBtu (iii) $10/MMBtu (i)Buyer prepays Seller $10/MMBtu, and Buyer fails to receive Gas (ii)Seller covers by selling Gas to 3 rd Party Buyer at $12/MMBtu (iii)Seller pays $10/MMBtu to Buyer $10/MMBtu original prepayment Seller keeps $12/MMBtu cover payment, including $2/MMBtu profit

38 III. Prepayment (cont.)  Force Majeure  Generally excuses both parties from delivery and/or receipt obligations to the extent and for the duration of the Force Majeure event.  Buyer’s prepayment to Seller creates risk to Buyer if Force Majeure event subsequently excuses:  Seller from delivering the commodity; or  Buyer from receiving the commodity

39 III. Prepayment (cont.)  Force Majeure (cont.)  General Rule:  If either Seller or Buyer declares Force Majeure and Buyer has prepaid Seller, then Seller returns Buyer’s entire prepayment for the period affected by Force Majeure.  If Seller claims Force Majeure and is unable to deliver the commodity to Buyer, then Buyer should get its prepayment back because it did not receive the commodity.  If Buyer claims Force Majeure and is unable to receive the commodity from Seller, Buyer should get its prepayment back because it is excused.

40 IV. Master Netting Agreements  Two counterparties sign a Master Netting Agreement to net transactions between them and possibly those between affiliates  3 Aspects of Master Netting Agreements: 1.Netting of payments 2.Netting of exposure 3.Setoff upon bankruptcy

41 IV. Master Netting Agreements (cont.)  From a credit risk perspective, a Master Netting Agreement should have all three aspects:  ISDA Energy Agreement Bridge: Not a true Master Netting Agreement, rather a cross default tool  EEI Master Netting Agreement: Includes all three Master Netting Agreement features

42 IV. Master Netting Agreements (cont.)  Benefits of Master Netting Agreements  Efficient use of collateral capital  Enterprise-wide netting and setoff if affiliates are included  Uniform credit terms enterprise-wide with a counterparty and all of its affiliates

43 IV. Master Netting Agreements (cont.)  Disadvantages of Master Netting Agreements  Unwieldy  Can be complex  Expensive  Time-consuming to negotiate  Ex. EEI Master Netting Agreement  Enforceability  Cross-affiliate Master Netting Agreements have been difficult to enforce in bankruptcy

44 IV. Master Netting Agreements (cont.)  Bankruptcy courts are hostile toward cross- affiliate Master Netting Agreements because they undermine the core principal that every unsecured creditor is treated identically  Limited case law  Enron v. Reliant indicated cross-affiliate MNA was unenforceable unless all involved affiliates sign and agree to joint and several liability  Effectively destroys multiple affiliate Master Netting Agreements

45 V. Master Agreement with Annexes  Use a Master Agreement with common terms and various annexes specific to each product  EEI: Less widely used  ISDA: Increasingly popular

46 V. Master Agreement with Annexes (cont.)  Advantages  Net exposure across products: Leads to more efficient collateral deployment  Single-agreement setoff treatment in bankruptcy  Avoids negotiating sticky issues that slow down negotiations more than once  Ex. Credit terms, Events of Default  Once Master Agreement is negotiated, annexes are usually very easy to add

47 V. Master Agreement with Annexes (cont.)  Disadvantages  Master Agreement with annexes can take longer to negotiate than individual single- product Master Agreement  Gap risk between product-specific annexes to Master Agreement and single-product Master Agreement  Ex. ISDA Gas Annex v. NAESB

48 VI. Credit Default Swaps  Buyer purchases credit protection from Seller relating to the obligation of some other entity (a “Reference Obligation”)  Buyer does NOT have to have any interest in the Reference Obligation  Buyer pays Seller a periodic fee for such protection

49 VI. Credit Default Swaps  If a “Credit Event” occurs with respect to the Reference Obligation, Seller pays Buyer the difference between:  The face value of the Reference Obligation; and  The current market value of the Reference Obligation.  Commonly documented through the ISDA

50 VI. Credit Default Swaps  Purpose of CDS Transactions  Increase or decrease credit exposure without the need for transferring assets or obligations  Seller in a CDS Transaction immediately increases its credit exposure without having to outlay any cash  Buyer in a CDS Transaction immediately decreases its credit exposure without having to dispose of any outstanding obligations  Ability to manage exposure makes CDS Transactions popular with banks and hedge funds

51 VI. Credit Default Swaps (cont.)  Regulation:  CDS transactions generally exempt from CFTC and SEC regulation  Exempt from CFTC regulation because:  Not executed on a Trading Facility (Over-the-Counter)  Entered into between Eligible Contract Participants  Exempt from certain SEC regulations because:  Constitutes a “Security-Based Swap Agreement”, which is expressly excluded from the definition of “Security” in the Securities Act and Exchange Act.

