New swap rules issued under the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), which became fully effective on April 1, 2013, have significant implications for borrowers and lenders in credit facilities where guarantees and security documents cover swap obligations. Borrowers are often required to maintain certain hedges for interest or currency risk and the loan documentation is often structured so that the guarantee and security documents cover not only the loan obligations but also the swap obligations. Under the new rules, if a guarantor or grantor of security is not an “eligible contract participant”, the entire guarantee or security document may be unenforceable, even where the direct counterparty to the swap itself is an eligible contract participant. This is an issue that can often arise in financings where a parent borrower qualifies as an eligible contract participant but its obligations are guaranteed or secured by its subsidiaries.
Under Section 2(e) of the Commodity Exchange Act, as amended by the Dodd-Frank Act (the “CEA”), unless a swap is entered into on, or subject to the rules of, a board of trade designated as a contract market by the U.S. Commodity Futures Trading Commission (the “CFTC”), the swap must be entered into by an entity that is an “eligible contract participant”, as defined under the CEA. The CFTC has interpreted “swap” to include a guarantee of a swap. The Office of General Counsel of the CFTC, in an October 12, 2012 no-action letter no. 12-17 (the “CFTC 12-17 Letter”) provided that guarantors of swap obligations generally must be eligible contract participants and that entities that are not eligible contract participants may not be jointly and severally liable for swap obligations. The CFTC 12-17 Letter provides that it covers guarantees only and does not address other credit support arrangements (such as pledge and security agreements or mortgages) and noted that the CFTC may address such issues in the future. Although the application to security documents is not clear, parties are generally interpreting the new rules to apply to security agreements and other provisions of collateral as well as guarantees.
It is important that borrowers and lenders promptly and carefully consider the implications of the new swap rules and take steps to address them in loan documentation.
Eligible Contract Participant
Section 1a(18) of the CEA sets forth the definition of “eligible contract participant”, which includes, among others, a corporation, partnership, proprietorship, organization, trust, or other entity (i) that has total assets exceeding $10,000,000, (ii) the obligations of which are guaranteed or otherwise supported by a letter of credit or keepwell, support, or other agreement by an entity that has total assets exceeding $10,000,000 or (iii) that has a net worth exceeding $1,000,000 and is hedging its commercial risk. Many borrower entities have sufficient assets to reach the dollar threshold or otherwise satisfy one or more of the clauses of the definition; however, a borrower’s subsidiaries, which are often guarantors and grantors of security in credit facilities, may not.
In situations where a swap is hedging commercial risk, it is not clear whether a subsidiary guarantor or grantor would qualify as an eligible contract participant under clause (iii) because the commercial risk would not be its own risk but rather that of the swap counterparty entity (the borrower).
As a result, parties are generally seeking to qualify guarantors and grantors as eligible contract participants under clause (i) or (ii).
If the guarantor or grantor with respect to swap obligations is not an eligible contract participant, then the guarantee or security documents would be unenforceable and illegal. Because guarantees and security documents usually do not contain a severability provision, the entire guarantee or security document could be unenforceable, including the guarantee or security provided (i) to secure loan obligations and (ii) by co-guarantors or grantors that are eligible contract participants. Such a result would trigger default provisions in the loan documents and the swap documents, which could in turn trigger cross-default provisions in other agreements.
In addition, since under the CEA it is unlawful for a person to enter into a swap if it is not an eligible contract participant, unless the swap is entered into or subject to a designated contract market, an entity that is not an eligible contract participant may be subject to an enforcement action by the CFTC.
The rules with respect to swap guarantors apply not only to new loan documents but also to existing loan documents in certain circumstances. Eligible contract participant status is determined at the time a swap is entered into, so the new rules apply to existing loan documents where the swap documentation or guarantee or security documents covering the swap obligation are entered into on or after the effectiveness of the rules, including a guarantee joinder agreement entered into by a new subsidiary. In addition, the new rules apply to amendments to loan documents where the amendments would constitute entering into a swap.
There are several recommendations for additional loan documentation provisions to address the implications of the new swap rules on guarantees and security documents covering swap obligations:
- Loan documentation and related guarantee and security documents covering swap obligations should contain appropriate provisions so that guaranteed and secured obligations exclude obligations of a guarantor or grantor that is not an eligible contract participant.
- Parties should also consider adding severability provisions in guarantees and security documents covering swap obligations so that if part of the guarantee or security is provided by an entity that is not an eligible contract participant, the guarantee or security granted by eligible contract participants would still be enforceable.
- Provisions in loan documents dealing with waterfall and sharing among lenders and swap counterparties (including intercreditor arrangements) should be examined and drafted to provide that swap counterparties would not get the benefit of proceeds from guarantees made by entities that are not eligible contract participants.
- Additional termination event provisions in the swap documentation with respect to guarantee, waterfall and sharing provisions should also be carefully reviewed and drafted so as to not trigger early termination.
- “Keepwell” and other support arrangements should be included in guarantees or in separate parent support agreements where necessary in order for entities that would not otherwise be an eligible contract participant to qualify as an eligible contract participant.
- Parties should consider adding an eligible contract participant representation in the credit agreement, which representation would be made by the guarantors or grantors each time a guarantee or security document is entered into, as well as at the time each secured swap is entered into. Swap documents already usually include an eligible contract participant representation; however, it is usually made only with respect to the direct swap counterparty entity (the borrower), not its guarantors or grantors, and only at specific times. Credit agreements have not typically contained such a representation with respect to the borrower or its guarantors or grantors.
- On February 15, 2013, the Loan Syndications and Trading Association (the “LSTA”) published a market advisory which includes recommended definitions for use in guarantees and security documents, including definitions of “Excluded Swap Obligation” and “Swap Obligation,” to carve out swap obligations of a guarantor or grantor that is not an eligible contract participant from guaranteed or secured obligations. The market advisory also includes a recommended “keepwell” provision among joint and several guarantors. Because LSTA model credit agreement provisions are included in most syndicated loan documentation, these provisions are being added to new loan documents as well as amendments to existing loan documents.