On April 21, 2010, the Senate Agriculture, Nutrition and Forestry Committee marked up and referred to the full Senate, by a vote of 13 to 8, Chairman Blanche Lincoln's (D-AR) derivatives regulatory reform legislation, entitled The Wall Street Transparency and Accountability Act of 2010, as amended by her Manager's Amendment (the Bill). The Bill would impose restrictions on the over-the-counter (OTC) derivatives market that go well beyond those included in previous Senate proposals and those included in the House bill passed in December of 2009. The Bill also goes far beyond the Administration's initial proposal on derivatives regulatory reform (described in this Sonnenschein client alert, dated May 21, 2009).
The Bill would require clearable Swaps to be traded on an exchange or swap execution facility, but it would exempt certain end users that use Swaps to hedge commercial risks. Under the Bill, banks and other entities that engage in swap trading would be ineligible for Federal assistance in the event of a bail-out. The Bill would require contemporaneous ("real-time") public disclosure of pricing and other information for cleared Swaps. Swap Dealers and Major Swap Participants (each as defined in the Bill and discussed below) would be subject to capital and margin requirements, would be required to register with the Commodity Futures Trading Commission (CFTC) or the Securities Exchange Commission (SEC), and would have a fiduciary duty to counterparties that are governmental entities, pension plans, endowments, and retirement plans. The $60 trillion over-the-counter FX market would become subject to regulation by the CFTC. The Bill would prohibit regulation of Swaps as insurance under state law. (See Sonnenschein client alerts here and here detailing state legislators' efforts to regulate credit default swaps as insurance.)
The issue of how best to regulate derivatives now will become part of the larger debate on financial services regulatory reform in the U.S. Senate. Banking Committee Chairman Chris Dodd (D-CT) will seek to bring to the Senate floor next week his comprehensive financial regulatory reform bill, S. 3217, the Restoring American Financial Stability Act. However, Minority Leader Mitch McConnell (R-KY) has objected on behalf of Senate Republicans to what they consider to be an exclusionary process for the bill's development and consideration, and many Senate Republicans say they view the Dodd bill to be a highly partisan work product that does not reflect their views. As a result of these concerns, Minority Leader McConnell has threatened that Republicans will oppose proceeding to a debate on the merits of the Dodd bill and to the consideration of amendments to that bill unless agreements can be reached that will result in what they consider to be a more balanced bill.
As currently drafted, S. 3217 contains "placeholder" language addressing derivatives regulation. Though the Agriculture Committee has driven the debate on derivatives issues in the last two weeks, Chairman Dodd continues to negotiate with Banking Committee Ranking Member Richard Shelby (R-AL) on a broad compromise on financial services regulatory reform. Both Chairman Dodd and Senator Shelby continue to express optimism that they are nearing such a compromise. Should Senators Dodd and Shelby be able to agree on bipartisan compromise legislation, the derivatives title of the final bill may end up differing substantially from that approved by the Agriculture Committee.
Given the foregoing, the legislative landscape with respect to the treatment of derivatives issues is quite fluid and the prospects for the Agriculture Committee's Bill or some variant thereof becoming law remain uncertain. While Chairman Lincoln is negotiating with both Chairman Dodd and his designee, Senator Jack Reed (D-RI), to include the Senate Agriculture Committee's derivatives bill in the Dodd bill when it is finally debated, recent reports indicate that both the White House and Chairman Dodd have expressed some reluctance to simply fold the Agriculture Committee's derivatives bill into the text of S. 3217. Chairman Dodd says that he is confident that he and Chairman Lincoln will be able to work out an agreement on derivatives language before the Senate begins to debate the Dodd bill on the merits. However, unless Chairman Dodd and Chairman Lincoln reach such an agreement, Chairman Dodd could choose to put S. 3217 on the floor with the "placeholder" language on derivatives that is currently in the bill and require any changes to that language to be achieved through amendments that are adopted by the full Senate. That outcome would make it far less likely that the Agriculture Committee's Bill would become law. We will continue to monitor this situation closely and will report developments as they occur.
What follows is a discussion of selected provisions of the Bill.
Broad Authority to Regulate the OTC Derivatives Markets
The Bill generally allocates regulatory jurisdiction over Swaps and Security-Based Swaps to the CFTC and the SEC, respectively. The Bill's definition of Swap (and hence the jurisdictional reach of the CFTC) is quite broad, whereas the definition of Security-Based Swap (and, concomitantly, the jurisdictional reach of the SEC) is more restricted.1
The Bill separately defines Swaps and Security-Based Swaps, though most aspects of the Bill are applicable to both. This client alert uses the term Swap to refer generally to both Swaps and Security-Based Swaps, except where noted. Similarly, the Bill separately defines Swap Dealer and Security-Based Swap Dealer, and Major Swap Participant and Major Security-Based Swap Participant, and this client alert in each case uses the former term to include the latter, except where noted.
