The Dodd-Frank Wall Street Reform and Consumer Protection Act1 and related regulations have introduced a wide variety of new rules governing activities in the previously unregulated swap market and imposing significant obligations on swap market participants. While most of these rules apply to newly regulated entities such as swap dealers (“SDs”) and major swap participants (“MSPs”)2, the cooperation of end-users3 will be necessary to aid in their SD and MSP counterparties’ compliance efforts.
The International Swaps and Derivatives Association (“ISDA”) August 2012 Dodd-Frank Protocol (the “Protocol”), which became available beginning August 13, 2012, is a mechanism designed to enable market participants to effect standardized amendments or supplements to swap trading documentation in order to comply with certain Dodd-Frank Act-related regulations without the need for bilateral negotiations. An end-user’s failure to take appropriate action under the Protocol could threaten the ability of its regulated counterparty to comply with these regulations and, in some cases, could result in an interruption in the end-user’s swap trading activities.
This memorandum outlines the regulatory background and the structure of the Protocol, and highlights the effect of the Protocol and the related regulations on endusers.
The Protocol is intended to address compliance obligations under seven CFTC final rules (the “Covered Rules”)4 issued pursuant to the Dodd-Frank Act relating to:
- External business conduct standards of SDs and MSPs;
- Large trader reporting for physical commodity swaps;
- Position limits;
- Real-time public reporting of swap transaction data;
- Swap data recordkeeping and reporting; and
- SD and MSP conflicts of interest.
The Protocol is primarily focused on the External Business Conduct Rules, which dramatically change the manner in which SDs and MSPs may transact and otherwise interact with their swap counterparties. As discussed in more detail below, an end-user is expected to provide certain information that will enable its SD or MSP counterparty to comply with the External Business Conduct Rules, or, if both parties agree, to establish the elements of a “safe harbor” under the relevant rules. Therefore, as a practical matter, the rules will require modified or additional documentation between an SD or MSP and its end-user counterparty in over-the-counter swap transactions.
SDs and MSPs must comply with many of the External Business Conduct Rules beginning on January 1, 2013, though compliance with a few important provisions is still required by October 15, 2012.5 The compliance date for the other Covered Rules will generally occur on or about October 12, 2012.6 These deadlines give swap market participants little time to implement necessary changes to swap trading documentation, especially considering that many of the rules were finalized relatively recently. In response to this time pressure, ISDA has designed the Protocol to provide for standardized amendments or supplements to uncleared swap documentation in order to eliminate the need for prolonged bilateral negotiations and enable swap activities to continue without interruption.
STRUCTURE OF THE PROTOCOL
Under the Protocol, parties to a swap master agreement exchange information, representations and agreements. These representations and agreements from end-user counterparties will enable SDs and MSPs to satisfy many of their obligations under the relevant portions of the Covered Rules, and some SDs and MSPs may require that counterparties provide these in order to continue trading swaps.
The Protocol, unlike earlier ISDA protocols, involves several documents and steps because it contemplates the exchange of a substantial amount of information between two swap parties:
- The Protocol Agreement sets forth the scope of the Protocol and provides instructions for participation.
- In order to participate in the Protocol, each party must execute an Adherence Letter by the adherence cut-off date7 and pay an adherence fee.
- Each adhering party8 must also deliver a Questionnaire to each of its adhering counterparties within 30 days after the adherence cut-off date. Questionnaires may be delivered via an ISDA/Markit electronic platform called “ISDA Amend” where each party designates the specific counterparty or counterparties with which it intends to amend and supplement its swap agreement using the Protocol.9
- The DF Supplement consists of six schedules of representations, disclosures and agreements that address substantive requirements under the Covered Rules (the “Schedules”). All adhering parties are deemed to incorporate Schedules 1 and 2 of the DF Supplement. Schedules 3 through 6 are elective and designed to permit an SD to comply with the “safe harbors” provided under the External Business Conduct Rules relating to the “suitability” and “best interest” assessment obligations of SDs. Each adhering party designates the Schedules it wishes to incorporate into a particular swap agreement, and the Protocol allows parties to apply different Schedules to different counterparties.
- The DF Terms Agreement permits an SD and its counterparty to apply selected terms of the DF Supplement to swaps that are not already subject to a written swap master agreement but are instead documented based on, for example, a long form confirmation.
If each party to a swap agreement has (i) submitted an Adherence Letter to ISDA, (ii) designated the other party as a counterparty, and (iii) delivered the Questionnaire to the other party, then the parties are deemed to have amended their swap agreement (or entered into a new agreement) to incorporate the mandatory terms under the DF Supplement as well as the elective terms to which both parties have agreed.
