Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank”) imposes registration, reporting, clearing, conduct and other requirements on previously unregulated swaps markets. Dodd-Frank left much of the regulatory detail for the Commodity Futures Trading Commission (“CFTC”), the Securities and Exchange Commission (“SEC”) and other regulators to complete through rulemaking. Dodd-Frank contemplated that the SEC would regulate “security-based swaps” (swaps based on single securities or narrowly based securities indices), and that the CFTC would regulate most other swaps (including interest rate swaps, commodity swaps, currency swaps and credit default swaps based on broader indices). Much of the CFTC’s Dodd-Frank rulemaking is now complete.
The CFTC’s rules fundamentally change how swaps will be entered into, documented and maintained, and impose clearing, execution, reporting and recordkeeping requirements where no such requirements had previously existed. Although the burden of compliance with these rules falls most heavily on swap dealers (“SDs”) and major swap participants (“MSPs”), corporate end-users have some additional responsibilities too -- and the compliance dates for those responsibilities have either arrived or are fast approaching.
Although Sullivan & Worcester LLP’s Financial Derivatives Group advises both swap dealers (including bank dealers) and end-users of swaps and other derivatives, this advisory is focused on corporate end-users of swaps and is intended to alert these end-users to certain common items that should be on their “to do” list for attention now or within the next nine months. These items (discussed in more detail below) are:
1. Current “to do’s” for corporate end-users:
• Obtain an LEI/CICI (see paragraph II.A below), • Review and adhere to the ISDA August 2012 Dodd-Frank (DF) Protocol (see paragraph II.B below), • Identify any “historical swaps” as to which the end-user is a “reporting party” (see paragraph II.C below), and • Confirm compliance with all CFTC swap recordkeeping requirements – to which end-users are already subject (see paragraph II.D below).
2. For completion by end-users prior to April 10, 2013:
• If the end-user is a reporting party for any “historical swap,” prior to the reporting compliance date for that swap (for end-users, April 10, 2013), report all required information to the applicable swap data repository (“SDR”) or, if none, the CFTC (see paragraph II.C.2 below).
3. End-users to target for completion prior to the end of the 2nd quarter of 2013:
• The end-user should determine whether it makes sense as a commercial matter for it to clear any swap that will be subject to a clearing requirement (see paragraph II.E.1 below); • If clearing is not a sensible option, the end-user should determine whether the non-financial end-user exception to the swap clearing requirement is available to it (see paragraph II.E.2 below) for such swap; • If clearing is a sensible option, or if the non-financial end-user exception is unavailable, the end-user should select the regulated derivatives clearinghouse (known as a “derivatives clearing organization” or DCO) it will use to clear its swaps, and to finalize clearing documentation with the DCO and one or more of its clearing members; and • If the end-user elects to use the non-financial end-user exception to avoid clearing the swap --
- The end-user must arrange for the filing of an annual report with the SDR or CFTC confirming the end-user’s entitlement to the non-financial end-user exception, and
- The end-user (if an SEC filer) must adopt a board vote approving the decision to use the non-financial end-user exception for swaps of that class (see paragraph II.E.2 below).
II. END-USER ACTION ITEMS
A. Legal Entity Identifier
The CFTC’s reporting and recordkeeping rules (see below) require that each counterparty to any swap be identified in all recordkeeping and swap data reporting by its Legal Entity Identifier (“LEI”) (also referred to as a “CFTC Interim Compliant Identifier” or “CICI”). The CFTC has designated DTCC/SWIFT to provide CICIs.
B. ISDA August 2012 Dodd-Frank (DF) Protocol
The purpose of this protocol is to modify and supplement International Swaps and Derivatives Association (ISDA) documentation to facilitate SD and MSP compliance with counterparty eligibility and “know your counterparty” rules.
An end-user may accept the protocol through the submission of an online adherence letter to ISDA. The second step of the adherence process involves the exchange of completed questionnaires between the end-user and its SD or MSP counterparty as to their swap agreements (a “Protocol Covered Agreement”). Each questionnaire will include representations from each relevant adherent as to its legal status under Dodd-Frank (eligible contract participant, SD, MSP, etc.). The questionnaire incorporates the ISDA August 2012 DF Supplement, which lists six Schedules, of which only Schedules 1 and 2 are expected to be applicable to all counterparties. The Schedules impose additional reporting obligations and undertakings on end-users, require end-users to acknowledge receipt of certain information and may modify existing confidentiality undertakings (among other things) -- and should be carefully reviewed by end-users. Notwithstanding this cautionary note, from January 1, 2013 (if not before), end-user adherence to the protocol will likely be a condition to any SD’s agreement to enter into a new swap with an end-user.
