Post on 30-Dec-2015
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7th Annual Gas & Power Institute
September 4-5, 2008
Managing “Gap Risk” Between Standard FormTrading Agreements
Craig R. Enochs
Craig R. Enochs cenochs@jw.com
Jackson Walker L.L.P.1401 McKinney, Suite 1900
Houston, Texas 77010(713) 752-4200 phone
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Selected Sources of “Gap Risk”
I. Issues Common to the NAESB, ISDA, EEI and CTAA. Notices
B. Events of Default
C. Setoff
II. Other Agreement Differences:A. Termination, Liquidation & Settlement: NAESB, ISDA and EEI
B. Confirmation Procedures: NAESB, ISDA and CTA
C. Netting: NAESB and ISDA
D. Transfer and Assignment: CTA and ISDA
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A. Notices1. NAESB § 9
Methods: Fax, mutually-accepted electronic means, overnight courier, first class mail or hand delivery
General Rule: deemed delivered when received on a Business Day
If no proof of actual receipt, the following presumptions apply: Fax: deemed delivered when sending party receives fax machine’s
confirmation of successful transmission. If after 5:00 p.m., deemed received the following Business Day
Overnight Courier or Mail: deemed delivered on following Business Day after sent, or earlier if confirmed by receiving party
First Class Mail: deemed delivered five (5) Business Days after mailing
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A. Notices2. ISDA Master § 12(a): Gas, Power and Coal Annexes
Writing/Hand Delivery: effective on date delivered
Fax: effective on date received by responsible recipient in legible form
Proof of receipt is on sending party and cannot be proven through fax confirmation
Certified or Registered Mail: effective on date delivered (or delivery is attempted)
Electronic Messaging System: effective on date received
Email (2002 ISDA): effective on date delivered
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A. Notices
2. ISDA Master § 12(a): Gas, Power and Coal Annexes (cont.)
If notice (i) not delivered on Local Business Day, or (ii) is delivered after close of business, notice deemed delivered on following Local Business Day
Notices relating to Events of Default or Termination Events may not be sent by electronic messaging system (1992/2002), fax (1992) or email (2002 ISDA).
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A. Notices
3. EEI § 10.7
Fax or Hand Delivery:
If received during business hours on a Business Day, notice deemed effective at the close of business on such day
If received after business hours, deemed effective at close of business on following Business Day
Overnight Courier or U.S. Mail:
Deemed effective on the following Business Day after sent
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A. Notices
4. CTA § 10.3
Electronic means, fax or hand delivery:
If delivered during business hours on a Business Day, notice deemed received at close of business on such day
If delivered after business hours, deemed received on close of business of following Business Day
Overnight mail or courier:
Deemed received one (1) Business Day after sent
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A. Notices
5. Risk Analysis
Operational Risk:
Various methods of notice permitted in trading contracts
Ex: ISDA contemplates electronic means, including email (2002 ISDA), but EEI does not contemplate electronic means unless otherwise elected by the parties
Inconsistent notice provisions across trading agreements
More likely that manner or method of notice may be insufficient
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A. Notices5. Risk Analysis (cont.)
Credit and Payment Risk: Ineffective notice may create credit risk as to a defaulting
counterparty:
Ex: ISDA does not allow electronic means (1992/2002), fax (1992) or email (2002) notices with respect to Events of Default or Termination Events
If notice is ineffective, Non-Defaulting Party cannot declare an Early Termination Date
Parties should consider consistent notice provisions across trading contracts
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B. Events of Default
1. 2002 v. 2006 NAESB: § 10.2
2002 and 2006 NAESB: each includes the following Events of Default:
Failure to pay Bankruptcy Default under Credit Support Obligations
2006 NAESB: adds “Additional Event of Default,” which may be elected on Cover Sheet
Indebtedness Cross Default: party or Guarantor defaults on agreements relating to indebtedness for borrowed money
Transactional Cross Default: party or Guarantor defaults under a Specified Transaction.
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B. Events of Default
1. 2002 v. 2006 NAESB: § 10.2 (cont.)
Risk Analysis:
Additional Events of Default in 2006 NAESB mitigate credit and commercial risks by looking to performance of obligations outside the NAESB
2006 NAESB closes some “gap risk” by moving the 2002 NAESB closer to the EEI and ISDA
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B. Events of Default
2. 1992 v. 2002 ISDA: § 5(a)-(b)
2002 ISDA modifies cure periods:
Failure to pay or deliver: § 5(a)(i) One (1) Local Business Day instead of three (3) Local Business Days
Default Under Specified Transaction: § 5(a)(v)(2) One (1) Local Business Day instead of three (3) Local Business Days
Bankruptcy § 5(a)(vii)(1)(B): Fifteen (15) days instead of thirty (30) days
Risk Analysis: shorter cure periods mitigate credit risk
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B. Events of Default
2. 1992 v. 2002 ISDA (cont.)
