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Understanding the ISDA Credit Support Annex: Know Your Rights and Risks

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Title: Understanding the ISDA Credit Support Annex: Know Your Rights and Risks


1
Understanding the ISDA Credit Support Annex
Know Your Rights and Risks
  • CRAIG ENOCHS
  • Jackson Walker L.L.P.
  • International Energy Credit Association
  • 2011 IECA Spring Education Conference
  • March 20-22, 2011
  • Hilton Head Island, South Carolina

2
Discussion Topics
  • Overview of the CSA
  • Key Provisions of the CSA
  • Security Interest
  • Credit Support Obligations
  • Conditions Precedent
  • Transfer Timing
  • Calculations of Value and Exposure
  • Substitutions of Collateral

3
Discussion Topics
  • Key Provisions of CSA (cont.)
  • Dispute Resolution
  • Holding and Using Posted Collateral
  • Events of Default
  • Certain Rights and Remedies
  • Representations
  • Costs and Expenses
  • Additional CSA Obligations
  • Paragraph 13 to the CSA

3
4
Discussion Topics
  • Credit Implications of Dodd-Frank
  • Clearing Requirement and End-User Exception
  • Segregation of Collateral Securing Uncleared
    Swaps
  • Reporting and Recordkeeping Obligations
  • Capital and Margin Requirements

4
5
Discussion Topics
  • Overview of the CSA
  • Key Provisions of the CSA
  • Paragraph 13 to the CSA
  • Credit Implications of Dodd-Frank

5
6
Overview of the Credit Support Annex
  • Paragraph 13 contains elections and amendments
    modifying Paragraphs 1 through 12
  • Protects against mark-to-market exposure
  • Most often used by sophisticated trading
    counterparties
  • Requires consistent monitoring and back-office
    systems
  • Preferred over adequate assurances because allows
    100 collateralization over threshold.

6
7
Discussion Topics
  • Overview of the CSA
  • Key Provisions of the CSA
  • Paragraph 13 to the CSA
  • Credit Implications of Dodd-Frank

7
8
Security Interest in Posted Collateral
  • Paragraph 2 Each Pledgor grants to the Secured
    Party a first priority continuing security
    interest, lien on, and right of Set-Off against
    all Posted Collateral.
  • When the Secured Party transfers the Posted
    Collateral back to the Pledgor, the security
    interest and lien shall be released immediately
    without further action.

8
9
Security Interest in Posted Collateral
  • Practice Notes
  • Only applies to Posted Collateralnot Posted
    Credit Support.
  • Eligible Collateral that is posted with a
    Secured Party is called Posted Collateral.
  • Most common Eligible Collateral elected in
    Paragraph 13 is Cash.
  • Security interest would not apply to other forms
    of credit support, such as Letters of Credit.
  • Primarily aimed at banks which may use
    Treasuries, bonds, equities or other assets as
    collateral.

9
10
Credit Support Obligations
  • Paragraph 3(a) Delivery Amount. Upon a demand
    by the Secured Party
  • If on any Valuation Date the Delivery Amount
    equals or exceeds the Pledgors Minimum Transfer
    Amount, then
  • The Pledgor Transfers Eligible Credit Support
    with a Value at least equal to the Delivery
    Amount.

10
11
Credit Support Obligations
  • Paragraph 3(a) Delivery Amount (cont.) If on
    any Valuation Date the Delivery Amount equals or
    exceeds the Pledgors Minimum Transfer Amount
  • Delivery Amount the amount by which the Credit
    Support Amount exceeds the Value of all Posted
    Credit Support held by the Secured Party.
  • What is the Credit Support Amount?
  • Does it exceed the Value of all Posted Credit
    Support (e.g., Cash, Letters of Credit, etc.)
    currently held by the Secured Party?

11
12
Credit Support Obligations
  • Paragraph 3(a) Delivery Amount (cont.) If on
    any Valuation Date the Delivery Amount equals or
    exceeds the Pledgors Minimum Transfer Amount
  • Credit Support Amount
  • Secured Partys Exposure, plus
  • Pledgors Independent Amount, minus
  • Secured Partys Independent Amount, minus
  • The Pledgors Threshold provided if such value
    is negative, the Credit Support Amount is zero
    (0).

12
13
Credit Support Obligations
  • Paragraph 3(a) Delivery Amount (cont.) If on
    any Valuation Date the Delivery Amount equals or
    exceeds the Pledgors Minimum Transfer Amount
  • Exposure
  • Defined in Paragraph 12 of CSA
  • The amount payable under Section 6(e)(ii) of the
    ISDA Master Agreement as if all Transactions
    terminated as of the Valuation Date.
  • Takes into account all forward mark-to-market
    positions.

