The U.S. Margin Requirements: The Treasury Affiliate Exclusion and the Captive Finance Company Exclusion

Transcription

1 April, 2017 The U.S. Margin Requirements: The Treasury Affiliate Exclusion and the Captive Finance Company Exclusion Key Takeaways: > The Prudential Regulators and the CFTC approved final rules establishing minimum margin requirements for Non-Cleared Swaps where one counterparty is a registered swap entity and the other is a financial end user. > Several market participants are exempt or excluded from the definition of financial end user, including those entities eligible for the Treasury Affiliate Exclusion and the Captive Finance Company Exclusion, and such entities will not be required to post and collect margin when counterparty to a registered swap entity. > The Treasury Affiliate Exclusion is available to an entity that (i) enters into swaps to hedge or mitigate the commercial risk of another entity, and the commercial risk being hedged or mitigated has been transferred to the entity; (ii) does not have a corporate relationship with a financial entity ; (iii) does not provide any services, financial or otherwise, to any affiliated entity that is a nonbank financial company designated as systemically important by the U.S. Financial Stability Oversight Counsel or is otherwise supervised by the Board of Governors of the Federal Reserve System; and (iv) maintains a centralized risk management program in relation to its Non-Cleared Swaps. > The Captive Finance Company Exclusion is available to an entity that (i) has as its primary business the provision of financing and (ii) uses derivatives for the purpose of hedging underlying commercial risks related to interest rate or foreign currency exposures (a) 90% or more of which arise from financing that facilitates the purchase or lease of products and (b) 90% or more of which are manufactured by the parent company or another subsidiary of the parent company. Contents Introduction... 2 Who is subject to the U.S. Margin Rules?... 2 Who is a Financial End User?... 3 U.S. Margin Rules Exemptions and Exclusions... 5 The Treasury Affiliate Exclusion... 5 The Captive Finance Company Exclusion Can a Special Purpose Vehicle be a Financial Services Affiliate? What if the Financial Services Affiliate cannot claim an exclusion? Conclusion > An entity which may not be eligible for the Treasury Affiliate Exclusion or the Captive Finance Company Exclusion should consider whether it could be captured by the definition of financial end user. 1

2 Introduction The U.S. bank regulators 1 (the Prudential Regulators ) and the U.S. Commodity Futures Trading Commission (the CFTC, and together with the Prudential Regulators, the Agencies ) finalized their respective versions of the margin requirements for swaps and security-based swaps not cleared through a clearinghouse ( Non-Cleared Swaps ) in However, many market participants did not fully appreciate the implications of the margin requirements until the most significant compliance date for variation margin requirements, which implicated all market participants captured by the definition of financial end user when counterparty to a Covered Swap Entity (as defined below), was nearly upon them. 2 The Prudential Regulators final rule (the PR Rule ) and the CFTC s final rule (the CFTC Rule, together with the PR Rule, the U.S. Margin Rules ) 3 were largely consistent. You can find a summary of the U.S. Margin Rules in our Client Note published on June 8, 2016 (the MR Client Note ) 4 as well as a detailed discussion covering the treatment of SPVs under the U.S. Margin Rules in our Client Note published on November 11, 2016 (the SPV Client Note ). 5 In this Client Note, a bank, dealer and other regulated financial entities subject to the U.S. Margin Rules are referred to as a Covered Swap Entity or CSE. The U.S. Margin Rules generally apply to Non-Cleared Swap transactions between a CSE and a financial end user, unless an exclusion or exemption is available. This Client Note will focus on two of the available exclusions, the Treasury Affiliate Exclusion and the Captive Finance Company Exclusion, which allow Non-Cleared Swaps between CSEs and a counterparty eligible for either exclusion to remain exempt from the U.S. Margin Rules. Who is subject to the U.S. Margin Rules? The PR Rule applies to any entity that: (1) is regulated by one of the Prudential Regulators; (2) is registered as a swap dealer, major swap participant, securitybased swap dealer or major security-based swap participant; and (3) enters into a Non-Cleared Swap. 1 Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency, the Federal Reserve Board, the Farm Credit Administration or the Federal Housing Finance Agency. 2 As relates to covered swap entities subject to the CFTC Rule, the term Non-Cleared Swap is only with respect to a swap and does not include a security based swap FR 229, November 30, 2015, available at 30/pdf/ pdf; 81 FR 636, January 6, 2016, available at (note that the CFTC interim final rule is included with the FR release of the CFTC final rule); 81 FR 34818, May 31, 2016, available at 4 Linklaters Client Note, UPDATED: Prudential Regulators and the CFTC Finalize Swap Margin Requirements and Cross-Border Rules (June 8, 2016), publications/pages/updated-prudential-regulators-cftc-finalize-swap-margin-requirements- Cross-Border-Rules.aspx. 5 Linklaters Client Note, The U.S. Margin Requirements: The Impact of Special Purpose Vehicles used in Securitizations, Repackagings and other Structured Products (Nov ), Purpose-Vehicles-used-Securitizations-Repackagings-other-Structured-Products.aspx. 2

