Understanding the ISDA Credit Support Annex: Know Your Rights and Risks CRAIG ENOCHS Jackson Walker L.L.P. International Energy Credit Association 2011

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

CRAIG ENOCHSJackson Walker L.L.P.

International Energy Credit Association2011 IECA Spring Education Conference

March 20-22, 2011Hilton Head Island, South Carolina

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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

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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

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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

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Discussion Topics





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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.

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Discussion Topics





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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.

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Security Interest in Posted Collateral• Practice Notes:

• Only applies to “Posted Collateral”—not “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.

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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 Pledgor’s Minimum Transfer Amount, then

• The Pledgor Transfers Eligible Credit Support with a Value at least equal to the Delivery Amount.

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Credit Support Obligations• Paragraph 3(a): Delivery Amount (cont.): If on any

Valuation Date the Delivery Amount equals or exceeds the Pledgor’s 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?

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• Credit Support Amount:

• Secured Party’s Exposure, plus

• Pledgor’s Independent Amount, minus

• Secured Party’s Independent Amount, minus

• The Pledgor’s Threshold; provided if such value is negative, the Credit Support Amount is zero (0).

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• 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.

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• 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.

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• Once you calculate any Delivery Amount, does it exceed the Pledgor’s 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.

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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 Party’s Minimum Transfer Amount, then

• The Secured Party Transfers Posted Credit Support with a Value at least equal to the Return Amount.

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Credit Support Obligations• Paragraph 3(b): Return Amount (cont.): If on any

Valuation Date the Return Amount equals or exceeds the Secured Party’s 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?

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Credit Support Obligations• Paragraph 3(b): Return Amount (cont.): If on any

Valuation Date the Return Amount equals or exceeds the Secured Party’s Minimum Transfer Amount:

• Once you calculate any Return Amount, does it equal or exceed the Secured Party’s Minimum Transfer Amount?

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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

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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.

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Transfer Timing• Paragraph 4(b): Transfer Timing (cont.)

• Practice Notes:• Notification Time elected by the parties in Paragraph 13

(e.g., 1:00 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?

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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.

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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”).

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Substitutions of Collateral

• Practice Notes: • Substitution terms often amended in the Paragraph 13

elections:• Secured Party’s 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.

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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.

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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.

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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.

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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.

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• 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

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Holding and Using Posted Collateral• Paragraph 6(b): Eligibility to Hold Posted

Collateral; Custodians:

• Why Use a Custodian?• Usually only preferred when a party doesn’t 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.

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• 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 party’s ability to hold and use Posted Collateral.

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• 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.

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• 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.

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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.

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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.

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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.

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Certain Rights and Remedies

Paragraph 8(a): Secured Party’s Rights and Remedies.

• When do Secured Party’s 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

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Paragraph 8(a): Secured Party’s 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.

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Paragraph 8(b): Pledgor’s Rights and Remedies.

• When do Pledgor’s 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: Pledgor’s rights do not arise until the occurrence or designation of an Early Termination Date—not merely upon the occurrence of an Event of Default or Specified Condition.

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• 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.

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• 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.

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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 party’s Posted Credit Support.

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• 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.

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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;

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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.

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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 Party’s use of Posted Collateral).

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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.

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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.

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• 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 company’s 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.

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• 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 Party’s exercising its rights to use Posted Collateral).

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• 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.

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Discussion Topics





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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.

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• 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).

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• 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.

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• 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 party’s credit group.

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• 13(b)(iv)(B): Threshold: Directly offsets a party’s obligation to Transfer a Delivery Amount or Return Amount.

• The amount of a party’s 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 party’s (or its Credit Support Provider’s) credit rating.

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• 13(b)(iv)(C): “Minimum Transfer Amount”: A Delivery Amount must equal or exceed a Pledgor’s 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.

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• 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.

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• 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.

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• 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.

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• 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 CSA’s 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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• 13(d): Conditions Precedent and Secured Party’s 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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• 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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• 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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• 13(f): Dispute Resolution.

• The default “Resolution Time” is 1:00 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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• 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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• 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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• 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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• 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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• 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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• 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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• 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





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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 SDs—it 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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• 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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• 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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• 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 CFTC’s 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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• Reporting and Recordkeeping: Key Requirements:*

A. § 727: Real-Time Public Reporting

B. § 729: Reporting and Recordkeeping (SDRs)

C. § 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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• 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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• 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 company’s 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

[email protected]

KEVIN PAGE(713) 752-4227

[email protected]

JACKSON WALKER L.L.P.

1401 McKinney Street, Suite 1900

Houston, Texas 77010

Documents

Understanding the ISDA Credit Support Annex: Know Your Rights and Risks CRAIG ENOCHS Jackson Walker L.L.P. International Energy Credit Association 2011