Chapter 17 Use of Lien-Supported Financial Derivatives
D. Credit Support for the Swap Transaction
Two crucial points in understanding the motivation behind the parties to the swap transaction are, first, that Project Company is entering into the swap transaction to hedge against the volatility of market prices for the electric energy it generates and, second, that Swap Provider is entering into the swap transaction at a minimum for the fee income and potential upside it can earn from the transaction and, possibly, to hedge (i.e., offset against) some other swap transaction or physical transaction in which it has already taken (or expects to take) a position. In effect, each party is relying on pay- ments by the other party to enable that party to meet other financial obligations.
On every payment date under the swap transaction, each party to the swap transac- tion will owe a payment amount to the other party. These payment obligations are
offset against each other with the party owing the net larger amount to the other paying the incremental amount by which its payment obligation exceeds the other party’s pay- ment obligation. For example, if the fixed price is higher than the floating price, then the Swap Provider will owe a payment to the Project Company, and if the floating price is higher than the fixed price, then the Project Company will owe a payment to the Swap Provider.
Thus, on any payment date under the swap transaction, either party may owe the other a payment under the swap transaction. As a result, both parties are at risk for the other party not making a payment that is owed to it when due under the swap transac- tion. Accordingly, each party will expect some level of credit support from the other party to minimize this risk that one or more payments owed under the swap transaction will not be paid when due.
1. Credit Support Required by Each Counterparty For the Project Company to provide a reasonable level of comfort to the Lender that any swap transaction provides a reasonable assurance of debt-service protection, the Swap Provider should be a cred- itworthy counterparty. Presumably, the Swap Provider will have a strong credit rating, which will entitle the Swap Provider to a significantly high level of credit so long as its credit rating (or the credit rating of its guarantor) remains strong. The creditworthi- ness of the Swap Provider will impact the value of the swap transaction to the Project Company and, perhaps more importantly, to the Lender, since having a right to the fixed payments under the swap transaction is only as good as the creditworthiness of the party obligated to make those payments.
On the other hand, at the time the swap is entered into, the Project Company is a special purpose entity with few if any assets other than its proposed wind farm, its contracts (if any) with third parties, and the Project Developer’s equity contribution to the Project Company’s capitalization. On this basis, the Project Company will not likely have any credit rating from any of the major credit rating entities.
As a result, some form of additional credit support must be provided by the Project Company to support its floating price payment to the Swap Provider. This is especially true during the first two years after the swap transaction has been executed, because the wind farm has not yet been financed nor constructed and there is substantial risk that the Project Company may not be able to produce the revenues from which to make its floating price payment to the Swap Provider.
For this reason, the Project Company will be obligated to provide a letter of credit to the Swap Provider to provide credit support from the date that the swap transaction is executed until the date that construction of the wind farm has been completed and the wind farm achieves commercial operation. In fact, the Project Sponsor will have to utilize its available credit to provide the necessary letter of credit, which will be sized to cover the swap breakage costs that the Swap Provider would likely incur if it termi- nated the swap transaction at any time during the first two years from execution of the swap transaction until the Swap Commencement Date.
Upon completion of construction and the commencement of commercial operation of the wind farm, with the risks of obtaining financing and completing construction behind it, the Project Company’s assets now have substantially greater value than when the
LIEN-SUPPORTED FINANCIAL DERIVATIVES
swap transaction was executed and the Swap Provider will now accept a first priority lien on the Project Company’s assets as credit support for the Project Company’s floating price payment obligations and the Swap Provider will release the letter of credit back to the Project Company. Thereafter, the Project Company’s payment obligations to the Swap Provider will be secured by this first priority lien on the Project Company’s assets.
2. Credit Support Documents In a lien-supported financial derivative transaction, a security interest in the assets of the Project Company provides the credit support for the Swap Provider’s potential exposure to the Project Company. Since the wind farm is project financed, the Lender will also hold a first priority security interest in those same assets as the collateral supporting the project financing. Typical security instru- ments will be used to establish the applicable security interest in each of the various assets of the Project Company, and these security instruments will create security interests for the benefit of both the Swap Provider and the Lender(s).
