In a move that diminishes many of the legal uncertainties concerning the continued availability of swaps to ERISA plans in the Dodd-Frank world, the Department of Labor (DOL) recently issued an advisory opinion1 that addresses the applicability of the ERISA fiduciary and prohibited transaction rules to “cleared swaps” entered into by ERISA plans. The Opinion also provides support to common market practices relating to the applicability of such rules to collateral posted by ERISA plans to secure obligations under non-cleared swaps.
Congress adopted the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) in 2010 to establish a comprehensive regulatory framework for swaps. Dodd-Frank amended the Commodity Exchange Act (CEA), and the Commodity Futures Trading Commission (CFTC) issued a final regulation under the CEA2 in late 2012 (the Regulation) relating to the clearing process.
In effect, Dodd-Frank provides that, unless an exemption is available,3 it is unlawful to enter into any swap that is required to be cleared unless the swap is entered on a designated execution facility and cleared through a derivatives clearing organization or other recognized central clearing party (CCP).4
Similar to the process used in the futures market, the process to clear a swap involves at least three parties: (i) the counterparty that enters the swap to hedge a market risk or exposure (in the present context, the ERISA plan); (ii) a financial intermediary that is a clearing member of the CCP (the Clearing Member); and (iii) the CCP. To effect a cleared swap, the counterparty and (directly or indirectly) the Clearing Member negotiate the terms of the swap. Once agreed, the counterparty and the Clearing Member enter into the swap and the Clearing Member submits the swap to the CCP for clearing. If accepted for clearing, the CCP steps between the counterparty and the Clearing Member and the swap becomes subject to the rules of the CCP. As a result of this process, the counterparty looks to the CCP to perform on the swap and the CCP looks to the Clearing Member, as guarantor of the counterparty, to perform on the swap. Under an agreement that governs the clearing relationship, the Clearing Member looks to the counterparty to make it whole for amounts paid to the CCP. A CCP manages its risk to a Clearing Member through minimum capital and credit requirements, maintenance of a default fund, requirements for initial and variation margin and segregation of margin. A Clearing Member manages its risk to a counterparty by requiring margin and through broad remedies to liquidate the counterparty’s account and sell margin (whether held by the Clearing Member or the CCP).
As discussed more fully below, to address concerns expressed on behalf of the financial intermediaries that would enter into cleared swaps with ERISA plans, the DOL opined that (i) neither the Clearing Member nor the CCP would be an ERISA fiduciary upon the exercise of liquidation rights against an ERISA plan counterparty; (ii) margin posted by an ERISA plan pursuant to the requirements of the CCP or the Clearing Member would not constitute “plan assets”; (iii) the Clearing Member, but not the CCP, would be a party-in-interest to the plan counterparty, and (iv) transactions between the Clearing Member and the plan that would otherwise be prohibited under ERISA may be exempted if the conditions of either Prohibited Transaction Exemption 84-14 (QPAM Exemption) or Prohibited Transaction Exemption 96-23 (INHAM Exemption) are met.
Importantly, the DOL largely based its Opinion on its interpretation that neither Congress, in enacting Dodd-Frank, nor the CFTC in issuing the Regulation, contemplated that Clearing Members or CCPs would act as ERISA fiduciaries to plan customers. The DOL also conferred with the CFTC in drafting the Opinion, and received authorization from the CFTC to state that it concurred with the DOL’s description of “cleared swap” transactions, and that the CFTC does not believe that the conclusions the DOL reached are inconsistent with Dodd-Frank or the Regulation.
Is a Clearing Member or CCP a fiduciary to the plan counterparty?
Under ERISA, a person will be a plan fiduciary to the extent that it exercises any authority or discretionary control respecting management of the plan or exercises any authority or control respecting the management or disposition of the plan’s assets.
In its discussion, the DOL first opined that any margin held by the Clearing Member or CCP is not a plan asset. In reaching this conclusion, the DOL analogized the margin deposited with a Clearing Member for a swap to margin for a futures contract which it previously had determined not to be a plan asset.5 In particular, the DOL noted that margin for a cleared swap would be in the nature of a performance bond that indicates a commitment by the ERISA plan to abide by its obligations under the swap and that the plan would have no ownership interest in the assets deposited as margin. On this basis, the DOL concluded that such margin would not constitute a plan asset under ERISA. The DOL further noted that, in the context of a cleared swap, the plan assets would be the rights of the ERISA plan embodied in the swap contract as evidenced by the written agreement with the Clearing Member. The DOL took the view that the exercise of the Clearing Member’s contractual rights does not necessarily amount to the type of authority or control over plan assets contemplated under ERISA.
Accordingly, neither the Clearing Member nor the CCP will be an ERISA fiduciary with respect to a plan counterparty.
Is the Clearing Member or CCP a party in interest with respect to the plan engaging in a swap?
When a swap contract is cleared, each of the original swap counterparties makes payments to a CCP through a Clearing Member. The DOL took the position that the CCP does not provide services to the plan, and will not be deemed to be a party in interest with respect to the plan solely by reason of providing clearing services for the plan’s Clearing Member.
However, the DOL opined that, by virtue of its direct contractual agreement with the plan, the Clearing Member is providing services to the plan and, as a result, would be a party in interest with respect to the plan within the meaning of section 3(14)(B) of ERISA.
Will the exercise of the Clearing Member’s default rights or status as a party in interest result in “prohibited transactions” under ERISA?
Certain transactions between a plan and the Clearing Member that occur in connection with swap transactions are prohibited under section 406(a) of ERISA unless an exemption applies. Prohibitions include the sale or exchange of property between a plan and a party in interest under section 406(a)(1)(A), the provision of services between a plan and a party in interest under section 406(a)(1)(C), and the provision of the direct or indirect lending of money or other extension of credit between a plan and a party in interest under section 401(a)(1)(B). Because “extension of credit” includes the guarantee of an obligation, the Clearing Member’s guarantee of the plan’s obligations to the CCP would be a prohibited transaction under ERISA. Accordingly, the Clearing Member’s actions must be covered by an exemption to enable it to enter into any of these transactions with the plan.
The DOL opined that the “QPAM Exemption”6 provides relief from the prohibited transactions listed in section 406(a)(1)(A) through (D) of ERISA, provided that a “qualified professional asset manager” negotiates and makes the decision to enter into the transaction. The DOL stated that the “INHAM Exemption”7 would similarly provide relief.
The Opinion should bring more certainty to both ERISA plan fiduciaries and Clearing Members wishing to engage in cleared swaps with an ERISA plan. Although the Opinion has been rendered in the context of swaps for which the CFTC has determined that clearing is required, unless the SEC adopts a radically different approach to clearing, we would expect the Opinion also to be relevant to “securitybased swaps” entered into by an ERISA plan.