Derivatives Treatment in Bankruptcy Proceedings

Transcription

1 presents Derivatives Treatment in Bankruptcy Proceedings Minimizing Risks When a Counterparty Becomes Insolvent A Live 90-Minute Audio Conference with Interactive Q&A Today's panel features: Joel S. Telpner, Partner, Mayer Brown, New York William M. Goldman, Partner, DLA Piper, New York Jay L. Taylor, Special Counsel, DLA Piper, New York Tuesday, April 7, 2009 The conference begins at: 1 pm Eastern 12 pm Central 11 am Mountain 10 am Pacific The audio portion of this conference will be accessible by telephone only. Please refer to the dial in instructions ed to registrants to access the audio portion of the conference. CLICK ON EACH PDF IN THE LEFT HAND COLUMN TO SEE INDIVIDUAL PRESENTATIONS. If you need assistance or to register for the audio portion, please call Strafford customer service at ext. 10

2 Derivatives Treatment in Bankruptcy Proceedings Minimizing Risks When a Counterparty Becomes Insolvent Some Lessons Learned April 7,2009 Joel S. Telpner Partner jtelpner@mayerbrown.com Mayer Brown is a global legal services organization comprising legal practices that are separate entities ("Mayer Brown Practices"). The Mayer Brown Practices are: Mayer Brown LLP, a limited liability partnership established in the United States; Mayer Brown International LLP, a limited liability partnership incorporated in England and Wales; and JSM, a Hong Kong partnership, and its associated entities in Asia. The Mayer Brown Practices are known as Mayer Brown JSM in Asia.

3 Structuring Around the Bankruptcy Burden Protected Contracts If you are a Protected Party and you enter into a Protected Contract, even though it is the functional equivalent of a secured loan, a Protected Party is exempt from the secured lender s bankruptcy burden What are the Protected Contracts? Repurchase Agreements Swap Agreements Securities Contracts Commodities Contracts Forward Contracts Master Netting Agreements 2

4 Repo s and Securities Contracts Repurchase Agreements Hot Topics in today s Credit Markets Repurchase agreements have been around longer than securitizations and are a much bigger product in dollar terms 2005 Amendments expand use of repurchase agreements to include mortgage loans Subprime cases bring protected contracts to the forefront What is a Repurchase Agreement? Agreement to sell a pool of qualifying underlying financial assets Simultaneous agreement to repurchase Short term One year or on demand Qualifying Assets mortgage loans and highly rated mortgage related securities Functional equivalent of a secured loan 3

5 Repo s and Securities Contracts (cont d) Repurchase arrangements that do not qualify as Repurchase Agreements (e.g., due to tenor or asset type) can be a protected Securities Contracts Repo s are the functional equivalent of secured loans, and enjoy a free pass through the counterparty s bankruptcy proceeding 4

6 The Protected Parties Who are the Protected Parties? Each of the six types of protected contracts have their own sets of protected parties Generally, the protected parties are large financial institutions, but any party to a qualifying repo or a qualifying swap is automatically safe-harbored 5

7 The Free Pass What are the Protected Rights? Ability immediately to liquidate the underlying assets based on bankruptcy filing default Ability to net out positions and apply collateral Exemption from fraudulent transfer and preference risk (i.e., any new or additional assets taken as collateral on the eve of bankruptcy not subject to avoidance (in the absence of an intentional act to defraud creditors) Essentially, a free pass through the counterparty s bankruptcy proceeding 6

8 Protected Contracts In Current Practice Structuring opportunities, particularly in the swap area why would you ever extend credit on a non-safe-harbored basis if it can be done as a protected contract? In terms of workouts understand termination rights and process statute requires the exercise of remedies because of the bankruptcy of the counterparty must act reasonably quickly recognize these are liquidation cases, not reorganizations 7

9 Protected Contracts In Current Practice (cont d) The Effect of Protected Contracts have they worked? Generally, protected rights are being respected and Protected Contracts are being closed out as the statutes intend Effectively eliminate any prospect of reorganization particularly where the debtor s capital structure is dominated by Protected Contracts But what about collateral? 8