52 VI. Credit Default Swaps (cont.)  CDS Transactions v. Insurance Contracts  Material interest in underlying obligation  Insurance contract requires “insurable interest”  Buyer of CDS protection does not need to show any interest in the Reference Obligation  Proof of loss  Insurance contract requires insured to show “proof of loss” before amounts are paid under the policy  Seller pays Buyer amounts owed under CDS Transaction whether or not Buyer has actually incurred any loss related to the Reference Obligation.

53 VI. Credit Default Swaps (cont.)  CDS Transactions v. Insurance Contracts (cont.)  Payment of Premiums  Insurance contracts: Premiums paid on monthly basis, and rates adjusted by insurer on annual basis  CDS Transactions: Buyer pays CDS fee on a quarterly basis, and fee remains constant throughout the term of the deal.  Termination  Insurance contract: Generally insured can terminate at will  CDS Transaction: Set term is defined in the Confirmation, so Buyer cannot unilaterally terminate. If Buyer fails to pay CDS fee, then Seller may declare Event of Default under the agreement

54 VI. Credit Default Swaps (cont.)  Advantages:  Seller’s creditworthiness is substituted for the creditworthiness of the party whose obligations are secured by the CDS Transaction  Risks:  Seller may become less creditworthy over the term of a CDS Transaction  Seller may fail to pay CDS obligations upon the occurrence of a Credit Event  Buyer may be exposed if it is not holding some form of collateral or security from Seller

55 VII. First Liens  General Overview  Debtor under an existing credit facility has provided a first lien and security interest in a tangible asset to lenders  Debtor enters into trading agreements with hedge counterparties relating to the asset, and offers first lien as collateral  Ex: Debtor enters into ISDA with Gas Annex in order to purchase fuel for electric generation facility  Hedge counterparty holds first priority lien and security interest pari passu with lenders

56 VII. First Liens  General Overview  Lenders willing to share first lien because trading relationship with hedge counterparty:  Reduces risk  Ex: If hedge counterparty sells natural gas to run debtor’s power plant, reduces the risk that the plant will be unable to produce electricity  Increases value of the asset  Ex: If debtor sells a power plant’s electricity to hedge counterparty, this increases the value of the plant by mitigating the risk that debtor will not be able to find a purchaser for the plant’s output

57 VII. First Liens  Documents in First Lien Structures  Loan Documents: May impact a hedge counterparty’s rights in relation to other lenders  Credit Agreement  Intercreditor Agreement  Security Agreement or Collateral Trust Agreement  Designation and Joinder Agreement  Trading Documents: Between hedge counterparty and debtor  First Lien protections often documented under an ISDA, but can be incorporated into NAESB or EEI

58 VII. First Liens (cont.)  3 Types of First Lien Credit Structures  Replacement Structure  Threshold Structure  Tail Risk Structure

59 VII. First Liens (cont.)  Replacement Structure  First lien wholly replaces any other collateral obligations of debtor under the trading agreement  Debtor not required to provide any cash, letter of credit or guaranty  Cheaper to implement than other forms of credit support

60 VII. First Liens (cont.)  Threshold Structure  Hedge counterparty assigns a value to the first lien  Such value establishes a fixed collateral threshold for debtor under the trading agreement  Debtor only provides alternative forms of collateral if hedge counterparty’s exposure exceeds the threshold

61 VII. First Liens (cont.)  Tail Risk Structure  Debtor initially posts collateral to hedge counterparty up to a fixed amount  The First Lien covers debtor’s “tail risk” over and above the credit limit  Debtor’s collateral obligations are fixed despite any subsequent market fluctuations altering hedge counterparty’s exposure.

62 VII. First Liens (cont.)  Debtor’s Order of Preference for First Lien Structures  Replacement Structure  Debtor provides no collateral except the First Lien  Tail Risk Structure  Debtor’s collateral obligations are fixed up to a certain amount, and the First Lien covers all other hedge counterparty exposure  Threshold Structure  Debtor still receives value for its First Lien, but may have to post additional collateral depending on hedge counterparty’s exposure

63 VII. First Liens (cont.)  Counterparty’s Order of Preference for First Lien Structures  Threshold Structure  Accounts for the value of debtor’s first lien, but also protects against market risk by requiring additional collateral  Tail Risk Structure  Hedge counterparty initially receives collateral as security, and enjoys the benefits of First Lien protection  Replacement Structure  Risk that hedge counterparty’s exposure will exceed the value of the First Lien, and no other collateral available