C. Reporting requirements
CFTC rules generally require that an SD, MSP or non-SD/MSP end-user “reporting party” report data to an SDR as to any swap not executed on a swap execution facility (an “SEF”) or a designated contract market (a “DCM”). Swaps not executed on an SEF or DCM are referred to generally as “off-facility” swaps. Reporting is required for all swaps entered into after the applicable compliance dates described below (referred to in this advisory as “new swaps”), as well as for “historical swaps” (also described below).
1. Reporting requirement for new swaps
Happily for end-users, under the CFTC’s rules, the “reporting party” for any off-facility swap will be the end-user’s SD or MSP counterparty – if there is one. In the rare instance where both counterparties to the swap are non-SD/MSP counterparties (an inter-affiliate swap, for instance), one of the non-SD/MSP counterparties will be the reporting party. The CFTC rules provide a decision waterfall that sorts out which non-SD/MSP counterparty will be the reporting party.
At the creation of any off-facility swap, the applicable reporting party must provide the SDR with (among other information) -
• The swap’s primary economic terms and confirmation data (referred to as “swap creation data”), plus • The LEI/CICI for each counterparty to the swap, plus • The “unique product identifier” applicable to the swap (if any).
Swap creation data for swaps executed on an SEF or DCM are to be provided to the SDR by the relevant SEF or DCM.
“Continuation data” (which includes changes to the primary economic terms of the swap and valuation changes) must also be reported to the SDR by the reporting parties. For cleared swaps, only DCOs and SDs/MSPs have an obligation to report continuation data to SDRs. Non-SD/MSP counterparties are only obligated to report continuation data for uncleared swaps.
Where SDs or MSPs are the reporting parties, CFTC rules generally require swap creation data to be provided as soon as technologically practicable after the swap is entered into, but in any event within narrow reporting windows (in or near real time). Non-SD/MSP counterparty reporting windows are more generous than those afforded SDs or MSPs.
The CFTC’s reporting rules are being phased in over time based on counterparty and product type. The compliance dates are:
• October 12, 2012 -- All SEFs, DCMs, DCOs, SDs and MSPs must comply as to interest rate swaps and credit default swaps. • January 10, 2013 -- All SEFs, DCMs, DCOs, SDs and MSPs must comply as to all remaining swap types (equity swaps, FX swaps and commodity swaps). • April 10, 2013 – Non-SD/MSP counterparties must comply as to all swaps in all asset classes.
2. Reporting requirements for historical swaps
The CFTC rules also obligate reporting parties to report on their “historical swaps.” A “historical swap” is any swap (x) entered into prior to the enactment of Dodd-Frank (July 21, 2010) but not terminated or expired as of that date (“pre-enactment swaps”), or (y) entered into on or after July 21, 2010 but prior to the applicable reporting compliance date for such swap and counterparty (“transition swaps”).
The rules for determining which party is the “reporting party” as to historical swaps are similar to the rules applicable to new swaps. Historical swaps and new swaps have the same compliance phase-in dates. For historical swaps that were in existence after April 25, 2011 (the date of publication of the proposed reporting rules), the information to be reported is largely the same as that required for new swaps. For historical swaps that expired or terminated prior to April 25, 2011, the reporting party’s obligations are limited to such swap data as was in the reporting party’s possession on or after October 14, 2010 (for pre-enactment swaps) or December 17, 2010 (for transition swaps)
. D. Recordkeeping requirements
The CFTC rules obligate end-users to retain “full, complete and systematic records, together with all pertinent data and memoranda” with respect to each swap, including, with respect to any swap for which the end-user elects the clearing exception (see below), all records demonstrating its entitlement to that election. Records are to be retained throughout the life of the swap and for at least 5 years after termination. End-users are permitted to retain these records in either electronic or paper form, but the records must be retrievable within 5 business days during the retention period. A unique swap identifier for each new swap (which depending on the circumstances, will be generated by an SEF, DCM, SD, MSP or SDR) must be included in each counterparty’s records during the retention period.
Recordkeeping rules are applicable to both new and historical swaps.
The CFTC’s recordkeeping rules are currently in effect.
E. Swap Clearing
1. Swap Clearing Overview
Dodd-Frank requires a swap to be executed on an exchange and cleared on a DCO following a CFTC determination that swaps of that class are to be cleared.
