Implications of the Financial Reform Legislation for End Users of Derivatives
We have previously summarized the general implications of The Wall Street Transparency and Accountability Act (TWSTAA) for various participants in the derivatives markets. TWSTAA, which was enacted as Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act, amends the Commodity Exchange Act (CEA) and the Securities Exchange Act of 1934 (Exchange Act) to provide for comprehensive regulation of derivatives markets, including for the first time bi-lateral over-the-counter (OTC) transactions as well as new categories of regulated market facilities and regulated market professionals. This Legal News Alert focuses on those provisions of TWSTAA impacting end users that use derivatives primarily in connection with their financing and portfolio management activities, including a summary of the practical implications on existing end-user swap activities.
The Role of the Federal Regulators
Specific implications to end users of many of the TWSTAA provisions will depend on regulations to be promulgated by various federal regulators.
As a general matter, the Commodity Futures Trading Commission (CFTC) is responsible for implementing the provisions pertaining to swaps other than security-based swaps, and the SEC is responsible for implementing the provisions pertaining to security-based swaps. The two agencies will jointly regulate mixed swaps, which are a type of security-based swap with a commodity component.
The CFTC and SEC are given expansive authority to adopt rules and issue interpretations. For certain matters, they are required to adopt rules jointly; for others, they are required to consult with one another and with the prudential regulators before commencing a rulemaking or issuing an order to assure regulatory consistency, to the extent possible.
The Federal Reserve Board, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Farm Credit Administration, and the Federal Housing Finance Agency are the “prudential regulators,” and are given certain authority under TWSTAA with respect to banks, bank affiliates, or others subject to their oversight that act as swap dealers, security-based swap dealers, major swap participants, or major security-based swap participants. In particular, they are responsible for adopting capital requirements and margin requirements for uncleared swaps for any such entities, in lieu of the CFTC or SEC.
The CFTC and SEC are in the process of developing rules in the many areas required to implement this expansive legislation. Importantly, they are currently providing interested persons an opportunity to submit their views in advance of the publication of proposed rules by the CFTC and SEC for formal public comment.
Defining Swaps and Security-Based Swaps
“Swaps” are defined very broadly and include various interest rate protection products employed by end users in their financings, such as interest rate swaps, floors, caps, and collars. Foreign exchange forwards and swaps are covered by the swap definition, but the Secretary of the Treasury has the authority to exempt either or both from most regulation as swaps under the CEA, if the Secretary determines that such contracts are not structured to evade the legislation.
The definition of “security-based swap” covers swaps that are based (i) on a narrow-based index of securities, including any interest therein or on the value thereof; (ii) on a single security or loan, including any interest therein or on the value thereof; or (iii) on the occurrence, nonoccurrence, or extent of the occurrence of an event relating to a single issue or the issuers of securities in a narrow-based security index, if the event directly affects the financial statements, condition, or obligations of the issuer. The definition covers options on Treasury securities, but not other swap structures on Treasury securities, which are excluded from the definition. The definition also covers single issuer credit default swaps and swaps on a narrow-based credit default index, but not swaps on a broad-based credit default index.
Swap Dealers, Major Swap Participants, Security-Based Swap Dealers, and Major Security-Based Swap Participants
It is likely that typical counterparties facing end users will be considered swap dealers, security-based swap dealers, major swap participants, or major security-based swap participants; however, an end user also might fit within one of those definitions.
A person is considered to act as a “swap dealer” if it (i) holds itself out as a dealer in swaps; (ii) makes a market in swaps; (iii) regularly enters into swaps for its own account in the ordinary course of business; or (iv) engages in activities causing the person to be commonly known as a dealer or market maker in swaps. A “security-based swap dealer” is similarly defined with respect to security-based swaps. A person may be a swap dealer or a security-based swap dealer for a single type, class, or category of swap or security-based swap and not for others.
An FDIC-insured bank or savings association is excluded from the term swap dealer to the extent it offers to enter into a swap with a customer in connection with originating a loan with that customer.
A person is considered to act as a “major swap participant” if it is not a dealer, but (i) it maintains a substantial position in outstanding swaps for any major swap category, excluding positions held for hedging or mitigating commercial risk (see below) or, in the case of an employee benefit plan as defined in §§ 3(3) and (32) of ERISA, for hedging or mitigating risk associated with the plan’s operation; (ii) its outstanding swaps create substantial counterparty exposure that could have a serious adverse effect on the financial stability of the U.S. system or U.S. financial markets; or (iii) it is a financial entity that is highly leveraged relative to the amount of capital it holds, it is not subject to capital requirements established by a federal banking agency, and it maintains a substantial position in outstanding swaps for any major category of swap. A “major security-based swap participant” is similarly defined with respect to security-based swaps. A person may be designated as a major swap participant or a major security-based swap participant for one or more categories of swaps or security-based swaps.