13
14
Credit Support Obligations
  • Paragraph 3(a) Delivery Amount (cont.) If on
    any Valuation Date the Delivery Amount equals or
    exceeds the Pledgors Minimum Transfer Amount
  • Independent Amount
  • Elected by the parties in Paragraph 13
  • Collateral cushion required to be maintained by
    Pledgor in addition to any other Delivery Amount.
  • Threshold
  • Threshold for each party is stated in Paragraph
    13.
  • Most often credit ratings matrix that varies by
    counterparty.

14
15
Credit Support Obligations
  • Paragraph 3(a) Delivery Amount (cont.) If on
    any Valuation Date the Delivery Amount equals or
    exceeds the Pledgors Minimum Transfer Amount
  • Once you calculate any Delivery Amount, does it
    exceed the Pledgors Minimum Transfer Amount?
  • Minimum Transfer Amount Designated by the
    parties in Paragraph 13.
  • Credit evaluation that varies by counterparty and
    the anticipated volume of Transactions under the
    ISDA.
  • E.g., 250,000 for larger counterparties, and
    100,000 for smaller counterparties.

15
16
Credit Support Obligations
  • Paragraph 3(b) Return Amount. Upon a demand by
    the Pledgor
  • If on any Valuation Date the Return Amount equals
    or exceeds the Secured Partys Minimum Transfer
    Amount, then
  • The Secured Party Transfers Posted Credit Support
    with a Value at least equal to the Return Amount.

16
17
Credit Support Obligations
  • Paragraph 3(b) Return Amount (cont.) If on
    any Valuation Date the Return Amount equals or
    exceeds the Secured Partys Minimum Transfer
    Amount
  • Return Amount The Value of all Posted Credit
    Support held by the Secured Party, minus the
    Credit Support Amount.
  • What is the Value of all Posted Credit Support
    (e.g., Cash, Letters of Credit, etc.) held by the
    Secured Party?
  • Does it exceed the Credit Support Amount?

17
18
Credit Support Obligations
  • Paragraph 3(b) Return Amount (cont.) If on
    any Valuation Date the Return Amount equals or
    exceeds the Secured Partys Minimum Transfer
    Amount
  • Once you calculate any Return Amount, does it
    equal or exceed the Secured Partys Minimum
    Transfer Amount?

18
19
Conditions Precedent
  • Paragraph 4(a) Conditions Precedent. Each
    obligation to Transfer amounts under Paragraphs 3
    (Delivery/Return Amounts) and 5 (Dispute
    Resolution) is subject to the condition precedent
    that
  • No Event of Default, Potential Event of Default
    or Specified Condition has occurred and is
    continuing with respect to the other party and
  • No Early Termination Date for which unsatisfied
    payment obligations exist has occurred or been
    designated under the Agreement.
  • Caution Ipso Facto

19
20
Transfer Timing
  • Paragraph 4(b) Transfer Timing.
  • If a demand is made by the Notification Time,
    then Transfers are made no later than close of
    business on the next Local Business Day.
  • If a demand is made after the Notification Time,
    Transfers are made no later than the second Local
    Business Day.

20
21
Transfer Timing
  • Paragraph 4(b) Transfer Timing (cont.)
  • Practice Notes
  • Notification Time elected by the parties in
    Paragraph 13 (e.g., 100 p.m. EST on any Local
    Business Day).
  • No distinction between various types of Eligible
    Credit Support elected in Paragraph 13, including
    Letters of Credit.
  • Operational Concerns While Cash may be
    Transferred quickly, what about LOC issuances and
    amendments?
  • Does your company need to increase Transfer
    timing to avoid breach?

21
22
Calculations of Value and Exposure
  • Paragraph 4(c) Calculations. All calculations
    of Value and Exposure will be made by the
    Valuation Agent as of the Valuation Time.
  • Practice Notes
  • Valuation Agent and Valuation Time specified in
    Paragraph 13.
  • Ensures there is no gaming or manipulation of the
    snapshot of index prices used to calculate
    Exposure, as such amount may fluctuate throughout
    the day.
  • Note that if the Valuation Agent is always your
    counterparty, you are at their mercy.

22
23
Substitutions of Collateral
  • Paragraph 4(d) Substitutions.
  • Generally, Pledgor may Transfer substitute
    Eligible Credit Support (Substitute Credit
    Support) to the Secured Party on any Local
    Business Day by providing notice.
  • The Secured Party then Transfers the Posted
    Credit Support being replaced back to the Pledgor
    no later than the Local Business Day following
    the date it receives the Substitute Credit
    Support (the Substitution Date).

