Derivatives: How Do They Impact Your Client? Dallas Bar Association Securities Section October 22, 2012 Craig Enochs Jackson Walker L.L.P

Derivatives: How Do They Impact Your Client?

Dallas Bar Association

Securities Section

October 22, 2012

Craig Enochs

Jackson Walker L.L.P.

Overview• What are derivatives?

• How are derivatives documented?

• How are derivatives used?

• Why are derivatives used?

• Who uses derivatives?

• Regulatory impact of Dodd-Frank Act on derivative transactions.

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What are Derivatives?

• Also referred to as “swaps”

• Basic Definition:• Financial transaction – no physical delivery involved

• The value of the transaction is derived from the price or value of some other source

• E.g., an index price, a currency rate, a commodity price or an interest rate

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What are Derivatives?

Physical Gas Deal

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Producer BuyerGas

$$$$

Gas Derivative

Fixed Price Payor

BuyerFloating Price Payor

Fixed Price

Gas Index Floating Price

What are Derivatives?• Commodity Price Swap: Characteristics

• No physical delivery occurs

• Each party agrees to pay a floating or a fixed price with respect to a notional quantity of a commodity

• No “Seller” or “Buyer” – either party may be obligated to pay under the swap depending on whether fixed is greater than floating or floating is greater than fixed.

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What are Derivatives?• Commodity Price Swap: Example

• Fixed Price Payer (“A”) pays fixed gas price of $7/MMBtu• Floating Price Payer (“B”) pays floating gas index price per MMBtu

• If Index Price is $8: Party B pays Party A $1.• If Index is $5: Party A pays Party B $2.

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A BFixed Gas Price ($7)

Floating Gas Index Price

How are Derivatives Documented?

• Master Agreement published by the International Swaps and Derivatives Association (“ISDA”)

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Why is the ISDA Important?• Standardized termination rights for third party actions affecting the deal,

such as increased taxes.

• Rights to unwind the transaction if a counterparty defaults.

• Protections if a counterparty becomes less creditworthy.

• Multiple transactions under the same terms and conditions.• Cross-transactional netting• Streamlines negotiations

• Large body of supporting documentation, including definitions, User’s Guides, and explanatory memorandums.

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How Are Derivatives Used?

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Various Industries:

• Banking• Commodities• Price Risk Management (end-users and producers)

• Examples:• Manufacturers• Agriculture• Transportation• Oil and gas producers

Why Are Derivatives Used?• Commodity Price Swap:

• Timing Flexibility: swap can be entered into after a commodity purchase contract is already in place.

• Volume Flexibility: Can lock in total commodity volumes up front, or fix the prices for different portions of the total commodity volumes over time.

• Timing: a long-term fixed-price commodity contract creates risk as market prices shift. Instead, enter into swaps for shorter periods of time to lock in a fixed price.

• Market Liquidity: There may not be a market for a long-term fixed price commodity deal, or many buyers or sellers at a particular delivery point, but the swap market is more liquid.

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Why Are Derivatives Used?•Interest Rate Swap – Variable rate bonds•“Swaps Cost Hospital System $69 Million”, Ft. Worth Star-Telegram, December 24, 2010

•Christus Health issued long-term variable rate bonds.

•To hedge such payments, Christus entered into 20 and 30 year interest rate swaps with Citibank and Merrill Lynch.

• Christus pays a fixed rate of 3.38%• Citibank/ML pay a floating interest rate to cover Christus’ obligations to

bondholders• Notional amount is $1.22 billion.

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Why Are Derivatives Used?•“Swaps Cost Hospital System $69 Million”, Ft. Worth Star-Telegram, December 24, 2010

•What if Christus did not enter into any swaps?

• A decrease in variable interest rates benefits Christus because they pay less to bondholders in interest expense

• An increase in variable interest rates means higher, unpredictable interest rate expenses payable to bondholders.

•No Swap = UNPREDICTABLE INTEREST RATE RISK

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•How is Christus protected with the swaps?

• If variable rates decrease below the swap’s fixed rate:

• Christus pays the variable payment to bondholders

• Christus pays the difference between the fixed and floating amounts to Citibank/ML

• In total, Christus pays no more than the fixed rate payment agreed to under the swap

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Christus

Bondholders

Citi/ML

Net effect Christus pays 3.38%

Floating

Fixed 3.38%

Floating


•How is Christus protected with the swaps? (cont.)

• If variable rates increase above the swap’s fixed rate:

• Citibank/ML pays Christus the difference between the floating and fixed amounts

• Christus is fully protected in making higher variable rate payments to bondholders because of the swap payment it receives.

