The Commodity Exchange Act (the “CEA”), as modified by Title VII of the Dodd-Frank Act and interpreted by the Commodity Futures Trading Commission (“CFTC”), restricts the types of market participants that are permitted to enter into or provide guarantees with respect to a “swap,” a term defined by the CEA to include any interest rate swap used by a borrower to protect itself against increased borrowing costs under a loan. In particular, with limited exception, every counterparty or guarantor to a swap used for purposes of hedging interest rate risk under a loan must qualify as an “eligible contract participant,” as defined by Section 1a(18) of the CEA (an “ECP”). We have prepared this “Q&A” in order to provide banks, as well as borrowers, with an overview of the key legal principles of the ECP eligibility requirements under the CEA and related rules promulgated by the CFTC. This Q&A does not constitute legal advice and, therefore, you should consult with qualified counsel in order to determine how these principles may apply to the facts of your particular situation.
Does the Commodity Exchange Act place restrictions on which borrowers are eligible to use an interest rate swap to hedge interest rate risk exposure under a loan?
Yes. A borrower must be an “eligible contract participant,” as defined in section 1a(18) of the Commodity Exchange Act (“CEA”), in order to use an interest rate swap to hedge interest rate risk incurred by that borrower in a commercial lending transaction.
Why is that the case?
Because section 2(e) of the CEA makes it unlawful for a person that is not an eligible contract participant to enter into a swap – even if for hedging purposes – unless that swap is entered into over a board of trade that has been designated by the Commodity Futures Trading Commission as a contract market (e.g., a futures exchange). In an October 2012 interpretive letter, the CFTC’s Office of General Counsel (“OGC”) further stated, “Section 2(e) clearly makes it unlawful for a non-ECP to be a jointly and severally liable swap counterparty because such conduct would constitute entering into a swap, which the CEA prohibits from doing” unless the swap is entered into on or over a futures exchange. CFTC Letter No. 12-17¸ October 12, 2012 (“CFTC Letter 12-17”).
How does the CEA define an “eligible contract participant”?
Section 1a(18) of the CEA defines an eligible contract participant (or “ECP”) as an entity or an individual that satisfies specific criteria enumerated in the statute, as further implemented by CFTC Rule 1.3(m). For purposes of this Q&A, we have chosen to focus on the primary means by which a borrower using an interest rate swap for hedging purposes (a “Borrower Counterparty”) would typically qualify as an ECP – it should be noted that we have not attempted to capture every possible ECP qualification test. Rather, we focus on two categories that most banks and borrowers look to – the “entity” ECP category, on the one hand, and the “natural person” ECP category, on the other.
Category I: ECP Eligibility Tests where Borrower Counterparty is a corporation, partnership, proprietorship, organization, trust or other entity (other than a governmental entity)
Total Assets Entity ECP – A Borrower Counterparty can qualify as an ECP if it has greater than $10 million in total assets.* Section 1a(18)(v)(I) of the CEA
*For purposes of qualifying under this $10 million total assets test, a Borrower Counterparty that actually receives the proceeds of a loan is permitted to count those proceeds towards its total assets. Based upon nterpretive guidance from CFTC Letter 12-17 at page 5.
Also, in CFTC Letter 12-17, the CFTC granted no-action relief that allows a Borrower Counterparty to count the proceeds of the loan towards its total assets prior to the borrower receiving such proceeds , as long as these conditions are met:
- The swap for which ECP status is necessary is intended to manage the Borrower Counterparty’s floating interest rate risk on the loan;
- The Borrower Counterparty has received a bona fide loan commitment for such loan, with the further clarification that a commitment will be bona fide if: a) It is in writing; b) The loan closing is subject only to the satisfaction of commercially reasonable conditions to closing; and c) The loan commitment is entered into solely for business purposes unrelated to qualifying as an ECP.
If the loan is to be disbursed in stages (by way of non-limiting example, a construction loan), then such disbursements and related commitment to fund the loan may only be subject to:
- Commercially reasonable closing conditions; and/or
- The occurrence, after loan disbursements have commenced, of any events set forth in the loan or swap documentation that would excuse the lender’s obligation to continue funding the loan (as long as such events are not designed to permit the lender to fail to fund the loan while leaving the swap in place); and
- The loan is funded in an amount that will cause the Borrower Counterparty to qualify as a Total Assets Entity ECP, unless it fails to fund for commercially reasonable closing conditions or the occurrence of any post-closing events that would excuse the lender’s obligation to continue funding the loan.
The OGC noted that it expects a swap to be terminated automatically or contemporaneously with the termination of the related loan – the CFTC made this observation in the context of raising concerns about the use of this no-action relief for purposes of evading the statutory requirement that only ECPs can enter into swaps. CFTC Letter 12-17 at footnote 56.