23
24
Substitutions of Collateral
  • Practice Notes
  • Substitution terms often amended in the Paragraph
    13 elections
  • Secured Partys consent for any substitution?
  • Eliminating the notice requirement?
  • Often used by Pledgor to increase liquidity by
    substituting a less liquid form of Eligible
    Credit Support (e.g., Letter of Credit) for
    previously-posted Cash.
  • The substituted collateral must be a type of
    Eligible Credit Support agreed upon by the
    parties in the Paragraph 13 elections.

24
25
Dispute Resolution
  • Paragraph 5 Dispute Resolution How can
    disputes arise?
  • Calculation of Delivery/Return Amount
  • What amount of collateral is a party obligated to
    deliver or return?
  • Value of Eligible Credit Support or Posted Credit
    Support
  • What is the Value of the collateral being posted
    or held?
  • May arise when dealing with fluctuating
    collateral, e.g. securities.

25
26
Dispute Resolution
  • Paragraph 5 Dispute Resolution (cont.)
    Procedure for resolving disputes
  • Disputing Party gives notice by close of business
    on the Local Business Day following the date of
    the demand or Transfer (as applicable)
  • The appropriate party will Transfer the
    undisputed amount no later than the close of
    business on the Local Business Day following the
    date of the demand or Transfer (as applicable)
    and
  • The parties will attempt to resolve the dispute
    informally.

26
27
Dispute Resolution
  • Paragraph 5 Dispute Resolution Procedure for
    resolving disputes (cont.)
  • If the parties fail to resolve the dispute by the
    Resolution Time (elected in Paragraph 13), then
  • For disputes regarding Delivery/Return Amount
    The Valuation Agent will recalculate using
    undisputed calculations or mid-market quotations
    from Reference Market makers.
  • For disputes regarding the Value of collateral
    The Valuation Agent will recalculate the Value as
    of the date of the Transfer in the manner set
    forth in the Paragraph 13 elections.

27
28
Holding and Using Posted Collateral
  • Paragraph 6(a) Care of Posted Collateral.
  • Secured Party is required to exercise reasonable
    care to assure safe custody of Posted Collateral,
    which means the same degree of care the Secured
    Party would use as to its own property.
  • Note that Posted Collateral is defined by the
    parties in Paragraph 13.
  • Typically means Cash.

28
29
Holding and Using Posted Collateral
  • Paragraph 6(b) Eligibility to Hold Posted
    Collateral Custodians
  • The Secured Party generally may hold Posted
    Collateral or appoint a Custodian to hold Posted
    Collateral.
  • In Paragraph 13, most parties elect specific
    requirements and conditions to holding Posted
    Collateral
  • Not a Defaulting Party
  • Only held in the U.S.
  • Ratings triggers

29
30
Holding and Using Posted Collateral
  • Paragraph 6(b) Eligibility to Hold Posted
    Collateral Custodians
  • Why Use a Custodian?
  • Usually only preferred when a party doesnt meet
    the conditions to holding Posted Collateral
  • Paragraph 13 generally requires that a Custodian
    be a Qualified Institution by meeting some form
    of credit rating and asset standards.
  • Custodians take time to establish and can be
    expensive.
  • ? Dodd Frank Note Under the Act, a counterparty
    could unilaterally require a Custodian
    irrespective of the CSA.

30
31
Holding and Using Posted Collateral
  • Paragraph 6(c) Use of Posted Collateral.
  • If the Secured Party is not a Defaulting Party or
    an Affected Party and no Early Termination Date
    has occurred, then the Secured Party has the
    right to sell, invest, assign, commingle or
    otherwise dispose of any Posted Collateral.
  • However, the Secured Party shall be deemed to be
    holding such Posted Collateral for purposes of
    calculating Delivery/Return Amounts and Disputed
    Amounts.
  • ? Dodd Frank Note The Act could restrict a
    partys ability to hold and use Posted Collateral.

31
32
Holding and Using Posted Collateral
  • Paragraph 6(c) Use of Posted Collateral.
  • Practice Notes
  • Rehypothecation of collateral is an important
    right that is generally favored.
  • In light of recent credit downgrades across the
    industry, some counterparties may limit the
    ability of a Secured Party to rehypothecate Cash
    and instead require the safekeeping of Posted
    Collateral in a segregated collateral account.

32
33
Holding and Using Posted Collateral
  • Paragraph 6(d) Interest Amounts.
  • The Secured Party shall Transfer to the Pledgor
    the Interest Amount with respect to Posted
    Collateral at the time designated in Paragraph
    13, so long as a Delivery Amount would not be
    created or increased by such Transfer.
  • Any Interest Amount not Transferred shall
    constitute Posted Collateral.
  • Practice Note The Transfer of the Interest
    Amount is negotiated between the parties, usually
    on a monthly basis.

33
34
Events of Default
  • Paragraph 7 Events of Default An Event of
    Default occurs under Section 5(a)(iii)(1)
    (Credit Support Default) of the Agreement if
  • A party (or its Custodian) fails to make any
    Transfer of Eligible Collateral, Posted
    Collateral or Interest Amount when required if
    not cured within two (2) Local Business Days
    after receiving notice of same.

