On December 9, 2010, the Commodity Futures Trading Commission held its seventh public meeting to consider rules implementing the Dodd-Frank Wall Street Reform and Consumer Protection Act. The CFTC proposed rules for public comment and approved an interim final rule, addressing:
the scope of the end-user exemption from the mandatory clearing of swaps;
the reporting of certain swap transactions entered into on or after the date of Dodd-Frank’s enactment but before the effective date of the new swap data reporting rules;
business conduct standards for swap dealers and major swap participants when dealing with counterparties; and
governance requirements for clearinghouses, exchanges, and swap execution facilities, and requirements concerning the mitigation of conflicts of interest.
The CFTC had planned to address proposed rules concerning core principles for swap execution facilities, but decided to defer that proposal to its next meeting on December 16. This delay is apparently due to differences of opinion with regard to certain aspects of the swap execution facility proposal, including the pre-trade transparency requirements. During the meeting, Commissioners Sommers and O’Malia criticized the proposal as it stood, arguing that it interpreted the statute too narrowly and in essence required swaps to trade like futures. However, the true nature of any disagreements regarding the swap execution facility proposal was not revealed at the meeting.
In addition to addressing the swap execution facility rulemaking at the December 16 meeting, the CFTC plans to consider long-awaited rules addressing position limits.
The following summary is based on the discussion at the CFTC public meeting and related materials published by the CFTC. As of the release of this alert, the proposed rules have not been published in the Federal Register.
End-User Exemption from Mandatory Clearing
In an eagerly anticipated action, the CFTC approved for publication a proposed rule implementing the “end-user” exemption from the mandatory clearing of swap transactions. The CFTC’s proposed definition is fairly broad, which may come as a relief to certain entities that use swaps to manage their commercial risk. However, the lack of precision in the key definitions of swap dealer, major swap participant, and end-user still create uncertainty for affected entities.
Under the structure imposed by Dodd-Frank, it generally is unlawful to engage in a swap unless the swap is submitted for clearing to a derivatives clearing organization. However, swaps are exempt from the clearing requirement, among other things, if one of the parties to the swap is an “end-user.” Under the Act, an end-user is an entity that meets three requirements: (i) it is not a “financial entity"; (ii) it is using the swap to hedge or mitigate commercial risk; and (iii) it provides notice to the CFTC regarding how it generally meets its financial obligations associated with entering into non-cleared swaps. If an entity satisfies the end-user criteria, the swap need not be cleared (and hence need not be traded on an exchange or regulated facility), although the end-user retains the option to clear the transaction.
The proposed rule sheds more light on who will be able to take advantage of this exemption by broadly defining the term “hedge or mitigate commercial risk” and by creating a process that an end-user must follow in order to notify the CFTC regarding how it meets its financial obligations associated with entering into non-cleared swaps.
“Hedging or Mitigating Commercial Risk”
The CFTC’s proposed approach to determining if a swap is being used to “hedge or mitigate commercial risk” is similar to the approach used in the CFTC’s prior rulemaking session in the context of establishing which derivatives positions may be counted for purposes of defining a “major swap participant” (click here for additional analysis of the proposed rules addressing the “major swap participant” definition).
A swap position would be considered to be used to “hedge or mitigate commercial risk” if it:
qualifies as a “bona fide hedge” under Commodity Exchange Act rules;
qualifies for hedging treatment under Financial Accounting Standards Board Accounting Standards Codification Topic 815, Derivatives and Hedging (formerly known as Financial Accounting Standards Board Statement No. 133); or
is economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise, where the risks arise in the ordinary course of business from the following:
a potential change in the value of (i) assets that a person owns, produces, manufactures, processes, or merchandises, (ii) liabilities that a person incurs, or (iii) services that a person provides or purchases;
a potential change in value related to (i)–(iii), above, arising from foreign exchange rate movements; or
a fluctuation in interest, currency, or foreign exchange rate exposures arising from a person’s assets or liabilities.