Net Worth Entity ECP – A Borrower Counterparty can qualify as an ECP if it has a net worth in excess of $1 millionand is entering into the swap in connection with the conduct of its business or to manage the risk associated with an asset or liability owned or incurred or reasonably likely to be owned or incurred by it in the conduct of its business. Section 1a(18)(iv)(III) of the CEA
Counting the Net Worth of ECP Owners – CFTC Rule 1.3(m)(7) allows a Borrower Counterparty to count the net worth of its owners, subject to several technical requirements. In particular, in determining its net worth, a Borrower Counterparty can count the net worth of its owners, as long as:
- The swap is used by the Borrower Counterparty to hedge or mitigate commercial risk, in a manner that satisfies the conditions in CFTC Rule 1.3(kkk). An interest rate swap used by a Borrower Counterparty to hedge interest rate risk relating to a loan used by the borrower for commercial purposes will usually satisfy the conditions of that rule;
- All of its owners are ECPs;
If any owner is a natural person, then that person may be a “proprietorship ECP” only if –
- That person’s proprietorship status is independent of the business conducted by the Borrower Counterparty (i.e., that person actively operates a business other than the Borrower Counterparty);
- That person directly owns all of the assets of the other business;
- That person directly is responsible for the liabilities of the other business; and
- That person acquires his/her interest in the Borrower Counterparty (i) in connection with the conduct of the individual’s proprietorship or (ii) to manage the risk associated with an asset or liability owned or incurred or reasonably likely to be owned or incurred by the proprietorship.
In determining the net worth of its owners, the Borrower Counterparty must “look through” any shell company that is the counterparty’s owner. In other words, every owner of a shell company must be an ECP. A “shell company” means any entity that limits its holdings to direct or indirect interests in entities that are relying on CFTC Rule 1.3(m)(7). Further, as explained by the CFTC, the shell company “look through” requirement “may apply repeatedly in a chain. For example, if in determining whether an entity may rely on [CFTC Rule 1.3(m)(7)], an owner of that entity that is a shell company is disregarded, then if the owner of that shell company is also a shell company, that second shell company also is disregarded, and so on.” CFTC Rule 1.3(m)(7)
Guarantee Conferred Entity ECP – A Borrower Counterparty can qualify as an ECP, if its obligations under the swap are guaranteed by an entity (the “Guarantor”) that is any one of the following:
- A Total Assets Entity ECP (i.e., corporation, partnership, proprietorship, organization, trust or other entity with more than $10 million in total assets);
- A financial institution;
- A state-regulated insurance company;
- An investment company;
- A commodity pool with $5,000,000 in total assets and that meets certain other specified conditions;
- A governmental entity;
- An agency, instrumentality, or department of a governmental entity that owns and invests on a discretionary basis $50,000,000 or more in investments; or
- An entity that the CFTC designates, under authority granted in section 1a(18)(C) of the CEA, as being eligible to confer ECP status on a Borrower Counterparty. Such a designation is rare and is likely to apply to a single applicant (for example, a single bank that seeks relief for a very particular class of its client base), rather than on a “industry wide” basis. Thus, as apractical matter, this last item is likely to be of limited utility.
Section 1a(18)(v)(II) of the CEA
In CFTC Letter 12-17, the OGC stated that it would not recommend that the CFTC pursue an enforcement action against a Guarantor guaranteeing the swap obligations of a third party that is not an ECP (such non-ECP third party, a “Guaranteed Swap Counterparty”), as well as the beneficiary of the guarantee (the “Beneficiary”), if all of the following conditions are satisfied.
The Guarantor is:
- A corporation, partnership, proprietorship, organization, trust, or other entity that has a net worth exceeding $1 million; or
- An indirect proprietorship that consists of an individual (or individuals, to the extent that the laws of the state in which the proprietorship operates permit a proprietorship to be comprised of more than one person) with either i) net worth exceeding $1 million or ii) amounts invested on a discretionary basis in excess of $5 million. For purposes of this relief, the OGC defined an indirect proprietorship as, a natural person with more than $1 million in net worth or more than $5 million in amounts invested on a discretionary basis who operates small businesses through entities for any one or more legitimate business reasons, including creditor protection and tax efficiency, and is seeking to guarantee swaps entered into by those small businesses to manage the floating interest rate risk of their business loans; and
All of the following conditions, if applicable, are also satisfied:
- The Guaranteed Swap Counterparty enters into the swaps solely to manage the floating interest rate risk associated with a loan received, or reasonably likely to be received, by the Guaranteed Swap Counterparty in the conduct of its business. A loan is “reasonably likely to be received,” if borrower has received a bona fide loan commitment or bona fide loan agreement from a lender, as more fully outlined in section II.B of CFTC Letter 12-17.
