On July 10, 2012, the Commodity Futures Trading Commission (“CFTC” or “Commission”) adopted regulations governing the “end-user exception” to the requirement under the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) that standardized swaps be cleared through a derivatives clearing organization. Swaps that are required to be cleared must be executed on a designated contract market (“DCM”) or swap execution facility (“SEF”) if the swap is available for trade on a DCM or SEF. The regulations implement Section 723 of the Dodd-Frank Act, which provides an exception to this general clearing mandate if one of the counterparties to the swap “(i) is not a financial entity; (ii) is using swaps to hedge or mitigate commercial risk; and (iii) notifies the Commission, in a manner set forth by the Commission, how it generally meets its financial obligations associated with entering into non-cleared swaps.”
The regulations set forth the requirements to qualify to elect the end-user exception, the methods for electing the exception, and the reporting requirements when the exception is elected. Generally, the counterparty electing the end-user exception must not be one of a group of enumerated financial entities and must use the swap to hedge physical or financial risks arising from the conduct of its business. The election is made on a swap-by-swap basis, and the fact of the election and the identify of the electing counterparty must be reported by the counterparty responsible for reporting the primary economic terms of the swap. The regulations set forth options for reporting the electing counterparty’s eligibility to make the election, either by the reporting counterparty at the time of swap execution or by the electing counterparty on an annual basis. The Commission added the option to report eligibility on an annual basis, rather than a swap-by-swap basis, in response to comments received in response to the proposed rules.
The regulations technically will become effective 60 days after publication in the Federal Register, but compliance will not be required until the CFTC mandates the clearing of particular categories of swaps (likely beginning in late 2012) and those orders become enforceable on different categories of market participants. In an earlier release, the CFTC proposed a staggered schedule under which swap dealers and major swap participants would have 90 days to comply with such clearing mandates and non-financial entities who are not swap dealers or major swap participants would have 270 days to comply.1 If that proposal is ultimately adopted by the CFTC, non-financial entities that are not swap dealers or major swap participants would likely have until the fall of 2013 either to begin clearing their swaps or to comply with the end-user requirements outlined in the newly adopted regulations.
Definition of Financial Entity.
For a swap to qualify for the end-user exception to the clearing requirement, the party electing the exception must not be a “financial entity.” The regulations incorporate the definition of “financial entity” set forth in Section 2(h)(7)(C)(i) of the Commodity Exchange Act (“CEA”), which includes:
- swap dealers and security-based swap dealers;
- major swap participants and major security-based swap participants;
- commodity pools;
- private funds as defined in section 202(a) of the Investment Advisers Act of 1940 (15 U.S.C. 80-b-2(a));
- employee benefit plans as defined in paragraphs (3) and (32) of section 3 of the Employee Retirement Income Security Act of 1974 (29 U.S.C. 1002); and
- persons predominantly engaged in activities that are in the business of banking, or in activities that are financial in nature, as defined in section 4(k) of the Bank Holding Company Act of 1956.
The regulations also exempt from the definition of financial entity a bank with total assets of $10 billion or less on the last day of the most recent fiscal year.
The Dodd-Frank Act also provides that an affiliate of a person that qualifies for the end-user exception may qualify for the exception as well, even if the affiliate is a financial entity or if the affiliate is acting as an agent on behalf of the qualifying entity and the swap at issue is used to hedge or mitigate the commercial risk of the qualifying non-financial entity. However, this affiliate exception does not apply to affiliates that are swap dealers, major swap participants, or other specified entities.2
The Commission clarified that it will not treat inter-affiliate swaps differently than other swaps for purposes of qualifying for the end-user exception. If one affiliated counterparty qualifies to elect the exception, it may do so, even if its other affiliated counterparty is a financial entity that does not qualify to elect the exception.
In addition, certain captive finance companies are excluded from the definition of financial entity if they satisfy three criteria. First, their primary business must be providing financing. Second, they must use derivatives “for the purpose of hedging underlying commercial risks related to interest rate and foreign currency exposures, 90 percent or more of which arise from financing that facilitates the purchase or lease of products . . . .” Third, 90 percent or more of the products financed must be manufactured by the captive finance company’s parent company or another subsidiary of the parent company.
