- The passage of the "Promoting Job Creation and Reducing Small Business Burdens Act" in the House continues ongoing efforts to alter Dodd-Frank.
- Even if the bill fails to become law, its provisions – which include a two-year extension for banks to divest themselves of CLOs – are expected to resurface in subsequent legislation.
On Jan. 14, 2015, the effort to repeal or amend certain provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank) continued in the heavily Republican House of Representatives with the passage by that body of H.R. 37., the "Promoting Job Creation and Reducing Small Business Burdens Act." H.R. 37, among other things, includes the following:
exempts certain end-users from mandatory margin requirements in connection with uncleared swaps1
exempts certain affiliate swaps from clearing requirements
provides relief with respect to indemnification related to swap data repositories and derivative clearing organizations
extends for two years the deadline by which banks and other financial companies must divest themselves of collateralized loan obligations (CLOs)
If H.R. 37 does not become law, the Dodd-Frank related provisions it includes are very likely to resurface in subsequent legislation, perhaps as part of "must-have" legislation" on unrelated topics.
A. Margin Requirements Under H.R. 37
Section 731 of Dodd-Frank requires mandatory margin in connection with uncleared swaps entered into by swap dealers and major swap participants (collectively known as "swap entities").2 Separately, certain non-financial entities that enter into swaps to hedge or mitigate commercial risk (known as "end-users") and satisfy certain other requirements are not required to clear swaps that are otherwise required to be entered into only on a cleared basis. Following the passage of Dodd-Frank, it was not certain if end-users exempt from clearing are also exempt from mandatory margin requirements when they enter into uncleared swaps with swap entities. H.R. 37 states that those end-users exempt from the clearing requirement are also exempt from mandatory margin requirements.
The bill also extends relief from mandatory margin requirements to certain cooperative entities3 and certain affiliates of end-users that in each case would be exempt from the clearing requirement.
Exemption from mandatory margin requirements means that the swap entity is not required to demand that its counterparty post initial and variation margin in the amounts at the times and in the manner required by the appropriate regulator. It does not mean that the swap entity may not (and will not) impose margin requirements of its choosing on its end-user counterparty in order to mitigate its risk under the swap.
Margin Regulations Under Dodd-Frank – Does the Legislation Change Anything?
Although Dodd-Frank mandates margin requirements in connection with uncleared swaps, such requirements are subject to implementing regulations that have not yet been finalized. Each swap entity for which there is a "prudential regulator"4 must meet margin regulations imposed by its prudential regulator, and each swap entity for which there is no prudential regulator must meet regulations imposed by the CFTC or the Securities and Exchange Commission (SEC, together with the CFTC, the Commissions).5
On Oct. 3, 2014, the CFTC issued a proposed rule with respect to margin requirements for uncleared swaps.6 Under the proposed rule, margin is not required to be posted by entities that are not "financial end-users" (as defined therein), and initial margin is not required to be posted by entities that are financial end-users but not swap entities, unless the financial end-user crosses a "material swaps exposure." Therefore, the proposed rule provides an exemption from posting that is significantly broader than what is proposed to be enacted by H.R. 37. The SEC also issued a proposed rule providing for an exemption from margin requirements similar to that in the bill for "commercial end-users" (as defined therein) using swaps to hedge or mitigate commercial risk.7 In the face of the Commission implementing regulations, the perceived need for an amendment of Section 731 of Dodd-Frank is not clear.
However, the House Committee on Agriculture cites the recent proposed regulation by the prudential regulators as requiring an explicit amendment. The prudential regulators with jurisdiction over margin requirements for swaps and security-based swaps for federally insured deposit institutions, farm credit banks, federal home loan banks, the Federal Home Loan Mortgage Corporation and the Federal National Mortgage Corporation took a different approach from the Commissions with respect to mandatory margin.8 The prudential regulators stated that since Dodd-Frank does not contain an express exclusion for non-financial end-users, they are charged with adopting margin requirements that are appropriate for the risk. However, the proposed rule does not require a swap entity to collect initial margin or variation margin from non-financial end-users. It only requires a swap entity to collect margin at the times and in the amounts such party determines is appropriate to the risk. As discussed above, swap entities as a matter of practice require margin where they deem it appropriate, and the prudential regulator-proposed rule does not appear to present increased risk to non-financial end-users.
As a general matter, the legislative action seems only to have accelerated the outcome proposed in a more deliberate manner by the respective regulators.
B. Treasury Affiliate Amendment
The Current Law
Section 2(h)(7)(D)(i) of the Commodity Exchange Act (CEA) and Section 3C(g)(4)(A) of the Securities Exchange Act (the "Treasury affiliate provisions") provide that an affiliate of an entity that is an end-user exempt from the clearing requirement is also exempt from the clearing requirement with respect to swaps entered into to hedge or mitigate financial risk of the end-user or another affiliate of the end-user that is not a financial entity. Parties seek to use the Treasury affiliate provisions to organize themselves so that only one or a limited number of entities in the corporate group hedge on behalf of the end-users in the corporate group. The hedging risk and benefit will then be allocated within the corporate family.
The Proposed Amendment
However, use of the Treasury affiliate provisions has been limited because they require the outward hedging entity to enter into the hedges "acting on behalf of the person or as an agent." Having the outward-facing affiliate enter into swaps on behalf of or as an agent of the affiliate destroys the desired hedging center model and is not consistent with market practice. H.R. 37 removes this requirement.
In addition, the proposed amendment provides that when the Treasury affiliate enters into such a swap with a swap entity, "an appropriate credit support measure or other mechanism must be utilized." The House Committee on Agriculture states that it "unequivocally does not want the CFTC to interpret this statutory language as a mandate to require initial margin." The margin exception discussed in part A above exempts Treasury affiliates from mandatory margin requirement. If this requirement becomes law, there will be significant uncertainty around its implementation.
C. Indemnification Requirements
Pursuant to Section 725 and 728 of Dodd-Frank when a derivatives clearing organization or a swap data repository shares information, including with foreign financial supervisors, it is required to obtain a written agreement providing for confidentiality and indemnity for any expenses arising from any litigation related to the information provided. The requirement for indemnity has interfered with information sharing, and threatened the prospect of creation of multiple and duplicative data bases so that foreign regulators have the data they need. H.R. 37 removes the indemnification provision.
D. Change of Holding Period for CLOs
In perhaps its most controversial provision, H.R. 37 extends the period of time by which a banking entity or nonbank financial entity supervised by the Federal Reserve Board must dispose of collateralized loan obligations issued before January 31, 2014 by two years to July 21, 2019. In general, under the Volcker Rule provisions of Dodd-Frank a banking entity is prohibited from acquiring or retaining an ownership interest in covered funds, which includes certain but not all CLOs.
Representative Maxine Waters (D-Calif.) cited a statistic that 95 percent of the CLOs are owned by banks with more than $50 billion in assets. The provision to extend the disposition period for CLOs appears to be more the result of a response to special interests than the product of a lack of clarity or efficacy of the provisions of the Volcker Rule.