10 What Have We Learned From the Lehman Bankruptcy? Many of Lehman s trading partners and clients were left holding the bag Counterparties learned the protection wasn t really there Bankruptcy procedures allow counterparties to avail themselves of their contractual rights They do not create protections where none otherwise exist 9

11 What Have We Learned From the Lehman Bankruptcy Collateral Posting Counterparties doing business with various Lehman entities unit posted cash and other collateral with Lehman Collateral was comingled with other Lehman assets As a result of bankruptcy, those assets were not protected and were frozen as part of bankruptcy proceeding 10

12 What Have We Learned From the Lehman Bankruptcy Collateral Posting (cont d) Counterparties have not been able to gain access to their collateral Among other things, hedge funds have been hurt particularly hard have not been able to meet redemption requests Have experienced difficulty valuing assets 11

13 What Have We Learned From the Lehman Bankruptcy Market Practice Broker-dealers enter into derivative contracts through unregulated affiliates Customer Protection Rule (Rule 15c3-3) does not apply Therefore, no obligation to segregate customer collateral from general assets of secured party Banks also not obligated to segregate counterparty collateral 12

14 What Have We Learned From the Lehman Bankruptcy Market Practice (cont d) The ISDA Credit Support Annex secured party may: Sell, pledge, rehypothecate, assign, invest, use, commingle or dispose of posted assets Use posted collateral free and clear from any claim or right or any nature of pledgor Treat posted collateral as though it were its own 13

15 What Have We Learned From the Lehman Bankruptcy Consequences of Insolvency Under ISDA Master Agreement: non-defaulting party can terminate and close-out existing transactions Determine the net payment owed by one party to the other and Demand the return of any collateral held by the secured party in excess of amounts owed to the secured party 14

16 What Have We Learned From the Lehman Bankruptcy Consequences of Insolvency (cont d) Unless excess collateral was held by a brokerdealer or in a segregated third-party custodial account and not commingled with the secured party s assets, the pledgor will likely find itself with nothing more than a general unsecured claim in the insolvency proceeding. 15

17 What Have We Learned From the Lehman Bankruptcy Consequences of Insolvency (cont d) Dealing with a common parent guarantor is not likely to expand the nondefaulting party s right of setoff The nondefaulting party may not be able to reduce the amounts it owes against the amounts payable to it by affiliates of the defaulting party Collateral held by affiliates of the defaulting party may have to be disregarded in any setoff calculations 16

18 What Have We Learned From the Lehman Bankruptcy Foreign Exchange Problems arose because payments are never truly simultaneous The party who pays first runs the risk that its counterparty will fail to pay The first payer is left with an unsecured claim for the entire failed payment 17

19 The Following Provisions May Have Protected You Additional Termination Events Counterparty-specific ATEs may allow early termination of trades before a counterparty s creditworthiness deteriorates to the point of bankruptcy. ATEs can also be tied to declines in net value or changes in management or business conditions. 18

20 The Following Provisions May Have Protected You (cont d) Conditions Precedent to Payment Obligations Consider including time limits on how long a nondefaulting party can withhold its payment obligations after a default but prior to declaring an early termination. Set-off Clauses Set-off clauses should be carefully examined. While questions as to enforceability persist, set-off clauses should nevertheless be extended to affiliates of the nondefaulting party when appropriate. 19

21 The Following Provisions May Have Protected You (cont d) Credit Support Annex Provisions Where possible and appropriate, CSA provisions should be bilateral. Bilateral provisions can protect against negative movements in transactions. As discussed in an early slide, limits as to the right of the secured party to sell, pledge or rehypothecate posted collateral may be appropriate. Try-party custody arrangements should also be considered. Rights to return excess collateral should be reviewed and tightened. 20

22 Derivatives and the Bankruptcy Code William M. Goldman April 7, 2009

23 Statutory History Protection for swap agreements added to the Bankruptcy Code in 1990 Commodity contracts and forward contracts protected since 1978 Security contracts protected since 1982 Repurchase agreements protected since 1984 Prior to 2005, the definition of swap agreement in the Bankruptcy Code created uncertainty as to whether certain non-vanilla swaps, particularly equity and credit derivatives were protected 2

