Using Derivatives to Finance New Power Plants; the challenge for independent generators to finance new projects
Derivatives are risk-shifting products whose value is based on an underlying asset or instrument, called an “underlying.” Underlyings generally include commodities (such as oil, natural gas or electricity), financial instruments (such as stocks, bonds, indices and interest rates), and virtually anything that has an economic value that can be tracked.
A derivatives contract consists of bilateral promises. One party undertakes to sell and the other to buy an underlying asset at a preset date in the future and at a specific price. The instruments usually involve a financial settlement where the party that lost the bet about how much the underlying asset would be worth at the maturity date set in the contract pays the other the difference between the actual value and the present price in the contract.
In the 1970s and 1980s, while much went wrong on Wall Street, derivatives began to change business and financial dealings as pervasively as the Internet has revolutionized communication. Derivatives have become a vital planning and financing tool.
Recent International Swaps and Derivatives Association, or ISDA, surveys are illuminating. Globally, in June 2003, derivatives markets amounted to a staggering $785 trillion in outstanding contracts, more than 10 times the gross national product of the United States. In 1991, that amount stood at $10 trillion and in 1995, at $56 trillion! More than one-third of derivatives activities occurred in off-exchange or over-the- counter markets where the notional amount of OTC derivatives contracts in 2003 was more than $170 trillion. In addition, a recent ISDA report revealed that 92% of the 500 largest companies in the world — located in 26 countries and representing a broad variety of industries from aerospace, energy to wholesalers of office and electronic equipment — use derivatives instruments to manage and hedge their risks more effectively.
The issue today for most CFOs and CEOs is not whether to use derivatives but how to do so.
Anyone buying a derivative is usually interested in hedging an economic risk. In unstable markets, he may want to lock in a price, an interest rate or a currency exchange rate. In markets involving commodities, like electricity, for which demand is relatively inelastic, small changes in supply can lead to wide swings in prices. Independent generators like Mirant, Reliant or AES, for whom fuel costs make up 85% to 90% of the total costs of running their power plants, are very much affected by spot energy prices: high natural gas or coal prices may quickly eat up their margins. Such companies usually try to hedge against fuel prices by entering into long-term fuel contracts or by shifting the fuel price risk to the fuel supplier through tolling agreements. These are a form of hedge, as are going into the commodities markets to buy futures contracts that lock in prices but involve financial settlements rather than physical deliveries of the fuel. Federal banks are limited in their ability to enter into tolling arrangements. “Regulation Y” prohibits such banks from taking or making delivery of non- financial commodities such as natural gas and electricity.
The most popular derivatives instruments are options, swaps, futures and forwards. Which one a company should use depends on its tolerance for the risk of change in prices of the underlying asset or a default by the counterparty.
Options carry the least risk, at least from a buyer’s perspective. The buyer of an option has the right, but not the obligation, to buy or sell an underlying asset or commodity at a specified “strike price” during a certain period. All the holder of the option stands to lose if the option is never exercised is the small amount he paid for the option. However, the seller is in a more risky posture. It must execute the promise it made if the holder exercises. The holder’s exposure to counterparty risk that the seller will not perform may be considerable.
A forward is a contract where one party promises to sell and another promises to buy, at a future date, a commodity at a predetermined price. For example, on December 1, 2006, X, as seller, and Y, as buyer, sign a natural gas forward contract. Under the terms of the contract, the seller promises to deliver 100 million cubic feet, or mcf, of natural gas at $5 an mcf on February 28, 2007 to the buyer. Each party to the contract hopes its predictions about future market movements will prevail. The seller anticipates that an mcf of gas will be selling by late February at less than $5, and the buyer is worried that gas prices will increase. At maturity, if the transaction is cash settled, one party must pay the other the difference between the actual price of gas and $5 an mcf. If gas prices have fallen, the buyer pays the difference to the seller. If the transaction is physically settled, then the buyer will take actual delivery of the gas, but the economic result will be the same. Instead of buying gas in the spot market at the lower spot price and paying the difference up to $5 to the seller of the forward contract, it pays the full $5 to the seller and takes the gas. The point is that, unlike with an option, both parties to a forward contract must perform.