3 The CFTC Rule applies to any entity that: (1) is a swap dealer or major swap participant for which there is no Prudential Regulator; and (2) enters into a Non- Cleared Swap. The U.S. Margin Rules do not apply to a Non-Cleared Swap involving (i) a CSE and a counterparty that is not a CSE or a financial end user or (ii) a CSE and a counterparty that is a financial end user, but for which an exemption or exclusion is available. Who is a Financial End User? The U.S. Margin Rules define financial end user by listing the various types of entities the Agencies intend to treat as such and can capture many entities that engage in financial activities, even if such an entity s Non-Cleared Swap activities are limited to hedging activities. The Agencies provided that the list is designed to capture entities engaging in financial activities requiring Federal or State registration or giving rise to chartering requirements, such as deposit-taking and lending, securities and swaps dealing, or investment advisory activities. Pension funds and other employee benefit plans, including foreign non-erisa plans, are also captured by the definition. The list also expressly includes certain special purpose vehicles, asset management and securitization entities (e.g., private funds, commodity pools and 3a-7 securitization vehicles). To more generally capture financial entities, the definition expressly includes an entity that is a finance company, money/consumer lender or lending company, bank, premium finance company, commercial finance or lending company or money services business, and is either state-licensed or registered as such (or would be if organized under the laws of the United States or any state therein). 6 The U.S. Margin Rules do not, however, describe what many of the identified entities are and for any non-u.s. entities, the U.S. Margin Rules would appear to require a 50 state survey of all laws requiring the registration of engaging in any financial activities within such state. Non-U.S. entities which are centralized financial and treasury services entities within a larger corporate family (each such entity, a Financial Services Affiliate ) may cause particular concern when trying to determine one s position for compliance purposes. A Financial Services Affiliate is often created to achieve certain synergies within a corporate family by consolidating financial operations and expertise into a single corporate entity, that not only serves the entire corporate family, but likely benefits from guarantees and/or other financial support from all other affiliates. The Financial Services Affiliate will then go to the market to raise capital for the corporate family and/or a particular affiliate, and may obtain better terms due to its expertise in such matters and lower credit risk due to corporate family guarantees. Unfortunately for any Financial Services Affiliate incorporated outside of the United States, it may have difficulty in determining if there is a law within any state in the United States that would consider the Financial Services Affiliate to be an entity that must be registered or state-licensed. A Financial 6 See PR Rule.2 and CFTC Rule (definition of financial end user ). 3

4 Services Affiliate entering into Non-Cleared Swaps with a CSE, and unable to sufficiently determine that it is not a financial end user, will need to consider the full implications of the U.S. Margin Rules summarized below: Counterparty Margin Collection Requirement 7 Financial end users with material swaps exposure 8 Financial end users without material swaps exposure Collect and post minimum initial and variation margin. 9 Collect and post variation margin. Collect initial margin at such times and in such forms and amounts (if any) that the CSE determines appropriately addresses the credit risk posed by the counterparty and the risks of such swaps. The most immediate concern for Financial Service Affiliates that (i) are financial end users and (ii) are entering into Non-Cleared Swaps with CSEs, will be the variation margin requirements. Initially, these requirements were scheduled to come into effect on March 1, 2017, thereby causing market participants executing Non-Cleared Swaps to (1) make the determination as to whether or not they are a financial end user and (2) if it were determined that they are a financial end user, to then hurry to execute appropriate credit support annexes or amendments to ensure trading could continue after the March 1 compliance date. However, a week before the March 1 compliance date, many global regulators provided various types of relief or forbearance from the strict compliance date. With respect to the U.S. Margin Rules, the CFTC published a No-Action Letter 10 providing relief to those CSEs subject to the CFTC Rule. Specifically, the CFTC has provided a transition period to bring financial end users into compliance by September 1, 2017, subject to certain stipulations, such as the requirement that good faith negotiations continue from March 1, With respect to those CSEs 7 Under PR Rule.5(c) and CFTC Rule (d) and (e), a CSE will not be deemed to have violated its obligation to collect or post initial or variation margin from or to a counterparty if: (1) the counterparty has refused or otherwise failed to provide or accept the required margin to or from the CSE; and (2) the CSE has (i) made the necessary efforts to collect or post the required margin, or has otherwise demonstrated upon request to the satisfaction of the appropriate Agency that it has made appropriate efforts to collect or post the required margin, or (ii) commenced termination of the Non-Cleared Swap with the counterparty promptly following the applicable cure period and notification requirements. 8 An entity has material swaps exposure if that entity and its affiliates have an average daily aggregate notional amount of non-cleared swaps, non-cleared security-based swaps, foreign exchange forwards and foreign exchange swaps with all counterparties for June, July and August of the previous calendar year that exceeds US$8 billion, where such amount is calculated only for business days. PR Rule.2 and CFTC Rule (definition of material swaps exposure ). See also notes 26 and 27 of the MR Client Note (the Agencies provided that this calculation is a legal entity calculation that must aggregate separate accounts and portfolios of a single legal entity). 9 PR Rule.3(a) and (b),.4(a); CFTC Rule (a) and (b), (a). 10 CFTC Letter No (February 13, 2017) Re: Commission Regulation : Time Limited No- Action Position for Failure to Collect and/or Post Variation Margin, a copy is available at 4

