July 21, 2012 marked the second anniversary of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) becoming law and imposing a comprehensive regulatory regime on swaps and security-based swaps. Shortly before that anniversary, the Commodity Futures Trading Commission (CFTC) adopted a rule (End-User Rule) implementing the end-user exception (End-User Exception) to the mandatory swap clearing requirement (Clearing Requirement) of Section 2(h)(1) of the Commodity Exchange Act (CEA).1 The Clearing Requirement will apply to particular swaps once the CFTC makes an effective determination that the requirement applies to those swaps or a group, category, class or type of swaps into which such swaps fall.
Of particular importance to companies with a class of securities registered under Section 12 of the Securities Exchange Act of 1934 (Exchange Act) or required to file reports under Section 15(d) of the Exchange Act (Reporting Companies) that want to elect the End-User Exception is the End-User Rule’s requirement that the decision to enter into non-cleared swaps must be approved by an appropriate committee of their boards of directors.
The End-User Rule will become effective on September 17, 2012. For reasons discussed below, the compliance date for the End-User Rule remains uncertain.
This client alert discusses the End-User Rule and certain practical considerations for companies that use swaps to hedge or mitigate their commercial risks.
End-User Exception. When enacting Dodd-Frank, Congress recognized that swaps used by companies to hedge commercial risks constitute a relatively small portion of the swaps market and that most such swaps need not be subject to the Clearing Requirement. As a result, Congress enacted Section 2(h)(7) of the CEA to provide the End-User Exception.
The End-User Rule implements that statutory provision.2
Companies that use swaps to hedge commercial risks in their businesses will usually want to avoid submitting their swaps for clearing. For those companies, the End-User Exception will be of great importance because it permits eligible counterparties to exclude qualifying swaps from the Clearing Requirement.
Clearing and execution requirements. The Clearing Requirement provides that parties may not engage in a swap to which the Clearing Requirement applies unless the swap is submitted for clearing to a derivatives clearing organization that is registered or exempt from registration. Compounding the burden of the Clearing Requirement, Section 2(h)(8) of the CEA provides that transactions in a swap that is subject to the Clearing Requirement must be executed on a board of trade designated as a contract market (DCM) or a swap execution facility (SEF) that is registered or exempt from registration if a DCM or SEF makes such a swap available to trade on the DCM or SEF (Execution Requirement). Complying with these requirements for a swap will make a company’s entry into the swap more difficult and time consuming and might prove to reduce significantly a company’s ability to execute an efficient hedging program.
Election eligibility requirements. A counterparty to a swap may elect the End-User Exception for a swap if the electing counterparty:
- is not a “financial entity” (as defined in Section 2(h)(7)(C)(i) of the CEA);
- is using the swap for which the election is made to hedge or mitigate commercial risk; and
- provides or causes to be provided specified information to a registered swap data repository (SDR) or, if an SDR is not available to receive the information, the CFTC.
CFTC approval of an election to rely on the End-User Exception as to a swap will not be required. An affiliate of a person qualifying to use the End-User Exception may itself qualify to use the exception. To do so, the affiliate must (1) be acting on behalf, and as the agent, of a person qualifying to use the End-User Exception, (2) be using the swap to hedge or mitigate commercial risk of the qualifying person or another non-financial entity affiliate of that person and (3) not be a swap dealer, a major swap participant or certain other types of entity.
Who is a “financial entity”? The term encompasses more than banking institutions and includes any:
- swap dealer (as defined in the CEA and related rules);3
- major swap participant (as defined in the CEA and related rules);
- security-based swap dealer (as defined in the Exchange Act and related rules);
- major security-based swap participant (as defined in the Exchange Act and related rules);
- commodity pool (as defined in the CEA and related rules);
- private fund (as defined in Section 202(a) of the Investment Advisers Act of 1940) (e.g., a hedge fund);
- employee benefit plan of the type defined in Sections 3(3) and 3(32) of the Employee Retirement Income Security Act of 1974 (generally speaking, employee welfare and pension benefit plans); and
- a company predominantly engaged in activities that are in the business of banking or that are “financial in nature” (as defined in Section 4(k) of the Bank Holding Company Act of 1956).
Most commercial companies using swaps are unlikely to be a financial entity unless their swaps or security-based swaps create such significant outward exposure to counterparties that they are a major swap participant (discussed below) or major security-based swap participant.