Futures are similar to forwards except that, unlike forwards, they are traded on a regulated commodities exchange like the Chicago Board of Trade or New York another type of interest rate swap called “zero coupon,” where one of the parties agrees to pay a fixed or floating rate, while the other pays nothing until the maturity date of the contract.
The most popular types of interest rate swaps in the early days of the market were step-up or accreting swaps, where the notional amount increases during the period of the swap (for loans in the form of a line of credit), amortizing interest rate swaps, which are opposite to step-up swaps in that the notional amount decreases over time (for loans to be repaid in installments), forward swaps that start at a specific date in the future (for a debt set to start in X months’ time), arrear swaps, where at least one payment stream is based on a floating interest rate to be determined (LIBOR + 1/8%) in the future, generally at the end of the swap period, and reflects the average variation of such rate during such period (for example, the average variation of LIBOR over a two -year period of a swap, determined at the end of the two-year period).
In recent years, swap contracting has expanded into new markets. Today, almost any commodity or financial asset can be swapped. Equity swaps (exchange of returns or payoffs of a particular equity), and commodity swaps, including in power projects where there might be an exchange of commodity price payments, are common.
The lawyer’s role in derivatives traded on commodity exchanges is minimal. Such derivatives are standardized as to their maturity, quantity and delivery dates. Standardization produces four consequences. First, it limits the number of underlyings for exchange-traded derivatives. Second, the prospective purchaser or seller must place an order with a registered broker-dealer on a securities exchange, or with a futures commission merchant, who then will execute it on the market. Third, transactions are executed or settled through the interposition of a clearing organization, which reduces counterparty risk. Finally, immediately after execution of an order, the intermediary must send to his customer a “confirmation order.”
In contrast, in over-the-counter transactions, the parties usually exchange oral promises by email or telephone. These are followed by written confirmations to each other that recite essential terms of the transactions. These confirmations become part of the “master agreement” that is then executed, along with other documents, by both parties.
Most OTC derivatives transactions, including ones based on energy and electricity products, are currently documented using ISDA forms. Although ISDA documentation is somewhat long and complex, it can fairly be described as being composed of six documents: the master agreement, a schedule, the confirmations, an annex with ISDA definitions, the protocols and a credit support annex.
The master agreement was first published in 1987, modified in 1992 and again in 2002. It is used to document all types of transactions (such as swaps, options, and forwards) and is supplemented by various addenda to accommodate the growing complexity and diversity of OTC transactions. The master agreement has 14 sections relating to agreements and undertakings, representations, events of default and termination, netting, transfers and the contractual currency.
Once signed, the master agreement and all of its attachments, including the schedule, the confirmations, addenda such as the caps, collars and floors, constitute a single agreement. Using the same basic agreement to document many transactions reduces transaction costs.
The use of a single master agreement for multiple trans- actions significantly reduces the risk of “cherry-picking” in the context of bankruptcy - that is, the risk that a bankruptcy trustee or liquidator would “cherry-pick” profitable transactions between two parties while disclaiming unprofitable ones. It also enables the parties to simplify the settlement of their contractual obligations by making a single payment netting all transactions.
The schedule is a document that is incorporated by reference in the master agreement and is usually the most contentious part of the ISDA documentation. While the master agreement contains provisions that the parties may agree broadly to apply to their transactions, the schedule allows them to fine tune, amend or reject some of these provisions. In contrast to preparing the master agreement, which involves merely filling in the blanks, negotiating the schedule is a demanding process that requires careful negotiation, sound understanding of derivatives trading and careful drafting.
The critical issues raised during negotiations usually center around the following questions. What events should qualify as “events of default”? What events should qualify as “early termination events”? Should creditworthy affiliates be included in the definition of “party,” and should the default of non-party affiliates under unrelated agreements with one of the parties trigger a cross-default under the schedule? What type of collateral and credit support should accompany each party’s relative position? When hedging in the context of an asset or acquisition financing where collateral is shared with the lender, what are the relative rights of the lender, other hedge providers, and the counterparties in and to the collat- eral? Should a precipitous drop in market prices due to unforeseen events such as a terror attack constitute force majeure leading to the termination of the agreement or at least suspension of obligations? What is the method of calculation of close-out amounts?