Hedging or Mitigating Commercial Risk.
In order to be eligible for the end-user exception to the clearing requirement, a swap must be used to “hedge or mitigate commercial risk.” The risks hedged through the swap can be physical commodity risks or financial risks. A swap can satisfy the end-user hedging requirement in one of three ways. First, a swap qualifies as an end-user hedge if it is “economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise,” where the risks arise from changes in the value of assets, liabilities, services, or interest, currency or foreign exchange rates. Second, if the swap qualifies as a “bona fide hedge” under the CFTC’s position limits rule, it also qualifies as a hedge under the end-user rule.3 Third, any swap that qualifies for hedging treatment under Financial Accounting Standards Board Accounting Standards Codification Topic 815 or Governmental Accounting Standards Board Statement 53 meets the hedging requirement under the end-user rule.
Speculating, Investing, or Trading Activities Do Not Qualify for the End-User Exception.
Swaps entered into for the purpose of speculating, investing or trading do not qualify for the exception. The Commission described such swaps as “executed primarily for the purpose of taking an outright view on market direction or to obtain an appreciation in value of the swap position itself and not primarily for hedging or mitigating underlying commercial risks.” It further clarified that the term “trading” does not mean simply the process of buying and selling but “entering and exiting swap positions for purposes that have little or no connection to hedging or mitigating commercial risks incurred in the ordinary course of business.” Whether a swap qualifies is to be determined by the facts and circumstances that exist at the time of execution, and there is no requirement that counterparties continue to test the hedge’s effectiveness once the swap is entered.
It is important to note that eligibility for the end-user exception is determined on the basis of individual swaps. An entity that qualifies for the exception with respect to one or more swaps may enter into other speculative swaps, so long as it does not elect the exception with respect to those ineligible swaps. By the same token, simply because some of an entity’s swaps qualify for the exception does not extend the exception to other swaps that do not themselves qualify.
Swaps Used to Hedge Other Swaps Can Qualify for the End-User Exception.
Swaps used to hedge other swaps may qualify for the exception only if the underlying swap itself is used to hedge or mitigate commercial risk. Portfolio hedges and dynamic hedges may also qualify for the exception. The Commission does not require that hedges address a single risk or that they remain static after they are executed.
When a swap counterparty elects the end-user exception, the counterparty that is responsible for reporting the swap’s primary economic terms to a swap data repository (“SDR”) must provide the SDR notice that the end-user exception has been elected and the identity of the electing counterparty.4 If the reporting counterparty is not the counterparty electing the exception, it must have a reasonable basis to believe that the electing counterparty meets the requirements to elect the end-user exception. Other required information may either be reported by the reporting counterparty on a swap-by-swap basis or through an annual filing by the electing counterparty that covers swaps to be entered into during the ensuing 365 days. If the electing counterparty files an annual report, it must amend its annual filing in the event there are material changes to the information provided. The regulations do not elaborate on what would constitute a material change. Information that may be reported on a swap-by-swap basis or in an annual report includes:
- whether the electing counterparty is a financial entity and, if so, whether it is (a) electing the exception as a captive finance company or as an affiliate acting as an agent for a non-financial entity or (b) exempt from the definition of financial entity because it is a bank with total assets of $10 billion or less;
- whether the swap is used to hedge or mitigate commercial risk; and
how the electing counterparty generally meets its financial obligations associated with entering into non-cleared swaps through one or more of:
- a written credit support agreement;
- pledged or segregated assets (including posting or receiving margin);
- a written third-party guarantee;
- available financial resources; or
- other means.
Board Approval to Enter into Uncleared Swaps.
If the electing counterparty is an issuer of securities registered under Section 12 of the Securities Exchange Act of 1934 (“’34 Act”) or is required to file reports under Section 15 of the ’34 Act, its SEC Central Index Key must be reported, and it must report whether an appropriate committee of the counterparty’s board of directors, or similar body, has generally approved the decision to enter into non-cleared swaps subject to the end-user exception. Board review need not be done on a transaction-by-transaction basis, as the Commission had proposed in the proposed rules, but must be reviewed on at least an annual basis, or more often if the entity implements a new hedging strategy not contemplated in the original board approval.
Click here to link to the Final Rule.