Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and new Commodity Futures Trading Commission (CFTC) rules require that, subject to certain exceptions, swap counterparties clear swaps at a clearing house and execute them on a facility or exchange. One of these exceptions is the "end-user exception," which may be available for companies that are not "financial entities" and that use swaps to manage risk. There are several requirements that these entities must meet in order to rely on the end-user exception. For public companies, these include taking certain governance steps that involve board-level approval of the company's use of uncleared swaps and review of company policies on swaps. With the CFTC clearing requirements applicable to non-financial entities scheduled to take effect September 9, public companies can position themselves to take advantage of the end-user exception by completing these steps in the next few months.
Many public companies use swaps as a risk management tool. For example, interest rate swaps help companies limit their exposure to interest rate fluctuations and many companies use foreign exchange transactions to hedge exposure to currency fluctuations.
The Dodd-Frank Act enhanced regulation of swaps in an effort to reduce systemic risk and bring transparency to the swaps market. The Dodd-Frank Act and new CFTC rules require that swap counterparties clear certain swaps at a clearing house and execute them on a facility or exchange. However, in recognition of the important role that swaps play in mitigating commercial risks, Congress provided, and the CFTC implemented, an end-user exception to these requirements. The end-user exception permits eligible "non-financial entities" to continue using uncleared swaps to hedge risks associated with their business activities.
The CFTC has implemented a compliance timeline for swap clearing requirements that phases in at different times for different categories of market participants. The compliance deadline for non-financial entities is September 9, 2013. Starting on that day, clearing is required for certain types of swaps unless an exception (such as the end-user exception) is available. The CFTC is also phasing in clearing requirements by swap category, starting with two categories of swaps that include most interest rate swaps and most index credit default swaps. Information about the classes of swaps subject to clearing is available at http://www.cftc.gov/PressRoom/PressReleases/pr6429-12. The CFTC makes a determination, in accordance with the Commodity Exchange Act, about which swaps are subject to clearing requirements. Before requiring clearing for a category of swaps, the CFTC must propose the determination for public comment and consider any comments. In determining whether to require clearing, the CFTC must consider five factors, including trading liquidity, the effect on systemic risk and the effect on competition. It is anticipated that many swaps subject to mandatory clearing will have to be executed on a facility or exchange unless an exception (like the end-user exception) applies. The CFTC recently adopted rules on execution requirements that will be implemented over the coming months.
Non-financial entities generally can rely on the end-user exception for swaps with any counterparty, including external swaps with unaffiliated third parties and internal swaps between affiliates. In addition, the CFTC has issued a rule that provides an exemption from mandatory clearing for swaps between eligible affiliates ("inter-affiliate swaps") if several conditions are met. The exemption is available for swaps with or between counterparties that are majority-owned where the financial statements of both counterparties are consolidated. Generally, non-financial entities would not need to rely on the inter-affiliate exemption because they could use the end-user exception, for which it is easier to qualify. For public companies, the inter-affiliate clearing exemption includes a requirement of board-level approval that mirrors the approval required for use of the end-user exception (discussed below).
Finally, non-financial entities that execute swaps through a centralized treasury unit (CTU) such as a treasury subsidiary should be aware that they may not be able to rely on the end-user exception for their external swaps. This is because a CTU that is a separate legal entity may be treated as a financial entity and, therefore, would not meet one of the key eligibility criteria for reliance on the end-user exception; namely, that a non-financial entity be a party to the swap. The inter-affiliate exemption is not available because it is limited to internal swaps (between affiliates) and therefore would not extend to swaps between a CTU and a third party. To address these concerns, on June 4, 2013, the CFTC issued no-action relief that permits CTUs at non-financial entities not to clear swaps if several conditions are met. Among other things, the CTU must be wholly-owned directly by a non-financial entity, the CTU's ultimate parent company must be a non-financial entity, and the CTU cannot trade on behalf of any financial affiliates. Entities executing swaps through a CTU that are not eligible to take advantage of this relief are subject to the clearing requirements applicable to financial entities, which took effect June 10, 2013.
Criteria for Relying on the End-User Exception
In order to rely on the end-user exception for a swap, a company must meet the following criteria, which are set forth in CFTC Regulation 50.50:
- it is not a "financial entity," as defined in Section 2(h)(7)(A) of the Commodity Exchange Act;
- it is using a swap to hedge or mitigate commercial risk, as defined in CFTC Regulation 50.50(c);
- it generally meets its financial obligations associated with entering into uncleared swaps;
- it takes certain governance steps if it is a public company—specifically, if it is (a) an issuer of securities registered under Section 12 of the Securities Exchange Act of 1934 (Exchange Act) or (b) required to file reports under Section 15(d) of the Exchange Act (each a "reporting issuer"); and
- it reports the information described above to a swap data repository (SDR), or to the CFTC if no SDR is available, through an annual filing that would cover swap transactions taking place over the upcoming year.