Following agency adoption of registration rules (which must be completed within one year of TWSTAA’s enactment), persons acting as swap dealers or major swap participants with respect to swaps must register in that capacity with the CFTC. Persons acting as swap dealers or major swap participants with respect to security-based swaps must register as security-based swap dealers or major security-based swap participants with the SEC.
Swap dealers, security-based swap dealers, major swap participants, and major security-based swap participants also will have to comply with various requirements, ranging from business conduct practices, capital requirements, margin requirements for uncleared swaps, segregation of a counterparty’s initial margin deposits on non-cleared transactions at the counterparty’s request, swap documentation practices, and requirements to designate a chief compliance officer.
Special Duties Owed by Swap Dealers, Major Swap Participants, Security-Based Swap Dealers, and Major Security-Based Swap Participants to “Special Entities”
Certain special obligations will apply to swap dealers, major swap participants, security-based swap dealers, and major security-based swap participants when acting as an advisor or swap counterparty to a “special entity,” which term includes a federal agency; a state, state agency, city, county, municipality, or other state political subdivision; an employee benefit plan under § 3 of ERISA; a government plan under § 3 of ERISA; or an endowment, including one organized under § 501(c)(3) of the Internal Revenue Code. Some of these special obligations, however, may not apply to an FDIC-insured bank or savings association when it enters into a swap with a customer in connection with originating a loan with that customer, since it will not be considered to be acting as a swap dealer.
When acting as an adviser to a special entity with respect to swaps or security-based swaps, swap dealers, major swap participants, security-based swap dealers, and major security-based swap participants are expressly prohibited from engaging in certain fraudulent or deceptive conduct. In addition, a swap dealer or security-based swap dealer that acts as an adviser to a special entity has a duty to act in the special entity’s best interests and is required to make reasonable efforts to obtain such information as is necessary to make a reasonable determination that any swap it recommends is in the best interests of the special entity, including information relating to the special entity’s financial and tax status, investment or financing objectives, and any other information the regulators prescribe.
When acting as a counterparty to a special entity, swap dealers, major swap participants, security-based swap dealers, and major security-based swap participants must have a reasonable basis to believe that the special entity is represented by a qualified independent representative acting in the special entity’s best interests. Although not entirely clear, it appears that this requirement applies only with respect to special entities that are governmental entities. In addition, before initiating a swap transaction with a special entity, a swap dealer must disclose the capacity in which it is acting. The language is unclear whether the same requirement applies to a major swap participant when acting as a counterparty to a special entity. More specific standards and requirements may be promulgated by the regulators.
The foregoing obligations do not apply in connection with transactions initiated by a special entity on an exchange or a swap execution facility or security-based swap execution facility or if the swap dealer, security-based swap dealer, major swap participant, or major security-based swap participant does not know the counterparty’s identity.
Mandatory Clearing and Centralized Trading If the End User Exception Is Inapplicable
Mandatory clearing will not happen immediately and will likely be implemented incrementally, but that will depend upon how the CFTC (for swaps) and SEC (for security-based swaps) exercise their new regulatory authority. A particular swap or security-based swap, or group, category, type, or class of swap or security-based swap, is subject to mandatory clearing only after the CFTC or SEC, as applicable, has determined that it should be. Either agency may reconsider a mandatory clearing determination on its own initiative or upon application of a counterparty, and the clearing requirement is stayed during the reconsideration process. Before those provisions may be implemented, the CFTC and SEC have to adopt the requisite procedural rules, and have one year to do so.
Once mandatory clearing is implemented for any swap or security-based swap, transactions in that instrument must be traded on a CFTC- or SEC-regulated exchange or swap execution facility, unless no such centralized market exists offering the instrument for trading.
If a swap is required to be cleared, it is unlawful for a person to enter into a swap or security-based swap transaction that is not submitted to a clearing facility that is registered with, or exempted from registration by, the CFTC or SEC, as applicable.
End User Exception to Mandatory Clearing and Centralized Trading
Once mandatory clearing applies to a particular swap or security-based swap, transactions in that instrument may nonetheless be exempt from clearing and centralized trading requirements pursuant to an “end user exception.” The exception is available if: (i) one of the parties is not a financial entity; (ii) it is using swaps or security-based swaps to hedge or mitigate commercial risk; and (iii) it can demonstrate to the CFTC or SEC, as applicable, how it generally meets its financial obligations under its non-cleared swap or security-based swap transactions. The exception may be available to an end user’s affiliate under certain circumstances. The term “commercial risk” is not defined; however, the CFTC and the SEC each are authorized to define such term in their regulations. In addition, it remains to be seen how the regulators will implement the requirement regarding demonstrating satisfaction of financial obligations.
