Dodd-Frank Update: CFTC Proposed Rule on the End User Exemption

As we reported in a prior Alert, Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank") signed into law by President Obama on July 21, 2010, makes substantial amendments to the Commodity Exchange Act (the "CEA") which create a comprehensive new regulatory framework for swap transactions.

The CEA, as amended, requires^[1] that swaps:

• be cleared through a derivatives clearing organization;
• be traded on an exchange (i.e. executed on a registered trading platform or designated contract market); ^[2] and
• be reported to a registered swap data repository ("SDR") or the Commodity Futures Trading Commission ("CFTC").

Notably, end users may be exempt^[3] from the clearing and exchange trading requirements, unless the end user elects to trade on an exchange and/or have the swap cleared.  There are no exemptions, however, from the reporting requirements. 

Clearing, in plain English, allows a party to eliminate counterparty credit and performance risks, because the clearinghouse replaces the original counterparty in the transaction.  For a host of reasons, end users of swaps may not want to be subject to the clearing requirements imposed by Dodd-Frank, and have been anxiously awaiting clarification from the CFTC regarding the terms of this exemption.

On December 23, the CFTC published a notice of proposed rulemaking^[4] (linked here) on the so-called end user exemption, which is the subject of this Alert.  End users of swaps should review the proposed rules or discuss them with counsel to determine whether they would qualify for the proposed exemption.  In addition, end users may want to review their swap transaction documents or have them reviewed by counsel with an eye toward allocating onerous new reporting requirements to their counterparties.  The comment period for this proposed rule closes on February 22, 2011. 

1.         Who Qualifies as an End User?

Under Dodd-Frank, a counterparty qualifies to elect the end-user exemption for a swap only if it:

• is not a financial entity;
• uses the swap to hedge or mitigate commercial risk; and
• notifies the CFTC how it generally meets its financial obligations when entering into non-cleared swaps.

Public companies^[5] should also note that the end user exemption is available to the company only if an appropriate committee of its board or governing body has reviewed and approved the company's decision to enter into such exempt swaps^.[6] 

A.        What is a "financial entity"?

Financial entities do not qualify for the end user exemption.  A "financial entity" ^[7] is:

• a swap dealer;^[8]
• a major swap participant,^[9]
• a commodity pool;
• a hedge fund;
• an employee benefit plan as defined in ERISA, and
• a person predominantly engaged in the business of banking or finance. 

B.        What does it mean to "hedge or mitigate commercial risk"?

The CFTC's proposed rules make the exemption available only for those swaps that are used to hedge or mitigate commercial risk.  A swap is deemed to be used to hedge or mitigate commercial risk^[10] when it:

• is economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise;^[11]
• qualifies as bona fide hedging under the exemption from position limits;^[12] or
• qualifies for hedging treatment under Financial Accounting Standards Board accounting standards. ^[13]

A swap is disqualified from the exemption if it:

• is used for a purpose that is in the nature of speculation, investing or trading;
• is used to hedge or mitigate the risk of another swap, unless that swap is itself used to hedge or mitigate commercial risk.

The CFTC requests comments about every aspect of this proposed rule, including whether it should limit the exemption to only non-financial commodity hedges; whether this purpose test should be determined on a single risk or aggregate risk basis and for a single entity or on a consolidated basis; whether industry-specific rules are appropriate; whether hedge effectiveness should be considered; whether asset optimization and dynamic hedging should be included.

C.        Who is responsible to notify the CFTC?

In a swap transaction in which one of the counterparties elects the end user exemption, that party may only qualify for the exemption if the CFTC is notified how that counterparty generally meets its financial obligations when entering into non-cleared swaps.  Under the proposed rule, the counterparty that bears the burden of reporting swaps generally also bears the burden of fulfilling the additional notification requirements regarding swaps subject to the end user exemption.  This means that, in most circumstances, the end user would not be responsible for notifying the CFTC regarding exempt swaps, because, as we described in a prior Alert, the counterparty required to report swaps to an SDR or the CFTC will most often be a swap dealer or major swap participant.^[14]  The reporting responsibility rules are as follows:

• where only one counterparty is a "swap dealer" or "major swap participant," that party is required to report the swap;
• where one party is a swap dealer and the other party is a major swap participant, the swap dealer is required to report the swap;
• where neither party is a swap dealer or a major swap participant; the counterparties to the swap will decide who reports the swap. 

In order to avoid the rigorous notification and reporting requirement described below, we suggest that end users allocate the reporting requirement to the other counterparty when engaging in swap transactions with non-swap dealers and non-major swap participants.^[15]

D.        What must be reported to the CFTC?

In addition to other reporting requirements, the notice to the CFTC or SDR about a swap covered by the end user exemption must include the following information:^[16]

• identity of the counterparty electing to use the end user exemption;
• whether the end user is a financial entity;
• whether the end user is an affiliate of another person qualifying for the end user exemption;
• whether the end user is using the swap to hedge or mitigate commercial risk;
• whether the end user is a public company;
  • if so, the company's SEC Central Index Key number;
  • if so, confirmation that the company's appropriately authorized committee of the board of directors has reviewed and approved the election to engage in an exempt swap;
• whether a written credit support agreement is being used;
• whether the financial obligation of the end user is secured by collateral pledged pursuant to a security agreement which does not require the transfer of possession of the collateral to the swap counterparty (e.g., security agreements not perfected by the filing of a mortgage or agreements to transfer assets to collateral agents or escrow agents);
• whether any portion of financial obligation of the end user is guaranteed in writing by a person or entity other than the counterparties;
• whether the end user intends to meet its financial obligation solely by utilizing available financial resources (i.e., the counterparty is relying solely on the creditworthiness of the other counterparty); and  
• Whether the end user intends to employ other means, not described above, to meet its financial obligations.

Legal Stuff

Ms. Moore is a partner in Pierce Atwood's Washington, D.C. office.  Given the generality of its content, this Alert should not be relied upon without consideration of your particular facts and circumstances by qualified legal counsel or compliance professionals.  If you have questions regarding this Alert and/or its contents, please contact:

Janice Moore
(202) 470-6426
jmoore@pierceatwood.com