Key Dodd-Frank Act provisions are now in place. Those provisions that are likely to affect derivatives users that qualify as “end users” are summarized below. Businesses that are not “swap dealers” or “major swap participants” should be aware of these provisions and take all necessary steps to comply.
To qualify as an end user under Dodd-Frank, an entity cannot be a swap dealer or major swap participant. To be a commercial end user, the entity cannot be a financial entity (defined to include a swap dealer, major swap participant, commodity pool, private fund, employee benefit plan, or a person engaged in a banking or financial business), and it must be using swaps to hedge or mitigate its commercial risk. Only commercial end users can elect to have their swaps exempt from the clearing requirements discussed below.
Only “Swaps” Are Covered
Swaps are defined in Dodd-Frank and pursuant to a joint U.S. Securities and Exchange Commission (SEC) and U.S. Commodity Futures Trading Commission (CFTC) release issued on July 10, 2012, to include any agreement, contract or transaction that provides on an executory basis for the exchange of one or more fixed or contingent payments based on the value of one or more interest rates, currencies, commodities, or the occurrence (or non-occurrence) of an event or contingency or other transfer of financial risk (but not ownership). (The statutory definition goes on for several pages, and the joint release runs for close to 600 pages, so if you have any questions as to whether you are engaged in swap transactions, contact your regular lawyer or carefully read the rules and joint release yourself.) Options are included in the swap definition. Sales for future delivery intended to be physically settled (certain forward contracts) are not swaps, and commodity futures contracts and options on such futures are not swaps.
Recordkeeping and Reporting
Swaps entered into prior to, and that remained open on, July 21, 2010, and swaps entered into after July 21, 2010, are subject to recordkeeping requirements. Records must be accessible within three business days and must be kept for five years after the termination of each transaction. Most reporting will be done by swap dealers and major swap participants. End users will be able to rely on their swap dealer or major swap participant counterparties to do the required reporting, but if their counterparty is another end user, an agreement will be required as to which end user will be responsible for the reporting.
Position limit restrictions for swaps, futures and options become effective on a phased basis later in 2012 and in 2013. Position limits apply to designated energy and agricultural commodity products. There are serious penalties for exceeding position limits, which cannot be exceeded except for transactions that qualify as bona fide hedges and for which exemptions have been granted in advance.
Clearing Requirements/Commercial End User Exemption
Swaps are required to be “cleared” if a central clearing organization is willing to accept such swaps for clearing. Dodd-Frank provides an exception to the clearing requirement, however, for a commercial end user that is not a financial entity. Such a commercial end user may elect not to clear its swaps that are entered into to hedge its “commercial risk.” Swaps that are entered into for purposes that do not meet the hedging definition, including speculation and investment, are not exempt from the clearing requirement. A commercial end user can choose, at its sole discretion, to have its trades cleared or not cleared.
Public companies are subject to specific Dodd-Frank requirements. For example, the end user clearing exemption is only available to a public company if its board of directors (or an appropriate board committee) has reviewed and approved its swap transactions as remaining OTC.
End users that want to enter into swaps that are not centrally cleared can make an annual statement of their intentions to elect the exception to clear for one or more swaps.
Major changes in the way in which swaps are documented are already occurring. Regulations will limit the types of collateral that can be used (and with what “haircuts”). End users will be asked to make additional representations to their swap dealers in order to satisfy new Business Conduct Standards rules applicable to swap dealers. Tight timetables are likely to be imposed for trade confirmation turnarounds.
Dodd-Frank Obligations Imposed on End Users