The confirmation is a document where the parties record the financial and economic terms of specific transactions. Typically, transactions are initiated over the telephone. The parties reach an oral agreement that is documented in the confirmation. The principal terms of the confirmation include price, quantity, duration and tenor. The document is forwarded by one of the parties, generally the initiating party, to the other for its acceptance. The time frame of acceptance varies from two days to many months.
The confirmation is usually short - two to three pages - although the complexity of some transactions may lead the parties to draft a much longer form. ISDA published standardized confirmation forms recently.
One of the most useful achievements of ISDA is to provide derivatives dealers with a set of defined technical terms, thereby reducing the risk of misunderstanding between the parties. The standard definitions are used across many types of deals. The parties may still choose to either modify or disregard standard definitions.
ISDA also issues “user’s guides” and “commentaries” in an effort to reduce the room for misunderstandings. For example, there is a commentary accompanying the three recently-published supplements to the 1999 credit derivatives definitions.
The protocols govern future modifications by the parties of their agreements. For example, the parties would agree that on the occurrence of certain events, the contract would be amended at the option of one or both of them, or simply to adopt pre-agreed economic terms like whatever is prevailing in the market at the time. For example, the 1996 EMU protocol dealt with the consequences of the adoption of the euro.
The credit support annex is key to allocating and countering counterparty risk. Usually, each party to a derivatives transaction must post collateral in excess of an agreed amount to cover the risk that it will fail to perform under the contract. The collateral posted by each party must usually be assessed on a daily basis by marking it to market. Thus, if a party’s exposure relative to the collateral it tendered has increased, it would be required to provide additional collateral or otherwise it would be in default under the contract.
Like the master agreement, the credit support annex contains standard terms and a schedule. It is the key document for providing security and managing credit and performance risk. However, the parties remain free to amend or disregard the standard provisions. They might also decide not to use it to document their transaction.
Legal issues exist mainly in OTC derivatives transactions where many innovative and specifically-tailored contractual arrangements may be unenforceable.
The enforceability of a derivatives contract usually turns on risks that the contract might be recharacterized, insufficiently documented, entered into by an incapable or unauthorized party or unenforceable as the result of the application of bankruptcy provisions. In addition, one derivatives party may be held liable to the counterparty for failing to disclose the economic risks of the transaction.
Recharacterization is almost always a risk. A transaction may be recharacterized under securities and commodity laws, anti-gaming and anti-bucket shop laws and insurance laws. The Commodity Futures Modernization Act that was recently enacted reduced the risk of recharacterization under state anti-gaming and anti-bucket shop statutes. Any attempt to construe derivatives instruments as insurance will usually not succeed. The derivatives markets are supervised by both the US Securities and Exchange Commission and the Commodity Futures Trading Commission. The Federal Energy Regulatory Commission also oversees the physical trading of electricity and related contracts.
Instruments that are “securities” may not be traded unless they are registered with the SEC. Commodity-based derivatives that fall under the ambit of the CFTC may not be traded off-exchange, except for certain types of commercial options. Whether a particular instrument is a “security” or a “commodity” may not always be clear. The legal uncertainty can be costly. In case a derivatives product is reclassified as a security, severe consequences will attach against the parties: criminal and administrative sanctions for violation of securities acts and possible civil lawsuits by counterparties and by affected third parties for fraud and misrepresentation.
Likewise, recharacterization of an OTC derivatives contract as a “commodity” suggests that the parties have traded the instrument in violation of a broad prohibition against off- exchange trading. Until 2005, failure to comply with this off- exchange trading prohibition generally meant the OTC derivatives contract at issue could be held illegal and unenforceable, putting the parties at risk of heavy criminal and administrative sanctions and, possibly, high-stakes liability lawsuits from injured third parties. Exemptions granted by the Commodity Futures Trading Commission under the Futures Trading Practices Act proved unclear and inconsistent. In reaction, Congress adopted a new statute in December 2000 that provides more legal certainty to OTC market participants in two respects.