- In the case of all Guarantors other than a proprietorship Guarantor, the Guarantor is an owner of the Guaranteed Swap Counterparty and plays an active role in operating the business of such Guaranteed Swap Counterparty;
- In the case of a proprietorship Guarantor, the Guarantor and the Guaranteed Swap Counterparty are co-proprietors;
- The Guarantor computes its net worth or amounts invested on a discretionary basis in accordance with GAAP, consistently applied (provided that the value of real property can be determined in good faith using fair market value);
- The Guaranteed Swap Counterparty enters into the guaranteed swaps only as principal; and
- The Beneficiary (e.g., the bank making the loan to the borrower) verifies that the Guarantor and Guaranteed Swap Counterparty satisfy all of these conditions.
As a final point of clarification, the no-action relief provides market participants with certainty that the OGC will not recommend that the CFTC bring enforcement actions under the CEA. However, in implementing ECP compliance programs, some banks are choosing to only rely on the statute (Section 1a(18)(v)(II) of the CEA) and are, in essence, not utilizing the relief afforded under CFTC Letter 12-17 in respect of the ability of a Guarantor to confer ECP status.
Category II: ECP Eligibility Tests where Borrower Counterparty is a natural person (other than a natural person seeking to qualify as a proprietorship under Category I)
Total Discretionary Investments Natural Person ECP – A Borrower Counterparty can qualify as an ECP if he/she has amounts invested on a discretionary basis* in excess of $10 million. Section 1a(18)(xi)(I) of the CEA
Total Discretionary Investments + Hedging Natural Person ECP – A Borrower Counterparty can qualify as an ECP if he/she has amounts invested on a discretionary basis* in excess of $5 million, as long as he/she is entering into the swap in connection with the conduct of its business or to manage the risk associated with an asset or liability owned or incurred or reasonably likely to be owned or incurred by it in the conduct of its business. Section 1a(18)(xi)(II) of the CEA
*The OGC has indicated that the value of the “amounts invested on a discretionary basis” can be determined in the same manner as “investments” for purposes of SEC Rule 2a51-1 under the Investment Company Act of 1940. That rule contains a “list” of items for consideration in determining the value of any investment, including a requirement that the ownership of interests in a closely-held (or “family”) business will only count if the business has shareholders’ equity in excess of $50 million. CFTC Letter 12-17
Do the ECP eligibility requirements apply to a Guarantor of a swap?
Yes, in CFTC Letter 12-17, the OGC reiterated the requirement that every Guarantor of a swap must qualify as an ECP. Although that interpretive position was effective upon issuance, the OGC offered No-Action relief through the period ending March 31, 2013, from enforcement actions by the CFTC against a Guarantor, beneficiary, or swap counterparty for violations of the CEA, in circumstances where a swap is guaranteed by a Guarantor that does not qualify as an ECP.
Note: The requirement that each Guarantor be an ECP is a different issue than the ability of a Guarantor to confer ECP status, as provided for by Section 1a(18)(v)(II) of the CEA and discussed in the previous question.
How do the ECP eligibility requirements apply to other credit support arrangements in respect of a swap?
In CFTC Letter 12-17, the OGC stated that its interpretation under that letter requiring that each guarantor of a swap must be an ECP, “…is limited to guarantees of swaps and does not address any other credit support arrangements…Thus, for example, a non-ECP may provide collateral to support a third party’s swap obligations” (Footnote 12). In February 2013, the Loan Syndications and Trading Association (“LSTA”) issued a market advisory notice stating that, “The application of [the ECP qualification requirements] to security interests is uncertain, and lenders should consider the need to limit the obligations secured by any grant of a security interest by a non-ECP guarantor so that it only secures the loan obligations and not the swap obligations.” However, in April 2013, the International Swaps and Derivatives Association (ISDA) published the ISDA Non-ECP Guarantor Exclusionary Terms (the “ISDA Exclusionary Terms”) and in a related explanatory memorandum stated that, “Because the OGC’s interpretive position is explicitly limited to guarantees and excludes other credit support arrangements, the ISDA Exclusionary Terms are similarly limited to situations in which a person acts as guarantor or surety and do not include persons who provide collateral or other credit support in connection with a swap.” In other words, the LSTA appears to have taken the position that a non-ECP guaranteeing loan obligations may only pledge assets to support the loan (and not the swap), while ISDA appears to have taken the position that a non-ECP may pledge assets to support the swap (as well as the loan, of course).