This language is intended to capture a broad category of activities that reduce a firm’s business risks, regardless of whether they qualify as bona fide hedges or accounting hedges. Swaps that are held for speculation, investing, or trading, however, would not fall under the definition. The proposed approach considers the facts and circumstances at the time the swap was entered into.
The proposal establishes a notification process that the CFTC refers to as a “user-friendly, check-the-box approach.” The notification process stems from the Dodd-Frank requirement that an end-user inform the CFTC of how it generally meets its financial obligations with respect to non-cleared swaps. Under the proposal, at the time the swap is executed, the end-user would notify a swap data repository, if one is available, and provide it with facts relevant to its end-user status, including the methods it uses to mitigate counterparty credit risk, whether an affiliate or financial entity is involved, and an affirmative statement that the swap is being used for hedging.
Exception for Small Financial Institutions
Dodd-Frank directs the CFTC to consider whether to exempt small banks, savings associations, farm credit system institutions and credit unions from the definition of “financial entity,” thereby giving those entities the possibility of qualifying for the end-user exemption from mandatory clearing. The proposed rule leaves this issue open and requests comment on the question of whether these small financial entities should be allowed to qualify for the end-user exemption.
The proposed end-user rule was approved by a 3–2 vote, with Commissioners Sommers and O’Malia voting against the proposal.
Interim Final Rule Regarding Reporting of Certain Post-Enactment Swap Transactions
The CFTC also announced publication of an interim final rule governing the reporting of “transition” period swaps to either registered swap data repositories or to the CFTC. This rule complements an earlier interim final rule addressing reporting and record-keeping obligations with respect to “pre-enactment” swaps, i.e., those entered into before Dodd-Frank’s enactment (click here for additional analysis of the pre-enactment swap interim final rule).
“Transition” swaps are swaps that are entered into between the enactment date (July 21, 2010) and the general effective date (July 19, 2011) of Dodd-Frank. As with the CFTC’s prior interim final rule on pre-enactment swaps reporting, the current interim final rule does not impose present reporting requirements; rather, it informs market participants of their obligation to preserve certain data until the reporting rules required under Dodd-Frank are enacted. The new rule, which takes effect immediately upon publication in the Federal Register, identifies the reporting timetable, defines the term “transition swap” as used in the rules, and describes what information should be preserved.
Business Conduct Standards for Swap Dealers and Major Swap Participants Dealing with Counterparties
The CFTC also issued a proposed rule on business conduct standards for swap dealers and major swap participants. This proposal is particularly noteworthy because it implements the Dodd-Frank obligation that swap dealers and major swap participants acting as advisors to “special entities” follow numerous “special requirements." The proposed business conduct rules impose certain specific obligations that apply to all counterparties as well as “special entities.” Furthermore, as contemplated in Dodd-Frank, the proposed rules impose general provisions governing swap dealers and major swap participants, such as compliance related policies and procedures to prevent evasion of the Act, provisions requiring diligent supervision and knowing one’s counterparties, record retention requirements, duties of confidentiality, as well as prohibitions against “front running” a counterparty’s swap position or engaging in any fraudulent, deceptive, and manipulative acts or practices.
Among the specific duties that swap dealers and major swap participants owe to all counterparties are the following: (i) a duty to verify a counterparty’s eligibility to transact; (ii) a duty to disclose material risks, as set out in more detail in the proposed rules; (iii) a duty to provide the daily mid-market value of uncleared swaps; (iv) a duty to notify the counterparty of its right to clear and select the clearing organization for any swap that is exempt from clearing; (v) a duty of fair dealing and good-faith communication; (vi) a duty to ensure that any swap recommendations it makes are suitable for that counterparty; and (vii) for swaps traded on clearing organizations or swap execution facilities, a duty to execute orders on terms that are reasonably related to the best available terms.