Breach of Agreement: § 5(a)(ii)
2002 ISDA expands Breach of Agreement: Event of Default if a party “disaffirms, disclaims, repudiates or rejects…
or challenges the validity of” the ISDA
With respect to the 2002 language, the 30-day cure period in § 5(a)(ii) does not apply
Risk Analysis: allows swifter action when a counterparty clearly indicates it will not honor its ISDA obligations
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B. Events of Default
2. 1992 v. 2002 ISDA (cont.)
Default Under Specified Transaction: § 5(a)(v)
2002 ISDA expands on events which constitute a default, including: Default under credit support arrangement relating to a Specified
Transaction Challenging the validity of a Specified Transaction
“Specified Transaction” includes “catch-all” clause to capture future derivatives products not otherwise stated
Risk Analysis: Avoids the risk that certain actions may not properly trigger the
Event of Default Avoids the risk that certain derivatives may be inadvertently
excluded from the laundry list of “Specified Transactions”
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B. Events of Default
2. 1992 v. 2002 ISDA (cont.)
Cross Default: § 5(a)(vi)
2002 ISDA: To determine whether a party has exceeded Threshold Amount, party may look to both (i) principal of accelerated obligations, and (ii) unpaid amounts
1992 ISDA: Party cannot combine accelerated obligations and unpaid amounts to determine Threshold Amount
Risk Analysis: 2002 ISDA makes Cross Default much more sensitive and useful in situations where a counterparty commits multiple defaults, but some defaults are difficult to ascertain
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B. Events of Default
2. 1992 v. 2002 ISDA (cont.)
Merger Without Assumption: § 5(a)(viii)
2002 ISDA expands to include reorganization, reincorporation and reconstitution
Risk Analysis: Mitigates credit risk by diminishing the ambiguity of what corporate action triggers this Event of Default
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B. Events of Default
2. 1992 v. 2002 ISDA (cont.)
Credit Support Default: § 5(a)(iii)
2002 ISDA expands to include circumstances when a security interest granted under a Credit Support Document fails to be in full force and effect
Risk Analysis: Mitigates credit risk by expanding Event of Default upon failure under either (i) Credit Support Document, or (ii) security interest granted under such document.
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B. Events of Default3. NAESB v. ISDA Gas Annex
Common Events of Default: NAESB § 10.2; ISDA § 5(a) Failure to pay when due Breach of credit obligations Insolvency and bankruptcy-related events
Events of Default in ISDA not found in NAESB: Breach of Agreement (other than failure to pay) Misrepresentations Default under Specified Transaction
Similar to Transactional Cross Default election in 2006 NAESB Cross Default
Similar to Indebtedness Cross Default election in 2006 NAESB Merger Without Assumption
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B. Events of Default3. NAESB v. ISDA Gas Annex (cont.)
Termination Events in ISDA not found in NAESB: Illegality Force Majeure Event (2002) Tax Event and Tax Event Upon Merger Credit Event Upon Merger Additional Termination Event
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B. Events of Default
4. EEI v. ISDA Power Annex
Common Events of Default: EEI § 5.1 and ISDA § 5(a):
Failure to pay when due
False or misleading representations
Breach of Agreement (other than failure to pay)
Insolvency and bankruptcy-related events
Breach of credit obligations
Merger without assumption
Cross Default
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B. Events of Default
4. EEI v. ISDA Power Annex (cont.)
Events of Default and Termination Events in ISDA not found in EEI:
Default under Specified Transaction
Illegality
Force Majeure Event (2002 ISDA)
Tax Event and Tax Event Upon Merger
Credit Event Upon Merger
Additional Termination Event
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B. Events of Default5. CTA v. ISDA Coal Annex
Common Events of Default: CTA § 8.1; ISDA § 5(a) Failure to Pay Breach of Agreement (other than failing to pay/deliver)
CTA: Cure Period of ten (10) Business Days, but potential extension of up to sixty (60) days
ISDA: Thirty (30)/Fifteen (15) Business Days (1992/2002) Credit Support Default Misrepresentation Cross Default Bankruptcy
ISDA triggering events more broad (e.g., passing resolutions for winding up or appointment of receiver)
Failure by Seller to provide reasonable assurances as to future coal shipments after non-conforming shipments are delivered
CTA § 8.1(e); Coal Annex, Appendix 1, § 13
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B. Events of Default5. CTA v. ISDA Coal Annex (cont.)