A captive finance subsidiary using swaps to hedge the interest and currency rate risks of its business might not be a “financial entity.” The CEA excludes from the definition of “financial entity” an entity (1) whose primary purpose is to provide financing and (2) uses derivatives for the purpose of hedging underlying commercial risks related to interest rate and foreign currency exposures so long as 90 percent or more of those risks arise from financing that facilitates the purchase or lease of products and 90 percent or more of such products are manufactured by its parent company or a sister subsidiary. The CFTC will require that only the final products manufactured by the parent or sister subsidiary, not the components of those products, be considered when calculating the percentage of financed products manufactured by the parent or sister company.
The End-User Rule also provides that federally-insured banks, savings associations and credit unions with less than $10 billion of assets are exempt from the definition of “financial entity.”
Who is a “major swap participant”? A major swap participant is a person (1) who is not a swap dealer, and (2)(a) who maintains a substantial position in swaps for any of the major swap categories designated under the CFTC rules, excluding both positions held for hedging or mitigating commercial risk (defined in the same manner as in the End-User Rule) and positions maintained by any employee benefit plan to hedge or mitigate risk directly associated with the plan’s operation, (b) whose outstanding swaps create substantial counterparty exposure that could have serious adverse effects on the financial stability of the United States banking system or financial markets or (c) who is a highly leveraged financial entity not subject to federal regulatory capital requirements.
As a practical matter, companies whose swaps exist solely for the purpose of hedging or mitigating commercial risk should not have a “substantial position in swaps” for these purposes. Moreover, a company whose exposure to its swap counterparties is largely collateralized should not have “substantial counterparty exposure.” A company would have that type of exposure only if the daily average aggregate uncollateralized outward exposure under its swaps exceeds $5 billion or the daily average aggregate uncollateralized outward exposure plus daily average aggregate potential outward exposure under its swaps exceeds $8 billion.
What constitutes “hedging or mitigating commercial risk”? The End-User Rule uses the following two-pronged test to determine if a swap is used for “hedging or mitigating commercial risk:”
- first, the swap must:
- be economically appropriate to reduce risks in the conduct and management of a commercial enterprise, where the risks arise from one of six enumerated potential occurrences;
- qualify as a bona fide hedge for purposes of exemption from the position limits under the CEA;4 or
- qualify for hedging treatment under Financial Accounting Standards Board’s Accounting Standards Codification Topic 815 or the Governmental Accounting Standards Board Statement 53; and
- second, the swap must not be used:
- for a purpose in the nature of speculation, investing or trading; or
- to hedge or mitigate the risk of another swap or a security-based swap position unless the other swap or security-based swap position is itself used to hedge or mitigate commercial risk.
The enumerated potential occurrences from which the hedged or mitigated risks may arise for purposes of the “economically appropriate” element of the first prong of the test described above are:
- the potential change in the value of assets a person owns, produces, manufactures, processes or merchandises or reasonably anticipates owning, producing, manufacturing, processing or merchandising in the ordinary course of its business;
- the potential change in the value of liabilities that a person has incurred or reasonably anticipates incurring in the ordinary course of its business;
- the potential change in the value of services that a person provides, purchases or reasonably anticipates providing or purchasing in the ordinary course of its business;
- the potential change in the value of assets, services, inputs, products or commodities that a person owns, produces, manufactures, processes, merchandises, leases or sells, or reasonably anticipates owning, producing, manufacturing, processing, merchandising, leasing or selling in the ordinary course of its business;
- any potential change in value related to any of the foregoing arising from interest, currency or foreign exchange rate movements associated with such assets, liabilities, services, inputs, products or commodities; or
- any fluctuation in interest, currency or foreign exchange rate exposures arising from a person’s current or anticipated assets or liabilities.
The CFTC noted in the Adopting Release that whether a swap satisfies the criteria for hedging or mitigating commercial risk and whether the swap is economically appropriate to reduce the risks it is intended to address are facts and circumstances determinations to be made by the electing counterparty when it assesses whether it is eligible to elect the End-User Exception for the swap. The CFTC emphasized that the hedging or mitigation of financial risks must be an incidental, not central, part of the electing counterparty’s business. Moreover, the CFTC will view swaps entered into and exited for purposes having little or no connection with hedging or mitigating commercial risk as being traded and not used for hedging or mitigating commercial risk.
