Title VII of the Dodd-Frank financial reform, titled the “Wall Street Transparency and Accountability Act of 2010” (“Title VII”), was enacted on July 21, 2010.1 Under Title VII, which is generally intended to bring the $700 trillion over-the-counter (“OTC”) derivatives market under greater regulation, the Commodity Futures Trading Commission (“CFTC”) has primary responsibility for the regulation of “swaps” and the Securities and Exchange Commission (“SEC” and, together with the CFTC, the “Commissions”) has primary responsibility for the regulation of “security-based swaps.” The Commissions share responsibility for the regulation of “mixed swaps.” A summary of several noteworthy developments in the implementation of Title VII since our last update follows.
1. Joint Report on International Swap Regulation
As required by Section 719(c) of Title VII, the Commissions conducted a study comparing how swaps and security-based swaps are regulated in the United States, Asia and Europe and identifying areas of regulation that could be harmonized across geographic regions. The study also identified major dealers, exchanges, clearinghouses and regulators in each region, as well as the methods for clearing swaps and the systems for setting margin in each region. On January 31st, the Commissions provided a report (the “Joint Report”) to Congress setting forth the findings of their study. The Commissions believe that the substantial information on the global OTC derivatives market they gathered in connection with their study makes this report “a timely comparative tool in the ongoing effort to achieve consistency in regulation.”2
The Joint Report is separated into four sections: (i) a discussion of the Congressional mandate for the study and Joint Report, including the process and approach used by the Commissions in conducting the study; (ii) a description of the regulatory framework for OTC derivatives in each of the three geographic regions; (iii) an analysis of the similarities and differences across jurisdictions, including a discussion of potential areas for harmonization; and (iv) a conclusion of the study and related appendices. Among the many “open issues” identified by the Commissions were differences across proposed regulations in the United States and Europe in the scope of transactions potentially subject to mandatory clearing (and exemptions available to end-users), as well as potential differences in models for the segregation of collateral related to cleared swaps. The Joint Report concludes by pointing out that the regulation of OTC derivatives has just begun, and that efforts to identify gaps and inconsistencies across various regulations will require continued monitoring of global reform efforts and close collaboration with international counterparts.3
2. Publication of Final Rules
The CFTC has yet to publish many of the final rules required of it by Title VII. In an effort to manage market expectations and permit market participants to more effectively prepare for the publication of its remaining final rules and interpretive orders, at a meeting held on January 11th, the CFTC discussed a tentative timeline for the publication of many of its rules.4 This timeline specifies 11 rules and orders expected to be published before March 31st (including those relating to the “end-user” exception to clearing and product definitions) and 11 rules and orders expected to be published after April (including capital and margin rules and rules for the segregation of collateral for uncleared swaps). The timeline was produced in preliminary form and is subject to change.
3. Speculative Trading Limits
On November 18, 2011, the CFTC published its final rule5 establishing position limits for futures and options contracts on 28 commodities, as well as “economically equivalent” futures, options and swaps contracts. This rule, which is intended to curb speculation and initially gained traction as a result of the commodity price spikes of 2008, has been one of the most contested and controversial of all CFTC rulemakings under Title VII, with a staggering number of comment letters submitted by market participants.
The rule establishes two types of limits—spot-month position limits and non-spot-month position limits—and will be implemented in two phases. The first phase becomes effective 60 days after the effectiveness of the regulators’ final rule defining the term “swap” and the second phase, which is relevant for non-spot-month limits for certain contracts, becomes effective by CFTC order, once the Commission has obtained a year’s worth of open interest data for economically equivalent transactions. A limited exemption exists in the final rules for bona fide hedging transactions. The CFTC estimates that, based on historical information, approximately 84 traders in legacy agricultural contracts, 50 traders in non-legacy agricultural contracts, 85 traders in energy contracts and 12 traders in metals contracts will hold or control positions that could exceed the specified position limits annually.
Shortly after its publication, two industry groups, the International Swaps and Derivatives Association, Inc. (“ISDA”) and the Securities Industry and Financial Markets Association (“SIFMA”) jointly filed suit challenging the rule in both the federal district court for the District of Columbia and the federal court of appeals for the District of Columbia. Among other things, they allege that, in arriving at the final rules, the CFTC had not made the required findings as to whether position limits were even necessary, had not presented a reasoned explanation for the discretion it exercised in establishing the rules, and did not conduct an adequate cost-benefit analysis with respect to the rules. On January 17th, the district court stayed all proceedings and ordered the parties to file a joint status report at a later date advising the court of the status of the court of appeals proceedings and whether the district court should continue the stay.6 However, on January 20th, the court of appeals dismissed the case there, deciding that there is no express authority of direct appellate review of the petition.7 Specifically, the court of appeals stated that “[i]nitial review occurs at the appellate level only when a direct-review statute specifically gives the court of appeals subject-matter jurisdiction to directly review agency action,”8 which was not the case in the legislation applicable to the petition.