64 VII. First Liens (cont.)  Advantages to Debtor  No additional collateral needed  No liquidity needed  More equity may be available under Credit Agreement than in other credit structures  Lower administrative burden  More efficient use of the capital locked up in the assets of the first lien estate

65 VII. First Liens (cont.)  Advantages to Counterparty  Right in tangible asset rather than contractual interest  Aligned interests with lender  “Right-way risk”  As the price of input or product increases (thus potentially increasing a hedge counterparty’s exposure), the value of the asset on which counterparty holds a first lien also increases.

66 VII. First Liens (cont.)  Disadvantages to Debtor  Counterparty still may demand additional collateral or price concessions  Low asset valuation for credit purposes  First liens are fairly illiquid and contingent upon terms of a Credit Agreement or actions by lenders  Requires positive multiple of equity to debt on assets in facility

67 VII. First Liens (cont.)  Disadvantages to Debtor (cont.)  First lien places hard assets at risk that are not otherwise affected in other credit structures  Even if counterparty accepts first lien, counterparty may impose ultra conservative risk limits and parameters in the transactions secured by the first lien  Impacts ability to trade with hedge counterparty

68 VII. First Liens (cont.)  Disadvantages to Counterparty  Highly illiquid collateral  Extended delay between default and payment  Lack of control in collateral  Acting as part of a group of creditors rather than individually  Risk if counterparty’s interests diverge from other lenders and hedge counterparties  Not fungible

69 VII. First Liens (cont.)  Additional Considerations with First Liens  Voting Rights  Generally contained in the Credit Agreement  Matters on which hedge counterparty can vote (and weight of vote) often differ from lenders  Ratio of (i) exposure to debtor, compared to (ii) cumulative debt under credit facility  Compared to lenders in the credit facility, hedge counterparty may have little or no voting power  Hedge counterparties must work with lenders because interests are linked

70 VII. First Liens (cont.)  Additional Considerations with First Liens (cont.)  Payment of Debt  Hedge counterparty’s collateral rights stem from Credit Agreement  When Credit Agreement is paid in full or terminated, hedge counterparty must ensure that it will be covered  Can the lenders release the lien without the hedge counterparty’s consent?  Can the lenders release the lien without the debtor providing alternative forms of collateral?

71 VII. First Liens (cont.)  First Lien Terms in Trading Agreements:  Events of Default / Termination Events  Debtor’s obligations cease to be subject to first lien  Hedge Counterparty’s right to payment ceases to be pari passu with lenders  Value of estate drops below a specified level  Threshold  Threshold, Replacement, or Tail Risk Structure?

72 VII. First Liens (cont.)  First Lien Terms in Trading Agreements (cont.):  Representations, Warranties & Covenants  Debtor’s authorization to provide the First Lien under the Credit Agreement  Compliance with representations in the Credit Agreement  Transfer and Assignment  Align Trading Agreement with Credit Agreement  Ex: Can the trading agreement be assigned or encumbered?

73 VIII. Joint & Several Liability Agreement  J&S Liability Agreement:  Affiliate counterparties agree to be jointly and severally liable for the payment obligations of the other under their respective trading agreements  All parties agree to net credit exposures  When Used:  One party trades with two or more affiliated counterparties under separate trading agreements  Structure creates a natural offset of payment and credit obligations under all agreements  Well suited for structured transactions

74 VIII. Joint & Several Liability Agreement (cont.)  Example:  Party A owns a power generation facility  Party A purchases gas from Party B Gas under a NAESB, and sells its electricity to Party B Power under an EEI  Party A, Party B Gas and Party B Power could enter into J&S Liability Agreement so that:  Party B Gas and Party B Power would be J&S liable for each other’s payment obligations to Party A under the NAESB and EEI  The Parties could net any credit exposures together to limit collateral obligations

75 VIII. Joint & Several Liability Agreement (cont.)  How Different than a Master Netting Agreement?  Expressly creates joint and several liability between affiliated parties  MNA often provides for netting and set off across transactions with affiliates, but does not create J&S liability for payment among such affiliates  J&S Liability can be limited only to obligations under a single trading agreement  MNAs generally involve multiple agreements among multiple counterparties and affiliates

76 QUESTIONS? CRAIG R. ENOCHS Jackson Walker L.L.P McKinney, Suite 1900 Houston, Texas JOHN LIGHTBOURN NextEra Energy Resources 700 Universe Blvd. Juno Beach, Florida 33408