34
35
Events of Default
  • Paragraph 7 Events of Default An Event of
    Default occurs under Section 5(a)(iii)(1)
    (Credit Support Default) of the Agreement if
  • A party fails to comply with Paragraph 6(c) (Use
    of Posted Collateral) if not cured within five
    (5) Local Business Days after receiving notice of
    same.
  • A party fails to comply with any other obligation
    under the Annex (not otherwise a separate Event
    of Default) if not cured within thirty (30) days
    after receiving notice of such failure.

35
36
Events of Default
  • Paragraph 7 Events of Default Any default
    under Paragraph 7 of the CSA is an Event of
    Default under Section 5(a)(iii) of the Master
    Agreement
  • Right to suspend payments and performance under
    Section 2(a)(iii) of the Master Agreement.
  • Right to suspend Transfers of Eligible Credit
    Support under Paragraph 4(a) of the CSA.
  • Right to designate an Early Termination Date and
    liquidate all Transactions under the ISDA.

36
37
Certain Rights and Remedies
  • Paragraph 8(a) Secured Partys Rights and
    Remedies.
  • When do Secured Partys rights arise?
  • Event of Default as to Pledgor
  • Specified Condition as to Pledgor, or
  • Practice Note Specified Conditions are
    Termination Events elected by the parties in
    Paragraph 13.
  • The occurrence or designation of an Early
    Termination Date with respect to the Pledgor

37
38
Certain Rights and Remedies
  • Paragraph 8(a) Secured Partys Rights and
    Remedies.
  • What rights are available? Unless Pledgor has
    paid all Obligations then due, Secured Party may
    exercise any of the following remedies
  • All remedies available under applicable law
  • Any rights and remedies under Other Posted
    Support
  • E.g., Drawing on outstanding Letters of Credit
  • Setoff of amounts payable by Pledgor against
    Posted Collateral held by Secured Party or
  • Liquidate Posted Collateral and apply proceeds to
    any Obligations owed by Pledgor.

38
39
Certain Rights and Remedies
  • Paragraph 8(b) Pledgors Rights and Remedies.
  • When do Pledgors rights arise?
  • The occurrence or designation of an Early
    Termination Date arising from an Event of Default
    or Specified Condition with respect to the
    Secured Party.
  • Practice Note Pledgors rights do not arise
    until the occurrence or designation of an Early
    Termination Datenot merely upon the occurrence
    of an Event of Default or Specified Condition.

39
40
Certain Rights and Remedies
  • Paragraph 8(b) Pledgors Rights and Remedies.
  • What rights are available? Unless Secured Party
    has paid all Obligations then due, the following
    shall apply
  • Pledgor can exercise all remedies available under
    applicable law.
  • Pledgor can exercise any rights and remedies
    under Other Posted Support.
  • E.g., Drawing on outstanding Letters of Credit
  • Secured Party is obligated to immediately
    Transfer all Posted Collateral back to the
    Pledgor.

40
41
Certain Rights and Remedies
  • Paragraph 8(b) Pledgors Rights and Remedies.
  • What rights are available? Unless Secured Party
    has paid all Obligations then due, the following
    shall apply (cont.)
  • If Secured Party does not Transfer back all
    Posted Collateral to Pledgor, then Pledgor may
  • Set-Off amounts payable by Pledgor against any
    Posted Collateral held by the Secured Party and
  • If amounts are not Set-Off, withhold payment of
    amounts due up to the Value of Posted Collateral
    until such Posted Collateral is returned.

41
42
Certain Rights and Remedies
  • Paragraphs 8(a) and 8(b) Rights and Remedies
  • Practice Notes
  • These sections recognize that the Non-Defaulting
    or Non-Affected Party should have the right to
    protect its collateral if the other party
    defaults.
  • Rights are different depending on whether the
    Pledgor or Secured Party defaults, but both sets
    of rights and remedies are equally important to
    protect a partys Posted Credit Support.

42
43
Certain Rights and Remedies
  • Paragraph 8(c) Deficiencies and Proceeds.
    Secured Party must Transfer to Pledgor any
    proceeds and Posted Credit Support remaining
    after liquidation, Set-Off and/or application of
    funds after all amounts payable are satisfied in
    full.
  • Pledgor remains liable for any unpaid amounts.
  • Paragraph 8(d) Final Returns. When no amounts
    may become payable by Pledgor with respect to
    Obligations under the ISDA, Secured Party will
    Transfer all Posted Credit Support and Interest
    Amounts back to the Pledgor.