24 2005 Amendments Title IX of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (the 2005 Amendments ) Expanded the types of financial contracts entitled to special treatment Amended the Bankruptcy Code, the Federal Deposit Insurance Act, and related bank insolvency statutes to provide similar safe harbor treatment for derivatives and other protected financial contracts Added language to provide increase legal certainty of a successful unwind 3

25 2005 Amendments Recognize a new type of Protected Contract Master Netting Agreement Master Netting Agreement is defined in Section 101(38A) of the Bankruptcy Code to mean An agreement providing for the exercise of rights, including rights of netting, setoff, liquidation, termination, acceleration, or close out, under or in connection with one or more securities contracts, commodities contracts, forward contracts, repurchase agreements or swap agreements, or any security agreement or arrangement or other credit enhancement related to one or more of the foregoing, including any guarantee or reimbursement obligation related to one or more of the foregoing 4

26 2006 Amendments Financial Netting Improvement Act of 2006 (the 2006 Amendments) Further strengthen and clarified the enforceability of the termination, netting and related collateral arrangements Among other things, the 2006 Amendments: Expanded the definition of securities contract to include a total return swap transaction coupled with a securities sales transaction Revised the definition of financial participant to clarify that an entity can aggregate the dollar value of qualifying contracts across counterparties in order to qualify as a financial participant Expanded the types of derivatives specifically included in the Bankruptcy Code s definition of swap agreement 5

27 Swap Agreements The term swap agreement is defined in Section 101(53B) of the Bankruptcy Code statutory definition is tautological, but specifically includes total return swaps credit swaps, and any agreement of a type that is or in the future becomes the subject of recurrent dealings in the swap markets and, among other things, is a forward, swap, future or option on a debt instrument or contingency associated with a financial, commercial, economic consequence, or economic or financial indices or measures of economic or financial risk or value 6

28 Swap Agreements Most swap agreements are documented using the agreements and definitions published by the International Swaps and Derivatives Association, Inc. ( ISDA ) ISDA Master Agreement contain standard terms that apply to all swap agreements Schedules to Master Agreement contain negotiated terms that apply to all swap transactions between the parties Confirmations contain negotiated terms for each specific swap transaction 7

29 Hypothetical Simple Swap Agreement Parties executed appropriate ISDA Master Agreement and Schedule to Master Agreement Confirmation Party A (Fixed Rate Payer): pays 10% fixed monthly Party B (Floating Rate Payer): pays LIBOR + 2% monthly Notional Amount: $1 million Effect If on a payment date, LIBOR = 7%; Party A pays Party B $ ($8, $7,500.00) If on a payment date, LIBOR = 10%; Party B pays Party A $1, ($10,000 - $8,333.33) If on a payment date, LIBOR = 8%; no payment is made by either party Economic effect Party A has locked in its interest payment on $1 million of floating rate debt 8

30 Credit Default Swap (Example) Parties: Protection Buyer/Protection Seller Reference Entity: GE Reference Obligation: $10 million of GE bonds Effective Date: October 1, 2008 Scheduled Termination Date: September 30, 2013 Credit Event: bankruptcy/downgrade Price: 700 basis points, i.e., Protection Buyer pays $700,000/year to Protection Seller Settlement Option: physical/cash 9

31 No Default Protection Buyer $700,000/year $0 Protection Seller 10

32 Credit Event Physical Settlement Protection Buyer $10 million face amount of GE Bonds $10 million Protection Seller 11

33 Credit Event Cash Settlement Protection Buyer $0 Cash = $10 million value of $10 million face amount of GE Bonds Protection Seller 12

34 Normal Bankruptcy Rules Acceleration/ipso facto clauses Invalid Sections 365(b)(2); 365(e); 541(c)(1)* Automatic stay Prevents the commencement or continuation of most enforcement actions against a debtor or its property and also enjoins most setoffs Section 362(a) Trustee avoiding powers Certain pre-petition transfers can be invalidated including preferences and fraudulent transfers Sections 544; 545; 547; 548 * Except where otherwise indicated, all statutory references are to the Bankruptcy Code 13

