The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) included a mandate for new clearing requirements for swaps. While these requirements will have the biggest impact on financial institutions that act as counterparties to swaps, there are aspects of the new requirements that will impact all companies that enter into swaps. In particular, as described below, a public company will want to make sure that it obtains specific board approval prior to entering into any swaps under the new regime.
The new regulatory structure will require swaps to be cleared through a derivatives clearing organization (DCO), reported to a swap data repository (SDR) or the Commodities Futures Trading Commission (CFTC), and executed on a designated contract market (DCM) or swap execution facility (SEF), unless the swap has been exempted by CFTC rules. Meeting these new requirements will be burdensome to swap participants. The good news is that final rules published by the CFTC this summer clarify and give form to a relatively broad exemption that will provide a less burdensome alternative for most businesses that use swaps solely to hedge their business risks, as long as those businesses meet the criteria for the "end user exception."
The end-user exception may be elected if one of the counterparties to the swap (1) is not a financial entity, (2) is using the swap to hedge or mitigate commercial risks (such as interest rate changes or currency fluctuations), (3) notifies the CFTC how it meets its financial obligations associated with non-cleared swaps, and (4) elects not to clear the swap. "Financial entity" includes any entity that is a swap dealer, major swap participant, security-based swap dealer or participant, commodity pool, private fund, ERISA plan, as well as certain banks, but any bank, savings institution or credit union with total assets of less than $10 billion is not a financial entity for purposes of this rule. Certain foreign entities and certain financing affiliates of non-financial entities may also be eligible for the end user exemption.
If at least one party is eligible for the end user exception, the parties may take advantage of the exception by reporting notice of election and the identity of the eligible counterparty to a swap data repository (SDR) or, if no SDR is available, to the CFTC. A reporting counterparty must provide the following information:
- whether the electing counterparty is a financial entity but eligible for the exception as a small financial institution or as a financial entity acting as an affiliate of a non-financial entity;
- whether the swap for which the end user exception is being elected is used to hedge or mitigate commercial risk;
- information regarding how the electing counterparty generally meets its financial obligations with respect to non cleared swaps; and
- if the electing counterparty is a public company, whether its board of directors has approved the decision to enter into swaps that are exempt from the swap clearing requirements.
Nothing in the rule prohibits a reporting party from providing the information above on a swap by swap basis, but as a practical matter most companies wishing to rely on the end user exception will prefer to provide this information on an annual basis (an improvement upon the initial proposal, which required notification of each and every swap transaction).
The final rule went into effect on September 17, 2012, but reporting obligations will not begin until the swap clearing regimen is put into place. This will occur in stages beginning early in 2013 (with reports from end users not due until at least the third quarter of 2013), and for now, there is not much to do except plan ahead. Each public company that expects to take advantage of the end user exception should make sure that its board of directors (or an appropriate committee of the board) has explicitly approved the use of swaps for hedging or mitigating risk and the use of the end user exception for non-cleared swaps, and identified the means through which the issuer meets its financial obligations with respect to non-cleared swaps. This approval and identification should be scheduled at least annually.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