43
44
Representations
  • Paragraph 9 Representations. Each Party
    represents the following on the date the CSA is
    executed and each date the Pledgor transfers
    Eligible Collateral
  • It has the power to grant a security interest and
    lien on the Eligible Collateral and has taken all
    necessary actions to effect same
  • It is the sole owner of the Eligible Collateral
    it Transfers, and it Transfers such Eligible
    Collateral free and clear of liens or other
    encumbrances

44
45
Representations
  • Paragraph 9 Representations. Each Party
    represents the following on the date the CSA is
    executed and each date the Pledgor transfers
    Eligible Collateral (cont.)
  • Upon a Transfer, the Secured Party will have a
    valid and perfected first priority security
    interest and lien on the Eligible Collateral and
  • The performance of its obligations under the CSA
    will not result in any other security interest,
    lien or encumbrance other than provided to the
    Secured Party.

45
46
Costs and Expenses
  • Paragraph 10(a) General. Each Party generally
    pays for its own expenses in performing its
    obligations under the CSA.
  • Paragraph 10(b) Posted Credit Support. The
    Pledgor shall promptly pay all taxes or charges
    imposed with respect to Posted Credit Support
    held by the Secured Party upon becoming aware of
    same (except taxes with respect to the Secured
    Partys use of Posted Collateral).

46
47
Costs and Expenses
  • Paragraph 10(c) Liquidation/Application of
    Posted Credit Support.
  • All reasonable costs and expenses incurred in
    connection with the liquidation and/or
    application of Posted Credit Support shall be
    payable either by the Defaulting Party, or if
    there is no Defaulting Party, equally shared by
    the parties.

47
48
Additional CSA Obligations
  • Paragraph 11(a) Default Interest. If Secured
    Party fails to make any Transfer of Posted
    Collateral or Interest Amount, such amount shall
    accrue interest at the Default Rate from the date
    such amount was required to be Transferred until
    the date actually paid.
  • Practice Note
  • Note that the Default Rate under the ISDA is a
    penalty rate, with a higher rate than is paid for
    interest on Cash held as Posted Collateral.

48
49
Additional CSA Obligations
  • Paragraph 11(b) Further Assurances. Upon
    demand by a party, the other party shall execute
    or deliver any financing statement, specific
    assignment or other document that may be
    necessary or desirable with respect to creating,
    perfecting, enforcing and/or releasing any
    security interest or lien granted under the
    Annex.
  • Practice Notes
  • Beware of language granting to counterparty a
    power of attorney to execute security documents
    on your companys behalf.
  • While permitted by Article 9 of the UCC, most
    companies require a board resolution or other
    corporate action to grant a power of attorney.

49
50
Additional CSA Obligations
  • Paragraph 11(c) Further Protection. Pledgor
    will give notice to the Secured Party of, and
    defend against, any suits, actions or proceedings
    relating to Posted Credit Support Transferred by
    the Pledgor or that could adversely affect the
    security interest and lien granted under the CSA
    (unless such suit or action results from Secured
    Partys exercising its rights to use Posted
    Collateral).

50
51
Additional CSA Obligations
  • Paragraph 11(d) Good Faith and Commercially
    Reasonable Manner.
  • Performance of all obligations and calculations
    under the Annex shall be made in good faith and
    in a commercially reasonable manner.

51
52
Discussion Topics
  • Overview of the CSA
  • Key Provisions of the CSA
  • Paragraph 13 to the CSA
  • Credit Implications of Dodd-Frank

52
53
Paragraph 13 Elections Variables
  • 13(b)(ii) Eligible Collateral.
  • Paragraph 13 permits the parties to specify which
    forms of collateral shall constitute Eligible
    Collateral under the Annex, as well as the
    applicable Valuation Percentage used in
    determining the Value of such collateral.
  • Practice Note
  • Most energy commodity counterparties elect for
    Cash to qualify as Eligible Collateral, but do
    not elect for Treasury Bills, Notes or Bonds.

53
54
Paragraph 13 Elections Variables
  • 13(b)(iii) Other Eligible Support.
  • Paragraph 13 permits the parties to specify what
    collateral may constitute Other Eligible
    Support apart from any Eligible Collateral.
  • Practice Note
  • Many parties elect for Letters of Credit to
    constitute Other Eligible Support and provide
    that the Valuation Percentage shall be 100
    unless (i) an Event of Default occurs and is
    continuing, or (ii) fewer than 20 days remain
    before expiry of the Letter of Credit, in which
    case the Valuation Percentage shall be zero (0).

54
55
Paragraph 13 Elections Variables
  • 13(b)(iv) Threshold.
  • Each party specifies its applicable Independent
    Amount, Threshold and Minimum Transfer
    Amount used in determining its applicable Credit
    Support Amount under Paragraph 3.
  • Such designations are important because they
    directly affect whether a party is required to
    post collateral to the Secured Party.
  • The parties also may specify the amount by which
    calculations under the CSA will be rounded up or
    down.

