Canadian fund managers that trade in over-the-counter (OTC) derivatives for their investment funds should be aware of two significant U.S. developments that can be expected to affect such trading; particularly since it is recommended that action be taken before the end of 2012.
- August 2012 DF Protocol (the Protocol) published by the International Swaps and Derivatives Association, Inc. (ISDA): The Protocol enables parties to master agreements for OTC derivatives to amend those agreements to fulfill statutory and regulatory requirements. Adhering to, or joining, the Protocol is not a statutory or regulatory requirement; instead, it is an ISDA-sponsored device to facilitate the amendment of master agreements for OTC derivatives in an efficient manner. December 2012 is the recommended deadline to adhere to the Protocol.
- CFTC registration exemptions: Certain changes to exemptions to registration requirements recently promulgated by the primary derivatives regulator in the United States, the Commodity Futures Trading Commission (CFTC), are already effective. Registration may be required by December 31, 2012.
Both developments described in this Bulletin result from some of the final OTC derivative regulations that implement Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act).
We describe these developments in this Bulletin and urge Canadian fund managers to consider the steps that must be taken to ensure that their funds’ OTC derivative trading continues uninterrupted in conformity with the new industry practice and regulatory regime.
The ISDA August 2012 DF Protocol
Starting on October 12, 2012, dealers in the United States must now calculate their swap activities and, as at the end of the calendar month in which they exceed a USD$8 billion threshold, register as a swap dealer with the CFTC. Given the timing of the implementation of this registration requirement, it is expected that the first swap dealer registrations will be effective late in the fourth quarter of 2012.
Once swap dealers begin to register, the regulations that affect the relationship between swap dealers and major swap participants (MSPs) and their counterparties will become effective. Seven final rules have been adopted by the CFTC that affect the documentation between counterparties, including in respect of external and internal business conduct, reporting and recordkeeping, swap trading relationship documentation and portfolio reconciliation. Under the CFTC’s external business conduct rules, swap dealers and MSPs are required to obtain various types of information from their counterparties and to apply suitability rules that require potentially intrusive due diligence, unless the counterparty provides adequate representations and certain safe harbors are used.
If your funds have a counterparty that registers as a swap dealer or a MSP with the CFTC, you may be required to update your ISDA documentation, including providing representations regarding legal status under the Dodd-Frank Act, in order to continue to trade with these counterparties. To ensure your ability to continue to transact under your ISDA documents, it is recommended that your funds adhere to the Protocol by the end of 2012.
The Protocol addresses the documentation and informational requirements imposed under the final rules of the CFTC and greatly simplifies and streamlines amendments to existing “Protocol Covered Agreements”. In order to provide the required information to swap dealers and MSPs, the architecture of the Protocol is quite complex and has been structured to provide participants with the ability to exchange information in a non-public manner, to apply only certain provisions based on the information provided and to allow participants to elect to agree to certain provisions on a counterparty by counterparty basis.
The Protocol consists of five components:
- The Protocol Agreement sets out the agreement of participants regarding how they may supplement existing Protocol Covered Agreements or enter into a DF Terms Agreement.
- The Adherence Letter evidences a party’s agreement to be bound by the Protocol.
- The Questionnaire allows a party to provide information about itself, make certain safe-harbor elections and identify counterparties with whom it is willing to apply DF Supplement provisions.
- The DF Supplement contains representations, covenants, disclosures, acknowledgements and notifications relating to the final rules that counterparties may apply to their swap trading relationship.
- The DF Terms Agreement allows parties to select certain provisions that will apply to their trading relationship in respect of swaps and is available if the parties do not have an existing ISDA master agreement or if they wish to apply the DF Supplement without supplementing an existing master agreement.
In order to begin the process of adhering to the Protocol, you will first need to execute and submit to ISDA through its website a letter and pay the applicable fees. The adherence letter, which will be made public on ISDA’s website, will contain your contact information and will specify how you would like to receive the questionnaire from other Protocol participants (mail, fax, Alert or ISDA Amend (an automated online platform developed to facilitate the process of completing and exchanging questionnaire information)). Managers may submit the adherence letter on behalf of one or more investment funds under master agreements. A fee for adherence is required for each adherence under the Protocol.