Event of Default in CTA not found in ISDA: Material Adverse Change
Parties elect MAC definition on Cover Sheet: Credit Rating Trigger (as set by Parties) Event that has a material adverse effect on operations, financial condition
or business of a Party as a whole Even if MAC occurs, it is not an Event of Default if Defaulting Party
establishes and maintains Performance Assurance for the duration of the MAC
Risk Analysis: MAC provision mitigates credit risk by entitling a Party to either (i) receive
Performance Assurance, or (ii) declare Event of Default when the other Party shows signs of financial distress that may not fit cleanly in another Event of Default
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B. Events of Default5. CTA v. ISDA Coal Annex (cont.)
Events of Default/Termination Events in ISDA not found in CTA:
Default Under Specified Transaction
Merger Without Assumption
Illegality
Force Majeure Event (2002)
Tax Event/Tax Event Upon Merger
Credit Event Upon Merger
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B. Events of Default6. Automatic Early Termination under ISDA
How it works: Upon occurrence of certain bankruptcy events, an Early Termination
Date is deemed to occur Parties do not follow Early Termination Date notice procedures
Not in standard NAESB, EEI or CTA
May be useful in jurisdictions without U.S. Bankruptcy Code “safe harbor” provisions
Between U.S. counterparties, often not elected: Avoids risk of termination without Non-Defaulting Party’s knowledge Allows for cure and/or negotiation of better terms Avoids risk of unwanted Settlement Payments by Non-Defaulting Party
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B. Events of Default7. Risk Analysis: Events of Default
Events of Default mitigate credit and payment risks with respect to the Defaulting Party
More ways to terminate under ISDA than under NAESB, EEI or CTA, but all may not be necessary for every transaction
Risks of underlying transaction help determine which Events of Default make sense
Short-Term v. Long-Term Index Price v. Fixed Price
Automatic Early Termination: May be beneficial under certain circumstances May create operational and credit risk if elected in some but not all contracts with a
counterparty
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C. Setoff
1. 2002 v. 2006 NAESB: § 10.3.2
Elected on Cover Sheet of both 2002 and 2006 NAESB
2002 NAESB: Other Agreement Setoff
If Other Agreement Setoffs apply, bilateral setoff is the only option
Non-Defaulting Party sets off Net Settlement Amount against:
Margin or collateral held by Non-Defaulting Party
Any amounts payable by the Defaulting Party to the Non-Defaulting Party under any other agreement
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C. Setoff
1. 2002 v. 2006 NAESB: § 10.3.2 (cont.)
2006 NAESB: Other Agreement Setoffs – 2 Options
Bilateral Setoff: Same as setoff in 2002 NAESB
Triangular Setoff: Same as setoff in 2002 NAESB, plus
Setoff Net Settlement Amount owed to Non-Defaulting Party against amount(s) owed by Non-Defaulting Party or Affiliates to Defaulting Party;
Setoff Net Settlement Amount owed to Defaulting Party against amount(s) owed by Defaulting Party to Non-Defaulting Party or Affiliates;
Setoff Net Settlement Amount owed to Defaulting Party against amount(s) owed by Defaulting Party or Affiliates to Non-Defaulting Party
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C. Setoff
2. 1992 v. 2002 ISDA
1992 ISDA: No setoff provision
2002 ISDA: Setoff provision in § 6(f)
Non-defaulting Party may setoff Early Termination Amount against any other amounts owed between the parties
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C. Setoff3. NAESB v. ISDA Gas Annex
NAESB § 10.3.2: Election on Cover Sheet
Other Agreement Setoffs Apply: 2002 NAESB: Bilateral 2006 NAESB: Bilateral or Triangular, as elected by the parties
Other Agreement Setoffs Do Not Apply Setoff limited to amounts owed under the NAESB.
