On August 16, 2012, the CFTC issued a proposed rule to exempt swaps between certain affiliated entities within a corporate group from the clearing requirement imposed by the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). Dodd-Frank amended the Commodity Exchange Act (CEA) to require clearing of any swap that the Commodity Futures Exchange Commission (CFTC) determines should be subject to mandatory clearing. However, the statute does not exempt from this requirement transactions between affiliates. A number of commenters and market participants have urged the CFTC to adopt a regulatory clearing exemption for inter-affiliate swaps, arguing that such swaps offer significant benefits and create substantially less risk than swaps between unaffiliated entities. The proposed rule would allow the counterparties to an inter-affiliate swap to elect not to clear the swap, subject to the following limitations:
- Only majority-owned affiliates would be eligible for the exemption;
- Both counterparties would have to elect not to clear the swap;
- Swap trading relationship documentation would be required;
- The swap would need to be subject to a centralized risk management program within the group of affiliated entities that is reasonably designed to monitor and manage the risks associated with inter-affiliate swaps;
- Daily marking-to-market and posting of variation margin would be compulsory if both counterparties are financial entities, except in the case of 100% commonly owned and commonly guaranteed affiliates where the common guarantor is also 100% commonly owned;
Each affiliated counterparty would be required to satisfy one of the following conditions:
- it is located in the United States;
- it is located in a country with a comparable and comprehensive clearing regime;
- it is required to clear swaps with unaffiliated counterparties in compliance with U.S. law; or
- it does not enter into swaps with unaffiliated counterparties; and
- Additional reporting requirements would apply.
The proposal was passed by a seriatim vote of 3 to 2, with Commissioners Jill Sommers and Scott O’Malia dissenting. The dissenting commissioners strongly supported a clearing exemption for inter-affiliate swaps but opposed conditioning it upon the posting of variation margin. The comment period will be open for 30 days after notice of the proposed rulemaking is published in the Federal Register.
SCOPE OF THE PROPOSED INTER-AFFILIATE EXEMPTION
Eligible Affiliate Counterparties
As proposed, the inter-affiliate exemption would only be available to “eligible affiliate counterparties,” which are defined as entities that satisfy the following conditions:
- One counterparty directly or indirectly holds a majority ownership interest in the other, or a third party directly or indirectly holds a majority ownership interest in both counterparties; and
- The financial statements of both counterparties are reported on a consolidated basis.
In the proposing release, the CFTC explained that it is not proposing to extend the exemption to swaps between minority-owned affiliates because it does not believe that such swaps involve significantly reduced counterparty risk as compared with swaps between unaffiliated counterparties. The CFTC requested comment on whether to require a higher or lower ownership threshold.
Swap Trading Relationship Documentation
Under the proposed rule, counterparties that wish to rely on the exemption would be required to document inter-affiliate swaps in a swap trading relationship document that contains all terms governing the trading relationship between the affiliates, including payment obligations, netting of payments, events of default or other termination events, calculation and netting of obligations upon termination, transfer of rights and obligations, governing law, valuation and dispute resolution procedures. Affiliates would be able to satisfy this requirement by entering into an ISDA Master Agreement and exchanging confirmations after each trade. A swap dealer or major swap participant that complies with the swap trading relationship documentation requirements for swap dealers in part 23 of the CFTC’s regulations would satisfy the requirements of the proposed rule.
Centralized Risk Management
The proposed rule would require inter-affiliate swaps for which an exemption is claimed to be subject to a centralized internal risk management program reasonably designed to monitor and manage the risks associated with inter-affiliate swaps. The proposing release suggests that the program might be run by the parent company or a treasury affiliate. A swap dealer or major swap participant that complies with the risk management rules for swap dealers in part 23 of the CFTC’s regulations would satisfy the requirements of the proposed rule.
When both counterparties are financial entities, as defined under Dodd-Frank,1 the proposed rule would require each counterparty to pay and collect variation margin. The proposing release explains that variation margin entails marking open positions to their current market value each day and transferring funds between the parties to reflect any change in value since the previous time the positions were marked. In the proposing release, the CFTC does not propose to require variation margin be held in a segregated account or otherwise be unavailable for use and hypothecation.2 The proposal does not set forth minimum standards for calculating variation margin but would require that the methodology be set forth in the swap trading relationship documentation with sufficient specificity to allow the counterparties, the CFTC and any appropriate prudential regulator to calculate the margin requirement independently. As proposed, the exemption would not provide affiliates that are swap dealers or major swap participants with relief from the CFTC’s proposed margin requirements for uncleared swaps for swap dealers and major swap participants. The proposing release also raises a question of whether there should be a similar requirement for initial margin.