With respect to the fifth requirement, we expect most companies will make the annual filing, but CFTC rules offer the option of reporting the required information on a swap-by-swap basis, along with other information that must be reported in connection with every swap transaction. In that situation, typically the swap dealer (not the end-user) will report the information.
For companies that are otherwise eligible to rely on the end-user exception, and that are reporting issuers, the governance steps that are a pre-requisite for relying on the exception are:
- The board (or an "appropriate committee" of the board) review and approve the company's use of uncleared swaps. The approval must authorize the company to enter into swaps that will not be cleared, and will not be executed on a facility or exchange, due to the company's intention to rely on the end-user exception.
The CFTC has said that a committee is "appropriate" only if it is "specifically authorized to review and approve the . . . decision to enter into swaps." Board or committee approval can be done on a general basis, and if done on a general basis, it must occur at least annually because public companies must include confirmation of the approval each year as part of the annual filing discussed above under the heading "Criteria for Relying on the End-User Exception." Approval also can be done on a swap-by-swap basis and reported to an SDR in connection with each swap transaction.
Significantly, the CFTC indicated in adopting the end-user exception that the review/approval requirement applies to the reporting issuer and to any entities controlled by the issuer. The CFTC also stated that the reporting issuer's board "would have reasonable discretion to determine the appropriate committee for approving decisions on swaps for its subsidiaries or affiliates."
- The board or committee must "set appropriate policies" governing the use of swaps subject to the end-user exception and review these policies at least annually, or more often if there is a significant change in the policies (such as implementing a new hedging strategy that was not contemplated in the original board or committee approval).
Companies could comply with this requirement by having the board or committee review and discuss with management policies that management has developed on the use of swaps. This review and discussion could occur as part of the process of approving the company's use of uncleared swaps.
If the company does not currently have written policies in place on the use of swaps, it should review its existing practices and document them. The CFTC has not issued guidance on what should be addressed in these policies. We anticipate that these policies will vary based on a company's circumstances, including the type of company and the reasons it uses swaps. At a minimum, a company's policies should address the types of swaps for which the company may rely on the end-user exception, although companies may wish to adopt broader policies that address their use of swaps more generally.
What Companies Should Do Now
Reporting issuers that plan to begin relying on the end-user exception once the clearing requirements take effect on September 9, 2013 should consider making the annual filing discussed above in the next few months so it is in place by the effective date. For these companies, the filing must include information about the board or committee approval, so the approval will need to be done before the filing. With the September deadline approaching, companies planning to avail themselves of the end-user exception should consider taking the following steps:
- Confirm whether the company intends to rely on the end-user exception and whether the company has, or is in the process of developing, written policies on the use of swaps. If the company does not have written policies, it should prepare a policy that documents how it uses swaps, with a particular focus on swaps subject to the end-user exception.
- Brief the board of directors on the end-user exception, develop recommendations on how the board should oversee this area and grant the required approvals, and discuss the recommendations with the board.
This should involve consideration of whether to perform the oversight function at the board level or through a board committee. For example, this could be the audit committee or the finance committee if the board has one.
The company also should consider whether the board or committee approvals will occur on a general basis at least annually or on a swap-by-swap basis. This will depend primarily on the nature of the company's swaps activities. We believe that annual approval will be the preferred course of action for companies doing multiple transactions each year in swaps that are subject to the clearing requirements.
If the company conducts swaps activities through subsidiaries and/or affiliates, the company should consider whether to conduct the necessary review/approval at the parent company level (that is, through the board or a board committee of the reporting issuer) or at the subsidiary/affiliate level. Depending on a company's swaps activities, its corporate structure and its governance practices, a company may determine that parent company approval on behalf of any subsidiaries is appropriate.
- If a committee of the board will oversee matters relating to the end-user exception, grant the necessary authority to the committee.
As noted above, the CFTC has said that a board committee must be "specifically authorized to review and approve the . . . decision to enter into swaps." Accordingly, the board should consider amending the committee charter to delegate this authority to the committee along with the authority to review and discuss policies on the company's use of swaps. There is no requirement to cover this in the charter, but doing so would confirm the committee's authority. Alternatively, the board could adopt resolutions giving the committee this authority.
- Brief the board or responsible committee on company policies on the use of swaps (and, in particular, swaps subject to the end-user exception) and the categories of swaps for which the company plans to rely on the end-user exception. Ideally, this should occur before or in connection with the first approval to enter into uncleared swaps so that directors have sufficient information to make an informed decision.
- Update board or committee calendars and agendas to include an annual review of company policies on the use of swaps and approval to enter into uncleared swaps if that approval will be done annually. Additionally, the board or responsible committee should develop an understanding with management about the types of significant changes and the use of swaps that would trigger board or committee review of the company's swaps policies outside the annual cycle.