The third installment of our ongoing series on the 2014 CFTC Reauthorization Act covers a potential change to the definition of a "financial entity", which has been a particularly troublesome and confusing definition for end-users, and the banks that enter into swaps with them. In addition, the CFTC may be able to address the confusion through its rule making and interpretations, without the need for a legislative change.
We will start with an overview of the financial entity definition and some background as to its ambiguities. Those familiar with these issues can read ahead and skip to the potential solutions after the jump.
The Ambiguities Within the Financial Entity Definition
A key part of the End-User Exception to the Dodd-Frank Act clearing and trading requirements is that it is not available to a "financial entity" as defined in Section 2(h)(7)(C) of the Commodity Exchange Act. (For more on the End-User Exception, see our prior post, including a walking map to claiming the End-User Exception). Section 2(h)(7)(C) includes all of the following as financial entities:
- swap dealers and security-based swap dealers;
- major swap participants and major security-based swap participants;
- commodity pools;
- private funds (as defined in Section 202(a) of the Investment Advisers Act of 1940); and
- employee benefit plans (as defined in paragraphs (3) and (32) of the Employee Retirement Income Security Act of 1974).
Those descriptions are defined and clear. The Dodd-Frank Act, however, also added a catch-all prong in the financial entity definition which includes: "a person predominantly engaged in activities that are in the business of banking, or in activities that are financial in nature, as defined in section [4(k) of the Bank Holding Company Act ("BHCA")]" (the “Catch-All”).
Congress' intent in the Catch-All was to avoid having a loophole allowing entities to avoid the clearing and trading requirement. However, the Catch-All adds multiple layers of ambiguity onto the definition of a financial entity and the resulting ability to claim the end-user exception. First, the definition of "predominantly" with respect to the Catch-All is never clearly defined, either in Title VII of the Dodd-Frank Act or the CFTC rules. We note that Titles I and II of the Dodd-Frank Act also contain tests using language similar to the Catch-All on the financial entity definition, but in each case, the statute also provides a specific test of what “predominantly engaged” means (i.e., 85% of the consolidated revenues comes from financial activities), but we note that each title has a slightly different test. Title VII of the Dodd-Frank Act provided no such test. In the CFTC’s adopting release for the end-user exception, it described that when financial activities are incidental and not primary activities, the entity is not “predominantly” engaged in financial activities, but CFTC has not provided a clear rule for what constitutes being “predominantly” engaged.
In addition, the use of activities "that are in the business of banking" or "are financial in nature, as defined in section [4(k) of the BHCA]" result in ambiguity and confusion as to the application of the definition.
To understand the confusion, we first have to look at the purpose of the business of banking and Section 4(k) of the BHCA. Banking regulation generally limits the activities of banks and precludes them from engaging in commercial activities (considered to be too risky for a bank). However, over the years, the prudential bank regulators have allowed banks to engage in certain activities that are related or incidental to banking operations or are financial in nature. For example, a bank is permitted to engage in trust services, real estate settlement, and courier services for money or checks. The business of banking and Section 4(k) of the BHCA are permissive regulations that define what activities a bank may engage in. However, the Catch-All refers to those terms to define what activities are financial and those permissive regulations do not cleanly apply to the application of financial entity definition. Moreover, commercial entities (or those entities that people would typically consider commercial) also engage in some of the activities that banks are permitted to engage in. In the adopting release for the end-user exception, the CFTC specifically declined to interpret what activities fall under the business of banking and Section 4(k) of the BHCA because those terms come from statutes interpreted by the Office of the Comptroller of the Currency (the “OCC”) and the Board of Governors of the Federal Reserve (the “Fed”), respectively.
Importantly, Section 4(k) of the BHCA includes engaging as principal in forward contracts, options, futures, swaps, and similar contracts. However, many commercial manufacturers, producers, shippers, energy firms and others use those exact products to hedge and manage their risks and in an incidental or ancillary role to their commercial activities.
In addition, many corporations are structured so that all of the organization’s treasury, borrowing, and hedging activities are located in one subsidiary (a treasury affiliate). A treasury affiliate would likely be a financial entity under the Catch-All, while the same activities ultimately for the same company, under a different organizational structure, would not be a financial entity
For those readers that have stuck with us this long, we continue with some potential solutions after the jump . . .
Potential Solutions for the Financial Entity Definition
Section 351 of the CFTC Reauthorization Act would add an additional limitation to the definition of a financial entity. The limitation would exclude from the definition any entity that:
- is not described in the financial entity prongs other than the Catch-All;
- is not supervised by a prudential regulator; and
- is a “commercial market participant” that is considered a financial entity due to its involvement in physical delivery contracts; or
- enters into derivative contracts to hedge or mitigate commercial risks of an affiliate that is not supervised by a prudential regulator.
Section 351 then defines a "commercial market participant” as a producer, processor, merchant or commercial user of a non-financial commodity.
The solution in Section 351 addresses the most pressing issues with the current definition of a financial entity, treasury affiliates and commodity producers and merchants, but it does not address some of the inherent ambiguities in the Catch-All.
Another approach can be seen in the rules requiring swap dealers and major swap participants to hold margin for uncleared swaps (the "Re-Proposed Margin Rules"). See our prior post for more information on the Re-Proposed Margin Rules. The prudential regulators initially proposed to use the financial entity definition to distinguish between commercial and financial swap counterparties. However, in the Re-Proposed Margin Rules, the prudential regulators recognized the difficulty of working with the ambiguities in the Catch-All and stated that: "In order to provide certainty and clarity to counterparties as to whether they would be financial end users for purposes of this proposal, the financial end user definition provides a list of entities that would be financial end users as well as a list of entities excluded from the definition." (79 Fed. Reg. 57348, 57360 (emphasis added)). Recall that the CFTC deferred to the OCC and the Fed with respect to interpreting what activities are in the business of banking or are financial in nature, as defined in Section 4(k) of the BHCA, and here, those same regulators are opting to use an alternate definition to avoid ambiguities in the Catch-All.
With respect to the End-User exception, the CFTC cannot create an entirely new definition because it is bound by the language in the Dodd-Frank Act. However, the CFTC can interpret the ambiguous portions of the financial entity definition. Title VII of the Dodd-Frank Act provided no definition of "predominantly engaged" for the financial entity definition and the prudential regulators have indicated that activities that are financial in nature is ambiguous. The CFTC could reasonably interpret the Catch-All to include an enumerated list of entities and exclude a separate list of types of entities that would not be predominantly engaged in financial activities (ideally this would be the same as the lists in the Re-Proposed Margin Rules).
The CFTC and its staff have been on a recent streak of passing sensible rules, interpretations, and letters addressing problems for end users caused by the Dodd-Frank Act, we hope that the streak continues.