The CFTC issued its first proposed swap clearing determination on August 7, 2012. The proposed determination would require clearing in four classes of interest rate swaps and two classes of credit default swaps. The comment period for this proposed determination expired on September 6, 2012, and no final determination has yet been issued. As a result, the clearing compliance date for non-financial end-users still is some ways off, since clearing for those end-users does not become mandatory until 270 days after a final clearing determination.
To the extent they have not already done so, end-users would be advised to consider over the next few months whether or not it makes sense for them to clear their swaps (assuming they have a choice in the matter). End-users need to be aware that swap clearing arrangements will require considerable time and effort to put in place.
For end-users, the advantages of swap clearing include:
• Additional liquidity. The end-user should be able to easily trade out of its cleared swap, much as it could do in a regulated futures market. • The mitigation of end-user concerns regarding the creditworthiness of its SD or MSP counterparty. Clearing a swap through a DCO means that the DCO has replaced the SD or MSP as the end-user’s counterparty. However, there are various costs and disadvantages associated with swap clearing: • Initial margin requirements (independent amount, in ISDA parlance) will be required by all DCOs, although the amounts may vary by DCO. This is a liquidity drain that will deter most end-users. End-users should be aware, however, that Federal banking regulators have proposed minimum margin requirements for uncleared swaps. These rules would be applicable to swap dealers and other entities (referred to as “covered swap entities”) covered by federal banking regulations. Although these rules are not yet final, if implemented in their current form they could force covered swap entities to hold more collateral for uncleared swap end-user counterparty obligations than is currently the case. • Clearing brings with it daily mark-to-market variation margin requirements (as is the case with futures markets). • The time and cost associated with having to negotiate and document clearing arrangements with the applicable DCO and one (or more) of its clearing members.
2. Non–financial end-user exception
A swap end-user has the option not to clear a swap subject to a mandatory clearing determination if the end-user qualifies for the non-financial end-user exception. Availability of the exception is determined on a swap-by-swap basis.
As a practical matter, a typical corporate end-user of swaps should not find it difficult to qualify under this exception if it so chooses.
The exception is only available to a counterparty that (i) is not a “financial entity” (or is exempt from the definition), (ii) is using the swap in question to “hedge or mitigate commercial risk” and (iii) provides, or causes to be provided, certain information with respect to such swap to the SDR or (if none) the CFTC.
Under Dodd-Frank, the term “financial entity” means:
- a swap dealer;
- a security-based swap dealer;
- a major swap participant;
- a major security-based swap participant;
- a commodity pool under the Commodity Exchange Act,
- a private fund as defined in the Investment Advisers Act of 1940;
- an employee benefit plan as defined in the Employee Retirement Income Security Act of 1974; and
- a person predominantly engaged in activities that are in the business of banking, or in activities that are financial in nature, as defined in the Bank Holding Company Act of 1956.
The CFTC has exempted from the definition of “financial entity” certain banks, savings associations and other entities with total assets of $10 billion or less. Certain finance affiliates are also exempt from the definition.
The CFTC has generously defined the meaning of “hedging or mitigating commercial risk.” To hedge or mitigate commercial risk, the swap must
• Be economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise, or • Qualify as “bona fide hedging” for the purposes of the position limits provisions of the Commodities Exchange Act, or • Qualify for hedging treatment under FASB standards topic 815 (f/k/a Statement No. 133) or GASB Statement 53; and • Not be used for a purpose that is in the nature of speculation, investing or trading or be used to hedge or mitigate the risk of another swap or security-based swap position (unless that other position is itself used to hedge or mitigate commercial risk).
The non-financial end-user exception is also subject to the satisfaction of reporting requirements. For each swap as to which a counterparty has elected to use the non-financial end-user exception, the “reporting party” for such swap must furnish the SDR (or if no SDR is available, the CFTC) with notice of such election, including
• Identity of the electing counterparty to the swap, and
• The following information (which the electing end-user may provide in an annual filing to the SDR or CFTC):
˃ Whether the swap is being used to “hedge or mitigate commercial risk,”
˃ How the electing end–user generally meets its financial obligations, and
˃ If the electing end-user is an SEC reporting company --
› Its SEC central index key number (CIK), and
› Whether the end-user’s board of directors or an authorized committee has reviewed and approved the decision not to clear the swap or execute it on an SEF or DCM.
Although the notice of the election of the clearing exception must be made on swap-by-swap basis, the relevant board or committee approval for SEC filers may be on a general basis. The board or committee approval must be renewed annually, and updated as appropriate (for example when a new hedging strategy is implemented that was not contemplated in the original board vote). End-users can expect that their SD or MSP counterparties will want to review the board approval.