The US Commodity Futures Trading Commission (CFTC) recently granted two forms of regulatory relief for swaps between affiliated entities, but significant conditions apply, particularly when one affiliate is located outside of the US. Specifically, on April 1, 2013, the CFTC issued its final rule exempting certain inter-affiliate swaps from the CFTC’s mandatory clearing requirement (the Inter- Affiliate Clearing Exemption).1 Further, on April 5, 2013, the CFTC’s Division of Market Oversight together with the CFTC’s Division of Clearing and Risk issued a no-action letter exempting certain inter-affiliate swaps from the CFTC’s reporting requirements (the Inter-Affiliate Reporting No-Action Letter).2 This Client Alert discusses the concerns that prompted the CFTC to issue the Inter-Affiliate Clearing Exemption and the Inter-Affiliate Reporting No-Action Letter, the specifics of those releases and the concerns that remain.
Throughout the rulemaking process under Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act), market participants have argued that key provisions of swaps market reform should not apply to interaffiliate swaps because of the substantial benefits and limited risks posed by such inter-affiliate transactions. For example, having a single entity that faces unaffiliated third-parties, with exposures reallocated within a group through inter-affiliate swaps, minimizes documentation requirements, enhances netting opportunities, and allows more centralized risk management. Subject to applicable prudential regulations, in most circumstances the use of inter-affiliate swaps does not create significant changes in risk exposure, either within the corporate group or beyond it.
The CFTC has expressed significant concerns, however, that an inter-affiliate exemption might be used to evade the clearing requirements of the Dodd Frank Act. The proposed guidance on extraterritoriality published on July 12, 20123 also reflects the CFTC’s concern that entities will respond to the new rules by migrating their swap activities to jurisdictions that do not have comparable and comprehensive regulatory regimes. Notwithstanding such concerns, commercial end-users have been excepted from the clearing requirements as long as they meet certain conditions.4 Commercial end-users that may rely on the end-user exception from clearing for third-party facing swaps will also be able to rely on that exception for inter-affiliate swaps. For financial entities and others that do not meet the requirements of the end-user exception, however, the CFTC’s concern about significant activity moving offshore to jurisdictions that will not be regulated seems to have driven the “relief” that the CFTC has provided for clearing inter-affiliate swaps.
As mentioned above, on April 1, 2013, the CFTC released its Inter-Affiliate Clearing Exemption, which is conditioned on compliance with a number of requirements. This includes the requirement that all “outward-facing” swaps of each party relying on the relief be cleared or exempt from clearing under US or comparable rules. As a practical matter, therefore, many parties to cross-border, inter-affiliate swaps involving a US counterparty may find that the consequences of relying on the relief are sufficiently onerous that they will choose not to avail themselves of the relief.
The Inter-Affiliate Reporting No-Action Letter similarly requires reporting of all swaps entered into by non-US parties that rely on it, including swaps that are wholly off-shore with non-US counterparties. Thus, as with the Inter-Affiliate Clearing Exemption, the CFTC’s imposition of new regulatory conditions that will apply to transactions outside the US may make counterparties to cross-border interaffiliate swaps similarly hesitant to rely on the reporting relief provided by the Inter- Affiliate Reporting No-Action Letter.
Although the Inter-Affiliate Clearing Exemption and Inter-Affiliate Reporting No-Action Letter will provide relief to many market participants that engage in domestic inter-affiliate swaps, the CFTC’s decision to use these releases to expand the reach of its rules to an extended range of activities outside the US may effectively make the relief unavailable for financial entities that use cross-border, inter-affiliate swaps.
We discuss the requirements of the Inter-Affiliate Clearing Exemption and the Inter-Affiliate Reporting No-Action Letter in more detail later in this Client Alert; however, below is a brief summary regarding the applicable clearing exemptions and reporting requirements for inter-affiliate swaps:
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Eligibility for the Inter-Affiliate Clearing Exemption
The CFTC anticipates that the Inter-Affiliate Clearing Exemption will be elected primarily where both of the swap counterparties are financial entities, because nonfinancial entities would likely rely on the end-user exception to clearing, rather than the Inter-Affiliate Clearing Exemption.5 However, the Inter-Affiliate Clearing exemption is generally available to all market participants (i.e., not only financial entities) that satisfy the required conditions.
