The first half of April has seen a flurry of activity from the Commodity Futures Trading Commission (CFTC) that is relevant for commercial end-users of swaps. On April 1, the CFTC published a final rule that establishes an exemption from mandatory clearing for certain swaps between affiliates, building upon proposed rulemaking published last August. Mandatory clearing for specified classes of interest rate and credit default swaps began on March 11 for certain entities and will extend to all swaps in those classes (including those where the commercial end-user is the counterparty) on September 9. Accordingly, end-users that do not wish to clear interest rate and credit default inter-affiliate swaps will have to take certain steps between now and September in order to be exempt from clearing those swaps.
The final rule will go into effect on June 10. On April 5, the CFTC introduced no-action relief from swap data reporting requirements for inter-affiliate swaps between entities that are not swap dealers or major swap participants. On April 9, the CFTC published a no-action letter providing temporary relief from swap data reporting until later in the year, with the exact compliance date dependent on the class of swap and the identity of the reporting party.
The combination of the CFTC’s recent actions and the commercial end-user exception finalized by the CFTC in July 2012 could give commercial end-users relief from certain of the “unintended applications” of Title VII of the Dodd-Frank Act. This SEC Update describes how parties can qualify for the exception and no-action relief and what steps they should take to obtain relief.
What commercial end-users need to do now
Inter-affiliate exception. Commercial end-users that enter into inter-affiliate swaps should first check whether they are eligible for the end-user exception to clearing, which provides for a simpler compliance regime and may be used for eligible inter-affiliate swaps. The commercial end-user exception may be used by counterparties who are not “financial entities” within the meaning of the Dodd-Frank Act and who use the swap to hedge or mitigate commercial risk. If the end-user exception is available, we recommend using this exception as its requirements are simpler. Our memorandum dated September 7, 2012 describes how end-users can meet the conditions of the end-user exception. If the end-user is a financial entity or has swaps that do not hedge or mitigate commercial risk, it should next check whether its affiliates’ ownership and financial reporting structures make them eligible to elect the exception. If they do, commercial end-users should implement a centralized risk management program and procedures for written documentation of such swaps, which must be more robust than a book entry but need not involve an ISDA Master Agreement. Further, commercial end-users should consider filing with a registered swap data repository (SDR) information as to how each affiliate entering into non-cleared swaps generally meets its financial obligations associated with entering into such swaps. Filing this information for each affiliate on an annual basis obviates the requirement to have this information filed for each non-cleared swap, and thus it is most advantageous to file just before the applicable clearing compliance date. Also, commercial end-users should ensure that their outward-facing swaps meet the CFTC’s regulatory conditions.
Commercial end-users should have applied for a CFTC Interim Compliant Identifier (CICI) via the online CFTC Interim Compliant Identifier Utility Portal by April 10 to facilitate the reporting of inter-affiliate swaps. The CICI fulfills the role of the Legal Entity Identifier, which is among the data elements required to be reported for each entity entering into a swap. Even if an entity is not the swap counterparty charged with reporting the swap, such entity should still apply for the CICI, which it will submit to the reporting counterparty to allow for proper swap data reporting. A CICI should be requested for each affiliate that enters into swaps but is not required for individual branch offices and operating divisions of entities. While mandatory swap data reporting has been pushed back until later in 2013, reporting counterparties should ensure that they retain all reportable swap data so that they are ready to report on the applicable compliance date.
Reporting. End-users should continue to inventory their outstanding swaps and separate the swaps into “affiliate swaps” and “third party swaps.” If the swaps are “affiliate swaps," the end-user should determine whether they are between wholly-owned subsidiaries. If they are between wholly-owned subsidiaries, there are no reporting requirements, and if they are between majority-owned affiliates, the reporting requirement is quarterly, not real-time. If the affiliates are less than majority-owned, there is no relief and the swaps are treated as third party swaps. For third party swaps, end-users should determine which entity is the “reporting party." If the counterparty to the swap is a swap dealer or major swap participant, such swap dealer or major swap participant will have the reporting requirement. Section V.2 of our memorandum dated September 7, 2012 provides a description of the parties having reporting requirements.
