ADOPTING THE AUGUST 2012 ISDA PROTOCOL FOR DODD FRANK SWAP REQUIREMENTS

Transcription

1 ADOPTING THE AUGUST 2012 ISDA PROTOCOL FOR DODD FRANK SWAP REQUIREMENTS Thompson & Knight Notes on the ISDA August 2012 DF Protocol (the Protocol ) I. Introduction 1 The Protocol is the first of a planned series of protocols intended to address the requirements of a series of rules adopted by the Commodity Futures Trading Commission (the CFTC ) pursuant to the Dodd Frank Wall Street Reform and Consumer Protection Act ( Dodd Frank ). These rules impose various reporting requirements on parties to over-the-counter swaps. Most of these requirements are intended either to give the CFTC more granular information about the swap market or to insure that swap dealers adequately know their customer. The CFTC rules do not generally require both parties to report the required information; there is generally a Reporting Counterparty and a Non-Reporting Counterparty. When swap participants are trading with swap dealers such as banks, the CFTC requires the swap dealer to be the Reporting Counterparty. Swap dealers need to obtain some of the required information from their swap participants, and there are certain tasks that these participants must perform themselves. The CFTC rules covered by the Protocol will become effective on May 1, After that date, swap participants that have not entered into either the Protocol or bilateral arrangements with their swap dealers to ensure compliance with CFTC rules will not be able to enter into new swap transactions or materially modify existing transactions. Some banks have developed form amendments to ISDA Master Agreements in order to deal with the requirements of the CFTC rules, and these amendments may be useful to customers that deal with only one or two banks. For market participants that deal with multiple counterparties (or, if participants prefer, even with a single counterparty), ISDA has developed the Protocol to allow the relevant information to be exchanged on a more general basis and to provide a process for amending all ISDA master agreements of a swap participant (each such ISDA master agreement is defined as a Protocol Covered Agreement ). We believe that most independent oil companies will prefer to use the Protocol. The Protocol involves the following documents, which are hyperlinked in this memorandum: ISDA s online introduction to the Protocol and accompanying FAQ (the Introduction ). The ISDA August 2012 DF Protocol Agreement (the Protocol Agreement ). 1 This memorandum has been prepared to provide background information for clients and friends of Thompson & Knight. It is not intended as legal advice or a legal opinion with respect to any specific circumstances or any specific client. 2 The effective date for these rules has been postponed twice, but market participants have been advised by the CFTC that there will be no further postponements. As of January 1, 2013 rules regarding anti-fraud, daily marks, communication-fair dealing, general suitability, and political contributions became effective.

2 The ISDA August 2012 DF Supplement (the DF Supplement ). The Adherence Letter to the Protocol (the Adherence Letter ). The ISDA August 2012 DF Protocol Questionnaire (the Questionnaire ). 3 The Questionnaire Answer Sheet (the Principal Answer Sheet ). Amended and Restated Addendum I to ISDA August 2012 DF Protocol Questionnaire (the Addendum ). The number of documents listed above makes the process of becoming a party to the Protocol seem complicated, but fundamentally it is relatively simple: Obtain a CICI number. Fill out online, print out, sign, scan as a pdf document, and return to ISDA an Adherence Letter, which will be posted on ISDA s web site. Answer the questions in the confidential Questionnaire (which are straightforward and are summarized below); elect, if desired, to have Schedule 3 of the DF Supplement (discussed below) apply; and deliver the Questionnaire to their swap counterparties, either directly or online. Two other actions may be necessary in some circumstances: If a swap participant elects to have Schedule 3 of the DF Supplement apply, it must adopt written policies and procedures that are reasonably designed to ensure that the persons evaluating swap recommendations and making trading decisions on behalf of the company (whether those persons are employees or outside advisors) are capable of doing so. Such policies could, for example, identify who is authorized to trade derivatives and what kind of board approval or oversight applies. More full-blown policies could also (i) refer to the requirements of the company s credit agreement or set out overall trading limits, such as those contained in a typical bank credit agreement; (ii) prohibit speculation, and require that hedges not be entered into never exceed anticipated actual production; (iii) describe internal reporting requirements for overall hedge positions; (iv) describe how a fall in production that results in hedges exceeding the overall trading limits are to be brought to the attention of senior management or the board; and (v) identify processes for temporarily waiving or permanently amending these policies. It is likely that most oil companies will want to elect to have Schedule 3 apply and therefore should adopt such policies and procedures. The board of directors of public companies should adopt a resolution that allows the company to enter into uncleared swap transactions. 4 These notes are a simplified summary of the Protocol Agreement and related documents. Among other things, we have assumed that participants in the Protocol are acting directly on their own behalf and 3 If asked for a User Name when going to the Questionnaire, select Cancel instead of inserting any name. 4 See 17 CFR 50.50(b)(iii)(D)(2), which requires a swap reporting entity to ask its counterparty: (2) Whether an appropriate committee of that counterparty s board of directors (or equivalent body) has reviewed and approved the decision to enter into swaps that are exempt from the requirements of sections 2(h)(1) and 2(h)(8) of the Act. 2