55
56
Paragraph 13 Elections Variables
  • 13(b)(iv)(A) Independent Amount. Similar to a
    minimum collateral amount that a party must
    maintain at all times under the Agreement.
  • Practice Notes
  • An Independent Amount is in addition to Exposure,
    so it effectively represents the amount by which
    the party posting an Independent Amount will
    over-collateralize its obligations.
  • Any request for an Independent Amount should be
    reviewed by a partys credit group.

56
57
Paragraph 13 Elections Variables
  • 13(b)(iv)(B) Threshold Directly offsets a
    partys obligation to Transfer a Delivery Amount
    or Return Amount.
  • The amount of a partys Threshold is heavily
    negotiated between the parties credit
    departments.
  • A party that is more creditworthy may receive a
    higher Threshold, while a party that is less
    creditworthy may receive a lower Threshold.
  • Thresholds may be a fixed dollar amount, but more
    commonly are set forth in a Threshold matrix
    where Threshold amounts vary based on a partys
    (or its Credit Support Providers) credit rating.

57
58
Paragraph 13 Elections Variables
  • 13(b)(iv)(C) Minimum Transfer Amount A
    Delivery Amount must equal or exceed a Pledgors
    Minimum Transfer Amount before the Pledgor is
    required to Transfer collateral.
  • 13(b)(iv)(D) Rounding The parties may
    specify the dollar amount by which calculated
    values will be rounded up or down.
  • Practice Notes
  • MTA and Rounding Amounts can be amended to make
    collateral obligations more or less onerous.
  • Avoid making the MTA and Rounding Amounts
    identical.

58
59
Paragraph 13 Elections Variables
  • 13(c) Valuation and Timing.
  • 13(c)(i) Valuation Agent.
  • Generally, the Valuation Agent is the party
    making a demand under Paragraph 3, but the
    parties may amend this requirement.
  • The Valuation Agent is the party calculating the
    Delivery or Return Amount under Paragraph 3 of
    the Annex.

59
60
Paragraph 13 Elections Variables
  • 13(c) Valuation and Timing.
  • 13(c)(ii) Valuation Date.
  • The parties specify in Paragraph 13 what date
    shall constitute a Valuation Date for purposes
    of determining whether a Delivery Amount or
    Return Amount is due.
  • Parties often elect that the Valuation Date shall
    be each Local Business Day, requiring the parties
    to daily monitor whether a Delivery Amount or
    Return Amount is due.

60
61
Paragraph 13 Elections Variables
  • 13(c) Valuation and Timing.
  • 13(c)(iii) Valuation Time.
  • The parties may select the time when the Delivery
    Amount or Return Amount shall be calculated,
    either
  • By close of business on the Valuation Date, or
  • By close of business on the Local Business Day
    before the Valuation Date.

61
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Paragraph 13 Elections Variables
  • 13(c) Valuation and Timing.
  • 13(c)(iv) Notification Time. The parties
    designate the time by which a demand for a
    Transfer may be made under Paragraph 3.
  • When designating the Notification Time, consider
    how quickly you can Transfer Cash, issue Letters
    of Credit or provide other Eligible Credit
    Support.
  • The CSAs standard Transfer timing is (i) the
    next Local Business Day if demand made by
    Notification Time, or (ii) second Local Business
    Day if after the Notification Time.

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Paragraph 13 Elections Variables
  • 13(d) Conditions Precedent and Secured Partys
    Rights and Remedies.
  • The parties may specify certain Termination
    Events which shall qualify as Specified
    Conditions with respect to either party under
    the CSA.
  • Specified Conditions arise when parties desire to
    exercise remedies under Paragraphs 8(a) and
    8(b).
  • Because Specified Conditions give rise to
    collateral rights, consider whether it makes
    sense for only select Termination Events to be
    Specified Conditions.
  • E.g., Credit Event Upon Merger

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Paragraph 13 Elections Variables
  • 13(e) Substitution.
  • The parties specify in Paragraph 13 whether the
    Substitution Date has the meaning specified in
    the CSA or whether the parties wish to amend such
    definition.
  • Substitution Date generally means the Local
    Business Day following the date on which the
    Secured Party receives the Substitute Credit
    Support from the Pledgor.
  • The parties also may amend the general
    requirement that consent is required for
    providing substitute Credit Support.

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Paragraph 13 Elections Variables
  • 13(e) Substitution.
  • Practice Notes
  • Allowing substitution without consent should
    generally be acceptable, so long as Cash and
    Letters of Credit are the only forms of Eligible
    Credit Support elected under the CSA.
  • If other forms of Eligible Credit Support are
    permitted, substitution without consent should
    not be permitted.