If the end-user is the reporting counterparty, the April 9 no-action letter provides temporary relief from the reporting requirement, though the relief is more limited if the reporting party is a financial entity. The relief varies according to swap class. The new compliance dates for non-financial reporting counterparties are July 1, 2013 for interest rate and credit swaps and August 19, 2013 for equity swaps, foreign exchange swaps and other commodity swaps. If reporting is required, the end-user should contact a swaps data repository as soon as possible to enable reporting. As of the date of this SEC Update, Chicago Mercantile Exchange Inc.’s Swap Data Repository, DTCC Data Repository and ICE Trade Vault have provisionally registered with the CFTC as swap data repositories for clearing credit, foreign exchange swaps, interest rate swaps (DTCC and CME only), other commodity swaps (DTCC and CME only) and equity swaps (DTCC only).
Reporting relief for affiliated counterparties that are neither swap dealers nor major swap participants. On April 5, the CFTC issued a no-action letter, providing relief for certain commercial end-users from compliance with swap data reporting rules. The scope of relief depends on whether (1) one counterparty, directly or indirectly, wholly owns another counterparty or a third party, directly or indirectly, wholly owns both counterparties (wholly-owned subsidiaries) or (2) one counterparty, directly or indirectly, holds a majority ownership interest in the other counterparty, or a third party, directly or indirectly, holds a majority ownership interest in both counterparties (majority-owned subsidiaries).
Background: reporting requirements under parts 45 and 46. The CFTC finalized swap data reporting rules in 2012. Reporting counterparties are required to report both newly entered swaps and legacy swaps to an SDR or directly to the CFTC if no SDR accepts the reporting of swaps in the asset class in question. When commercial end-users enter into swaps with major swap participants, swap dealers or financial entities, the reporting obligation falls on the major swap participant, swap dealer or financial entity. However, if the financial entity is a non-U.S. person and the commercial end-user is a U.S. person, the commercial end-user has the reporting obligation. For swaps between two commercial end-users, the counterparties may decide among themselves whom to designate as the reporting counterparty, unless one of the counterparties is a U.S. person, in which case such counterparty has the reporting obligation.
Part 45 reporting. The Part 45 regulatory reporting regime addresses swap transactions entered into on or after April 10, 2013. Absent no-action relief, the reporting obligations are as follows. For uncleared off-facility swaps not subject to mandatory clearing that have end-users as the reporting counterparty, all primary economic terms are required to be reported “as soon as technologically practicable following execution” but no later than 48 business hours after execution during the first compliance year (i.e. April 10, 2013 through April 9, 2014 for all swaps), 36 business hours following execution during the second compliance year (i.e. April 10, 2014 through April 9, 2015 for all swaps), and 24 business hours following execution during the third compliance year (i.e. beginning April 10, 2015 for all swaps).
Part 46 reporting. The Part 46 regulatory reporting regime addresses legacy swap transactions, which consist of:
- Swaps that were entered into prior to July 21, 2010 that were not expired as of that date (pre-enactment swaps); and
- Swaps entered into on or after July 21, 2010 and before the applicable reporting compliance date, which is April 10, 2013 for those swaps where an end-user is the reporting counterparty (transition swaps).
Absent the no-action relief described below, swap data for pre-enactment swaps and transition swaps for which an end-user is the reporting counterparty would have been required to be reported to an SDR by April 10, 2013.