3 not through agents and that they are not Special Entities. (Special Entities are described below; independent oil companies, other than ERISA entities, would not be Special Entities). II. Obtaining a CICI Number. A CICI number can be obtained at the following linked web site: The cost is $200, and payment is made by credit card. III. Protocol Agreement and Adherence Letter. The Protocol Agreement is not intended to be modified. It contains basic representations and warranties (due organization, corporate power, no conflict with law or contract, enforceability, etc.) by the parties (the Protocol Participants ). It also permits the Protocol Participants, through their Questionnaires, to elect to make certain optional representations or enter into certain optional agreements. These are discussed below. Swap participants adhere to the Protocol by delivering an Adherence Letter to ISDA. The form of Adherence Letter is Exhibit 1 to the Protocol Agreement. Blanks in the Adherence Letter can be filled in online at ISDA s web site. The letter can then be printed out, signed, scanned as a pdf document, and uploaded for return to ISDA. Scanned Adherence Letters should be saved to your computer and then uploaded to ISDA s web site by clicking an upload button at the web site. (They are not sent by to an ISDA address.) It may take one or two days for ISDA to process and accept an Adherence Letter. Until it is accepted, you cannot proceed to fill out and deliver its Questionnaire. A $500 fee must be paid to ISDA in connection with submitting an Adherence Letter. Credit cards are accepted for payment. Adherence Letters will be posted publicly on ISDA s web site. An Adherence Letter will not be effective with respect to the Protocol Participants party to a Protocol Covered Agreement unless those Protocol Participants exchange Questionnaires. IV. Questionnaire and Principal Answer Sheet Protocol Participants supplement their Protocol Covered Agreements and make the Protocol effective by completing and delivering Questionnaires to each other. Questionnaires can be delivered directly in accordance with the notice provisions specified in the Protocol Participants Adherence Letters. Questionnaires can also be filled out and delivered online through ISDA Amend by Markit by going to the following web site: 3

4 Using ISDA Amend by Markit for filling in and delivering Questionnaires is free for buy-side Protocol Participants. Whether delivered directly or online, different Questionnaires can be given to different counterparties. Questionnaires are available only to other Protocol Participants to which they are delivered or that are authorized to receive them online. If a buy-side Protocol Participant delivers its Questionnaires online via ISDA Amend, the swap dealers that the buy-side Protocol Participant has authorized to receive those Questionnaires automatically will be deemed to have delivered their Questionnaires to it. The Questionnaire, if not completed online, includes both questions and a Principal Answer Sheet attached as Annex A to the Questionnaire. Applicable questions must be answered on the Principal Answer Sheet. The questions relevant to a swap participant that is not a swap dealer or Special Entity are summarized below. Basic questions are in Part II of the Questionnaire: (1) What is your CICI number? (2) What is your name and address? (3) What is your principal business? (4) Are any persons guaranteeing your swap obligations? If yes, what are their names and addresses? Note that this requirement appears to require listing each separate subsidiary guarantor, as well as all other guarantors. 5 (5) Is any person (other than an employee) exercising any control with respect to your swap positions? There appears to be no explanation of what control means in this context, so the client should answer based on a common sense interpretation of the question. (6) Do you want to designate any person as your Designated Evaluation Agent? A Designated Evaluation Agent is a person that is responsible for (i) evaluating investment risks with regard to swaps and trading strategies involving swaps as well as any swap recommendations provided by a swap dealer and (ii) makes trading decisions with respect to swaps on your behalf. If you designate a Designated Evaluation Agent, you must provide its name and contact information. (7-8) These questions are for Special Entities and are not relevant to most oil companies. 5 In adopting final rules adopted by the CFTC and the Securities and Exchange Commission on October 12, 2012, the CFTC stated that the term swaps includes swap guaranties. Swap guarantors must themselves, therefore, be Eligible Contract Participants (see the discussion below). If any guarantors are not Eligible Contract Participants, their guaranties are unenforceable and violate the rules. Most banks are inserting protective language into their guaranty forms to address this problem. 4