A. SECURITY DOCUMENTS
Security documents are the various instruments and contracts that grant security inter- ests in certain assets of the Project Company to the Collateral Agent on behalf of the secured creditors (the Lender and Swap Provider). These documents create the secu- rity interests to be held by the Collateral Agent (typically the lead Lender) expressly for the benefit of the lenders and the Swap Provider; ensuring that both parties have the same rights in the assets and related proceeds from such assets. The Security documents are discussed below.
(I) SECURITY AGREEMENT
The security agreement identifies, creates, and grants the security interests to the Collateral Agent on behalf of the secured creditors. It may be filed as an attachment to a Uniform Commercial Code (UCC) financing statement at the appropriate recorder of deeds, or equivalent agency, to perfect the security interests and provide notice in accordance with the applicable UCC provisions. As previously discussed, typically all of the project company’s assets are treated as collateral and are thus described in detail in the financing statement.
(II) MORTGAGE/DEED OF TRUST
The mortgage gives the Collateral Agent a lien on the real property interests of the Project Company for the benefit of the secured creditors. Some jurisdictions require a deed of trust instead of a mortgage, whereby the Security interests are conveyed to a trustee who holds title to the property for the benefit of the secured creditors.
(III) PLEDGE AGREEMENT
In connection with the project financing, the creditors may require that the Project Company’s parent, also known as the Project Developer, pledge the parent’s owner- ship interests in the Project Company. In pledges, the type of organization is of much relevance, and it is necessary that the parties follow the proper procedures to pledge the ownership interests, which will depend on governing state law and the type of ownership interest (for instance, stock shares or partnership interests).
(IV) DEPOSIT ACCOUNT CONTROL AGREEMENT
The deposit account control agreement permits the Collateral Agent to have control over the cash flow accounts of the Project Company.
B. INTERCREDITOR ISSUES
Lien-supported financial derivatives in project financing require an intercreditor agree- ment to establish the relationship between the Lender and the Swap Provider as secured creditors holding security interests in the Project Company’s assets as collateral, even if the Lender and the Swap Provider do not hold security interests in all of the same collateral, or if there are senior and subordinated security interests.
(I) INTERCREDITOR AGREEMENTS IN GENERAL
The intercreditor agreement designates the rights, remedies, and obligations among all of the secured creditors and is usually the only binding contract between the Swap Provider and the Lender. Each secured creditor relies upon the intercreditor agreement to protect its respective interests, so this agreement must establish a mechanism where the Collateral Agent can make decisions efficiently in any liquidation of collateral assets.
The intercreditor agreement must be drafted carefully to handle any disputes that arise. It is crucial that all the intercreditor agreement parties diligently negotiate and thoroughly understand the terms of the agreement. Generally, a properly negotiated intercreditor agreement contains a “controlling clause,” which designates the provi- sions of the intercreditor agreement as “controlling” if there is a conflict between the terms of the credit agreement or the swap transaction agreement and the terms of the intercreditor agreement.
Often, lenders believe that only the lenders should be the beneficiaries of a first priority security interest and that the Swap Provider should be the beneficiary of a subordinate, or second priority, security interest in the Project Company’s assets. This view ignores the fact that the Swap Provider is effectively mitigating a significant por- tion of the credit risk otherwise borne by the Lender and is thus essentially like another lender that simultaneously enhances the credit of the Project Company.
Admittedly, the Lender is not a party to the swap transaction, but since the swap transaction is part of the collateral supporting the project financing, the Lender is essentially an indirect beneficiary of that swap transaction. On this basis, many of these transactions specify that both the Swap Provider and the Lender will be sharing a first priority security interest in the Project Company’s assets.