General prerequisites for inter-affiliate permanent no-action relief. The following are the general prerequisites for the no-action relief from the above Part 45 and Part 46 requirements applicable to inter-affiliate trades:
- Consolidated financial reporting;
- Neither counterparty (1) is, or is affiliated with, a swap dealer or major swap participant, or (2) is affiliated with a financial company designated as systemically important by the Financial Stability Oversight Council;
- Swap is not executed on or pursuant to the rules of a designated contract market, a swap execution facility, a foreign board of trade, a trading facility, or any other trading platform where the orders of the affiliates may be exposed to potential execution against unaffiliated counterparties;
- Swap is not voluntarily submitted for clearing to a derivatives clearing organization;
- Parties do not elect the inter-affiliate exception from clearing (thus, the end-user exception must be selected); and
- All swaps entered into between either one of the affiliates and an unaffiliated counterparty are reported to a registered SDR, regardless of the location of the affiliated counterparty.
The no-action relief is not time-conditioned and has no expiration date.
Wholly-owned subsidiaries. Wholly-owned subsidiaries that enter into inter-affiliate swaps are exempt from reporting primary economic data, life cycle event data, the daily mark as of the last day of each fiscal quarter and reporting related to election of the end-user exception. Such subsidiaries, however, must maintain all records of swap data required to be kept by CFTC rules. Further, they must create and maintain an internally generated swap identifier, consisting of a unique alphanumeric code, for each inter-affiliate swap subject to no-action relief.
Majority-owned subsidiaries. The CFTC has decided to treat majority-owned subsidiaries differently pursuant to this round of no-action relief. Majority-owned subsidiaries must report all swap data to an SDR no later than 30 days following the end of each fiscal quarter, with the initial quarterly report due within 30 days after the end of the first fiscal quarter ending on or after June 30, 2013. The initial report must include all swap transaction data required to be reported for the period between April 10, 2013 and the end of the fiscal quarter. Subsequent quarterly reports cover reportable swap data for each fiscal quarter. Majority-owned subsidiaries also must maintain all records of swap data required to be kept by CFTC rules.
Legacy swaps. Pursuant to CFTC’s no-action relief, wholly-owned subsidiaries and majority-owned subsidiaries that comply with general prerequisites (a) through (d) listed above and that maintain records of all pre-enactment and transition swap data pursuant to CFTC rules are exempt from reporting such swaps to an SDR.
Time-limited reporting relief for all swaps. On April 9, the CFTC issued a no-action letter, extending the compliance dates for swap data reporting. The new compliance dates depend on the type of swap and the identity of the reporting counterparty.
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What is “clearing”? Clearing changes the traditional relationship between counterparties by placing a clearinghouse in the middle of each transaction. Clearing places an intermediary, which is likely to be a clearing member, between the counterparties. The clearing member acts as the clearing agent for the counterparties. The structure of cleared trades can take one of two forms, depending on whether the clearing member is acting as agent or as principal.
Under the first structure, when the clearing member acts as agent, the counterparty will face the clearinghouse directly. The clearing member generally is required to guarantee the performance of the counterparty’s obligations to the clearinghouse, but the clearing member does not guarantee the clearinghouse’s obligations.
Under the second structure, when the clearing member acts as principal, the counterparty will face the clearing member and the clearing member will face the clearinghouse. The relationship between the counterparty and the clearing member in this second situation would be governed either by a new customer agreement covering, among other matters, margin requirements, events of default, position liquidation, and payment obligations, or by a modified ISDA Master Agreement. Under both structures, the clearing member novates (or “gives up”) the transaction to the clearinghouse.
What are the implications of clearing? Clearing requires both counterparties to post collateral (initial margin) with the clearinghouse when they enter into a swap. The clearinghouse can use collateral to cover defaults in the swap. As the valuation of the swap changes, the clearinghouse marks the swap to market and may collect additional collateral (variation margin) from the counterparties in response to fluctuations in market values. The clearinghouse can apply collateral to cover defaults in payments under the swap. Although central clearing is meant to minimize risks to the financial system resulting from defaults, it makes entering into swaps more expensive.
Conditions to the inter-affiliate exception. The conditions to the inter-affiliate exception involve a determination of affiliate status and compliance with specified procedural requirements.