5 (9) This question is for Swap Dealers and Major Swap Participants and is not relevant to most oil companies. (10) Which address do you want your swap counterparty to use to send information and notices relating to the DF Supplement? (11) Do you want to receive oral disclosure of certain information relating to trades, with posttrade written confirmation? Market practice appears to be that much information in swap transactions is initially conveyed orally. Agreeing initially to receiving information orally obtained in a phone call, without waiting for written disclosures, appears to be the most practicable approach. Specific questions regarding the status of the Protocol Participant are in Part III of the Questionnaire: (1) Are you a commodity pool? Most oil companies would answer No. A commodity pool is any investment trust, syndicate, or similar form of enterprise operated for the purpose of trading in commodity interests. Oil companies that hedge their own production to reduce market risk would not be commodity pools. (2) Are you an Eligible Contract Participant? Most oil companies would answer Yes and would specify that they qualify under paragraph (b)(ix) of Question 2 as a corporation, partnership, or other entity that has total assets exceeding $10,000,000 or whose obligations are guaranteed by an entity that has such total assets. 6 If an oil company cannot confirm that it is an Eligible Contract Participant, it cannot generally enter into swap transactions. (3) Are you a Swap Dealer? Most oil companies would answer No. If they trade enough to be a swap dealer, they would know it. (4) Are you a Major Swap Participant? Most oil companies would answer No for the same reason as in question 3. The CFTC has said that this definition picks up only a relatively small number of companies, probably less than 25, that are major swap participants but are not swap dealers. (5) Are you a Financial Entity? Most oil companies would answer No. A financial entity for this purpose is a swap dealer, a major swap participant, a commodity pool, certain private funds, and persons predominantly engaged in banking. If your company is a private fund as defined in Section 202(a) of the Investment Advisors Act, or if your company is predominantly engaged in financial businesses, rather than in the active operation of oil and gas properties or other non-financial business assets, further analysis is needed with respect to this question. 6 If an oil company does not qualify under this paragraph, it may qualify under paragraph (b)(x) of Question 2, which provides that entities that have a net work exceeding $1,000,000 and enter into swaps in connection in connection with the conduct of their business or to manage risk associated with an asset or liability owned or incurred or reasonably likely to be owned or incurred by it in the conduct of its business also qualify as Eligible Contact Participants. 5

6 (6) Are you a Special Entity? Special Entities include federal agencies, states and any political subdivision or agency thereof, ERISA plans, public pension plans and endowments acting as such, and other employee benefit plans. Most oil companies would answer No. (7-8) These questions apply only to Special Entities and are not relevant to most oil companies. (9) Are you agreeing to incorporate Schedule 3 of the DF Supplement as part of your agreement? Schedule 3 is discussed below. Companies may want to discuss this with their swap dealers. (10) This question applies only if there is no signed ISDA Master Agreement. By exchanging Questionnaires, Protocol Participants also automatically incorporate Schedule 2 of the DF Supplement. The provisions of Schedule 2 are described below. If you have designated a Designated Evaluation Agent, that Designated Evaluation Agent will also have to execute the Questionnaire (or, if ISDA Amend is used, a signature page for it will have to be uploaded). V. DF Supplement The DF Supplement sets forth certain standardized representations, acknowledgments, notifications, and agreements relating to the CFTC rules. These are set forth in Schedules. The Protocol Covered Agreements between any two Protocol Participants that have delivered completed and executed Adherence Letters to ISDA and exchanged Questionnaires will be automatically deemed to have supplemented their Protocol Covered Agreements by DF Supplement Schedules 1 and 2. Those Protocol Participants can elect in their Questionnaires to incorporate the other Schedules that are applicable. Both parties must elect to incorporate one of those other Schedules for it to be incorporated. DF Schedule 1 contains defined terms used in the Protocol documents. Schedule 2 contains agreements between a Swap Dealer and any other party to a Protocol Covered Agreement. These are not elective. They are, however, intended to be neutral and not controversial. Certain sections of Schedule 2 are only applicable to certain types of Protocol Participants based on representations they have made to each other in their Questionnaires, and paragraphs (g) and (h) below address certain narrow categories of transactions. Paragraph (i), on the other hand, imposes continuing reporting requirements. Schedule 2 generally provides that: (a) (b) Each party agrees to give the other party the information the other party needs ( DF Supplement Information ) to comply with Dodd Frank. [Section 2.4] Each party represents that, as of the date on which each swap transaction is entered into, its DF Supplement Information (other than financial information) is true and has no material omissions and all financial information furnished pursuant to the DF Supplement has been prepared in accordance with applicable accounting standards. [Section 2.1] 6