First, Congress established separate treatments for derivatives transactions in three classes of commodities: “excluded commodities,” “agricultural commodities” and “exempt commodities.”
OTC derivatives transactions based on excluded commodities — essentially, financial variables (interest rates, currency rates) and off-exchange contracts based on exempt commodities — are not subject to CFTC oversight, provided that they are entered into solely between eligible contract participants and not on a “trading facility” like an exchange, or they are entered into between eligible commercial entities on a trading facility. Derivatives contracts based on agricultural commodities may only be traded on futures exchanges and are regulated by the CFTC.
Second, Congress directed that no OTC derivatives contract may be rescinded for the sole reason that it failed to comply with the statutory exclusions or government regulations. This no-rescission clause significantly increases the security of OTC transactions since a party can no longer escape its contractual obligations on the claim that the OTC contract at issue is illegal. Instead, Congress allowed the parties to cure the legal deficiency that the contract contains without permanently compromising its enforceability.
The legal security is not absolute. Most notably, it does not insulate the contracting parties from heavy administrative and criminal sanctions under US commodity and securities laws. Nor does it shield the parties from expensive lawsuits from affected third parties. Finally, in all circumstances, the parties remain accountable under the anti-fraud and anti-manipulation provisions of the commodity act and the securities acts.
The bottom line is that parties to an OTC derivatives transaction still face considerable, though abated, recharacterization risks. Another potential legal issue is lack of documentation. Parties initiate contacts and agree upon the most essential terms of the deal by telephone, and exchange confirmations that they execute later. Until recently, such delays in documenting the transaction - usually referred to as “backlog” - were at odds with statutes of frauds that require enforceable contracts to be in writing. Fortunately, a 1994
amendment has practically eliminated the problem in New York, where most OTC derivatives transactions take place. Under the amended law, which applies to qualified financial contracts entered into as of September 20, 1994, oral agreements are enforceable provided that there is sufficient evidence to indicate that an agreement was made; such evidence may also be implied from prior dealings between the parties. In any event, a written confirmation must be received by the counterparty within five business days, who may object within three business days after receipt of such written confirmation. Such deadlines may be amended by the parties.
Another common legal problem is lack of capacity. Capacity refers to a party’s legal authority to enter into a derivatives transaction. A party’s lack of capacity is likely to foil the proper enforcement of a derivatives contract and, as a result, may cause substantial losses to any of the parties whose positions were in the money.
Capacity concerns regarding derivatives are not particularly relevant for major corporations. Generally, corporate charters are written in broad terms and grant expansive powers to the board to conduct business operations. Even where the articles of incorporation appear restrictive on their face, courts are likely to rely on the theory of apparent authority to quash any lack-of-authority claim.
However, the issue does arise with respect to derivatives agreements entered into with state and local governments and highly-regulated financial institutions such as insurance companies and banks. In such cases, questions may surface as to whether these entities, or the persons representing them, have the capacity to enter the transactions.
While a strict application of state law might result in invalidation of derivatives contracts entered into by most state and local authorities, states generally permit licensed insurers to engage in derivatives activities. The New York insurance law provides an informative illustration. In 1999, the New York state legislature added a new section to article 14 of the insurance law that governs the use of derivatives by insurance entities. The new law removed major restrictions to derivatives activities of domestic and foreign insurers and reinsurers licensed to operate in the state.
With respect to banks, although they do not have explicit authority to engage in derivatives transactions, federal and state regulatory agencies have proven accommodating. They generally make an expansive reading of bank regulatory powers.
Another potential legal issue is change in law, like the introduction of the euro. Generally, a change in law can cause executory contracts to be terminated if it causes a material alteration of the respective obligations of the parties. The introduction of the euro as the new currency in 12 countries in Europe in January 2002 was not a problem. The adopting legislation specifically directed that all executory contracts would remain legal, valid and enforceable. Major US states like New York, Illinois and California enacted similar statutes.
