This article (current as of September 21, 2012) highlights key Dodd-Frank Act provisions that are applicable to portfolio companies that are derivatives users. Most portfolio companies will be regulated as “end users” under Dodd-Frank; this summary does not relate to portfolio companies that are swap dealers or major swap participants, or to investments in public companies (all of which are subject to further regulation).
Evolving Regulations. Although key recordkeeping rules are already in effect, many Dodd-Frank regulations will be issued or phased in later in 2012 and in 2013.
Broad Applicability. The regulations apply to portfolio companies engaging in “swaps.” Swaps are defined broadly under new extensive regulations; however, neither commodity futures contracts nor sales for future delivery intended to be physically settled are swaps.
Recordkeeping and Reporting Compliance. Portfolio companies must make records accessible to regulators, and those records must be kept for five years after each trade terminates. Most reporting will be done by swap dealers and major swap participants, but swaps between two end users will require an agreement as to which end user will be responsible for the reporting.
Position Limits. For designated energy, metal and agricultural commodity products, including futures, options on futures, and swaps on these designated products (except for exempt bona fide hedges), position limit rules have been finalized and will be imposed starting October 12, 2012, or in 2013.
Clearing Requirements and Commercial End User Exemption. Private equity firms entering into interest rate swaps for initial financings and refinancings must be careful as to which corporate entity will enter into those swaps. All swaps must now be “cleared” if a central clearing counterparty (Derivatives Clearing Organization) is willing to accept the swaps for clearing. However, an end user that is not a “financial entity” (note that a private equity fund itself is a “financial entity”) is eligible for an exemption from clearing those swaps that it enters into only to hedge its “commercial risk.” Also, only “eligible contract participants” (for a corporation with more than $10 million in assets and $1 million in net worth, or more than $1 million in net worth and engaging in commercial hedging) can enter into over-the-counter (OTC) swap transactions. An end user still can choose, in its sole discretion, to have its trades cleared.
Documentation. Dodd-Frank rules are also changing how swap transactions are documented. Regulations require the types of collateral that can be taken (and with what “haircuts”), and swap dealers face extensive requirements as to how much collateral they must obtain when entering into OTC trades. Although these requirements may not apply in trades with exempt commercial end users, dealers may attempt to impose them as “best practices.” End users (such as portfolio companies) also must make additional representations to their swap dealers, requiring more recordkeeping and due diligence. While there have been efforts toward standardization of documents, such as the International Swaps and Derivatives Association (ISDA) “protocol” that can be entered into by end users and dealers to supply required representations and information needed by dealers for compliance with U.S. Commodity Futures Trading Commission Business Conduct Rules, such measures have yet to be widely implemented. We are continuing to monitor best practices on behalf of our clients and friends in the private equity community.