7 (c) (d) (e) (f) (g) (h) (i) Each party acknowledges that the other party is relying on the DF Supplement Information. The failure of DF Supplement Information to be true will not, however, cause an Event of Default or Termination Event under the ISDA Master. [Section 2.2] Each party agrees to update its DF Supplement Information to keep it true and to provide any information reasonably requested to comply with Title VII of Dodd Frank. [Section 2.3 & 2.4] Notwithstanding any confidentiality agreement between the parties, each party consents to the disclosure of information under applicable CFTC regulations. [Section 2.5] If the parties do not enter into a confidentiality agreement, CFTC regulations provide for the treatment of confidential information, and Schedule 2 modifies those regulations (which those regulations permit) to resolve certain omissions and ambiguities in the regulations regarding what is not material confidential information and permitted disclosures. [Section ] (The modifications to CFTC regulations made by Schedule 2 are not likely to be controversial. In some respects, the CFTC regulations confidential information provisions, as modified by Schedule 2, may be more protective than many confidentiality agreements currently in use.) Each party consents to the recording of conversations of its trading personnel. (This is required by CFTC regulations and is intended to eliminate any issue under the laws of some states regarding recording conversations.) [Section 2.6] Each party represents that, if it enters into any Commodity Trade Option under the Protocol Covered Agreement, that option contains a binding obligation that results in the sale and physical shipment of a commodity. Commodity Trade Option means a commodity option that is intended to be settled by physical delivery and shipment and involves a producer or consumer of the commodity or certain other industry participants. [Section 2.7 & 2.8] If a Non-Reporting Counterparty enters into an international swap with a Reporting Counterparty, it must provide certain information to the Reporting Counterparty. [Section 2.9] An international swap is a swap a swap required by U.S. law and the law of another jurisdiction to be reported both to a swap data repository and to a different trade repository registered with the other jurisdiction. Swap data repositories are entities created by Dodd-Frank in order to provide a central facility for swap data reporting and recordkeeping. Each Non-Reporting Counterparty also must notify the Reporting Counterparty of the occurrence of certain life cycle events that are related to a corporate event in respect of such Non-Reporting Counterparty. Notice must be provided by 10:00 am on the second business day after the occurrence of such event. [Section 2.10] (These notifications are required under CFTC regulations.) Although it is not entirely clear how the CFTC will interpret life cycle events, it appears that these events will, for commodity swaps, primarily be changes to the terms of the swap itself. The terms of equity swaps might, by contrast, be affected by corporate mergers or changes to the terms of the securities that underlie the equity swaps, and it appears that these are the kinds of corporate events required to be reported. 7