Whether a swap is hedging or mitigating commercial risk must be determined on a swap-by-swap basis. Fortunately, the CFTC has indicated that it will not require end users to demonstrate the effectiveness of hedges at the time they elect the End-User Exception for swaps or to test hedges periodically for continuing effectiveness unless the CFTC sees abuses of the End-User Exception. The CFTC considers swaps used in dynamic hedging or portfolio hedging of commercial risk as possibly qualifying for the End-User Exception.
Reporting requirements. The information to be reported to elect the End-User Exception as to a swap is:
- notice of the election of the End-User Exception for that swap;
- the identity of the electing counterparty;
- whether the electing counterparty is a financial entity and, if it is a financial entity, whether it is electing the End-User Exception as an affiliate of a person qualifying to use the exception or a captive finance subsidiary or it is exempt from the “financial entity” definition as a smaller financial institution as described above;
- whether the swap for which the election is made is used by the electing counterparty to hedge or mitigate commercial risk;
- how the electing counterparty generally meets its financial obligations associated with entering into non-cleared swaps; and
- for a Reporting Company only, the company’s SEC Central Index Key number and a statement of whether an appropriate board committee has approved the company’s decision to enter into swaps that are exempt from the Clearing Requirement and the Execution Requirement.
The election notice and the electing counterparty’s identity must be provided on a swap-by-swap basis at the time of the election (as a practical matter, when the swap is to be initially executed). The other information described above may be provided either on a swap-by-swap basis by the reporting counterparty or on an annual basis by the electing counterparty. Information provided annually must have been reported to an SDR or, if applicable, the CFTC within the 365 days prior to the date on which the swap is initially executed.
At this time, only one SDR is registered with the CFTC, although other SDRs have applications pending before the CFTC. The registered SDR is provisionally registered to receive reports relating to an election of the End-User Exception for only certain categories, classes and types of swaps, including certain interest rate swaps.
Information provided on a swap-by-swap basis will be reported by the reporting counterparty for the swap. Whether the electing counterparty or the other counterparty to the swap is the reporting counterparty will be determined under the CFTC’s rules for determining the reporting counterparty for the swap generally,5 although the electing counterparty will report any information being reported on an annual basis.
The reporting counterparty must have a reasonable basis to believe that the electing counterparty meets the requirements for the End-User Exception for a particular swap. The Adopting Release noted that a reporting counterparty must do reasonable due diligence to establish the basis for its belief regarding the electing counterparty’s eligibility to elect the End-User Exception, and that such due diligence obligation may often be satisfied by the receipt of representations from the electing counterparty. However, the CFTC cautioned that if the reporting counterparty has a reasonable basis to believe that such representations are not accurate for a swap, it may not rely on such representations to discharge its due diligence obligation.
The End-User Rule specifies that an electing counterparty will report how it generally meets its obligations under its non-cleared swaps by identifying one or more of the following means:
- a written credit support agreement (CSA);
- pledged or segregated assets (including posting or receiving margin pursuant to a CSA);
- a third party written guarantee;
- the electing counterparty’s available financial resources; or
- other means.
Those familiar with existing swaps practice will recognize that swap counterparties often use a combination of means to ensure performance of their swap obligations. The combination of a CSA, often providing for the posting of cash or other collateral when the exposure of a swap party to its counterparty exceeds a stated threshold, and available financial resources frequently constitute the means for meeting those obligations. The CFTC expects that this practice will continue and for multiple means of meeting the electing party’s obligations to be reported.
Board committee approval of the End-User Exception election. A Reporting Company’s decision to enter into swaps that are exempt from the Clearing Requirement and the Execution Requirement must be approved by an appropriate committee of its board of directors. Oddly, approval by the entire board of directors will not satisfy this specific requirement of the CEA and the End-User Rule. This approval requirement does not apply to any company that is not a Reporting Company.
The CFTC will consider an appropriate board committee for these purposes to be a committee of the board of directors that “is specifically authorized to review and approve the [Reporting Company]’s decision to enter into swaps.”6 Although the CFTC may not have intended this statement to be taken literally and may have intended that the board committee need only be authorized to approve the company’s entry into swaps that are exempt from the Clearing Requirement and the Execution Requirement, to avoid an issue of technical compliance, the board committee should have the authority to approve the company’s entry into all swaps.