5 subject to the PR Rule, the Prudential Regulators reaffirmed the March 1 compliance date, but only for those financial end users which present significant credit and market risk exposures. 11 For other counterparties that do not present significant credit and market risks, the Prudential Regulators expect CSEs to make good faith efforts to comply with the PR Rule in a timely manner, but no later than September 1, Subject to the Legacy Swap Exemption (defined below), Non-Cleared Swaps between a CSE and a Financial Services Affiliate that is a financial end user will be subject to minimum variation margin requirements. With respect to initial margin requirements, many financial end users will not be subject to initial margin requirements until However, for many Financial Services Affiliates, it may be possible to avoid being required to post/collect margin under the U.S. Margin Rules if such entity is eligible for the Treasury Affiliate Exclusion or the Captive Finance Company Exclusion. A Financial Services Affiliate eligible for either exclusion can identify itself as not a financial end user and therefore would not be required to comply with the U.S. Margin Rules when counterparty to a CSE. U.S. Margin Rules Exemptions and Exclusions The CSE s Non-Cleared Swaps entered into before the applicable compliance date (e.g., March 1, 2017 and September 1, 2017 for variation margin for such entities specified above) are exempt from the U.S. Margin Rules margin requirements (swaps entered into prior to the compliance date, Legacy Swaps, and their exclusion from the U.S. Margin Rules, the Legacy Swap Exemption ). The Legacy Swap Exemption will allow some swap activity between CSEs and financial end users to continue as it had prior to the compliance date, but for a long-term solution, financial end users will need to rely on certain limited exclusions to the U.S. Margin Rules. Amongst such exclusions are the Treasury Affiliate Exclusion and the Captive Finance Company Exclusion, as further discussed below. The analysis for any particular Financial Services Affiliate is fact specific, and the below analysis is not exhaustive of how any particular requirements provided by the CFTC may be interpreted. There are a number of ambiguities that can arise with any particular Financial Services Affiliate when considering how it interacts with affiliated entities, the roles of other affiliated entities and whether a particular fact could cause such Financial Services Affiliates to be ineligible for a particular exclusion. The Treasury Affiliate Exclusion The U.S. Margin Rules exclude from the definition of financial end user certain entities which provide corporate treasury functions (the Treasury Affiliate Exclusion ) and meet the requirements of Section 2(h)(7)(D) of the U.S. 11 The joint press release from all Prudential Regulators is available at 5