Affiliate status. The determination of whether two affiliates are eligible to elect the inter-affiliate exception requires two conditions to be meet:
- Common ownership; and
- Consolidated financial statements.
Two parties are affiliates for purposes of the exception if (1) one counterparty, directly or indirectly, holds a majority ownership interest in the other counterparty, or (2) a third party, directly or indirectly, holds a majority ownership interest in both affiliate counterparties.
The consolidated financial statements prong is satisfied if (1) the majority-interest holder’s financial statements are reported on a consolidated basis and include the financial results of its majority-owned counterparty, or (2) the third-party majority-interest holder’s financial statements are reported on a consolidated basis and include the financial results of both affiliate counterparties.
Procedural requirements to use the inter-affiliate exception. Compliance with the Dodd-Frank Act swap data reporting regime for both new and certain historical swaps was scheduled to begin on April 10, 2013 but was extended pursuant to no-action relief issued by the CFTC on April 9, 2013. CFTC rules require all swaps to be reported to an SDR or directly to the CFTC if no SDR accepts the reporting of swaps in the asset class in question. The inter-affiliate exception imposes additional reporting obligations for affiliates entering into swaps and relying on the inter-affiliate exception from mandatory clearing.
The CFTC adopted the reporting requirements of the inter-affiliate exception rule as proposed, setting forth the three reporting obligations outlined below. In its guidance to the final rule, the CFTC clarified that the additional inter-affiliate reporting obligations can be fulfilled by one affiliate counterparty on behalf of both affiliate counterparties.
Swap-by-swap reporting. If parties elect the inter-affiliate exception from clearing, a confirmation that both counterparties are electing not to clear the swap and that each counterparty satisfies the requirements of the inter-affiliate exception must be reported for each swap to either a registered SDR or directly to the CFTC if no SDR accepts the reporting of swaps in the asset class in question. This is the only reporting obligation arising out of the inter-affiliate exception that cannot be performed on an annual basis, and the CFTC has estimated that it could take 15 seconds to two minutes to input the confirmation into the SDR electronic reporting system. However, if neither affiliate is a swap dealer or major swap participant and they do not elect the inter-affiliate exception and do not clear their swaps, they are exempt from swap-by-swap reporting, as further explained below.
Annual reporting. The other two reporting obligations may be satisfied either on a swap-by-swap basis or via an annual report that is effective for the prospective 365 days, which must be amended if material changes occur within the 365-day period. The first of these applies to all affiliate counterparties, and requires reporting of how a counterparty generally meets its financial obligations associated with entering into non-cleared swaps. This requires the identification of one or more of the following categories for each eligible affiliate counterparty:
- A written credit support agreement;
- Pledged or segregated assets (including posting or receiving margin pursuant to a credit support agreement or otherwise);
- A written guarantee from another party;
- Counterparty’s available financial resources; and/or
- Means other than those described above.
The third reporting obligation only applies to issuers of registered securities and entities that are required to file reports under the Securities Exchange Act of 1934. Those counterparties must report or have reported for them the following:
- SEC Central Index Key; and
- An acknowledgment that an appropriate committee of the counterparty’s board has reviewed and approved the decision to enter into swaps exempt from the CFTC’s mandatory clearing regime.
Swap documentation. When the CFTC proposed the inter-affiliate exception in August 2012, it provided for mandatory swap trading relationship documentation and included a non-exhaustive list of terms that must be documented, such as payment obligations, netting of payments and events of default, for inter-affiliate swaps where neither counterparty is a swap dealer or major swap participant. In response to public comments on the proposed rule, the CFTC’s final rule contains a more flexible standard, merely requiring a written swap trading relationship document to “include all terms governing the trading relationship” for such swaps. In the guidance accompanying the final rule, the CFTC noted that formal master agreements are not required, while book entries are inadequate if such entries do not contain sufficient information to adequately document the swap and trading relationship. The CFTC’s guidance says that counterparties have the “the obligation to ensure that their documentation contains an accurate and thorough written record of their swaps.” The CFTC also said that it “anticipates that affiliates will include rigorous valuation provisions and procedures for elevating and resolving disputes in their risk management programs,” signaling that valuation and dispute resolution should be addressed in the formal documentation. The CFTC mandated that the documentation “shall be in writing” but did not explain whether electronic documentation is sufficient or whether signatures are required. Formal swap transaction confirmations for swaps between affiliates that are not swap dealers and major swap participants are also not required.