35 The Safe Harbor Provisions of the Bankruptcy Code relating to Swap Agreements 14

36 Protected Parties Swap participant: Defined in Section 101(53C) as an entity that, at any time before the filing of the [bankruptcy] petition, has an outstanding swap agreement with the debtor Financial participant: Defined in Section 101 (22A) as an entity with securities contracts, commodity contracts, forward contracts, swap agreements and repurchase agreements totaling, at any time in the 15 months preceding bankruptcy: $1 billion in notional amount, or $100 million on a mark-to-market basis, but Excluding contracts with affiliates 15

37 Trumps Invalidity of Ipso Facto Clauses Contractual right to liquidate, terminate or accelerate because of bankruptcy or insolvency is protected. Section 560 Right should be exercised seasonably Contractual rights include rights set forth in a rule or bylaw of a derivative clearing organization, a multilateral clearing organization and certain similar organizations 16

38 Trumps Automatic Stay Section 560 of the Bankruptcy Code provides that Contractual right to liquidate, terminate or accelerate shall not be stayed, avoided, or otherwise limited by operation of any provision of this title or by order of the court The 2005 Amendments supplemented the protections by amending section 362 accordingly 17

39 Trumps Trustee Avoiding Powers Protection against most of the trustee s voiding powers Can not avoid any pre-petition transfer made by or to a swap participant or financial participant under, or in connection with, any swap agreement unless the transfer was done with the actual intent to hinder, delay or defraud creditors Sections 546(g) and 548(d)(2)(D) Master Netting Agreement Sections 546(j) and 548(d)(2)(E) provide similar protection 18

40 Damages Prior to the 2005 Amendments it was unclear whether damages were calculated as of petition date or as of termination date Damages are now generally determined as of the earlier of the date the contract is rejected in bankruptcy or the date the contract is liquidated, terminated or accelerated. Section 562(a) If there is no commercially reasonable determination of value on the relevant date, damages are measured on the earliest subsequent date on which there is a commercially reasonable determination of value. Section 562(b) 19

41 Municipal / Cross-Border Cases Prior to the 2005 Amendments it appeared that the special protections for swap agreements did not apply to municipal or ancillary bankruptcy cases The 2005 Amendments make it clear that the special protections now apply to those cases Section 901 of the Bankruptcy Code now specifically incorporates the relevant protective provisions into chapter 9 (municipal) bankruptcy Sections 103(a) and 1519(f) of the Bankruptcy Code incorporates the relevant protective provisions into chapter 15 (ancillary and other cross-border cases) 20

42 SIPA Stockbrokers (broker-dealers with customers) can not seek relief under chapter 11 of the Bankruptcy Code. Bankruptcy Code 109(d) Although stockbrokers can be liquidated in a chapter 7 case, most U.S. stockbrokers are liquidated pursuant to the provisions of the Securities Investor Protection Act of 1970 ( SIPA ) The automatic stay does not prevent the Securities Investor Protection Corporation ( SIPC ) from commencing a SIPA case against the debtor and the commencement of such a case operates as a stay of any pending bankruptcy case. Bankruptcy Code

43 SIPA SIPA incorporates by reference most of the relevant provisions of the Bankruptcy Code. SIPA 78fff(b) Prior to the 2005 Amendments, SIPC had the ability to enjoin the close out of certain transactions. The 2005 Amendments amend both the Bankruptcy Code and SIPA such that SIPC can no longer enjoin the liquidation, acceleration or termination of a protected contract, although it may enjoin the foreclosure or other disposition of certain securities pledged as collateral by a debtor. SIPA 78eee(b)(2)(C) 22

44 Derivatives and the Bankruptcy Code William M. Goldman April 7, 2009

45 Derivatives in Bankruptcy Counterparty Guide to Navigation of Relevant Issues Jay L. Taylor

46 ISDA Master Agreement Published by the International Swaps and Derivatives Association Inc. ( ISDA ). Contains Bankruptcy Event of Default (EOD). Bankruptcy EOD found in Section 5(a)(vii) of 1992 and 2002 Form ISDA Master Agreement. Various methods of triggering the Bankruptcy EOD