6 Commodity Exchange Act (the CEA ) (such entities, eligible treasury affiliates ). CEA Section 2(h)(7)(D) is the current controlling law for an eligible treasury affiliate exempt from the U.S. Margin Rules, however, the CFTC has stated that it intends to implement a separate rulemaking in regards to CEA Section 2(h)(7)(D) 12. As such, the below analysis should be reconsidered following the implementation by the CFTC of any final rule in this respect. Prior to the finalization of any such rulemaking, market participants may consider the CFTC s No-Action Letter issued by the CFTC on November 26, 2014 ( CFTC Letter No ) for helpful guidance. 13 However, since CFTC Letter No was issued prior to the passing of CEA Section 2(h)(7)(D), it can only provide clues as to potential interpretations, but it is not controlling. For a Financial Services Affiliate to be eligible for the Treasury Affiliate Exclusion it must satisfy a six-prong test, but as a threshold matter the Financial Services Affiliate must also be able to confirm is not the type of entity listed in the CEA as not eligible to utilize the Treasury Affiliate Exclusion. Many of the listed entities focus on registered bank, dealers and other financial institutions, and as such it would be highly unlikely that any Financial Services Affiliate considering the Treasury Affiliate Exclusion would identify as one of the excluded entities. 14 However, if such Financial Services Affiliate is an SPV or other limited purpose entity, it should consider whether it would be a commodity pool, 15 which is not able to utilize the Treasury Affiliate Exclusion. If the entity is not such an entity as set out in CEA Section 2(h)(7)D)(ii), the sixprong test under CEA Section 2(h)(7)(D)(i) and (vi) should be conducted, as detailed here: (1) The entity enters into the Non-Cleared Swap to hedge or mitigate the commercial risk of the person or other affiliate of the person that is not a financial entity, and the commercial risk being hedged or mitigated has been transferred to the entity. The first prong requires that the Non-Cleared Swaps of the Financial Services Affiliate be for the purpose of hedging or mitigating its own commercial risk or those of another affiliate. If the Financial Services Affiliate is hedging the risks of an affiliate, then it must also be confirmed that such affiliate (1) is not a financial entity (a term further discussed below under What is a financial entity? ) and (2) the particular risk being hedged by the Financial Services Affiliate has transferred from the affiliate to the Financial Services Affiliate. In CFTC No-Action Letter No FR 636, CFTC No-Action Letter (Nov 26, 2014), available at 14 The list includes swap dealers, major swap participants, insurance companies, bank holding companies, insured depositories, certain private funds, pension plans and certain other institutions supervised by the Federal Reserve. See CEA 2(h)(7)(D)(ii). 15 A term that generally captures any entity engaged in a business which is of the nature of a collective investment vehicle, investment trust, syndicate or similar form of enterprise which trades in (whether speculative or for hedging) derivatives. 6

7 14-144, the risk may be transferred by back-to-back swaps, the use of book-entry transfers or other methods, noting that [t]he method by which the risk is transferred can be dependent on the type of risk being hedged. However, if the risk is not transferred by virtue of back-to-back swaps, the CFTC requires that the treasury affiliate (i.e., the Financial Services Affiliate) be able to identify the related affiliate or affiliates on whose behalf the swap was entered into by such treasury affiliate. (2) The entity is directly and wholly-owned by an entity that either (a) is not a financial entity or (b) is also an eligible treasury affiliate. (3) The entity is not indirectly majority-owned by a financial entity. (4) The entity is not ultimately owned by a parent company that is a financial entity. Prongs (2), (3) and (4) of this analysis focus on whether or not the Financial Services Affiliate has any corporate relationships with a financial entity and echo similar requirements found in CFTC No-Action Letter No For Prong (2), CFTC No-Action Letter No deemed a Financial Services Affiliate to be directly and wholly-owned by a person if such person, directly or indirectly, holds 100% of the equity securities of the Financial Services Affiliate, or the right to receive upon dissolution, or the contribution of, 100% of the capital of a partnership of the Financial Services Affiliate, and the Financial Services Affiliate s financial results are included in the financial statements of the person as prepared on a consolidated basis under Generally Accepted Accounting Principles or International Financial Reporting Standards (the Appropriate Accounting Standards ). For Prong (3), a Financial Services Affiliate is considered majority-owned by a person if the person, directly or indirectly, holds a majority of the equity securities of the Financial Services Affiliate, or the right to receive upon dissolution, or the contribution of, a majority of the capital of a partnership of the Financial Services Affiliate, and the Financial Services Affiliate s financial results are included in the consolidated financial statements of the person under either of the Appropriate Accounting Standards. For Prong (4), a Financial Services Affiliate s ultimate parent is the top most, direct or indirect, majority owner of the Financial Services Affiliate, in the corporate hierarchy of which such Financial Services Affiliate is a member. (5) The entity does not provide any services, financial or otherwise, to any affiliate that is a nonbank financial company supervised by the Federal Reserve. 7

