Dodd-Frank Title VII Update: Where Are We Today and Where Are We Going? Ten Important Issues Facing Derivatives Users Nov 07, 2011 Top Ten By James M. Cain This resource is sponsored by: Where Are We Today? - Dodd-Frank Act passed July 21, 2010-52 CFTC Proposed Rulemakings and 1 Interpretive Order - Not including Advanced Notices of Proposed Rulemaking - 2 Open Comment Periods - 1 Exemptive Order and a Proposed Amendment thereto - Final CFTC Rules on the following topics: - Agricultural commodity definition - Anti-manipulation and anti-fraud rules - Protection of consumer information - Privacy protections under Gramm-Leach-Bliley Act - Large trader reporting (temporary exemption granted) - Process for review of swaps for mandatory clearing - Part 40 of the CFTC s regulations - Removal of reliance on credit ratings - Agricultural swaps - Whistleblower incentives and protections - Registration/regulation of swap data repositories By James M. Cain, Partner, Sutherland
- Position limits futures and swaps - Derivatives clearing organization general provisions and core principles Where Are We Going? - CFTC Final Rules Expected in 2011: - Data Recordkeeping and Reporting - End-User Exception - Entity Definitions/Registration - External Business Conduct - Internal Business Conduct (Duties, Recordkeeping and Chief Compliance Officers) - Product Definitions/Commodity Options - Real-Time Reporting - Segregation for Cleared Swaps - Trading Designated Contract Markets and Foreign Boards of Trade - CFTC Final Rules Expected in 2012: - Capital and Margin - Client Clearing Documentation and Risk Management - Conforming Rules - Disruptive Trading Practices - Governance and Conflicts of Interest - Internal Business Conduct (Documentation) - Investment of Customer Funds - Swap Execution Facilities - Segregation for Uncleared Swaps - Straight-Through Trade Processing Top Ten Issues Facing Derivatives Users 1. Capital and Margin Requirements - Proposed Rules - Proposed Rules to set capital and margin requirements issued by the Prudential Regulators on April 12, 2011 - Proposed Rules to set margin requirements issued by the CFTC on April 12, 2011 - Proposed Rules to set capital requirements issued by the CFTC on April 27, 2011 - Capital Requirements for Cleared and Uncleared Swaps - Swap Dealers and Major Swap Participants regulated by Prudential Regulators must comply with capital requirements currently imposed on such entities by the applicable Prudential Regulator - Swap Dealers and Major Swap Participants not regulated by Prudential Regulators must comply with CFTC s capital requirements - In general, $20 million minimum capital requirement - Margin Requirements for Cleared Swaps - Set by derivatives clearing organizations (DCOs) and futures commission merchants (FCMs)
- Both initial and variation margin required - FCMs required to collect margin above that required by the DCO for non-hedging transactions - Types of eligible collateral dictated by the DCO and CFTC - DCOs are prohibited from accepting letters of credit (but may be accepted by FCMs subject to negotiated limitations/haircuts) - Margin Requirements for Uncleared Swaps - Prudential Regulators set requirements for margin collected by Swap Dealers and Major Swap Participants that are regulated by a Prudential Regulator - Initial margin and variation margin required from financial entity end-user counterparties: - Margin requirements for low-risk financial entity end-users may be subject to negotiated thresholds - Margin requirements for high-risk financial entity end-users may not be subject to thresholds - Initial margin and variation margin required from non-financial entity end-user counterparties - May be subject to negotiated thresholds without numerical limits thresholds must take into account and address counterparty credit risk and risks of swaps themselves - CFTC sets margin requirements for margin collected by Swap Dealers and Major Swap Participants that are not regulated by the Prudential Regulators - Substantively the same as Prudential Regulators requirements, except that for non-financial entity end-user counterparties, there are no CFTC limitations on the amounts of margin that must be collected or thresholds that may be negotiated - Proposed Rule issued on September 8, 2011, would phase in compliance with the CFTC s margin requirements for uncleared swaps (discussed below) - SEC sets margin requirements for security-based Swap Dealers and Major Security-Based Swap Participants that are not regulated by a Prudential Regulator; rules have not yet been proposed - Segregation of Margin for Cleared Swaps - CFTC Proposed Rule issued April 27, 2011 - Customer collateral to be legally segregated but may be physically commingled with collateral posted by other customers of an FCM in an omnibus account - Segregation of Initial Margin for Uncleared Swaps - CFTC Proposed Rule issued on November 19, 2010 - Market participants may require their swap dealer or major swap participant counterparties to segregate initial margin posted to the swap dealer/major swap participant 2. Mandatory Clearing Requirements - To date, CFTC regulations have not addressed this issue in a way that clearly puts market participants on notice as to what swaps will be eligible for clearing
- Process for Review of Swaps for Mandatory Clearing - CFTC Final Rule issued July 19, 2011; effective September 26, 2011 - Derivatives clearing organizations and, in some cases, CFTC and SEC, determine which swaps will be cleared - End-User Exception from Mandatory Clearing - CFTC Proposed Rule issued on December 9, 2010 - Transactions that hedge or mitigate commercial risk - May be available to certain financial institutions - Venues for Cleared Swaps - Designated Contract Markets (i.e., regulated exchanges) - Swap Execution Facilities - Proposed Rule issued on September 8, 2011, would phase in compliance with the mandatory clearing requirement (discussed below under No. 10 Uncertainty ) 3. Swap Entity Definitions - CFTC Proposed Rule issued on December 1, 2010 - Swap Dealers - Entities that seek to accommodate the trading interests of other parties - Narrow safe harbors - Major Swap Participants - Substantial position - Potential exposure and potential future exposure - Out-of-the-money to dealers - High dollar thresholds - $1 Billion Daily Current Uncollateralized Exposure ($3 Billion for rate swaps) or - $2 Billion Daily Current Uncollateralized Exposure plus Aggregate Potential Outward Exposure ($6 Billion for rate swaps) - Intended to capture a small number of market participants - Consequences - Swap dealers and major swap participants subject to capital, margin, clearing, examination, reporting and business conduct rules 4. External Business Conduct Rules - CFTC Proposed Rule issued on December 9, 2010 - Current Treatment - Counterparties in the current OTC derivatives market generally address business conduct concerns by incorporating non-reliance provisions into their swap documentation that clarify the relationship between the parties - Proposed Business Conduct Standards - Verification of eligible contract participant status