While the Lender’s first priority security interest may include additional assets of the Project Company that are not subject to the Swap Provider’s first priority security interest, the Lender and the Swap Provider must enter into an intercreditor agreement to memorialize how the two secured creditors will share their first priority security interest in the common collateral.
(II) ESTABLISHING THE FORM OF INTERCREDITOR AGREEMENT
In a typical project financing involving multiple lenders, the lead Lender will act as the administrative agent under the credit agreement between the lenders and the Project Company and this administrative agent will generally hold the security interests in all the Project Company’s assets as collateral held for the benefit of all the lenders.
LIEN-SUPPORTED FINANCIAL DERIVATIVES
Not seeking to disrupt, impede or interfere with the lenders’ financing arrangements, the typical intercreditor agreement will designate the same lead Lender as the Collateral Agent holding the first priority security interest in the Project Company’s assets for the benefit of the Swap Provider and the other lenders as the secured creditors.
Typically, the Swap Provider will want its rights to a share of any proceeds from the sale or foreclosure by the Collateral Agent of any of the Project’s Company’s assets held as common collateral to be pari passu (discussed further below) with the rights of the lenders in any such proceeds, while quite often the lenders would prefer that the Swap Provider’s interests be subordinated (i.e., junior) to the Lender’s senior rights to such proceeds.
In various situations in which a Swap Provider shares a security interest with a senior Lender, the senior Lender may already have entered into a Credit Agreement with the Project Company, which may give the senior Lender a leveraged position suf- ficient to require that the Lender’s security interest be senior to the benefits of any junior (or subordinated) security interest in the Project Company’s assets held by a Swap Provider.
In the case of the lien-supported financial derivative in project financing, as described herein, the Swap Provider will have put its swap transaction documents into effect prior to the finalization of the Credit Agreement. In fact, in the type of transaction described herein, the Swap Provider will negotiate the swap transaction and the inter- creditor agreement provisions with the Project Company, in some instances, prior to the Project Company’s identification of the lead Lender. In such situations, the lead Lender will be presented with the executed swap transaction, with its attached form of intercreditor agreement provisions, as yet another finalized component of a (hope- fully) well-conceived collateral package, leaving the Swap Provider potentially better positioned to protect and advance its position that it and the lenders should be pari passu beneficiaries in any proceeds of the Project Company’s collateral.
Of course, the Lender may not simply accept the form of intercreditor agreement provisions attached to the swap transaction, but can be expected to negotiate the terms of the intercreditor agreement and then execute what could be a decidedly different intercreditor agreement from that attached to the swap transaction.
Admittedly, if the Swap Provider is overreaching its position in establishing the form of intercreditor agreement provisions, at the time of executing any swap transac- tion, it may have to compromise that position significantly, after it has locked in the terms of its respective hedges, in order to ensure that the Lender agrees to provide project financing to the Project Company for its wind farm.
(III) MISCELLANEOUS INTERCREDITOR PROVISIONS
The intercreditor agreement contains a number of other important provisions. What follows is a discussion of some of the most important of these issues.
(A) PARI PASSU AND RATABLE
A dictionary definition of the term pari passu is “proportionally; at equal pace; without preference.” As used in intercreditor agreements, pari passu typically means that all first priority secured creditors will receive a distribution of the collateral or the
proceeds from the sale/foreclosure of such collateral and that such distribution will occur prior to any distribution to any second priority secured creditors (i.e., junior secured creditors are subordinate to the senior secured creditors). The intercreditor agreement should define the outstanding debt owed to the lenders, typically called the
“loan obligations,” and the outstanding amounts owed to the Swap Provider, typically called the “swap obligations.” Accordingly, if the amounts owed by the Project Company to the lenders as loan obligations and to the Swap Provider as swap obliga- tions are, as stated, pari passu ; this means that those payment obligations are equal in priority between the creditors.