8 If no entity within the corporate family has been designated as systemically important by the U.S. Financial Stability Oversight Counsel, then the Financial Services Affiliate satisfies this requirement. If, however, an entity within the corporate family is supervised by the Board of Governors of the Federal Reserve System (the Federal Reserve ), then the Financial Services Affiliate should confirm it does not provide its treasury services (or any other services) to such supervised entity. (6) Non-Cleared Swaps entered into by the entity are subject to a centralized risk management program that is reasonably designed (a) to monitor and manage the risks associated with the swap, and (b) to identify the related affiliate or affiliates on whose behalf each exempted Non-Cleared Swap has been entered into by the entity. A similar requirement exists in the CFTC s end user clearing exception, which can also provide helpful guidance on the CFTC s expectations for a sufficient risk management program. Under the CFTC s end user clearing exception, an SEC Filer 16 that is electing such exemption must confirm that its board of directors has set appropriate policies governing the SEC Filer s use of swaps subject to the end user exception and such policies must be reviewed at least annually and as appropriate, more often up a triggering event (e.g., a new hedging strategy is to be implemented that was not contemplated in the original board approval). 17 Otherwise, parties will need to consider based on their particular facts and circumstances, whether existing programs are reasonably designed to monitor risk and identify the affiliate for whom the Financial Services Affiliate, as an eligible treasury affiliate, is executing a particular swap. What is a financial entity? As discussed above, prongs (2), (3) and (4) of the analysis for the Treasury Affiliate Exclusion focus on whether or not the Financial Services Affiliate has any corporate relationships with a financial entity. A financial entity is an entity predominantly engaged in financial activities, meaning that in either of its last two fiscal years: (i) the annual gross revenues derived by the company and all of its subsidiaries from activities that are financial in nature represent 85 percent or more of the consolidated annual gross revenues of the company; or (ii) the consolidated assets of the company and all of its subsidiaries related to activities that are financial in nature represent 85 percent or more of the consolidated assets of the company. A financial entity is defined to be any entity that is: 16 An entity that that is an issuer of securities that are registered under Section 12 of the Securities Exchange Act of 1934 or that is required to file reports pursuant to Section 15(d) of the Securities Exchange Act of 1934, or an entity controlled by such an issuer or filer of reports FR 42560, (July 19, 2012). 8

9 (i) (ii) a swap dealer; 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 section 202(a) of the Investment Advisers Act of 1940 (15 U.S.C. 80-b-2(a)); (vii) an employee benefit plan as defined in paragraphs (3) and (32) of section 3 of the Employee Retirement Income Security Act of 1974 (29 U.S.C. 1002); or (viii) a person predominantly engaged in activities that are in the business of banking, or in activities that are financial in nature, as defined in section 4(k) of the Bank Holding Company Act of Further, the definition does not include an entity that is eligible for the Captive Finance Company Exclusion, as further discussed below. Many of the identified entities within the definition of financial entity are easily confirmed and dismissed, but prong (viii) can often require significant analysis. Here, whether or not the Financial Services Affiliate is (a) predominantly engaged in (b) activities that are financial in nature requires that in either of its last two fiscal years: (x) the annual gross revenues derived by the company and all of its subsidiaries from activities that are financial in nature represent 85 percent or more of the consolidated annual gross revenues of the company; or (y) the consolidated assets of the company and all of its subsidiaries related to activities that are financial in nature represent 85 percent or more of the consolidated assets of the company. The CFTC has not formally interpreted the predominantly engaged in financial activities standard, but instead has consistently deferred to the Federal Reserve on this interpretation, 18 although there are market views that such deference is misplaced. 19 Activities that are financial in nature include lending, trading, investing (as principal, agent or advisor), insurance, trust company functions, providing financial advisory services (including advice with respect to any transaction in swaps), brokerage services, leasing or otherwise arranging, effecting 18 See Clearing Exemption for Swaps Between Certain Affiliated Entities, 78 Fed. Reg. 21,750, 21,755 n.27 (Apr. 11, 2013); See also CFTC Letter No , (Nov. 26, 2013) Re: No-Action Relief from the Clearing Requirement for Swaps Entered into by Eligible Treasury Affiliates, a copy is available at CFTC Letter No (February 13, 2017) Re: Commission Regulation : Time Limited No- Action Position for Failure to Collect and/or Post Variation Margin, a copy is available at 19 See Dickson C. Chin, James E. Gauch and Phillip G. Lookadoo, Commercial Outward-Facing Affiliates and the Definition of Financial Entity, Futures & Derivatives Law Report, Vol 33, Issue 8 (September 2013). 9