47 Automatic Early Termination The selection of Automatic Early Termination ( AET ) as applicable or non-applicable in the ISDA Schedule, or long form confirmation, is a crucial election in terms of when derivatives transactions are closed out in Bankruptcy. Counterparties should consider whether all transactions under the applicable ISDA Master Agreement should terminate upon the occurrence of an insolvency filing

48 Automatic Early Termination If applicable, termination applies immediately prior to an insolvency filing. if not applicable (or where no election is made), Non-defaulting Party decides when to terminate Affected Transactions. No less than all Affected Transactions are terminated. Issue for consideration when AET is applicable is when the insolvency event actually occurred. Uncertainty may affect close-out timing and therefore proper valuation of transactions

49 AET Not Applicable If Automatic Early Termination is not applicable, the nondefaulting party decides when the transaction is terminated. Legal recommendation is generally for Non-defaulting Party to close out and terminate all outstanding transactions as soon as possible. Non-defaulting Party serves notice of termination in accordance with Section 6 of ISDA Master Agreement

50 Notice of Termination Notice is delivered to the Defaulting Party in accordance with Section 12(a) of the ISDA Master Agreement and the notice details set forth in Part 4 of the ISDA Schedule. Designation of Early Termination Date within 20 days of Notice Date as per Section 6(a) of Master Agreement

51 Calculation & Valuation Pursuant to Section 6(d)(i) of the Master Agreement, each party calculates the net amount due. The net calculation may be included in the Termination Notice to the Defaulting Party. Alternatively, the Non-defaulting Party may notify the Defaulting Party of the net calculation Amount at a later date

52 Calculation Methodologies There are three calculation methodologies used to calculate a net amount due upon close-out. Loss Market Quotation Close-Out Amount

53 Loss Loss is an amount that the Non-defaulting Party reasonably determines to be its total losses and costs from the terminated transaction, including any loss of bargain, cost of funding or the loss or cost incurred as a result of its terminating, liquidating, obtaining or reestablishing any hedge. Loss may be determined by reference to quotations from one or more leading dealers in the relevant market (Reference Market Makers). Where Market Quotation is the selected method selection but cannot be obtained, Loss may be used

54 Market Quotation Party must make reasonable attempts to obtain at least four (4) market quotes from Reference Market Makers. If four quotes are available, the calculation is the mean average of the four. if three quotes are available the highest and lowest quotes are disregarded. If the Non-defaulting Party cannot obtain at least three quotes from Reference Market Makers or, in the reasonable belief of the Party making the determination, Market Quotation would not produce a commercially reasonable result, the Non-defaulting Party has a right to revert to a Loss calculation

55 Close-Out Amount ( COA ) COA offered as improved valuation methodology. Sole method utilized in the 2002 ISDA Master Agreement. Loss and Market Quotation no longer available in the 2002 ISDA documentation. Method provides more flexibility for the party making the valuation

56 COA (continued) the Non-defaulting Party may use a detailed list of factors which combine the fluidity of the 1992 Loss provision with the finality of the Market Quotation methodology in calculating a Close-out Amount (when quotes are readily available). Loss and Market quotation factors may be considered unless the calculating party believes, in good faith, that sufficient information is not readily available or would not produce a commercially reasonable result

57 COA (continued) In determining COA, the determining party may consider any relevant information, including, without limitation, one or more of the following types of information: (i) quotations (either firm or indicative) for replacement transactions supplied by one or more third parties that may take into account the creditworthiness of the Determining Party at the time the quotation is provided and the terms of any relevant documentation, including credit support documentation, between the Determining Party and the third party providing the quotation; (ii) information consisting of relevant market data in the relevant market supplied by one or more third parties including, without limitation, relevant rates, prices, yields, yield curves, volatilities, spreads, correlations or other relevant market data in the relevant market; or (iii) information of the types described in clause (i) or (ii) above from internal sources (including any of the Determining Party's Affiliates) if that information is of the same type used by the Determining Party in the regular course of its business for the valuation of similar transactions