Except as specified in the Bill, neither the CFTC nor any futures association registered under the Commodity Exchange Act would have jurisdiction over Security-Based Swaps or associated entities, and neither the SEC nor any national securities association registered under the Securities Exchange Act of 1934 ('34 Act) would have jurisdiction over other Swaps or associated entities. The Bill requires that the CFTC and the SEC individually, not jointly, promulgate the necessary rules and regulations within 180 days after the date of enactment.
The Federal banking agencies, including the Comptroller of the Currency, the Federal Deposit Insurance Corporation (FDIC), and the Board of Governors of the Federal Reserve System (referred to collectively as the Prudential Regulator) would retain certain jurisdiction over bank Swap Dealers and Major Swap Participants, and would continue to set capital and margin requirements for those entities. The CFTC or the SEC, as applicable, would set capital and margin requirements for non-bank Swap Dealers and Major Swap Participants.
Dramatic Change to Clearing and Trading of OTC Derivatives
The Bill would impose mandatory clearing and trading requirements for many, if not most, OTC derivatives entered into after the date of enactment of the Bill. The CFTC or the SEC, as applicable, would be obligated to review any Swap which a "derivatives clearing organization" (DCO) lists for clearing, and determine within 90 days whether the Swap is required to be cleared. If the CFTC or the SEC determines that a Swap or class of Swaps is required to be cleared, and that Swap or class of Swaps is listed on one or more DCOs, then that Swap or class of Swaps would be subject to mandatory clearing.
As a practical matter, a Swap would become subject to mandatory clearing only if a DCO lists the Swap for clearing. However, the Bill provides the CFTC and the SEC with the discretion to review for clearing any Swap not listed by a DCO. If the CFTC or the SEC finds that a Swap should be subject to mandatory clearing, but no DCO has listed the Swap, the CFTC or the SEC must investigate, issue a public report of its findings, and take action as necessary and in the public interest.
Any Swap subject to mandatory clearing must be traded through either a designated contract market (DCM) or a swap execution facility (SEF) that makes the Swap available for trading. Each DCM and SEF (a trading or confirmation facility which provides multiple participants the ability to execute/trade or facilitate execution of swaps) must register with the CFTC or the SEC, as applicable, and must adhere to newly revised requirements, including position limits/accountability, financial integrity, reporting, conflicts-of-interest, and other compliance requirements set by the CFTC or the SEC, as applicable.
Narrow Commercial End User Exemption
The Bill contains a narrow "commercial end user" exemption from mandatory swap clearing. The Bill defines "commercial end user" to mean a person (other than a Financial Entity, defined below) who, as its primary business activity, owns, uses, produces, processes, manufactures, distributes, merchandises, or markets goods, services, or commodities (including, but not limited to, coal, natural gas, electricity, ethanol, crude oil, gasoline, propane, distillates, and other hydrocarbons), either individually or in a fiduciary capacity. This exemption is intended to be narrowly drawn, but to include companies such as manufacturers and airlines, among others.
A Financial Entity is defined as (i) a Swap Dealer, a Major Swap Participant, a Security-Based Swap Dealer, a Major Security-Based Swap Participant, (ii) a person predominantly engaged in financial activities, (iii) a commodity pool or private fund as defined in the Investment Advisors Act of 1940 or (iv) a person that is registered or required to be registered with the CFTC or the SEC, as applicable.
The commercial end user exemption is available only for Swaps that hedge "commercial risk." The Bill authorizes the CFTC to adopt a rule defining this term.
Notwithstanding the availability of this exemption, a commercial end user may, if it so desires, elect to have a Swap cleared through a DCO, in which event the end user, and not the Swap Dealer or Major Swap Participant, may select the DCO through which the Swap would be cleared.
An affiliate of a commercial end user may rely on this exemption if the affiliate, acting as an agent on behalf of the commercial end user, uses a Swap to hedge or mitigate commercial risk of the commercial end user or another affiliate of the commercial end user that is not a financial entity. An affiliate may not rely on the exemption, however, if the affiliate is a Swap Dealer, a Major Swap Participant, an issuer that would be investment company but for certain exemptions in the Investment Company Act, a commodity pool, a bank holding company with more than $50 billion in consolidated assets, or an affiliate of any of these entities. The last clause of this rule could be read to imply that if a corporate group includes a Swap Dealer or another of these specified entities, then none of the affiliates may rely on the affiliate rule.