In addition to the pari passu treatment, intercreditor agreements should also treat loan obligations and swap obligations “ratably” such that they receive “pro rata” pay- ments. Ratable or pro rata treatment differs from pari passu in that the latter means that the creditors have equal standing with respect to the collateral, while ratable or pro rata mean that the amount received from distributions of the collateral to equally secured creditors should be distributed based on the ratio of the obligations owed to each creditor in proportion to the total obligations (swap obligations plus loans obliga- tions) owed to such creditors.
In mathematical terms, ratable or pro rata can be represented as follows:
Swap Provider’s Pro Rata Share
= Swap Obligations / (Swap Obligations + Loan Obligations) Lender’s Pro Rata Share
= Loan Obligations / (Swap Obligations + Loan Obligations) (B) PROCEEDS
The proceeds provision in the intercreditor agreement, which is sometimes referred to as the “waterfall,” provides for the order of priorities of the secured and unsecured creditors when monies realized from the sale or other foreclosure of collateral are dis- tributed. In a lien-supported financial derivative, the Swap Provider will typically want its share of the proceeds of a distribution pro rata with the Lender. The Lender, if it is also performing the role of Collateral Agent under the agreement, typically will receive priority distributions for expenses it incurs by acting as the Collateral Agent. As such, administrative fees under the intercreditor agreement must be clearly defined as sepa- rate from any amounts payable to the Lender in its capacity as a Lender. In the inter- creditor agreement negotiations, the Swap Provider will seek to have all amounts owed to it included in the definition of “swap obligations” so that its ratable share will be increased.
(C) OTHER ISSUES
Other important issues to be considered during the negotiations of an intercreditor agreement are the definitions of key terms (including “collateral,” “event of default,”
and “permitted liens”) and the proper identification of all the project documents — the agreements which establish and govern the project financing, the swap transaction, and the security interests.
The intercreditor agreement often incorporates many definitions and requirements from the loan agreement so those definitions and requirements must be carefully
SWAP TRANSACTION AGREEMENTS
analyzed to make certain they work in the context of the intercreditor agreement for all parties. For example, loan agreements often require that any additional liens on the collateral securing the Lender satisfy the requirements of a “permitted lien” as defined in the loan agreement. Additionally, the granting of a lien on the collateral may require a formal approval from the Lender. Requirements such as these must be addressed in the intercreditor agreement to avoid inconsistent contractual provisions.
It should always be remembered during the process of negotiations that the inter- creditor agreement is typically the only agreement in which all of the secured creditors (and often the debtor too) are a party, therefore, especially, for the Swap Provider who is not a party to the loan agreement, it represents an opportunity, likewise, a risk, to try to protect its interests in the best way possible and to protect itself from materially adverse provisions in the loan agreement.
Also because it is the only agreement executed among all the parties, it is important that it contain the right to require consent to any material amendment of any of the project documents. This does not necessarily have to apply to every amendment because not all will be relevant to a nonamending party. Parties should limit consent require- ments to issues that could materially affect each party’s rights to its security position.
III. SWAP TRANSACTION AGREEMENTS
In addition to all of the agreements discussed above, in an OTC lien-supported financial derivative transaction, the Project Company and the Swap Provider will also need to enter into an International Swaps and Derivatives Association (ISDA) Master Agreement, which establishes the general terms and conditions applicable to each individual swap transaction that is entered into between them. This ISDA Master Agreement and its related schedules, annexes, and transaction confirmations are published by ISDA.
Ideally, the ISDA Master Agreement should be executed prior to the time the parties intend to execute any swap transactions. The ISDA Master Agreement is essentially a form that contains a number of preestablished terms and conditions that have become industry standard. Negotiations of individual transactions to be entered into from time to time under such a master agreement are free to focus only on the crucial business issues, because the standard terms have already been established by the ISDA Master Agreement.
Certain elections among various alternative provisions, and any specific amend- ments or deletions of other general terms and conditions under the ISDA Master Agreement for a particular transaction are memorialized in a schedule to the ISDA Master Agreement (ISDA Schedule). Such changes are set forth in the ISDA Schedule and are never made to the ISDA Master Agreement itself.