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Paragraph 13 Elections Variables
  • 13(f) Dispute Resolution.
  • The default Resolution Time is 100 p.m. New
    York time on the Local Business Day following the
    date on which notice is given that gives rise to
    a dispute.
  • However, the parties may elect to extend the
    Resolution Time in order to allow sufficient time
    to work together in resolving the dispute before
    other remedies are necessary.
  • The parties also can specify the methods of
    valuing Posted Credit Support and the dispute
    resolution procedures in the event a party
    disputes a calculation.

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Paragraph 13 Elections Variables
  • 13(g) Holding and Using Posted Collateral
  • 13(g)(i) Eligibility to Hold Posted Collateral
    Custodians.
  • Paragraph 13 generally provides that a party or
    its Custodian may hold Posted Collateral provided
    that
  • Such party is not a Defaulting Party
  • Posted Collateral only may be held in a
    jurisdiction specified by the parties (generally,
    the U.S.)
  • Any other terms or conditions the parties may
    require in holding collateral, such as minimum
    credit ratings or other creditworthiness
    standards.

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Paragraph 13 Elections Variables
  • 13(g) Holding and Using Posted Collateral
  • 13(g)(ii) Use of Posted Collateral.
  • The parties may specify whether or not Paragraph
    6(c) applies to either party such that Posted
    Collateral may be sold, assigned, commingled or
    otherwise disposed of by the Secured Party.
  • Practice Note Many parties elect that Paragraph
    6(c) shall apply because (i) such parties want to
    use Cash posted to them and (ii) a Pledgor can
    avoid a Secured Party commingling Cash and
    potentially not returning it by providing a
    Letter of Credit as an alternative.

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Paragraph 13 Elections Variables
  • 13(h) Distributions and Interest Amount. The
    parties specify in Paragraph 13 the Interest
    Rate to be used under the Annex, the timing of
    Transfers of the Interest Amount (generally the
    last Local Business Day of each calendar month),
    and whether Transfers of the Interest Amount by
    the Secured Party shall apply under the Annex
    pursuant to Paragraph 6(d)(ii).
  • 13(i) Additional Representations. The parties
    may incorporate any additional representations
    into the Annex apart from those set forth in
    Paragraph 9 of the Annex.

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Paragraph 13 Elections Variables
  • 13(j) Other Eligible Support and Other Posted
    Support.
  • Paragraph 13 permits the parties to define how to
    calculate the Value of Other Eligible Support
    and Other Posted Support, as well as what
    constitutes a Transfer of same.

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Paragraph 13 Elections Variables
  • 13(j) Other Eligible Support and Other Posted
    Support.
  • Practice Notes
  • Because Other Eligible Support or Other Posted
    Support generally refers to forms of collateral
    other than cash, it may be beneficial to
    designate how such collateral is valued and
    transferred under the Annex.
  • For example, with respect to a letter of credit
    that constitutes Other Eligible Support, the
    Value of the Letter of Credit may not always be
    100 of the stated value if certain conditions
    exist (e.g., the Letter of Credit expires within
    20 days, etc.).

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Paragraph 13 Elections Variables
  • 13(j) Other Eligible Support and Other Posted
    Support.
  • Practice Notes (cont.)
  • Any terms or conditions that affect the Value of
    such Letter of Credit would be included in
    Paragraph 13.
  • Moreover, a Transfer of amounts with respect to
    a Letter of Credit does not necessarily mean a
    drawing of funds. Instead, a Transfer likely
    means increasing or decreasing the stated value
    of the Letter of Credit depending on the
    applicable Delivery Amount or Return Amount to be
    Transferred.

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Paragraph 13 Elections Variables
  • 13(m) Other Provisions. The parties may
    incorporate additional credit terms and
    conditions that apply to the CSA.
  • Additional definitions
  • E.g., Letter of Credit, Qualified
    Institution, Credit Rating.
  • Changes to Transfer timing
  • E.g., Increasing the time for Pledgor to issue or
    amend a Letter of Credit.

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Discussion Topics
  • Overview of the CSA
  • Key Provisions of the CSA
  • Paragraph 13 to the CSA
  • Credit Implications of Dodd-Frank

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Credit Implications of Dodd-Frank
  • Clearing Requirements
  • If a Swap is required to be cleared and the
    counterparty is not a Major Swap Participant
    (MSP) or Swap Dealer (SD), such counterparty
    has the right to select the Derivative Clearing
    Organization (DCO) used for clearing.
  • If a Swap is not required to be cleared and the
    relevant counterparty is not an MSP or SD, such
    counterparty has the right to
  • Require that the parties clear the Swap and
  • Select the DCO used for clearing.

