The Commodity Futures Trading Commission (the “CFTC”) has issued a rule jointly with the Securities Exchange Commission further defining the term “swap” and “security-based swaps”. In that rule, CFTC has taken the view that the guarantee of a swap is itself a “swap” for purposes of the Commodity Exchange Act, as amended (“CEA”), including by Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd‑Frank”). Under the CEA it is illegal for any person other than an “eligible contract participant” (“ECP”) to enter into a swap unless the swap is entered into on, or subject to the rules of, a board of trade designated by the CFTC as a contract market. As a result, the guarantee of a swap by a guarantor that is not an ECP—even if the direct counterparty to the swap is an ECP—raises significant issues. The CFTC is asserting broad jurisdiction, even extra-territorially, so caution needs to be applied even where the swap provider and/or its counterparty are not US persons.
Under many secured loan facilities, swaps entered into by a borrower (or one of its subsidiaries) benefit from the same credit support as the direct obligations under the loan facilities, including security and guarantees from the borrower group. Under the CEA, if any member of the borrower group which provides a guarantee or security of a swap is not an ECP, then the guarantee of the swap by such subsidiary would not be enforceable. Amendments to existing swaps and/or guarantees may raise similar issues in this respect.
The LSTA (a trade association the aim of which, among others, is to set standards for corporate lending and loan trading in the US) recommended approach to dealing with this issue, which has been generally accepted in the US market, is to draft any guarantees (and security documents) so as to exclude any guarantee of (or security for) swap obligations by an entity that is not an ECP at the time the swap is entered into. This helps to eliminate the risk that the guarantee (or security) as it applies to the loan obligations may also be tainted, which is a risk given that the credit support for the swaps is usually provided pursuant to the same documentation supporting the loan obligations. The LSTA also recommends, for added protection, the inclusion of “keepwell” arrangements in the documentation pursuant to which ECPs effectively confer ECP status on non-ECPs, thereby making them eligible under the CEA to guarantee swap obligations.
Given the potential extraterritorial application of the Title VII of Dodd-Frank amendments to the CEA, and the practical risk that a US institution directly subject to the CEA may provide a swap to the borrower group in the future, it is recommended that the LSTA approach is followed in all loan facilities (whether or not US institutions are initial lenders) to eliminate the risk of a violation of the CEA with respect to the credit support provided for the swaps themselves, as well as any risk of tainting the credit support for the direct loan obligations.