ISDA Gas Annex:
2002 ISDA § 6(f): Setoff provision
Setoff amounts owed between the parties arising under ISDA or any other agreement
No cross-Affiliate setoff
Identical to setoff in 2002 NAESB
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C. Setoff4. EEI v. ISDA Power Annex
EEI § 5.6: Setoff options elected on Cover Sheet
Option A: Non-Defaulting Party sets off obligations owed by Defaulting Party to Non-Defaulting Party under any agreements between the Parties
Options B: Non-Defaulting Party sets off obligations owed by Defaulting Party (or its Affiliates) to the Non-Defaulting Party (or its Affiliates) under any agreements between the Parties and/or their Affiliates
ISDA Power Annex:
2002 ISDA: Setoff provision in § 6(f)
Setoff amounts owed between the parties arising under ISDA or any other agreement
No cross-Affiliate setoff
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C. Setoff5. CTA v. ISDA Coal Annex
CTA § 8.3
Upon an Event of Default, Non-Defaulting Party sets off amounts owed between the Parties under the CTA
ISDA: 2002: Setoff provision § 6(f)
Setoff amounts owed between the parties arising under ISDA or any other agreement
No cross-Affiliate setoff
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C. Setoff6. Risk Analysis: Risks Mitigated by Setoff
Commercial Risks: Immediately extinguishes payment obligations Reduces involvement in bankruptcy proceedings
Credit Risks: Amounts owed by Defaulting Party are immediately setoff
Cash Flow Risk: No waiting for payments from Defaulting Party
Enterprise-wide risks among Affiliates: Manages risk of having to pay Termination Payments across trading contracts and
Affiliates
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II. Other Agreement Differences
Potentially Creating “Gap Risk”
A. Termination, Liquidation & Settlement (NAESB, ISDA and EEI)
B. Confirmation Procedures (NAESB, ISDA and CTA)
C. Netting (NAESB and ISDA)
D. Transfer and Assignment (CTA and ISDA)
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A. Termination, Liquidation & Settlement1. 2002 v. 2006 NAESB § 10.3: Terminating Transactions
2002 and 2006 NAESB: Upon designation of Early Termination Date, all transactions must be terminated and liquidated, except for “Excluded Transactions”
2002 NAESB: Excluded Transactions
May not be terminated and liquidated under law; and
Commercially impracticable to terminate in the reasonable opinion of Non-Defaulting Party
2006 NAESB: Excluded Transactions
May not be terminated or liquidated under law NOTE: does not include “commercially impracticable” transactions
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A. Termination, Liquidation & Settlement
1. 2002 v. 2006 NAESB § 10.3: Terminating Transactions (cont.)
Risk Analysis:
Practical Risk: Inability to Liquidate Transactions
A Non-Defaulting Party under the 2006 NAESB may not be able to terminate and liquidate certain transactions as of the Early Termination Date if they are commercially impracticable
Example: Gas purchases at illiquid Delivery Points
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A. Termination, Liquidation & Settlement
2. 1992 v. 2002 ISDA § 6: Calculation and Payment of Amounts Upon Termination
1992 ISDA § 6(e) Market Quotation or Loss calculation method One-way or two-way payment (First or Second method)
2002 ISDA § 6(d)-(e) Close-out Amount: Hybrid of Market Quotation and Loss
Calculation of gains, losses and costs incurred in replacing or realizing the economic equivalent of terminated transactions.
Determining Party may use internal valuations of its losses and costs, but also must use third-party quotations or market data in valuing transactions
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A. Termination, Liquidation & Settlement
2. 1992 v. 2002 ISDA § 6: Calculation and Payment of Amounts Upon Termination (cont.)
Risk Analysis:
Close-out Amount mitigates risk of subjective valuations under Loss calculation method
Close-out Amount more flexible than Market Quotation because a party may look to internal data and estimated losses
Close-out Amount is more subjective than Market Quotation and more objective than Loss
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A. Termination, Liquidation & Settlement3. NAESB v. ISDA Gas Annex: Calculation and Payments of
Amounts Owed Upon Termination
NAESB § 10.3.1
Non-Defaulting Party determines: Amount owed by each party for Gas delivered and received on or before the
Termination Date
All other applicable charges related to such deliveries and receipts for which payment has not yet been made
If “Additional Termination Damages” apply: Liquidation and acceleration of Terminated Transactions at Market Value
If Market Value greater than Contract Value, difference due to Buyer
If Market Value less than Contract Value, difference due to Seller
Default two-way payment
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A. Termination, Liquidation & Settlement3. NAESB v. ISDA Gas Annex: Calculation and Payment of Amounts
Owed Upon Termination (cont.)