As a threshold matter, the exemption is available for swaps entered into between majority-owned affiliates6 (i.e., where one of the counterparties directly or indirectly holds a majority interest in the other party, or where a third entity directly or indirectly holds a majority interest in both counterparties), provided that the entity holding a majority ownership in one or both of the counterparties reports its financial statements on a consolidated basis.7 The rule defines majority ownership as: (i) the direct or indirect possession of a majority of the equity securities in an entity, or (ii) the right to receive upon dissolution, or the contribution of, a majority of the capital of a partnership.8
Additionally, inter-affiliate swaps, and the counterparties to such swaps, must satisfy the conditions described below in order to be eligible for the clearing exemption.
Conditions to the Inter-Affiliate Clearing Exemption
Inter-affiliate swaps must be documented in order to be exempt from clearing, but the Inter-Affiliate Clearing Exemption provides alternative means of documentation based on the identity of the counterparties. Specifically, if one or both of the parties are SDs or MSPs, then the swap must be documented according to the CFTC’s documentation rules found in CFTC rule 23.504. However, if neither of the parties is an SD or MSP, the parties may determine on their own how to document the swaps, provided that such documentation is in writing and includes “all terms governing the trading relationship.”9 Notably, the Commission determined not to codify a list of enumerated terms that the proposed rule would have required to be included in all inter-affiliate documentation.
Although the documentation requirement is relatively flexible, the CFTC did provide certain guidelines regarding documentation. First, the CFTC noted that book entries would not satisfy the swap documentation condition because such entries do not contain sufficient information to adequately document the swap or trading relationship between affiliates.10 Second, the CFTC clarified that non- SD/MSP affiliates are not required to execute a confirmation to comply with the terms of the Inter-Affiliate Clearing Exemption, but noted that the reporting rules require confirmation data to be reported nonetheless. Finally, the CFTC removed the requirement that inter-affiliate swap documentation set forth valuation and dispute resolution procedures, but stated that the CFTC nonetheless “anticipates that affiliates will include rigorous valuation provisions and [dispute resolution] procedures” in their risk management programs.”11
Centralized Risk Management Program
An affiliated group of entities must have a centralized risk management program to elect the Inter-Affiliate Clearing Exemption. If one of the counterparties is an SD or MSP, this risk management program must comply with CFTC rule 23.600. However, if neither of the parties is an SD or MSP, an affiliated group may structure its centralized risk management program according to its unique needs, provided that the program “reasonably monitors and manages the risks associated with” uncleared swaps.12
The CFTC finalized this requirement despite numerous comments that doing so would impose significant costs on many market participants, particularly for multinational enterprises. According to the CFTC, such entities would be imprudent to engage in inter-affiliate swaps without risk management systems integrated across international boundaries.13
Variation Margin Not Required
The proposed inter-affiliate clearing exemption would have required the exchange of variation margin between financial entity counterparties unless they were 100 percent commonly owned or commonly guaranteed affiliates. In response to comments arguing that variation margin was not necessary to protect group entities from the credit risk of other group entities and that this requirement would limit companies’ ability to efficiently allocate risk among affiliates, the CFTC determined not to require variation or initial margin as a condition for electing the Inter-Affiliate Clearing Exemption.14 However, as discussed further below, counterparties to cross-border inter-affiliate swaps that elect the clearing exemption may, in some circumstances, elect to exchange variation margin as an alternative to clearing “outward-facing” swaps.