8 (j) Each entity that is a Hedging Entity ECP 7 represents, at the time of each swap transaction that it enters into, that each swap transaction entered into by it will be in connection with the conduct of its business or to manage risk associated with an asset or liability reasonably likely to be owned or incurred in the conduct of its business. [Section 2.2] Oil companies that are Eligible Contract Participants because they meet the total assets test described above are not Hedging Entity ECPs. (k) Each counterparty that is not a swap dealer or a major swap participant makes other representations and agreements, generally relating to how the swap dealer or major swap participant will provide certain required pricing information. Schedule 3 includes certain representations relating to Designated Evaluation Agents or by buyside Protocol Participants that do not use such agents. A Protocol Participant can elect in its Questionnaire whether or not to make the representations in Schedule 3. (a) A Protocol Participants that has specified in its Questionnaire that it has a Designated Evaluation Agent may elect to have it and its Designated Evaluation Agent make certain representations and covenants: It represents that it has complied in good faith with written policies and procedures that are reasonably designed to ensure that its Designated Evaluation Agent is capable of evaluating swap recommendations of a swap dealer and making trading decisions on its behalf. The Designated Evaluation Agent represents that it is exercising independent judgment in evaluating swap recommendations. The Designated Evaluation Agent agrees to update information previously provide and representations previously made to maintain the accuracy thereof. It represents that it will exercise independent judgment in consultation with its Designated Evaluation Agent in evaluating swap recommendations of a swap dealer that are presented to it. (b) A Protocol Participant that has specified in its Questionnaire that it does not use a Designated Evaluation Agent may make elect to make the following representations: It has, and has complied with, written policies and procedures that are reasonably designed to ensure that the persons making trading decisions on behalf of [the company] are capable of doing so. The swap dealer is acting on its own behalf and not as an advisor as to the suitability of the swap. 7 A Hedging Entity ECP is an entity that represents that it is a corporation, partnership, or other entity with a net worth exceeding $1,000,000 and enters into swaps in connection with the conduct of its business or to manage risk but has not otherwise qualified as an eligible contract participant. 8

9 (c) (d) Note that the first representation described above in each of paragraphs (a) and (b) requires the preparation and adoption of specific policies and procedures by a company, if they are not already in place. These representations are intended to provide under CFTC rules a safe harbor for swap dealers. 8 If a buy-side Protocol Participant does not make these representations, a swap dealer that recommends a swap or trading strategy involving a swap must use reasonable diligence to determine and have a reasonable basis for determining the suitability of that swap or strategy. Diligence includes a client s investment profile, trading objectives, and ability to absorb losses. Whether a communication from a swap dealer is a recommendation will depend on the facts and circumstances. General marketing material probably would not be a recommendation; a customized pitch book probably would be. Protocol Participants should consider whether they are willing to make these representations or would prefer to have the CFTC rules apply to its relations with swap dealers. Swap dealers have expressed concern that doing reasonable diligence may require them to obtain information from their clients that clients will be unwilling to provide, and that doing such diligence may substantially interfere with ongoing relations with clients. While Schedule 3 does not seem particularly burdensome, there seem to be no strong reasons for an end-user to want to adopt it. Before electing Schedule 3, we think oil companies and other end-users may want to see whether their swap dealer counterparties will object if the end-users do not elect Schedule 3. Schedules 4, 5, and 6 only apply to Special Entities. Oil companies generally would not be Special Entities to which Schedule 4, 5, and 6 would be applicable and should focus on Schedule 3 only. VI. Amended and Restated Addendum I to ISDA August 2012 DF Protocol Questionnaire The Addendum updates the Questionnaire to reflect CFTC rules that became effective on December 12, It is not relevant to independent oil companies. A swap participant must represent whether it is an Active Fund, which is a private fund under the Investment under the Investment Advisers Act of 1940 that, among other things, on average executed more than 200 swaps per month in the 12 months preceding November 1, Most oil companies would not be Active Funds. 8 Certain swap dealer obligations are not affected by the safe harbor, including the obligation a reasonably sufficient time prior to entering into a swap to disclose material risks, material characteristics of the swap, material incentives or conflicts of interest, and the price and mid-market mark of the swap. Swap dealers also must notify their counterparties that they can request and consult on the design of a scenario analysis that includes a disclosure of material assumptions and methodologies (other than proprietary information). 9

10 The Addendum also addresses certain matters relating to commodity pools, which oil companies are unlikely to be, as discussed above. VII. Summary Oil companies that are end-users of commodity swaps and derivatives need to take certain steps in order to be able to trade in the over-the-counter derivatives markets, or to make material modifications to existing swap transactions, on and after May 1, They must obtain a CICI number and either enter into bilateral arrangements with swap dealers modifying existing ISDA Master Agreements or become a party to the Protocol by delivering an Adherence Letter and exchanging Questionnaires with their swap dealers. Two other actions also may need to be taken. If a swap participant elects to have Schedule 3 of the DF Supplement apply, it must adopt written policies and procedures that are reasonably designed to ensure that the persons making trading decisions on behalf of the company (whether they are Designated Evaluation Agents or company employees) are capable of doing so. The boards of public companies also should adopt a resolution that allows the company to enter into uncleared swap transactions Thompson & Knight LLP 10