Swap dealers and major swap participants that enter into inter-affiliate swaps are subject to more rigorous documentation standards that were enacted in a separate round of CFTC rulemaking and entered into force in November 2012.
Centralized risk management. For the centralized risk management requirement, the CFTC adopted the final rule as proposed, thus requiring affiliates that are not swap dealers or major swap participants and that enter into non-cleared swaps to have “a centralized risk management program that is reasonably designed to monitor and manage the risks associated with the swap.” The CFTC noted in the accompanying guidance that this is a flexible requirement and does not require the same level of processes and procedures required of swap dealers and major swap participants. If an affiliate group allows cross-border inter-affiliate swaps, it would be prudent business practice to have an integrated international risk management system, according to the CFTC, and programs that are consistent with current industry practice in all likelihood fulfill this regulatory requirement.
Swap dealers and major swap participants that enter into inter-affiliate swaps are subject to separate risk management program rules that were enacted in a separate round of CFTC rulemaking and entered into force in June 2012.
Treatment of external swaps. In the proposed rule, the CFTC had a relatively simple structure to ensure that all counterparties electing to use the inter-affiliate exception clear their outward-facing swaps if those swaps are subject to mandatory clearing. In the final rule, the CFTC implemented a more complex structure that provides some temporary relief for certain classes of outward-facing swaps. The final rule requires that external swaps, i.e. ones with unaffiliated counterparties, must either (1) be cleared in the U.S. or pursuant to comparable home country regulations, or (2) be exempt from clearing under the Dodd-Frank Act or a comparable foreign jurisdiction exception.
Because foreign derivatives regulators may be at a different stage in implementing their clearing regimes, the CFTC modified the proposed rule in this respect to allow a transition period until March 11, 2014, creating different categories for those swaps including eligible affiliates located in the European Union, Japan, and Singapore and those in other jurisdictions. In the guidance accompanying the final rule, the CFTC has indicated that it will make jurisdiction-specific comparability determinations by comparing the foreign regulatory regime with the Dodd-Frank Act’s clearing requirements and objectives. Comparability will largely depend on whether the swap required to be cleared by the CFTC is also required to be cleared under the foreign regime.
When to use the end-user exception instead of the inter-affiliate exception to clearing. To exempt their inter-affiliate swaps from clearing, counterparties may choose to elect either the commercial end-user exception to clearing, which is already in force, or the inter-affiliate swap exception. The commercial end-user exception may be used by counterparties that are not “financial entities” within the meaning of the Dodd-Frank Act and who use the swap to hedge or mitigate commercial risk.
The commercial end-user exception has reporting obligations that are similar to those in the inter-affiliate exception, including swap-by-swap reporting of notice of election and identity of the electing counterparty, and annual reporting regarding counterparty eligibility for the exception. Unlike the inter-affiliate exception, the commercial end-user exception does not require centralized risk management or swap documentation. Thus, affiliates that are not financial entities and that enter into swaps for hedging or mitigation purposes will find it easier to comply with the end-user exception. Indeed, in the guidance accompanying the final rule, the CFTC said it “anticipates that the inter-affiliate exemption will be elected only when the two counterparties are financial entities that do not qualify for the end-user exception.” If commercial end-users have speculative swaps among their affiliates, however, they will not be eligible for the end-user exception and will have to rely on the inter-affiliate exception.