For purposes of the exception, a “financial entity” is a person that is a swap dealer or security-based swap dealer; a major swap participant or major security-based swap participant; a commodity pool; a private fund under § 202(a) of the Investment Advisers Act; an employee benefit plan under §§ 3(3) and (32) of ERISA; or a person predominantly engaged in banking or financial activities as defined under § 4(k) of the Bank Holding Company Act. The CFTC or SEC, though, may exclude small banks, savings associations, and farm credit unions from the term.
Reporting, Margin, and Other Rules Applicable to Non-Cleared and OTC Transactions
Transactions that are not required to be cleared must be reported to a swap data repository registered with the CFTC or SEC, or to the CFTC or SEC if no swap data repository is available that will accept the transaction report. Margin requirements also will apply to swap dealers, security-based swap dealers, major swap participants, and major security-based swap participants with respect to their sides of the uncleared transactions. Those parties also may be required to hold funds posted by an end user counterparty to margin or secure the end user’s obligations on a segregated basis at an independent custodian, without comingling with their own funds.
The counterparties to transactions in swaps or security-based swaps that are permitted to occur on an OTC non-cleared basis must be “eligible contract participants” under the CEA definition. TWSTAA amended that definition to increase the qualification requirements with respect to (i) a governmental entity by increasing the amount it must own and invest on a discretionary basis from at least $25 million to at least $50 million in investments, and (ii) an individual by requiring the individual to have amounts invested on a discretionary basis (instead of total assets) of at least $10 million or $5 million if hedging.
Practical Implications for Current Swaps Activities
As a general matter, the TWSTAA provisions will not be implemented for at least one year, though certain provisions could apply sooner. Until then, end users may continue to engage in swap activities pursuant to the exclusions and exemptions from CEA regulation upon which they have previously relied. Thus, for example, counterparties that are eligible contract participants under the CEA definition may enter into interest rate swap transactions with one another as principals. Following implementation of the TWSTAA provisions, for swap transactions permitted to occur on an OTC basis, counterparties will still have to meet the eligible contract participant test (under a revised and more restrictive definition of the term).
Certain provisions, once implemented, could apply to swaps that an end user enters into during this interim period before the TWSTAA provisions take effect as well as to swaps entered into prior to enactment of the new law.
- Once the applicable regulator adopts reporting rules for uncleared swap transactions, as contemplated in the legislation, the reporting requirements will apply to any then-existing swap transactions. Based on discussions with the CFTC, we believe it is unlikely that those requirements will take effect sooner than one year from enactment of TWSTAA. So long as the transactions are reported, the mandatory clearing provisions will not apply to OTC swap transactions that may still be open when such clearing provisions are implemented.
- Once the regulators adopt margin requirements for swap dealers and major swap participants for uncleared transactions, those requirements will likely apply to then-existing swap transactions. This would effectively amend the credit support terms negotiated between the parties if one (or both) is a swap dealer or major swap participant. Unless specifically reserved in the documentation, the swap dealer or major swap participant may not use the imposition of margin as a basis to terminate or renegotiate the terms of the swap on grounds that it constitutes a termination event, force majeure, illegality, increased cost, regulatory change, or similar event.
- A counterparty to swaps on physical commodities also may become subject to CFTC-imposed position limits, if the counterparty increases the size of its position after the limits are adopted. Position limits are not likely to be an issue for interest rate or foreign currency swaps.
- Once the TWSTAA provisions are implemented, the end user, when negotiating a swap with a swap dealer or major swap participant, is given control over whether to: (i) require the swap to be cleared if clearing is available but not required, (ii) invoke (if eligible) the end user exception from clearing if clearing is required, and (iii) require its counterparty to hold the initial margin collateral it posts on a segregated basis with a third-party independent custodian.
The attached chart (http://www.foley.com/files/Derivatives2010.pdf), which we update on a regular basis, provides a more detailed analysis of TWSTAA.
Legal News Alert is part of our ongoing commitment to providing up-to-the-minute information about pressing concerns or industry issues affecting our clients and colleagues. If you have any questions about this update or would like to discuss this topic further, please contact your Foley attorney or the following:
Authors:
Kathryn M. Trkla
Partner
Chicago, Illinois
312.832.5179
[email protected]
David M. Reicher
Partner
Milwaukee, Wisconsin
414.297.5763
[email protected]
Contributors:
George T. Simon
Chair, Securities, Commodities & Exchange Regulation Practice
Chicago, Illinois
312.832.4554
[email protected]
Scott E. Early
Partner
Chicago, Illinois
312.832.4352
[email protected]
Robert J. Zimmerman
Partner
Chicago, Illinois
312.832.4521
[email protected]