On February 7th, ISDA and SIFMA filed a preliminary injunction motion with the district court to delay the implementation of the rule until the case was resolved, arguing that the rule was imposing significant and irreversible costs on certain market participants.
4. The Definition of “Swap Dealer”
Non-financial energy companies continue to express concern over the CFTC’s proposed rules regarding their potential regulation as “swap dealers”9 under Title VII. The Dodd-Frank Act subjects swap dealers to substantial regulation, including registration, mandatory exchange trading and clearing requirements, margin and capital rules, robust business conduct standards and reporting and recordkeeping requirements. The CFTC has estimated that approximately 40 non-bank entities, including energy companies and others, will seek registration as swap dealers under Title VII because they currently “offer” commodity and other swaps. Many of these nonbank market participants and industry groups object to being categorized as swap dealers and continue to voice their concern to the CFTC about the costs associated with registering as swap dealers. On February 14th, seven energy trade associations sent a letter to the White House Chief of Staff and others stating that the proposed definition of swap dealer “would result in commercial end-users who use swaps to hedge their commercial risk and reduce price volatility for their customers being misclassified as swap dealers.”10 One study published on December 20, 2011 by National Economic Research Associates Inc. (“NERA”) estimated that each of the 26 non-banks it studied would incur costs attributable to margin, capital and other expenses (e.g., compliance with reporting and recordkeeping requirements and business conduct standards) of approximately $388 million if subject to regulation as a swap dealer. However, supporters of a broad definition of “swap dealers” argue that the conclusions of the NERA report are inflated and that the creation of an exemption from regulation for nonbanks may inadvertently permit banks to also benefit from the exemption.
Market participants continue to examine risks, negotiate documentation and invest in infrastructure in connection with an increase in central clearing of swaps mandated by Title VII. To this end, on January 11th, ISDA announced the membership and charter of a new committee, known as the Industry Clearing Committee. The committee membership includes a broad range of market participants, including buy-side firms, sell-side firms, futures commission merchants (“FCMs”) and central clearing counterparties. The purposes of the committee, which was formed in June 2011, are to help coordinate industry efforts to extend the reach of central clearing, operate as a forum for potential product offerings, address challenges to clearing and coordinate with governmental and other bodies on clearing matters for the OTC derivatives market.
6. Collateral Segregation for Cleared Swaps
On February 7th, the CFTC published final rules11 regarding the protection of cleared swaps customer collateral (the “Final Collateral Rules”) in which it adopted an approach referred to as the “Legally Segregated Operationally Commingled Model” (also known as “complete legal segregation”).12 This model generally requires FCMs to hold the collateral of cleared swaps customers segregated from their own property, but permits FCMs to pool and commingle the collateral of such customers in a single omnibus account. The Final Collateral Rules also require that the collateral of cleared swaps customers be invested in accordance with CFTC Regulation 1.25, the same rule that governs the investment of futures customer collateral. The primary purpose of the Final Collateral Rules is to insulate cleared swaps customers from the risk of default of other customers of an FCM.
FCMs will be required to provide to derivatives clearing organizations (“DCOs”) of which they are a member daily information regarding cleared customer collateral, including the identity of underlying customers whose positions are being held in the account, the portfolio of positions held by those customers and the collateral required for those positions. Such reporting is intended to provide DCOs with recent and detailed information enabling them to respond to crises quickly and tie customer collateral to customer positions.
Under the complete legal segregation model adopted by the CFTC, if losses by an FCM’s cleared swaps customer result in a default to the DCO, then the relevant DCO would have recourse solely to the collateral of the defaulting customer and the FCM itself, and not the property of the non-defaulting customers of the FCM. Significantly, however, the rules do not protect customers from the risk of loss due to the actions (e.g., negligence, theft or other mishap) of its FCM or the risk of loss on investment of the collateral. As Commissioner Scott D. O’Malia noted in a statement accompanying the rulemaking, the Final Collateral Rules only protect customers from “fellow-customer” risk, and not from the two other inherent risks: “investment risk” (i.e., risk of loss from investing the collateral in risky instruments) and “operational risk” (i.e., risk of loss due to the improper segregation by intermediaries of collateral). For example, if upon the bankruptcy of an FCM there is a shortfall in the cleared swaps customer account due to misappropriation by the FCM, cleared swaps customers would share pro rata in that shortfall in accordance with the provisions of the U.S. Bankruptcy Code.