The charter of the relevant committee or a resolution adopted by the entire board of directors should delegate to the appropriate board committee the authority to review and approve the Reporting Company’s entry into all swaps. Although boards often delegate to members of management the authority to approve the company’s entry into a swap, the committee approving the decision to enter non-cleared swaps must have the authority described above to ensure technical compliance with the End-User Rule. Otherwise, the CFTC says it will leave to the reasonable discretion of boards of directors to determine the appropriate committee to perform such tasks. In addition, either the committee’s charter or a resolution of the entire board of directors should delegate to the relevant committee the authority to approve the Reporting Company’s decision to enter into swaps that are exempt from both the Clearing Requirement and the Execution Requirement.
In a change from the CFTC’s position regarding the proposed End-User Rule, the board committee may approve the decision to enter into non-cleared swaps on a blanket basis or a swap-by-swap basis, not just on a swap-by-swap basis. In exchange for this latitude, the CFTC expects the board committee to review any blanket approval at least annually. Moreover, if a triggering event, such as the company’s decision to implement a new hedging strategy, occurs after the most recent review of the blanket approval, the board committee would have to review its blanket approval and determine if it should also apply to swaps relating to the triggering event.
The CFTC’s position on these matters suggests that, in connection with its initial approval of the Reporting Company’s decision to enter into non-cleared swaps, the board committee should review (and the minutes of its pertinent meeting should memorialize that it reviewed) the company’s current and proposed hedging strategy or strategies. The approving committee may also want to consider other types of swaps that the Reporting Company might enter in order to avoid the need for reviews and approvals relating to swaps of a type not typically used by the company and that might need to be executed quickly. The CFTC will likely view a blanket approval of elections of the End-User Exception for any and all swaps, without the committee specifically considering the types of swaps to be entered or hedging to be done, as inconsistent with the intent of the End-User Rule.
The resolution of the board committee adopted to approve the decision of the Reporting Company to enter into non-cleared swaps must specifically approve the company’s decision to enter into swaps that are exempt from both the Clearing Requirement and the Execution Requirement. The CFTC will not deem an approval of a decision to enter into swaps exempt from the Clearing Requirement to satisfy the End-User Rule’s requirements if that approval does not also specifically approve the decision to enter into swaps exempt from the Execution Requirement.
The End-User Rule becomes effective on September 17, 2012. In the Adopting Release, the CFTC noted that compliance with the End-User Rule will not be necessary or possible until swaps become subject to the Clearing Requirement. A swap will become subject to the Clearing Requirement when the CFTC determines that the Clearing Requirement is applicable to such swap or a group, category, type or class of swaps into which such swap falls. On July 24, 2012, the CFTC issued proposed rules to make the Clearing Requirement applicable to certain classes of interest rate swaps and credit default swaps (Proposed Determination Rules), the first classes of swaps that the CFTC has proposed to be subject to the Clearing Requirement.7
In the Adopting Release, the CFTC noted its then-proposed compliance and implementation schedule for the Clearing Requirement would not require non-financial entities to comply with the Clearing Requirement for swaps until 270 days after the effective date of the CFTC’s determination that the Clearing Requirement applies to the class of swaps into which such swap falls. The CFTC recently adopted its final rule regarding that schedule8 and did not include a phase-in provision for swaps as to which one of the counterparties is eligible to claim, and proposes to claim, the End-User Exception. The CFTC attempts to explain away the absence of such a phase-in by noting in the adopting release for that rule that “[i]f a market participant can claim an exemption, the Clearing Requirement will not be applicable.” This statement appears to ignore the End-User Rule’s requirement that one of the swap counterparties must affirmatively report certain information to an SDR or the CFTC to “claim” the End-User Exception for a swap and that an end user’s eligibility to claim the End-User Exception does not, in and of itself, excuse compliance with the Clearing Requirement.
In light of these matters and the imminent expiration of a CFTC exemption of certain agreements and persons from compliance with particular Dodd-Frank provisions, including the Clearing Requirement,9 it appears as if, on and after the date on which the Proposed Determination Rules are adopted and become effective and the CFTC exemption has expired, an end user either will have to make an effective election of the End-User Exception as to each swap the end user enters that is within a class of swaps to which the Clearing Requirement is then applicable or will have to comply with the Clearing Requirement for each such swap.