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Credit Implications of Dodd-Frank
  • Clearing Requirements PRACTICE NOTES
  • The general mandatory clearing requirement is not
    specific to MSPs or SDsit could apply to any
    party to a Swap.
  • Non-MSPs or Non-SDs should confirm whether the
    End-User Exception applies.
  • Whether a Swap or category of Swaps is required
    to be cleared is a moving target subject to CFTC
    determination.
  • Parties will need to monitor ongoing CFTC
    rulemakings.

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Credit Implications of Dodd-Frank
  • Clearing Requirements PRACTICE NOTES (cont.)
  • Special clearing rules apply when dealing with
    Non-MSPs or Non-SDs
  • Even if Swap is not required to be cleared,
    clearing still may apply.
  • MSPs and SDs may be required to use different
    DCOs than they otherwise would select, depending
    on the election of the counterparty.

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Credit Implications of Dodd-Frank
  • Clearing Requirements End-User Exception
  • Generally A Swap otherwise subject to mandatory
    clearing is subject to an elective exception from
    clearing if
  • At least one party to the Swap is not a Financial
    Entity
  • Such party is using the Swap to hedge or mitigate
    commercial risk and
  • Notice is provided to the CFTC regarding how it
    generally meets its financial obligations
    associated with entering into non-cleared Swaps.

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Credit Implications of Dodd-Frank
  • Segregation of Collateral Securing Uncleared
    Swaps
  • Just because a Swap is not subject to mandatory
    clearing does not mean that an MSP/SD is off the
    hook
  • Notice requirement disclosing segregation
    election
  • Potential segregation/custodian obligations and
  • Even if segregation not elected, quarterly
    reporting.
  • Use of custodian and segregated account create
    additional costs that currently are not allocated
    by the CFTCs Proposed Rules.
  • It seems reasonable that such costs would be
    borne by the counterparty electing segregation,
    but the CFTC has not finalized this issue.

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Credit Implications of Dodd-Frank
  • Reporting and Recordkeeping Key Requirements
  • 727 Real-Time Public Reporting
  • 729 Reporting and Recordkeeping (SDRs)
  • 731 Reporting and Recordkeeping (CFTC)
  • Note that additional reporting obligations may
    apply to MSPs and SDs under the Clearing
    Transition Rules of 723 of the Act.

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Credit Implications of Dodd-Frank
  • Capital and Margin Requirements
  • 731 General Rule SDs and MSPs must meet
    minimum capital requirements and minimum initial
    and variation margin requirements as the CFTC
    shall determined by rule or regulation.
  • Capital Requirements
  • The CFTC shall take into account any risks
    associated with other types of Swaps the SD/MSP
    is engaged in and other activities of the SD/MSP
    that are not otherwise subject to regulation.
  • The capital requirements established by the CFTC
    shall (i) help ensure the safety and soundness of
    the SD or MSP and (ii) be appropriate for the
    risk associated with the uncleared Swaps held by
    the SD or MSP.

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Credit Implications of Dodd-Frank
  • Capital and Margin Requirements (cont.)
  • The CFTC shall permit the use of non-cash
    collateral, if appropriate to (i) preserve the
    financial integrity of markets trading Swaps and
    (ii) preserve the stability of the U.S. financial
    system.
  • PRACTICE NOTES
  • It does not seem clear what specific types of
    collateral the CFTC will permit to satisfy margin
    requirements. Letters of Credit? First liens?
  • If collateral exchanged under a trading agreement
    is not a type permitted by the CFTC, trading
    counterparties may need to amend their collateral
    obligations.

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Credit Implications of Dodd-Frank
  • Key Points to Consider
  • The most important determination is whether a
    party qualifies as an MSP or SD.
  • Most CFTC requirements hinge on that analysis.
  • If you qualify as an MSP or SD, you will be
    subject to numerous, detailed requirements that
    significantly impact your business operations and
    trading agreements
  • Mandatory clearing
  • Capital and margin requirements
  • Reporting and recordkeeping requirements
  • Position limits

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Understanding the CSA Conclusion
  • The CSA and accompanying Paragraph 13 should be
    carefully reviewed by a companys Credit Group.
  • When negotiating the CSA and Paragraph 13, keep
    in mind the ISDA Schedule and the various types
    of Transactions anticipated under the ISDA (e.g.,
    physical deals under a commodity annex, financial
    derivative transactions, etc.).
  • The CSA and Paragraph 13 should be tailored to
    each counterparty, as there is no one size fits
    all approach.
  • The Dodd-Frank Act may significantly impact
    rights and obligations under the CSA.

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Questions?
CRAIG ENOCHS (713) 752-4315 cenochs_at_jw.com KEVIN
PAGE (713) 752-4227 kpage_at_jw.com JACKSON WALKER
L.L.P. 1401 McKinney Street, Suite 1900 Houston,
Texas 77010
85
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