After submitting the adherence letter, adherence to the Protocol will only be effective once a manager completes on behalf of each investment fund to the trade a questionnaire and forwards it electronically or otherwise to each swap dealer facing the fund. Identifiers for each trading party need to be obtained and included in each questionnaire, which is also an important regulatory requirement relating to the reporting of trade data as required by the Dodd-Frank Act. In addition to providing factual information in each questionnaire, the investment fund will also be required to make certain representations and warranties, agree to specific covenants and elect to incorporate certain terms and conditions into the swap documentation. Through the questionnaire process, you will identify your funds’ legal status for purposes of the “know your counterparty” requirements of the CFTC’s external business conduct rules.
The DF Supplement accompanies the adherence to the Protocol. It sets forth, through six different schedules, certain standardized representations, covenants, disclosures, acknowledgements and notifications relating to the final rules. You will need to determine which schedule within the DF Supplement should apply to your trading status. The first three schedules include:
- Schedule 1 sets out the defined terms used in the supplement.
- Schedule 2 sets out the standard representations, covenants, disclosures, acknowledgements and notifications that will allow parties to comply with the final rules and may be incorporated into any agreement where your counterparty is a swap dealer.
Under the CFTC’s external business conduct rules, swap dealers that “recommend” a swap or a trading strategy involving a swap to a counterparty are subject to suitability requirements, including conducting a “reasonable diligence” to establish counterparty-specific suitability. A safe harbour for the swap dealer is available if the swap dealer can determine that the counterparty is capable of independently evaluating the investment risks of a swap. This determination can only be established if the counterparty represents that it has complied in good faith with written policies and procedures reasonably designed to ensure that the persons responsible for evaluating recommendations and making trading decisions are capable of doing so. Therefore, if your swap dealer(s) want to rely on this safe harbor, you will need to have these written policies and procedures in place for your funds.
- Schedule 3 sets out the representations, covenants and disclosures needed to allow parties to take advantage of the institutional suitability safe harbors available to counterparties who are not special entities. Generally speaking, each of your funds will need to represent that it has complied with written policies and procedures regarding the selection of the person responsible for evaluating swap recommendations and that it is exercising independent judgment in evaluating swap recommendations.
The remaining schedules are to be used by pension plans and other “special entities” and are not described in this Bulletin.
CFTC Rescinds the Private Fund Manager Exemption but Retains De Minimis Exemption
The CFTC has repealed the commodity pool operator (CPO) registration exemption that was widely used by private funds that are available only to highly sophisticated investors. The CPO exemption placed no limit on the amount of commodity interest trading by such funds.
With the repeal of the CPO exemption, private funds now need to rely on the de minimis registration exemption, which limits their trading in commodity interests and generally requires that their securities are offered only to “accredited investors”. In order to fit within the de minimis exemption, the fund’s commodity interest positions must be limited such that either:
- the aggregate initial margin and premiums required to establish such positions will not exceed 5 percent of the liquidation value of the fund’s portfolio, after taking into account unrealized profits and losses; or
- the aggregate net notional value of such positions, determined at the time the most recent position was established, does not exceed 100 percent of the liquidation value of the fund’s portfolio, after taking into account unrealized gains and losses.
In determining these limitations, fund managers should only include “swaps”, not “security-based swaps” (“security-based swaps” include swaps on single securities and on narrow-based securities indices). However, because the U.S. Treasury has not finalized its determination as to whether to exclude certain currency derivatives from the term “swap”, all currency derivatives must be included in the calculations for determining the availability of the exemption. It is expected that the U.S. Treasury will make a final determination regarding currency derivatives by year-end.
Although the CFTC did not explicitly address which entity should register as the CPO of a private fund, it has indicated that the investment adviser may be the logical entity. In addition, private fund advisers that currently rely on an exemption from the requirement to register as a commodity trading advisor (CTA) will now have to ensure that their advised funds limit their commodity interest trading or register with the CFTC as a CTA.
At this point, the CFTC has not adopted a foreign adviser exemption. The extent of CFTC jurisdiction over Canadian fund managers is not completely clear at this time. Most non-U.S. based private fund advisers that advise a fund with at least one U.S. investor will either be required to register with the CFTC or to reduce the fund’s commodity interest trading (i.e., OTC derivative trading in swaps, including all trades referencing or calling for the exchange of one or more currencies) to fall within the de minimis exemption. Advisers that are now required to register as a CTA may be able to qualify for regulatory relief from certain of the requirements relating to the preparation of a disclosure document, periodic and annual reporting to investors and recordkeeping.
The date set by the CFTC for registration or compliance with the de minimis amount registration exemption is December 31, 2012.
Because registration brings you and your investment funds into the regulatory ambit of the CFTC, and in light of the testing, recordkeeping, reporting and other new requirements, it is important to first consider carefully whether a registration exemption is available.