The specific duties with respect to “special entities” are more onerous. If a swap dealer or major swap participant “acts as an advisor to a special entity,” which includes recommending a swap or trading strategy involving swaps but does not include providing general transaction, financial or market information or swap terms in response to a special entity’s competitive bid request, it must act in the “best interests” of the special entity. When acting as a counterparty to a special entity, swap dealers and major swap participants must have a “reasonable basis” to believe the special entity has a “representative” who, among other things, (i) has sufficient knowledge to evaluate the transaction and risks, (ii) is independent of the swap dealer or major swap participant, (iii) evaluates the appropriateness and pricing of any swaps in accordance with any guidelines provided by the special entity, and (iv) acts in the best interest of the special entity. The proposed rule also includes restrictions on certain political contributions to municipal officials by swap dealers, known as “pay to play” prohibitions.
In their efforts to comply with the proposed rule, swap dealers and major swap participants are offered a variety of options. The proposed rules indicate, for example, that those entities may rely, if reasonable and absent red flags, on representations of counterparties to meet due diligence obligations, may make general disclosures to counterparties in a standard format, if appropriate, or may include representations and disclosures in a master agreement with a counterparty and deem the representations and disclosures renewed with each subsequent swap. Essentially, the proposed rules intend to provide swap dealers and major swap participants with flexibility in their compliance efforts with the business conduct standards.
While the proposal obtained the support of all five commissioners, Commissioner O’Malia stated that he was “not entirely convinced that these layers of protections are necessary in every relationship scenario” and was looking forward to receiving comments. Commissioner Dunn, by contrast, noted his concern that the proposed rules were not sufficiently “robust” and suggested that the CFTC should review the effect of the business conduct rules 12 to 15 months after implementation to determine if they have been working.
Governance Requirements for Clearinghouses, Exchanges, and Swap Execution Facilities and Mitigation of Conflicts of Interest
The CFTC also issued a proposed rule that imposes governance requirements on derivatives clearing organizations, designated contract markets, and swap execution facilities with respect to resolving conflicts of interest. The proposed rule is related to the CFTC’s October 1, 2010 proposed rule on structural governance and voting power of clearinghouses, exchanges, and swap execution facilities. This rule furthers the CFTC’s goal of mitigating conflicts of interest through reporting requirements, transparency in decision-making, and limitations on the use and disclosure of confidential information.
Specifically, the proposed rule requires a derivatives clearing organization to report to the CFTC when its board rejects recommendations made by its risk management committee. Designated contract markets and swap execution facilities must report to the CFTC when their boards reject recommendations from their regulatory oversight committee. Among other things, the proposed rule also requires derivative clearing organizations, designated contract markets, and swap execution facilities to: (i) implement programs to identify, on an ongoing basis, conflicts of interest; (ii) implement a process for resolving conflicts of interest; (iii) publicly disclose certain information regarding governance arrangements (such as summaries of “significant decisions” relating to access and membership); and (iv) limit the use and disclosure of confidential information by owners, employees, officers, and board and committee members. Further, the proposed rule implements core principles regarding governance fitness standards and the composition of governing bodies of derivative clearing organizations and designated contract markets.
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This article was prepared by Peggy A. Heeg (email@example.com or 713 651 8443), Michael Loesch (firstname.lastname@example.org or 202 662 4552), Jeff Sherman (email@example.com or 202 662 4573), Craig Oliver (firstname.lastname@example.org or 214 855 8139), Rabeha Kamaluddin (email@example.com or 202 662 4576), and Brandon Byrne (firstname.lastname@example.org or 214 855 7437) from Fulbright’s Energy Practice Group and Fulbright's Corporate Governance Practice Group.
 Under Dodd-Frank, a “financial entity” is generally: (i) a swap dealer; (ii) a security-based swap dealer; (iii) a major swap participant; (iv) a major security-based swap participant; (v) a commodity pool; (vi) a private fund as defined in the Advisers Act; (vii) an employee benefit plan as defined in the Employee Retirement Income Security Act; or (viii) a person predominately engaged in the business of banking, or in activities that are financial in nature, as defined by the Bank Holding Company Act.
 “Special Entities” include, but are not limited to, federal agencies, states and political subdivisions, municipalities, employee-benefit plans, governmental plans, and endowments. The “special requirements” are listed in section 731 of Dodd-Frank, which adds a new section 4s(h) to the Commodity Exchange Act.