Public companies must obtain audit committee review and approval in order to use the commercial end user exemption. Public companies also must obtain audit committee review and approval for all uncleared, bilateral positions. The Bill defines a public company to mean a company that has issued securities required to be registered under Section 12 of the '34 Act or a company that is required to file reports under Section 15 of the '34 Act.
The CFTC and the SEC are authorized to write rules to prevent abuses of the clearing exemption.
Potential Spin-off of Swap Desks in Bailouts
Federal agencies such the Federal Reserve and the FDIC would be prohibited from providing federal assistance to bail out banks or other swap entities that engage in derivatives transactions. Federal assistance includes the use of federal funds, FDIC insurance or guarantees, and access to the Federal Reserve discount window or any Federal credit facility.
Many banks conduct swap operations in the same entities in which they conduct their primary banking operations. As a result, prior to receiving federal assistance in a bail-out scenario, such a bank could be forced to spin off its swap desk. It is not clear, however, whether a standalone swap desk would be able to meet the capital requirements imposed under the Bill.
Public Disclosure of Derivatives Pricing and Other Information
The Bill requires public disclosure in "real time" of pricing and transaction information for Swaps subject to mandatory clearing, and for other Swaps cleared on a DCO. Such reporting may not identify the participants and must take into account whether the public disclosure would materially reduce market liquidity. For Swaps not cleared on a DCO but which are reported to a swap data repository, aggregate data on trading volume and positions will be made available. The Bill directs that such reporting not disclose the business transactions or market positions of any person.
All uncleared Swaps, including those entered into before enactment but which will not have expired as of enactment, must be reported to a Swap data repository or the CFTC or the SEC, as applicable, no later than 30 days after issuance of an interim final rule, and all counterparties to such Swaps must maintain records and provide reports to the CFTC or the SEC, as applicable, upon request.
Fiduciary Duty to Governmental and Pension Fund Counterparties
Under the Bill, a Swap Dealer or Major Swap Participant that provides advice regarding, or offers to enter into, or enters into, a Swap with a counterparty that is a governmental entity, including a municipality, or a pension plan, endowment, or retirement plan, would have a fiduciary duty to that counterparty.
One issue with this provision is that it is not clear what fiduciary standard would apply. The Employee Retirement Income Security Act of 1974 (ERISA) generally imposes a so-called "prudent expert" standard while generally fiduciary principles typically recognize a "reasonable man" standard. Moreover, most fiduciary standards, including those under ERISA, include a duty of loyalty which can be inconsistent with the activities of a swap provider.
Imposing a fiduciary duty to pension and retirement plans puts a premium on identifying whether a counterparty is a plan or is considered to hold plan assets. Under ERISA and other laws, certain entities, including hedge funds, private equity funds, and securitization vehicles, may be considered plans for certain purposes based on the level of equity investment in the entity by pension and retirement plans.
Registration and Capital and Margin Requirements
Swap Dealers and Major Swap Participants must register with the CFTC or the SEC, as applicable, regardless of whether they are required to register with other regulators. The Bill directs the CFTC and SEC to adopt rules for such persons, which may include business conduct standards, reporting, and recordkeeping requirements to protect investors.
Swap Dealers and Major Swap Participants would be subject to capital and margin requirements, which would be significantly higher for uncleared Swaps than for cleared Swaps. As noted above, the applicable Prudential Regulator would continue to specify the capital and margin requirements for bank Swap Dealers and Major Swap Participants, and the CFTC or the SEC, as applicable, would set them for non-bank Swap Dealers and Major Swap Participants. The Bill would permit the use of non-cash collateral to satisfy the capital and margin requirements, but notes that such use may be restricted by applicable regulator.
Swaps entered into before the date of enactment of the Bill would be exempt from these margin requirements, as would Swaps in which one party falls within and utilizes the commercial end user exemption.
Major Swap Participant is defined as any person who is not a Swap Dealer, and
- maintains a substantial position in Swaps (other than positions held for hedging or mitigating commercial risk, and positions maintained by an ERISA plan for hedging or mitigating risk directly associated with the operation of such plan) for any of the major Swap categories as determined by the CFTC or the SEC, as applicable; or
- 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
- is a financial entity (other than an entity predominantly engaged in providing customer financing for the purchase of an affiliate's merchandise or manufactured goods) that is highly leveraged relative to the amount of capital it holds and maintains a substantial position in outstanding Swaps in any major Swap category as determined by the CFTC (or the SEC, as applicable).