Another legal issue in derivatives transactions is the uncertain scope of bankruptcy provisions. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 clarified the treatment of derivatives contracts when a market participant defaults. Similar concerns prompted New York to amend its banking laws to clarify the role of the New York banking superintendent as a receiver or liquidator in the context of bankruptcy of an uninsured state-chartered bank or state-licensed agency of a foreign bank. Those provisions explicitly allow the set off of claims arising out of derivatives contracts when the bank becomes insolvent.
As background, under the 1898 bankruptcy code, upon filing of a bankruptcy petition, all lawsuits and collection activities against the debtor are automatically suspended. Until 1978, a debtor’s derivatives obligations were treated in the same manner as other debtor payment obligations. A non-debtor derivatives counterparty could not collect against a debtor in bankruptcy, a situation that did little to foster development of derivatives markets. Fortunately, the bankruptcy code was amended in 1978, 1990 and 1994 to exempt qualifying financial derivatives contracts from the “automatic stay” provisions and enable eligible non-debtor entities to terminate those derivatives agreements with their debtor counterparties in bankruptcy, liquidate or set off their mutual claims and seize the underlying collateral.
The new federal bankruptcy amendments in 2005 expanded both the scope of financial contracts and the categories of market makers covered by the safe harbor by which derivatives and financial contracts are not subject to automatic stays. They expressly permit derivatives counter- parties automatically to net payment amounts among different types of products without stay or avoidance “or any other court interference.”
The 2005 amendments extended the right to set off to any “financial participant,” meaning any large entity that is a party to one or more derivatives contracts or transactions with outstanding notional amounts of at least $1 billion in a 15-month period or that has gross mark-to-market positions of at least $100 million in one or more such derivatives contracts or transactions in a 15-month period. The catch-all phrases “or any other similar agreement” and “any agreement or transaction that is similar to any other agreement or trans- action referred to in this paragraph” have considerably expanded the scope of the right to set off, thereby allowing for the continued and rapid development of new derivatives instruments.
On the other hand, the 2005 amendments restricted the ability of trustees to avoid pre-petition payments and other transfers made to eligible derivatives non-debtor counterparties, under qualifying derivatives contracts, such as “securities contracts,","commodity contracts,”“forward contracts,”“repurchase agreements” and “swap agreements.” The bankruptcy code grants trustees broad powers to avoid or unwind certain pre-petition transfers made by a debtor in bankruptcy to its creditors to ensure the equitable distribution of the bankruptcy estate’s assets to similarly-situated creditors. While prior amendments to the bankruptcy code have insulated transfers made under qualifying financial contracts from trustee avoidance powers, the 2005 amendments expanded the meaning of such contracts, thereby extending the safe harbor to a wider group of derivatives instruments. However, transfers and payments made by the debtor in bankruptcy “with actual intent to hinder, delay, or defraud” creditors will remain subject to possible avoidance.
Finally, failure to disclose the risks of the transaction is also a potential legal issue. Recently, some discontented derivatives users tried to get out of bad deals by claiming that their counterparties failed to disclose the risks. While most civil actions brought have been settled, one Ohio court held in a case between Proctor & Gamble and Bankers Trust Company in 1996 that no fiduciary relationship can exist where the two parties were acting and contracting at arm’s length. The case involved a transaction that was governed by New York law. However, the court recognized an implied contractual duty to disclose in business negotiations when three conditions are met. There is a duty to disclose if one party has superior knowledge of certain information, that information is not readily available to the other party and the first party knows that the second party is acting on the basis of mistaken knowledge. That being said, it should be noted that the decision is limited to the specific transactions at hand and is not binding on other courts. As a result, in a derivatives transaction, the extent to which one party relies on another to disclose information must be carefully negotiated. Typically, in the schedule, each party will state that it does not rely on any communication (written or oral) of the other as investment advice or as a recommendation to enter into the transaction.
Derivatives are designed to subdivide and reallocate risks to those most willing to bear them. However, they do not eliminate risk. Derivatives themselves have built-in risks including collateral encumbrances that can cause substantial losses to market participants. Such risks can be mitigated through careful understanding of the market and deal documents.