58 COA Protocol ISDA published the 2009 ISDA Close-out Amount Protocol (the Protocol ) on February 27, The collapse of the Lehman Brothers derivatives and related entities brought to light the shortfalls of the Market Quotation and Loss methodologies with respect to closing-out transactions. The purpose of the Protocol is to permit parties who may be signatories to the 1992 form of Master Agreement to use the Closeout Amount valuation methodology set out on the 2002 ISDA Master Agreement to calculate amounts due upon on Early Termination. By publishing the Protocol, ISDA hopes to provide more efficiency and certainty to calculations upon the early termination of transactions

59 Implementation of the COA Protocol In any ISDA Protocol, a party to a Master Agreement notifies ISDA of its desire that their agreements become Covered Master Agreements under the protocol. The party to a Covered Master Agreement (an Adhering Party ) then completes and delivers an Adherence Letter to ISDA. ISDA acts as agent to Adhering Parties with respect to Covered Master Agreements. The Adhering Parties agree, through the Adherence Letter (received prior to a cut-off date), that the terms of their individual Covered Master Agreements will be amended on the Implementation Date of the Protocol with the language of the Protocol. The amending Protocol is not bilaterally negotiated and an Adhering Party may not identify additional provisions or limitations in the Adherence Letter as it relates to the Protocol. It is an all-or-nothing deal with respect to the protocol s purpose. The Protocol s purpose is for parties to adopt the COA methodology for existing agreements which are subject to other methodologies

60 Collateral issues upon occurrence of insolvency event KEY CONSIDERATIONS Which Party is in-the-money? How much is owed? Which, if any, party is collateralized? Is the party over or under collateralized? Is there an Independent Amount Posted? If collateral is posted, in what form? Cash or securities? Where is collateral being held?

61 Holding Collateral If the party holding collateral is the Defaulting Party, the Non-defaulting Party may have difficulty enforcing its right to a return of collateral. Complications arise when Defaulting Party holds collateral in the form of securities subject to rehypothecation. Parties may consider posting Independent Amounts not subject to rehypothecation. Alternatively, if the party holding collateral is the Non-defaulting party, it may offset amounts owed (under the Safe Harbor provisions of the Code) and return the remaining amounts owed to the Defaulting Party. Note: Set-off against affiliates and other agreement amounts should include all amounts available pursuant to agreement and permitted under the Code

62 Rehypothecation of Collateral Rehypothecation A practice whereby a bank or financial institution may use securities in its possession, but owned by another customer or counterparty, in the conduct of its other business (i.e., securities lending or to cover a short position) Rehypothecation rights are contractual. Right is granted in Paragraph 6(c) of Credit Support Annex unless election is made to dis-apply in Paragraph 13. Failure to grant rehypothecation rights may change the economics of the deal for a counterparty and should be discussed. Rehypothecation of securities increases the owner s risk because the collateral may be pledged twice, once to the secured party and again by the secured party

63 Cash Collateral If Non-defaulting Party posts cash collateral or securities and has a net in-the-money position, payment may legally be made by the Defaulting Party under the Safe Harbor provisions, although such payment not likely to occur. Non-defaulting Party is therefore left with an unsecured claim against the bankruptcy estate. Best practice is to: (i) minimize the amount of cash collateral posted to counterparties and/or (ii) reduce the amount of posted securities subject to rehypothecation rights

64 Independent Amount Amount posted by one counterparty which is independent of the outstanding exposure to that counterparty. Independent Amount as an added risk cushion for counterparty. Industry is moving towards protecting securities posted as Independent Amount from rehypothecation. Dealers open to protection of Independent Amounts but reluctant to relinquish rehypothecation rights over standard collateral tied to counterparty exposure

65 Securities Intermediary Parties may consider the appointment of a third-party custodian to act as Securities Intermediary to reduce risk associated with posting collateral. Securities Intermediary. An entity or person, including a bank or broker, that in the ordinary course of its business maintains securities accounts for others and is acting in that capacity. Securities accounts governed by Article 8 of the Uniform Commercial Code. Additional costs are associated with the appointment of a Securities Intermediary, as well as reluctance of banks and dealers to forego hypothecation rights of collateral. Reduces counterparty risk but results in increased transactional costs for both parties. (opportunity costs for banks/dealers)