10 or facilitating financial transactions for the account of third parties. 20 Additionally, any entity that provided services to the financial industry should consider whether their activities would be deemed financial in nature since the Federal Reserve also considers the following less obvious activities as financial in nature which can create issues for many account firms, consulting firms, data processors and other activities when engaged in as ancillary or otherwise related to other financial services: management consulting and counselling activities, processing of financial, banking or economic data or providing administrative and other services to mutual funds. 21 The Captive Finance Company Exclusion As with eligible treasury affiliates, Financial Services Affiliates which qualify as a captive finance company (a CFC ) are a unique type of financial entity that is excluded from the definition of financial end user and therefore a CSE counterparty will not be required to post and collect margin from a CFC- Financial Services Affiliate and Non-Cleared Swaps between a CFC-Financial Services Affiliate and a CSE will not be subject to the U.S. Margin Rules (the Captive Finance Company Exclusion ). A CFC is an entity whose primary business is providing financing, and uses derivatives for the purpose of hedging underlying commercial risks related to interest rate and foreign currency exposures, 90 percent or more of which arise from financing that facilitates the purchase or lease of products, 90 percent or more of which are manufactured by the parent company or another subsidiary of the parent company. 22 The four prong test for determining whether an entity is a CFC is further elaborated below: (1) The entity s primary business is providing financing. The CFTC has provided that the financing activity here finances the purchase or lease of products sold by the relevant parent company or its subsidiaries in a broad sense and includes service, labor, component parts and attachments related to the products. 23 More specifically, the financing must facilitate the purchase or lease of products. The CFTC interprets the term facilitates broadly. For example, any of the below characterizations of how a borrower utilizes loan proceeds from the entity, should satisfy this prong: > borrowed funds pay for labor and/or services to help make the final product; > borrowed funds pay for component parts to a final product; 20 See Definitions of Predominantly Engaged In Financial Activities and Significant Nonbank Financial Company and Bank Holding Company, 78 FR (Apr. 5, 2013). 21 Id.; see also Board Regulations Part 242, Appendix A (2013) (Appendix A to Board rule defining Predominantly Engaged in Financial Activities ) U.S.C. 2(h)(7)(C)(iii) FR 42560, (July 19, 2012). 10

11 > borrowed funds pay for attachments related to the final product; or > borrowed funds otherwise will indirectly help the borrower to sell or lease the products (e.g., service, labor, component parts and attachments related to the products). 24 (2) The entity uses derivatives for the purpose of hedging underlying commercial risks related to interest rate and foreign currency exposures. To the extent any risks related to the sold product or service also involves physical commodities (e.g., energy, oil, agricultural commodities) or any swap is being used to hedge a risk other than the interest rate and/or FX risk, such risk should be hedged by an entity other than the Captive Finance Company. (3) Ninety percent or more of such risk exposures being hedged result from financing that facilitates the purchase or lease of products. (4) Ninety percent or more of such products purchased/leased are manufactured by the parent company of the entity (or another subsidiary of such parent company). Prongs (3) and (4) will require the confirmation from the Financial Services Affiliate s treasury team (or other individuals charged with managing the financing and risk) and is intended to ensure that the Financial Services Affiliate s financing activities assist the corporate family (i.e., it facilitates the purchase of the corporate family s products and/or services, which are then ultimately sold to the market), not third parties. For more complicated corporate structures, where elements of corporate control based on voting rights, equity interests, contract rights or otherwise can make it difficult to determine if an entity is an affiliate or subsidiary, the guidance from the CFTC has focused on whether the possible-cfc and related entities consolidate their financial statements. The CFTC has not focused on a control analysis. In the original guidance for CFCs, the CFTC noted that financing thresholds, when there are multiple entities in a corporate family, should be viewed on a consolidated basis and in a more recent interpretive guidance, the CFTC noted that the consolidation of financial statements was a significant factor when determining if an entity was a CFC. In the context of the CFC-analysis, control is never identified as an element of the subsidiary-analysis. 25 Ultimately, it is the financial analysis, not control, that the CFTC has emphasized. 24 Id. at See CFTC Staff Letter (May 4, 2015), available at 11