Margining requirements would not apply to 100% commonly owned and commonly guaranteed affiliates where the common guarantor is also 100% commonly owned. The proposing release states that this exception is intended to apply to swaps between two wholly owned subsidiaries of a common parent or in instances where one affiliate is wholly owned by the other. The justification for the exception is set forth in the proposing release: when the economic interests of two affiliates are fully aligned, and a common guarantor bears the ultimate risk associated with swaps entered into by either affiliate with unaffiliated third parties, an inter-affiliate swap does not create new risks for the enterprise; it merely allocates risk from one affiliate to the other. Therefore, the posting of variation margin would not substantially mitigate the risk of an inter-affiliate swap.
The proposing release clarifies that a person would not be able to claim 100% ownership based on a contingent right or obligation to take ownership of an equity interest. Conversely, structures in which a person owns 100% of the equity but has an obligation or right to give up all or a portion of that equity interest would not meet the 100% ownership test.
The proposed rule would limit the inter-affiliate exemption to inter-affiliate swaps between two U.S.-based affiliates or between a U.S. affiliate and a non-U.S. affiliate that either (1) is located in a jurisdiction with a comparable and comprehensive clearing regime, (2) is otherwise required to clear swaps with third parties in compliance with U.S. law, or (3) does not enter into swaps with third parties. The proposing release explains that this limitation is intended to address concerns that the inter-affiliate swap exemption might be used to evade the clearing requirement through trades with affiliates located in foreign jurisdictions that do not have a comparable and comprehensive clearing regime.
The CFTC requested comment on an alternative condition to address evasion concerns. That condition would require non-U.S. affiliates to clear all swap transactions with non-U.S. persons, provided that such transactions are related to inter-affiliate swaps that would be subject to the clearing requirement if entered into by two U.S. persons.
In addition to any general reporting requirements applicable under other rules to a particular type of entity that is a counterparty to an inter-affiliate swap or to the inter-affiliate swap, the proposed rule would implement reporting requirements specifically for uncleared inter-affiliate swaps. One of the counterparties would be required to provide the following information to a swap data repository (SDR) or, if no SDR exists, to the CFTC:
- Confirmation that both counterparties to the swap are electing not to clear the swap and that each of the counterparties satisfies the requirements to claim the exemption;
- For each counterparty, how the counterparty generally meets its financial obligations associated with entering into uncleared swaps; and
- If a counterparty is an issuer of securities registered under section 12 of, or is required to file reports under section 15(d) of, the Securities Exchange Act of 1934, (1) the SEC Central Index Key number for that counterparty and (2) acknowledgment that an appropriate committee of the board of directors of that counterparty has reviewed and approved the decision not to clear the swap.
The information listed in the second two bullets above may be reported annually in anticipation of electing the exemption for one or more swaps.
DISSENT OF COMMISSIONERS SOMMERS AND O’MALIA
Commissioners Sommers and O’Malia voted against the proposed rule. In a joint statement, they explained that, while they wholly supported a clearing exemption for inter-affiliate swaps, they could not support the proposal because of the requirement that financial entities post variation margin to one another. Commissioners Sommers and O’Malia asserted that variation margin requirements are unnecessary and will create administrative burdens and operational risk, tie up capital that could otherwise be used for investment and have the unintended consequence of imposing substantial costs on the economy and consumers. They also noted that a variation margin requirement is inconsistent with the legislative history and with the European Market Infrastructure Regulation.
In July 2012, the CFTC issued proposed interpretive guidance regarding the cross-border application of the swaps provisions of the Commodity Exchange Act (CEA), and a proposed exemptive order that would permit non-U.S. swap dealers and major swap participants to delay compliance with certain provisions of the CEA. Both releases implicate inter-affiliate transactions but do not appear to have been coordinated with the proposed inter-affiliate clearing exemption. Consequently, the three releases may prove difficult to reconcile. Moreover, since the comment periods for the three releases are different, market participants will not be able to review and comment on all of them at the same time.
It is also important to note that the proposal would grant relief from the clearing mandate only. It would not provide a general exemption from the provisions of the CEA, nor would it provide guidance or a general policy addressing the treatment of inter-affiliate issues other than in relation to clearing.