Clearing of “Outward-Facing” Swaps
As a condition to the Inter-Affiliate Clearing Exemption, each eligible affiliate counterparty, regardless of its location, must generally clear all swaps that it enters into with unaffiliated counterparties to the extent that those swaps are subject to the CFTC’s clearing mandate or would be so subject, if they were executed in the US. In order to satisfy this requirement, eligible affiliate counterparties must (i) clear their third-party swaps pursuant to the CFTC’s clearing requirement, (ii) comply with the requirements for clearing the swap under a foreign jurisdiction’s clearing mandate that is determined by the CFTC to be comparable and comprehensive or (iii) satisfy certain temporary safe-harbors.15 As a result, even though swaps between two non-US persons (including non-US affiliates of US persons) would not be subject directly to the CFTC’s clearing requirement,16 non-US affiliates may be required to clear such swaps in order to be eligible for the inter-affiliate clearing exemption. Moreover, the requirements described below will apply to any “outward-facing” swaps entered into by an entity that elects to rely or has relied on the Inter-Affiliate Clearing Exemption (each, an Affiliate Counterparty), and not merely those swaps related to exempt inter-affiliate swaps, such as back-to-back swaps.17
Affiliate Counterparties can satisfy the conditions applicable to “outward-facing” swaps in several ways. The CFTC does not require that both counterparties to a given swap satisfy these conditions using the same approach, or that a counterparty always rely on the same approach. Affiliate Counterparties can satisfy the conditions applicable to “outward-facing” swaps in the following ways:
- comply with the CFTC’s clearing regulations for “outward-facing” swaps (i.e., by either clearing all such swaps subject to the CFTC’s clearing mandate under rule 50.4 or by relying on the end-user exception to mandatory clearing);
- comply with a non-US jurisdiction’s clearing requirement or exemption therefrom, provided that the CFTC determines that such clearing requirement, or such clearing requirement and exemption therefrom, are comparable to the CFTC’s regulations and are comprehensive; or
- if an Affiliate Counterparty is a non-US person, clear all of that entity’s outwardfacing swaps that are of the type required to be cleared under CFTC rule 50.4 through a clearing organization that is subject to supervision by appropriate government authorities in the home country of the clearing organization and has been assessed to be in compliance with the Principles for Financial Market Infrastructures.18
Another way to satisfy the outward-facing swap requirements is to rely on a temporary safe harbor available to affiliates located in jurisdictions that have finalized or have nearly finalized their own clearing mandates. The Inter-Affiliate Clearing Exemption provides two alternative safe harbors for market participants in EU countries, Japan and Singapore until March 11, 2014.19 The first excludes entities from the requirement to clear outward-facing swaps if the applicable parent entity is not a “financial entity” and the eligible Affiliate Counterparties are not affiliated with an SD or MSP. The second, more onerous, option allows parties to satisfy an alternative requirement if either:
- each Affiliate Counterparty, or a majority-interest holder on behalf of both Affiliate Counterparties, pays and collects full variation margin daily on all its swaps with unaffiliated counterparties; or
- each Affiliate Counterparty, or a majority-interest holder on behalf of both Affiliate Counterparties, pays and collects full variation margin daily on all its swaps with other Affiliate Counterparties.20
Finally, the Inter-Affiliate Clearing Exemption provides US entities that transact with Affiliate Counterparties located outside of the US, the EU, Japan and Singapore with a de minimis exemption from the requirement to clear inter-affiliate swaps. Specifically, such entities will be deemed to have satisfied the requirements for the inter-affiliate clearing exemption until March 11, 2014, provided that both of the following conditions are met:
- the aggregate notional value of all inter-affiliate swaps that are or would be subject to mandatory clearing under CFTC rule 50.4 entered into between a given US affiliate and all of its non-US affiliates (combined) is equal to or less than five percent of the aggregate notional value of all swaps entered into by such U.S. affiliate that are subject to mandatory clearing under CFTC rule 50.4; and
one of the following conditions is met with respect to the exchange of variation margin:
- each Affiliate Counterparty, or a third party that directly or indirectly holds a majority interest in both Affiliate Counterparties, pays and collects full variation margin daily on all swaps entered into between the Affiliate Counterparties located in jurisdictions other than the US, the EU, Japan and Singapore and an unaffiliated counterparty; or
- each Affiliate Counterparty, or a third party that directly or indirectly holds a majority interest in both Affiliate Counterparties, pays and collects full variation margin daily on all of the Affiliate Counterparties’ swaps with the other Affiliate Counterparties.21
Reporting and Annual Filing
Finally, the Inter-Affiliate Clearing Exemption requires the reporting counterparty to an inter-affiliate swap, as set forth in CFTC rule 45.8, to report certain information to an SDR. This information is largely similar to the information required to be reported when the end-user exception is elected. Also similar to the end-user exception reporting requirements, the rule permits counterparties to report certain information, such as how they generally meet their financial obligations associated with uncleared swaps, on an annual basis.22 Importantly, affiliates electing to use the Inter-Affiliate Clearing Exemption will be required to report all Part 45 and 46 data as well as the information described above even if they would otherwise have been eligible for the no-action relief from inter-affiliate reporting requirements (described below).23 Notably, similar to the end-user exception, the reporting requirements for the Inter-Affiliate Clearing Exemption require Affiliate Counterparties that are public companies to obtain board or committee approval of the decision to utilize the Inter-Affiliate Clearing Exemption.