•Swap = PROTECTION AGAINST INTEREST RATE RISK

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Christus

Bondholders

Citi/ML

Net effect Christus pays 3.38%

Floating

Fixed – 3.38%

Floating


•“Christus has had to pay as much as $1 million a month in additional interest costs, money that otherwise might have gone to its 30-plus healthcare facilities in Texas, six other states and Mexico.”

• What if interest rates had skyrocketed instead and swaps saved Christus millions of dollars in unforeseen expenses?

• How would rate uncertainty involving this much money impact Christus’ financial strategy and planning?

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•“The value of the swaps changes daily, depending on what interest rates do and the length of the swap.”

• The Christus swaps are for 20 and 30 year terms.

• Even if Christus pays today, they may experience substantial savings in the long run.

• It is impossible to judge whether the interest rate lock was better than floating with the market until the swap ends.

• Certainty of the rate and limitation of the volatility is captured on day 1.

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Why Are Derivatives Used?• Managing Price Risk: Commodity End User

• Plant owner purchases electricity to manufacture aluminum

• Under an existing Power Purchase Agreement (PPA), manufacturer buys 1,000 MWh of electricity at a floating price.

• Month 1: the floating price for electricity is $50/MWh, and manufacturer enters into a fixed-floating commodity swap with counterparty.

• Manufacturer pays fixed price of $50/MWh• Counterparty pays floating price.• Notional quantity = 1,000 MWh

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• Month 2: Floating price increases from $50/MWh to $60/MWh

• Under the PPA: Manufacturer owes $60,000 to power seller

• Under the Swap: Manufacturer owes $50,000 to counterparty, and counterparty owes $60,000 to manufacturer.• Net Effect: Counterparty pays $10,000 to manufacturer.

• Under the PPA and the Swap: Manufacturer pays $50,000 ($60,000 under PPA offset by $10,000 receivable under the swap).

• Practical Effect: Manufacturer pays a fixed price of $50/MWh for electricity, even though prices increase.

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• Month 3: Floating price decreases from $50/MWh to $40/MWh

• Under the PPA: Manufacturer owes $40,000 to power seller

• Under the Swap: Manufacturer owes $50,000 to counterparty, and counterparty owes $40,000 to manufacturer.• Net Effect: Manufacturer pays $10,000 to counterparty.

• Under the PPA and the Swap: Manufacturer pays $50,000 ($40,000 under the PPA and $10,000 under the swap).

• Practical Effect: Manufacturer pays a fixed price of $50/MWh for electricity, even if prices decrease.

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Who Uses Derivatives?

Banks Municipalities Large retailers

Private equity Mineral producers Commercial real estate owners

Pension funds Manufacturers Corporate borrowers

Energy companies Healthcare systems Corporate debt issuers

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CLIENTS MAY INCLUDE:

Impact of Dodd-Frank

• In the past, “over-the-counter” derivative transactions have not been regulated by the CFTC

• “Over-the-counter”: Bilateral trades between two persons (i.e., not traded on an exchange like NYMEX).

• In such case, certain exemptions applied under the Commodity Exchange Act.

• The Dodd-Frank Act changes this dramatically.

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Impact of Dodd-Frank

• Dodd-Frank applies to most swaps: (interest rate, currency, forex, commodity, etc.)

• NOTE: Dodd-Frank does NOT apply to “forward contracts” where physical delivery is anticipated unless certain elements of optionality are present.

• Dodd-Frank applies broadly to “Swap Dealers”:• Anyone who regularly enters into swaps with

counterparties as an ordinary course of business for its own account.

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Impact of Dodd-Frank• New Requirements:

• Registration and reporting requirements• Mandatory clearing• Position limits • Capital and margin requirements• Restrictions on transactions and documentation requirements

• Rules remain unclear – CFTC still working to finalize the rules even though compliance is now required for many rules.

• No discussion by CFTC as to how most of these requirements relate to or would avert another financial crisis, nor how the CFTC will sort through the information it receives

• Preliminary estimate are that around $400 billion has been spent to date trying to comply with Dodd-Frank

• Not clear if this will send swaps to friendlier jurisdictions with less scrutiny 25

Key Points to Take Away• Derivatives are documented under the ISDA

• Though ISDA may be presented as standard, it always can and should be negotiated.

• Derivatives can help clients across a variety of practice areas and industries.

• Major changes are coming to OTC derivative transactions.

• Derivative users include most clients.

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Craig R. EnochsJackson Walker L.L.P.1401 McKinney, Suite 1900Houston, Texas 77010Ph: (713) [email protected]://www.jw.com/Craig_R_Enochs/

Documents

Derivatives: How Do They Impact Your Client? Dallas Bar Association Securities Section October 22, 2012 Craig Enochs Jackson Walker L.L.P