12 Can a Special Purpose Vehicle be a Financial Services Affiliate? We have discussed in a prior Client Note 26 how the U.S. Margin Rules will impact Special Purchase Vehicles ( SPVs ). Since corporate end-users may utilize an SPV as a means to obtain access to the capital markets, it may be critical to the economics of a capital markets transaction that the SPV must hedge the risks associated with payment obligations on issued notes. If the proceeds from such notes go directly to another operating entity eligible for the Captive Finance Company Exclusion, then the CFTC has provided that the SPV-issuer in such instances may be eligible for the Captive Finance Company Exclusion, subject to certain requirements. 27 If, instead of going to a Captive Finance Company, the proceeds of issued notes go directly to another corporate end-user entity, then such SPV-issuer may also be eligible for the Captive Finance Company Exclusion, subject to the requirements stated above. What is less clear, is whether it would be possible for an SPV to elect the Treasury Affiliate Exclusion. For any SPV considering the Treasury Affiliate Exclusion, the threshold inquiry should be a determination of whether or not the SPV is a commodity pool. Given the presence of a swap in the investment pool of assets providing returns to any noteholders, parties will need to carefully analyze whether the SPV may be excluded from the definition of commodity pool 28 or otherwise deemed not to be a commodity pool. When considering whether any exclusions from the definition of commodity pool may be available, most exclusions associated with the commodity pool analysis are not exclusions from being a commodity pool but instead, are exclusions from commodity pool operator registration requirement (such exclusions, CPO Exclusions ). Therefore, the applicable entity is still a commodity pool, but is excluded from the requirement of having to appoint a registered commodity pool operator. Under such CPO Exclusions, the vehicle is still a commodity pool, which is not able to utilize the Treasury Affiliate Exclusion. Similar issues can arise when considering the various no-action letters with respect to certain SPVs, which also provide relief from various commodity pool-specific regulations. Where a particular relief is in the form of guidance it may be helpful (which may provide helpful precedent for what is and is not a commodity pool), but any relief in the form of a no-action letter may not provide precedent that particular SPVs are not commodity pools (instead, the relief may only provide that a SPVcommodity pool will not be subject to certain enforcement actions from the CFTC). However, even if the SPV were not a commodity pool, parties would need to determine if there are issues under Prong 1 (related to risk transfers) and/or Prong 6 (existence of a centralized risk management program). Market participants particularly interested in this analysis, and desiring great certainty, should consider 26 Supra note Supra note 25 (For an SPV that is a subsidiary of a CFC (and therefore only indirectly involved in financing), they are eligible for the Captive Finance Company Exclusion so long as: (i) the SPV is wholly-owned by the CFC, (ii) the SPV s financial statements are consolidated with those of the CFC and (iii) the SPV s sole activity is facilitating financing undertaken by the CFC). 28 CEA 1a(10) (the definition generally includes any collective investment operated for the purpose of trading in commodity interests, including swaps). 12

13 participating in the CFTC s forthcoming rulemaking process in respect of the Treasury Affiliate Exclusion by providing comments to any proposed rule. What if the Financial Services Affiliate cannot claim an exclusion? As discussed above, the definition of financial end user is a broad and multifaceted definition intended to capture regulated financial entities, such as entities engaged in deposit-taking and lending, securities and swap dealing, or investment advisory services. If a Financial Services Affiliate does not qualify for the Treasury Affiliate Exclusion or the Captive Finance Company Exclusion, the Financial Services Affiliate should seek help from counsel to determine if it can claim that it does not fall under the definition of financial end user, even if ineligible for any express exclusion. In other words, a Financial Services Affiliate may not be captured by any prong of the definition of financial end user. To the extent a Financial Services Affiliate solely acts with respect to its own account and the account of affiliates, and does not provide loans or other financial services to individual natural persons or entities unaffiliated with the Finance Services Affiliate, counsel may be able to confirm that the Financial Services Affiliate may identify itself to a CSE that it is not a financial end user due to the Finance Services Affiliate not being captured by the definition of financial end user, even if no express exclusion is available. Any Financial Services Affiliate which is organized under the laws of a State will be able to quickly determine if it has been required to obtain any licenses or register in any capacity such that it may be captured by prong (iii) of the definition of financial end user, intended to capture many credit, lending or other financing entities. 29 Any Finance Services Affiliate not organized under the laws of the United States or any State therein, will need to consider if it would be required to obtain any license or registration where it so incorporated, due to prong (xii) of the definition of financial end user. 30 On its face, this requirement at prong (xii) may require a Federal law and 50-state survey to determine if a non-u.s. Financial Services Affiliate is captured. However, depending on the activities of a Financial Services Affiliate, it may not require such effort to provide the CSE with a good faith representation. The CFTC expressly noted that to reduce the burden for foreign counterparties, it believed that CSEs may rely on good faith representations from their counterparties as to whether they are financial end users under the [CFTC Rule]. 31 A review of Federal and New 29 (iii) An entity that is state-licensed or registered as: (A) A credit or lending entity, including a finance company; money lender; installment lender; consumer lender or lending company; mortgage lender, broker, or bank; motor vehicle title pledge lender; payday or deferred deposit lender; premium finance company; commercial finance or lending company; or commercial mortgage company; except entities registered or licensed solely on account of financing the entity's direct sales of goods or services to customers; (B) A money services business, including a check casher; money transmitter; currency dealer or exchange; or money order or traveler's check issue PR Rule.2 (definition of financial end user ); CFTC Rule (definition of financial end user ). 30 (xii) An entity that would be a financial end user described [in this defined term] or a [CSE], if it were organized under the laws of the United States or any State thereof. Id FR 636, 642 (Jan 6,2016). 31 Id. 13