The Inter-Affiliate Reporting No-Action Letter
Shortly after releasing the Inter-Affiliate Clearing Exemption, the CFTC issued no-action relief from the requirement to comply with certain reporting requirements for inter-affiliate swaps.24 As with the Inter-Affiliate Clearing Exemption, however, the Inter-Affiliate Reporting No-Action Letter contains several conditions that may effectively limit its usefulness. Notably, the relief is not available to any entity that is an SD or MSP, is affiliated with an SD or MSP, or is a financial company is designated by the FSOC as being systemically important. The relief also is not available for exchange-traded swaps (e.g., those traded on a DCM, SEF, FBOT or similar platform), to swaps that are cleared through a derivatives clearing organization, or to swaps for which the parties are relying on the Inter-Affiliate Clearing Exemption. The Inter-Affiliate Reporting No-Action Letter also provides more extensive relief to wholly owned affiliates than to majority-owned affiliates.25 In all cases, the affiliates must be consolidated in financial statements prepared under US GAAP or IFRS.
For wholly owned Affiliated Counterparties, the Inter-Affiliate Reporting No-Action Letter provides broad relief from the requirements to report: (i) creation and continuation data under Part 45, (ii) historical swaps data under Part 46, and (iii) a notice that a counterparty is electing the end-user exception under Rule 50.50(b) (if applicable) with respect to its inter-affiliate swaps, in each case provided that specified conditions are met. Among other things, these conditions require that all outward-facing swaps with unaffiliated counterparties are reported to an SDR, and that the Affiliated Counterparties retain records of the intra-group swaps.26
The Inter-Affiliate Reporting No-Action Letter also grants relief from the reporting obligations under Parts 45, 46 and 50 (if applicable) for inter-affiliate swaps involving majority-owned affiliates. Reporting for such swaps under Parts 45 and 50 will be permitted to be made only on a quarterly basis, subject to conditions similar to those applicable to wholly owned affiliates. Under the Inter-Affiliate Reporting No-Action Letter, these quarterly reporting requirements would commence on June 30, 2013, and the reporting counterparty subject to this condition would have to make an initial quarterly report within 30 days after the end of the first fiscal quarter ending on or after June 30, 2013. The first quarterly report would have to include all swap transaction data required to be reported under Part 45 for the period between April 10, 2013 and June 30, 2013.
Finally, as mentioned above, the relief contained in the Inter-Affiliate Reporting No-Action Letter is subject to the condition that non-U.S. affiliates report all of their outward-facing swaps, even with non-US counterparties, if they are party to a swap that is exempt from reporting under the no-action letter.27 Specifically, the letter states that “[a]ll swaps entered into between either one of the affiliated counterparties and an unaffiliated counterparty (regardless of the location of the affiliated counterparty) must be reported to an SDR registered with the Commission, pursuant to, or as if pursuant to, parts 43, 45 and 46 of the Commission’s regulations.”28
Entities that do not intend to rely on the Inter-Affiliate Reporting No-Action Letter have been provided with a limited amount of additional time to make their reporting arrangements. Specifically. the CFTC recently provided further, temporary no-action relief in CFTC Letter 13-10 to market participants that are not SDs or MSPs from various reporting requirements.29 Although financial counterparties must still report interest rate and credit swaps beginning on April 10, 2013, CFTC Letter 13-10 provides financial swap counterparties with no-action relief from the reporting requirements under Part 45 until May 29, 2013 for equity, foreign exchange and other commodity swaps. That letter also provides non-financial swap counterparties with no-action relief from the reporting requirements under Part 45 until: (i) July 1, 2013 for interest rate and credit swaps, and (ii) August 19, 2013 for equity, foreign exchange and other commodity swaps. In each case, counterparties relying on this relief must report swaps entered into between April 10, 2013 and the end of the relief no later than a date one month after the new deadline. The deadline for reporting historical swaps was pushed back to September 30, 2013 for financial counterparties and until October 31, 2013 for non-financial counterparties. Recordkeeping requirements, however, still took effect for all swaps on April 10, 2013, and the CFTC noted that all counterparties must have a Compliant Interim CFTC Identifier by that date to be in compliance with the record-keeping requirements.
Due to implications and consequences of the various conditions to electing the Inter-Affiliate Clearing Exemption and the Inter-Affiliate Reporting No-Action Letter described above, the extent to which market participants will utilize the exemptions from clearing and reporting for inter-affiliate swaps remains unclear. The temporary relief provided by CFTC Letter 13-10, and the relief from clearing between now and the effective date of the Inter-Affiliate Clearing Exemption, will allow market participants a brief opportunity to evaluate whether they want to use the inter-affiliate exemptions and to make necessary arrangements to report, clear, or establish margin arrangements for their inter-affiliate swaps, if necessary. Determinations and arrangements will have to be made quickly, however. At a minimum, each organization will have to analyze, in light of its particular situation, the usefulness of the relief and the consequences of relying on it for the broader organization.