66 Netting of Derivatives ISDA Master Agreement is a netting agreement. Outstanding Transactions are netted upon insolvency and close-out. Covered by Section 1(c) of ISDA Master Agreement Single Agreement provision. Single Agreement provision is the fundamental basis for close-out netting

67 Set-off Under the 1992 form Master Agreement there was no right to set-off unless added into the negotiated Schedule. Under the 2002 form Master Agreement, Set-off was added to Section 6(f). Set-off is not to be confused with netting. Set-off refers to right to set off all of the Defaulting Party obligations to the Non-defaulting Party (and often the Non-Defaulting Party s affiliates). Set-off covers Other Amounts amounts outside of the net value of terminated derivatives transactions

68 Affiliate Set-off Counterparties may also elect that the Non-defaulting Party may set off obligations owed to its affiliates by the Defaulting Party as well. The election is limited by the U.S. Bankruptcy Code and by common law regarding the concept privity

69 Master Netting and Cross-affiliate Netting Arrangements Master Netting Agreements link various trade agreements between counterparties into a single integrated arrangement by which all transactions are netted upon the occurrence of certain events. This integration is important because it prevents an insolvent counterparty (debtor-in-possession) from cherry picking (i.e., choosing and excluding transactions based on their favorability). Current Cross-affiliate Netting language often appears in broker-dealer agreements and often operates one-way against a customer/counterparty

70 Recent Lessons Learned Credit Default Swaps and the Current Economic Crisis. Future of Clearing CDS and Other Derivatives. Collateral Issues. Events of Default and Termination Events. Other Agreements. Master Netting Arrangements: Reciprocity

71 Credit Default Swaps (CDS) The New Way Forward CDS have played some role in the current economic crisis. The extent of that role is open to debate. CDS were often used to take a speculative position on the debt Reference Obligation of a Reference Entity and sometimes to manipulate the market. ISDA has been supportive of efforts to regulate CDS, within reason. CDS clearing would mitigate insolvency concerns going forward and reduce systemic risk. Where will march to clearing stop? All derivatives potentially vulnerable

72 CDS Clearing Approvals LCH.Clearnet Temporary exemptions approved by the SEC, for LIFFE Administration and Management (LIFFE A&M) and LCH.Clearnet Ltd. to operate LCH.Clearnet as a central counterparty to clear Index CDS. ICE US Trust LLC Temporary exemptions approved by the SEC to allow the Intercontinental Exchange and The Clearing Corporation to operate ICE US Trust LLC as a central counterparty for clearing CDS. Chicago Mercantile Exchange Temporary exemptions approved by the SEC, permitting the Chicago Mercantile Exchange Inc. (CME) to operate as a central counterparty for clearing CDS, using the CMDX trading and processing platform developed by a joint venture of the CME and Citadel Investment Group LLC

73 How Central Counterparties Work A central counterparty ( CCP ) novates bilateral trades by entering into separate contractual arrangements with both counterparties, replacing the buyer to one and the seller to the other. CDS agreements typically have been negotiated and entered into bilaterally, but both parties may agree that either party may novate the agreement and substitute a third party to take responsibility for performance, by acting as the new counterparty, under the swap agreement. In a Central Counterparty arrangement, both parties entering into a CDS novate their trades to the CCP and the CCP is substituted as the counterparty to all parties of any CDS it clears. Through this novation process, the counterparty risk of a CDS would be effectively concentrated in the CCP

74 Important Derivatives Issues for Consideration Counterparties should pay more attention to the form, method of holding and location of collateral when negotiating derivatives documentation. Parties should consider the effect of all trigger events associated with the occurrence of Events of Default (including the list of insolvency events in Section 5(a)(vii) of the Master Agreement) and Termination Events when negotiating documentation. Parties should also pay more attention to insolvency and collateral provisions in other agreements as there is new awareness of the interconnectivity of the entire range of trade products, particularly through set-off. Parties should seek to negotiate greater reciprocity into master netting arrangements with bank and dealer counterparties