14 York laws may be sufficient for purposes of providing a representation that a Financial Services Affiliate is not a financial end user, even if an express exclusion is not available, given the financial sophistication of New York law. However, the nature of the Financial Services Affiliate s activities and other factors (e.g., any nexus to other States due to the swap activities and/or affiliates) may suggest a broader review may be necessary to provide the level of representation being asked by the CSE We noted that in The ISDA Regulatory Margin Self-Disclosure Letter (the ISDA SDL ) the representation provide therein is that any information provided is to the best of Principal s knowledge and belief accurate Counsel for a Finance Services Affiliate will need to determined what level of diligence is sufficient for purposes of such representation. A copy of the ISDA SDL is available at 14

15 Contacts Conclusion As discussed above, the CFTC and Prudential Regulators, along with regulators in other jurisdictions, have provided temporary relief from compliance with the variation margin requirements that otherwise would have come into effect on March 1, 2017 for certain CSEs. In international deals, CSEs may find counterparties outside of the United States have greater difficulty in providing the not a financial end user representation. Lack of familiarity with the U.S. Margin Rules and the complexity of determining whether an entity is eligible for the Treasury Affiliate Exclusion or Captive Finance Company Exclusion, are some of the issues a CSE s counterparty may face when considering whether or not it is a financial end user. For instances where a CSE is unable to get a not a financial end user representation from a counterparty, such CSE should perform its own diligence and consider what factual based representation(s) it may require to satisfy its own diligence and legal analysis. However, there is always less regulatory risk for a CSE that can get the desired not a financial end user representation from a counterparty, when such analysis aligns with the CSE s own internal review. As the global margin rules continue to develop and substituted compliance becomes available, it is advantageous for CSEs and financial end users to be aware of the various exemptions and exclusions which can relieve them from being subject to the U.S. Margin Rules. Although the Treasury Affiliate Exclusion and the Captive Finance Company Exclusion are only available to a limited number of entities, these two exclusions may allow such entities to continue their swap transactions without making changes to any of their processes or documentation, thereby avoiding additional costs and revisions that many parties to Non-Cleared Swap transactions will likely incur. Authors: Edward Ivey, Caird Forbes-Cockell, Jonathan Ching and Lauren McFadden This publication is intended merely to highlight issues and not to be comprehensive, nor to provide legal advice. Should you have any questions on issues reported here or on other areas of law, please contact one of your regular contacts, or contact the editors. Linklaters LLP. All Rights reserved 2017 Linklaters LLP is a limited liability partnership registered in England and Wales with registered number OC It is a law firm authorised and regulated by the Solicitors Regulation Authority. The term partner in relation to Linklaters LLP is used to refer to a member of Linklaters LLP or an employee or consultant of Linklaters LLP or any of its affiliated firms or entities with equivalent standing and qualifications. A list of the names of the members of Linklaters LLP and of the nonmembers who are designated as partners and their professional qualifications is open to inspection at its registered office, One Silk Street, London EC2Y 8HQ, England or on Please refer to for important information on Linklaters LLP s regulatory position. We currently hold your contact details, which we use to send you newsletters such as this and for other marketing and business communications. We use your contact details for our own internal purposes only. This information is available to our offices worldwide and to those of our associated firms. If any of your details are incorrect or have recently changed, or if you no longer wish to receive this newsletter or other marketing communications, please let us know by ing us at marketing.database@linklaters.com. For further information please contact: Caird Forbes-Cockell Partner (+1) caird.forbes-cockell@linklaters.com Jonathan Ching Counsel (+1) jonathan.ching@linklaters.com Edward Ivey Associate (+1) edward.ivey@linklaters.com Lauren McFadden Associate (+1) lauren.mcfadden@linklaters.com Andrew Kummer Law Clerk (+1) andrew.kummer@linklaters.com 15

16 If you have any questions, please contact the people on the right or your usual Linklaters contacts. 16