The CFTC and the SEC are directed to define the term "substantial position" at the threshold prudent for the effective monitoring, management, and oversight of entities that are systemically important or that can significantly impact the financial system of the United States. A person may be designated a Major Swap Participant for one or more categories of Swaps without being classified as a Major Swap Participant for all classes of Swaps.
Collateral Segregation and Bankruptcy Treatment of Cleared OTC Derivatives
Collateral posted in respect of cleared Swaps must be segregated, and the use and investment of this segregated collateral will be restricted by rules to be promulgated by the CFTC and the SEC.
For uncleared Swaps between a counterparty and a Swap Dealer or Major Swap Participant, the Swap Dealer or Major Swap Participant must offer the counterparty the right to have its initial margin payments segregated and maintained with a third-party custodian. If the counterparty does not elect such segregation, the Swap Dealer or Major Swap Participant must report to the counterparty on a quarterly basis that the back office procedures of the Swap Dealer or Major Swap Participant relating to margin and collateral requirements are in compliance with the agreement of the counterparties.
Under the Bill, a DCO-cleared Swap will be treated for bankruptcy purposes as a commodity contract.
The Bill directs the CFTC and the SEC to establish position limits, including related hedge exemption provisions, for positions in contracts based on the same underlying commodity (in the case of the CFTC) and for Security-Based Swaps (in the case of the SEC). The CFTC or the SEC may, in its discretion, exempt any person or class of persons from this requirement.
Foreign Exchange Transactions
The Bill would regulate foreign exchange Swaps and forwards generally in a manner similar to other Swaps, except in cases where the Secretary of the Treasury submits to Congress a written determination that such foreign exchange transactions were not structured to evade the requirements of the Bill and should not be regulated as Swaps. Notwithstanding such a determination, the Bill requires that all foreign exchange Swaps and foreign exchange forwards be reported to either a Swap data repository or the CFTC.
Control of Clearing and Trading Facilities and Conflict of Interest Rules
The Bill directs the CFTC and SEC to determine whether to adopt rules to establish limits on the control of any clearing agency that clears Swaps, or any Swap execution facility or national securities exchange that posts or makes available for trading Swaps, by certain bank holding companies, nonbank financial companies, or affiliates of either, or by a Swap Dealer, Major Swap Participant, or person associated with a Swap Dealer or Major Swap Participant.
The Bill also directs the CFTC and the SEC to determine whether to adopt rules to mitigate conflicts of interest in the conduct of business of a Swap Dealer or Major Swap Participant with a DCO, board of trade, or SEF that clears or trades Swaps in which such Swap Dealer or Major Swap Participant has a material debt or equity investment.
Abusive Swaps and Authority to Ban Foreign Entities
The Bill would empower the CFTC and the SEC to investigate any Swap or Security-Based Swap that is found to be "detrimental to the stability of financial markets or their participants," and would authorize the CFTC and the SEC, in consultation with the Secretary of the Treasury, to ban foreign entities from participating in U.S. Swap or Security-Based Swap markets if "it is determined that the regulation in the foreign entity's country undermines the United States financial system."
Swaps Not to be Regulated as Insurance
The Bill provides that Swaps and Security-Based Swaps may not be regulated as insurance under state law. This provision is intended to counter efforts of state legislators to regulate credit default swaps as insurance and ban a significant portion of the credit default swap market.
Carbon Markets Study
The Bill commissions an interagency working group to study the oversight of existing and prospective carbon markets to ensure an efficient, secure, and transparent carbon market, including oversight of spot markets and derivative markets. The working group would consist of the Chairman of each of the CFTC, the SEC and the Federal Energy Regulatory Commission, the Secretary of Agriculture, the Secretary of the Treasury, the Commissioner of the Federal Trade Commission, and the Administrator of each of the Environmental Protection Agency and the Energy Information Administration
Energy and Environmental Markets Advisory Committee
The Bill establishes an energy and environmental markets advisory committee, with nine members to be appointed by the CFTC. This committee is to serve as a vehicle for discussion and communication on matters of concern to exchanges, firms, end users and regulators regarding energy and environmental markets and their regulation by the CFTC.
Effective Date and Treatment of Pre-enactment Swaps
The Bill generally would take effect 180 days after the date of enactment unless otherwise stated.
The Bill clarifies the legal status of long-term transactions entered into before the date of enactment as legal, and exempts such pre-enactment Swaps from the mandatory clearing and margin requirements of the Bill. Pre-enactment Swaps must, however, be reported to a registered swap data repository or the CFTC.