ISDA § 6(e): Market Quotation and Loss
Market Quotation: Value of Terminated Transactions based on quotations from Reference-Market
Makers plus any Unpaid Amounts owed to Non-Defaulting Party; minus
Unpaid Amounts owed to the Defaulting Party
Loss: Non-Defaulting Party’s total losses and costs resulting from early termination
and liquidation, including loss of bargain, costs of funding, and costs of terminating, liquidating or reestablishing any hedge
ISDA § 6(e): First and Second Method
One-way v. two-way payment
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A. Termination, Liquidation & Settlement
4. EEI v. ISDA Power Annex: Calculation and Payment of Amounts Owed Upon Termination
EEI: § 5.2: Non-Defaulting Party calculates Settlement Amount for each
Terminated Transaction in a “commercially reasonable manner”
§ 5.3: Settlement Amounts netted into Termination Payment, payable either to or from the Non-Defaulting Party
Default two-way payment unless changed by parties
ISDA: § 6(e): Market Quotation or Loss, as elected by parties ISDA § 6(e): First or Second Method, as elected by the parties
(one-way or two-way payment)
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A. Termination, Liquidation & Settlement
5. NAESB, EEI and ISDA: Risk Analysis
Inherent operational risks in various calculation methods:
NAESB method and Market Quotation are substantively similar, while EEI requires calculation in a “commercially reasonable manner”
Use of market quotes may not accurately reflect actual or anticipated value of transactions
Subjective nature of Loss calculation
Inconsistent Payment Risks to Defaulting Party:
NAESB and EEI are two-way payment
Potential exposure if one-way payment elected in ISDA
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B. Confirmation Procedures
1. NAESB v. ISDA Gas Annex
NAESB § 1.2: Procedure elected on Cover Sheet
Oral Transaction Procedure Transaction is binding when parties orally agree upon terms Failure to send Transaction Confirmation does not affect performance
obligations
Written Transaction Procedure Parties must exchange non-conflicting Transaction Confirmation before
parties legally obligated to perform
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B. Confirmation Procedures
1. NAESB v. ISDA Gas Annex (cont.)
ISDA § 9(e)(ii):
Parties legally bound from the moment they agree on commercial terms
Confirm Transaction terms by sending written Confirmations
No other specific terms or procedures in form ISDA
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B. Confirmation Procedures
2. CTA v. ISDA Coal Annex
CTA § 1.1
Parties are bound when terms agreed upon (whether oral or written)
Buyer shall provide Confirmation with commercial terms
If Seller disputes terms, Parties use “commercially reasonable efforts” to resolve the dispute within ten (10) Business Days
If dispute cannot be resolved, Parties may seek “any other remedy” under the CTA
ISDA § 9.2(e)(ii)
Parties legally bound from the moment they agree on commercial terms, and confirm by sending written Confirmations
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B. Confirmation Procedures
3. NAESB, CTA and ISDA: Risk Analysis
Confirmation procedures should conform to risk in underlying transactions
Short-term v. Long-term
Risk of disagreement regarding future performance obligations
Operational Risk in Confirming Transactions
Buyer confirms in CTA, Seller confirms in NAESB and ISDA does not specify
Inconsistent Dispute Resolution Procedures NAESB and CTA v. ISDA
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C. Netting1. NAESB v. ISDA Gas Annex
NAESB § 7.7 All payments due and owing (or past due and owing) netted into single
amount The party owing the greater amount shall make a single payment to the other
party Not limited to amounts owed under a single transaction
ISDA § 2(c) Netting generally limited to amounts due (i) on the same date; (ii) in the same
currency; and (iii) in respect of the same Transaction. Can be modified by the parties in the Schedule
Risk Analysis: Inconsistent netting provisions across multiple agreements may create cash
flow and operational risks Cross-Transactional Netting: NAESB v. ISDA
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D. Transfer and Assignment
1. CTA v. ISDA Coal Annex
General Rule: No transfer or assignment without prior written consent of other party (CTA § 10.1; ISDA § 7)
CTA: Consent cannot be unreasonably withheld or delayed ISDA: No “reasonableness” requirement
Exceptions in CTA:
Financing or financial arrangements
Affiliate at least as creditworthy as assignor
Person succeeding to all or substantially all of Party’s assets (merger, reorganization, or otherwise)
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D. Transfer and Assignment
1. CTA v. ISDA Coal Annex (cont.)
Exceptions in ISDA:
Transfers of rights to receive Termination Payments from Defaulting Party
Consolidation, merger or transfer of all assets
Risk Analysis:
CTA provides more flexibility
ISDA may make transfers more difficult, time consuming and expensive