End-users should begin to review the Protocol in order to determine whether they are prepared to provide the representations and agreements required under the DF Supplement and the Questionnaire.
In addition to basic identification information regarding the parties, the Questionnaire is designed to solicit from an end-user information (i) required to be obtained by an SD or MSP in order to discharge its duties under the Covered Rules, primarily the External Business Conduct Rules, or (ii) necessary to establish an SD’s or MSP’s ability to rely on a safe harbor thereunder. End-users should be aware that they will be providing much of this information in the form of representations and agreements, and that some of the requisite information could require research and diligence efforts. Some of the requirements under the External Business Conduct Rules and the corresponding Protocol provisions are briefly outlined below:
- Know-Your-Counterparty Procedures: An SD (but not an MSP) must implement policies and procedures to obtain and retain a record of the “essential facts”10 concerning each counterparty. The Questionnaire (i) requires an end-user to provide (and update) any information that an SD may reasonably request to comply with these obligations, and (ii) solicits specific representations from an end-user regarding its status, such as whether it is a “commodity pool”11 or a “financial entity.”12
Counterparty Information: Each SD and MSP must obtain from its counterparty information regarding:
- the identity of the counterparty and its guarantors and control persons;
- the principal occupation or business of the counterparty; and
- the counterparty’s “legal entity identifier.”13 The Protocol solicits this information from all adhering parties.
- Verification of Counterparty Eligibility: Each SD and MSP must verify that its swap counterparty is an “eligible contract participant” (“ECP”)14 and ascertain whether a counterparty is a “special entity.”15 The Questionnaire therefore requires an end-user to represent whether it is an ECP or a “special entity.” Because an SD or MSP can only rely on such representation if the end-user specifies which prong of the applicable definition applies, the end-user is also required to represent which subsection(s) of the ECP or “special entity” definition, as applicable, describe(s) its status.
- Confidential Information: With limited exceptions, an SD must maintain the confidentiality of material confidential information provided to it by its counterparty.16 The Protocol enables an SD to qualify for some of these limited exceptions by having its end-user counterparty agree that the SD may use confidential information in order to establish the price or adjust the terms of a swap, or for the purpose of hedging market or liquidity risk or counterparty credit exposure.
- Disclosure of Material Information: Prior to entering into a swap, SDs and MSPs are required to disclose “material information”17 regarding the proposed swap to each end-user counterparty. While the Protocol does not fully address this requirement, ISDA is working to publish standardized disclosure statements that an SD or MSP may use for common product categories. In addition, under the Protocol the end-user counterparty may elect to receive oral disclosure (with written confirmation post-trade) of certain material information, including pre-trade mid -market marks and basic economic terms.
- Scenario Analysis: Prior to entering into a swap that is not available for trading on a designated contract market or swap execution facility, an end-user may request from its SD counterparty, and an SD must provide, a scenario analysis that would allow the end-user to assess the potential exposure of the swap. The Protocol provides for an acknowledgement by an end-user that if it wants to request a scenario analysis, it must do so prior to execution of the swap.
- Suitability/Best Interests: If an SD (but not an MSP) has “recommended”18 a swap to an end-user counterparty, then it may be required to assess whether the swap is “suitable”19 for such counterparty, or if the end-user counterparty is a special entity, whether the swap is in the special entity’s “best interests.”20 Schedule 3 of the DF Supplement is intended to establish the elements of a “safe harbor” available to an SD facing a nonspecial entity end-user, and contains representations by the end-user that it has implemented written policies and procedures that are reasonably designed to ensure that it (or its “designated evaluation agent,” if any)21 is capable of evaluating and making trading decisions with respect to swaps. While Schedule 3 is optional for both an SD and its end-user counterparty, it is possible that some SDs will require their end-user counterparties to elect this Schedule in order to allow the SD to benefit from the safe harbor. In this case, end-users will need to formulate the written policies and procedures required under the rule.
Given the complexity of the Dodd-Frank Act’s regulations and the tight timeframe for compliance, it would be prudent for end-users to review the Protocol and understand its implications for their swap trading activities. To participate in the Protocol, end-users should be prepared to provide the information required under the Protocol and to determine which elections and representations they will make. Market participants should also stay tuned for other documentation initiatives by ISDA and other organizations to bring overthe- counter swap trading in line with additional regulatory requirements. Since the swaps regulatory landscape is still taking shape, future protocols or similar initiatives may be expected to address SEC rules applicable to security-based swaps, other CFTC rules as they become final, and regulatory developments in other jurisdictions.