The alleged diversion of up to $1.2 billion in customer collateral by MF Global for its own use in October 2011 has cast a spotlight on the protection of customer funds from an FCM’s negligence or malfeasance. As a result of the MF Global situation, some market participants called for the inclusion in the Final Collateral Rules of an option for the full physical segregation of cleared swaps collateral.13 No such option was included, leading some to argue that the new clearing requirements and segregation rules may leave them in a more vulnerable position than the execution of over-the-counter bilateral arrangements that include tri-party custodial agreements with custody banks. The Final Collateral Rules become effective on April 9, 2012.
7. Reporting and Recordkeeping
On January 13th, the CFTC published final rules regarding swap data recordkeeping and reporting requirements.14 A few days earlier, on January 9th, the CFTC published final rules on the real-time reporting of swap transaction data.15 Together, these final rules establish a new regime for market counterparties to report swaps to regulated swap data repositories (“SDRs”), for SDRs to publicly report the basic economic terms of swaps in “real time” and for market participants to retain records relevant to their swaps.
The type of data to be reported, the party required to report and the time period within which such data is to be reported in accordance with the final rules is complicated and fact-dependent. Generally, if a swap is executed on an exchange or other trading platform, then that facility (and not the swap counterparties) must report specified data regarding the swap to an SDR, as soon as “technologically practicable.” If a swap is executed outside of an exchange or other trading platform, then the relevant “reporting counterparty” (e.g., the swap dealer where a swap is executed with an end-user) is responsible for reporting specified data regarding the swap to an SDR. In turn, SDRs are required to publicly disseminate certain swap data they receive as soon as technologically practicable after receipt, although time delays may apply in connection with block trades. SDRs are required to establish policies to protect the confidentiality of certain information they receive, such as the identity of the swap counterparties. Also, if the notional amount of a swap exceeds a cap specified by the CFTC, then the SDR will reflect that cap as the notional amount for the relevant swap.
Each of the relevant regulated parties (including swap dealers, major swap participants and trading platforms) are required under the final rules to maintain comprehensive records relating to an executed swap in paper or electronic form for five years following the termination of a swap; such information must be “readily accessible” in real time for the first two of these years, then retrievable within three business days for the subsequent three years. End-users have similar recordkeeping requirements to those applicable to swap dealers, except that they are allowed additional flexibility in the time allotted for the retrieval of records.
8. Business Conduct Standards
On January 11th, the CFTC adopted final business conduct rules for swap dealers and major swap participants (together, “regulated entities”).16 Among other things, the business conduct rules: (i) prohibit regulated entities from engaging in abusive practices (e.g., fraud, deception or manipulation) in entering into swaps with their counterparties; (ii) require disclosure of material information regarding a swap by regulated entities to counterparties; and (iii) require regulated entities to undertake certain due diligence when dealing with counterparties. The rules also require that regulated entities provide daily marks on uncleared swaps to their counterparties, notify them of their right to clear swaps (and select the DCO) and communicate with them in a fair and balanced manner based on principles of fair dealing and good faith.
The final business conduct rules also impose additional obligations on regulated entities when dealing with governmental entities, employee benefit plans subject to the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), and certain other counterparties, known collectively as “special entities.” A swap dealer that acts as an advisor to a special entity by recommending a swap or swap trading strategy tailored for that entity must act in the best interest of that entity. However, a swap dealer will not be deemed to be an advisor to a special entity if it does not express an opinion as to whether that entity should enter into a tailored swap; the special entity represents that it is not relying on the advice of the swap advisor, but rather on the advice of its “independent representative”; and the swap dealer discloses that it is not acting in the special entity’s best interest. Moreover, swap dealers must have a reasonable basis to believe that a special entity that is its counterparty (other than a plan subject to ERISA), inter alia, has an independent representative that is competent, is acting in the best interests of the special entity and evaluates the fair pricing and appropriateness of the swap for the special entity.
As discussed in an earlier client alert,17 the proposed business conduct rules, together with proposed U.S. Department of Labor (“DOL”) regulations that significantly expanded the definition of a “fiduciary” under ERISA, created significant uncertainty for swap dealers. Among other things, there was concern that those regulations could bestow fiduciary status on swap dealers, which would preclude them from entering into swaps with special entities subject to ERISA. The final business conduct rules, when coupled with the DOL’s withdrawal of its proposal, have substantially allayed swap dealer concerns.18