End users should qualify as an "eligible contract participant.” Dodd-Frank added Section 2(e) to the CEA, which provides that it is unlawful for a person, other than an “eligible contract participant,”10 to enter into a swap unless the swap is entered on, or subject to the rules of, a DCM. As a result, end users intending to elect the End-User Exception as to a swap should make certain that they are eligible contract participants as a part of their due diligence with respect to making such election.
Remember that other regulatory burdens remain. For companies using swaps to hedge commercial risks, the End-User Exception will provide relief from Dodd-Frank’s burdensome clearing and execution requirements, as well as greater flexibility and ease of execution for their swaps. Entering into only non-cleared swaps does not, however, allow end users to avoid completely the burdens imposed by Dodd-Frank and the related swap regulations. End users will have continuing reporting and record keeping obligations regarding their non-cleared swaps. Moreover, margin rules may require the electing counterparty to post margin on the non-cleared swaps, although the margin requirements may function very similarly to the current collateralization practices in the swap markets.
Determine whether the End-User Exception will be available for existing hedging programs. Prior to the date for initial compliance with the Clearing Requirement, end users intending to elect the End-User Exception should assess whether their status (i.e., as a financial entity or a non-financial entity) and their hedging programs will allow them to claim the End-User Exception for the swaps into which they typically enter. Where questions exist as to whether their swaps are hedging or mitigating commercial risks, those companies will also want to consider whether having their swaps subjected to the mandatory clearing and execution regime will impose an unacceptable burden on their hedging programs and whether and how they can adjust their hedging programs so they may take advantage of the End-User Exception.
Constitute a board committee to approve a Reporting Company’s swaps. Before the Clearing Requirements go into effect for a Reporting Company, the company’s board of directors should empower an appropriate board committee to review and approve the Reporting Company’s entry into swaps and its entry into swaps that are exempt from the Clearing Requirement and Execution Requirement. In addition, the authorized committee should act to approve the decision of the company to enter into swaps that are exempt from the Clearing Requirement and the Execution Requirement. The charters of existing board committees should be reviewed to determine if any committee is authorized to review and approve swaps. If the scope of a committee’s responsibilities or its expressly delegated authority does not include delegated power to review and approve swaps, a committee should be given that authority. If it is proposed to delegate that authority by means of a board resolution, care should be taken to ensure that such an action does not create an inconsistency between the committee’s charter and the delegated authority and raise a corporate governance issue.
Address reporting requirements with counterparties. Management of end users of swaps should understand the value of entering into swaps on a non-cleared basis and ensure that matters, such as the timely reporting of the End-User Exception election, are effectively addressed with their counterparties in connection with any new swaps to be entered after the initial date for compliance with the Clearing Requirement.
Remember that election is made on a swap-by-swap basis. Once the Clearing Requirement is in effect, management should keep in mind that the determination of the availability of, and the election of, the End-User Exception must be made on a swap-by-swap basis. While certain information, including whether the company’s swaps for which the End-User Exception is elected are used to hedge or mitigate commercial risk, can be reported on an annual basis, management must still ensure as to each swap entered that (1) such swap is being used to hedge or mitigate commercial risk, (2) the company‘s most recent annual report was filed within the 365 days prior to such swap being entered and remains accurate and (3) when the company enters such swap, a report giving notice of the election of the End-User Exception for such swap and the identity of the electing counterparty is filed with an SDR or the CFTC, as applicable.
Clearing requirements applicable to existing swaps. End users should note that the Clearing Requirement is applicable to a swap in a class of swaps the CFTC has made subject to the Clearing Requirement and which swap was entered into either (1) before July 21, 2010 or (2) on or after July 21, 2010 and prior to the date on which the Clearing Requirement first applies to the class of swaps in which such swap falls. However, as the Proposed Determination Rules contemplate, under Section 2(h)(6) of the CEA, such existing swaps will be exempt from the Clearing Requirement if certain reporting requirements have been met for those swaps. End users should consult with their counsel regarding the applicability of the Clearing Requirement to, and the reporting requirements for, their existing swaps.
Be certain to document decisions and elections properly. As part of the process for electing the End-User Exception as to swaps, end users should create and maintain complete and accurate records of their determinations and board committee and management actions relating to each election of the End-User Exception and of each report filed with an SDR or the CFTC, including reports filed by the other counterparty to the swap. The CFTC could audit an end user’s practices regarding the End-User Exception, and end users should maintain the necessary documentation to allow them to respond effectively to any questions the CFTC’s audit may raise.