- Disclosure requirements - Daily marks - SIFMA and ISDA Comment Letter Non-Reliance Revisited - Trade by trade vs. overall relationship 5. Swap Recordkeeping and Reporting Requirements - CFTC Proposed Rules issued on November 19, 2010 - Two rules with respect to reporting swap transaction data that will apply to all swap market participants, regardless of whether they are swap dealers or major swap participants - Swap Data Recordkeeping and Reporting Requirements - Real-Time Reporting - End users that are not Swap Dealers or Major Swap Participants will generally not be subject to reporting requirements - For cleared swaps that are executed on a designated contract market (DCM) or swap execution facility (SEF), the DCM/SEF and the derivatives clearing organization will have the majority of the reporting obligations - Major Swap Participants and Swap Dealers will also have reporting requirements, which will vary based on the type of swap, whether it is executed on a DCM or SEF and whether it is cleared - End users will be subject to recordkeeping requirements - End users must maintain full, complete and systemic records with respect to each swap to which they are a counterparty - Records must be kept throughout the life of the swap and for five years after final termination of the swap - Records must be retrievable within three business days - Recordkeeping requirements for swap dealers and major swap participants are more comprehensive - Must maintain daily trading records sufficient to conduct a comprehensive and accurate trade reconstruction (including pre-execution information and post-execution information) - Interim rules applying to trades before Dodd-Frank Act and new regulations only require market participants to maintain existing data in its current form 6. Legal Documentation for Clearing - Futures Account Agreements - Form, typically not negotiated - Vary from FCM to FCM - Cleared Derivatives Transactions Addendum - FIA Working Group - ISDA/FIA Cleared Derivatives Transactions Execution Agreement - Published in June
- Bilateral, tri-party or four-party, but CFTC Proposed Rule issued on July 19, 2011, would preclude the use of the tri-party or four-party version - CFTC Proposed Rule issued on January 20, 2011 - Requires Swap Dealers and Major Swap Participants to create a record of each swap transaction that conforms to the template established by the rules of the applicable derivatives clearing organization Collateral OTC Non-Cleared Trades - Established by contract - Independent amount limited - Delivery time fixed by contract Cleared Trades N/A Margin N/A - Established by derivatives clearing organizations - No limitation on initial margin additional margin may be required by FCM - Delivery on demand Transfer/Assignment Transfer/Porting - Counterparty consent required N/A N/A - Any time provided no event of default; consent not required Termination - Not authorized unless an event of default or other contractual termination event occurs - Permitted by either party upon written notice Events of Default - Payment default after notice and cure period - Other breaches after notice and cure period - Typically no default for insecurity unless termination event is triggered (Note: we are aware of negotiated Adequate Assurance provisions) - Payment default no notice or cure period - Other breaches no notice or cure period - FCM may declare if it deems it necessary for its protection - CFTC Proposed Rule Issued on January 20, 2011 - Valuation Methodology and Dispute Resolution - Written documentation for uncleared swaps entered into by swap dealers and major swap participants must include methods, procedures, rules and inputs for valuing such swaps at all times during the life of the swaps - Valuation methodology must be independently verifiable - Valuation disputes must be reported to the CFTC - Specific Documentation Requirements - Must include payment obligations, events of default, transfer rights, governing law, initial margin requirements, variation margin requirements and any custodial arrangements for collateral - Proposed Rule issued on September 8, 2011 would phase in compliance with these trade documentation requirements (discussed below under No. 10 Uncertainty ) 7. Confirmation, Portfolio Reconciliation and Portfolio Compression Requirements
- CFTC Proposed Rule issued on December 16, 2010 - Confirmation Requirements - Requires Swap Dealers and Major Swap Participants to provide their counterparties with acknowledgments and/or confirmations for all trades within specified periods of time - Portfolio Reconciliation - Requires Swap Dealers and Major Swap Participants to engage in portfolio reconciliation with respect to all of their uncleared swap transactions - Portfolio Compression - Swap Dealers and Major Swap Participants to participate in multilateral portfolio compression exercises prescribed by the CFTC, a self-regulatory organization or a derivatives clearing organization 8. Regulation of Commodity Options and Agricultural Swaps - Dodd-Frank Act prohibits agricultural swaps absent a CFTC rule allowing them - CFTC Proposed Rule issued on January 20, 2011 - Allows agricultural swaps - Regulates agricultural swaps and commodity options like other swaps - Replaces existing eligible swap participant safe harbor for agricultural swap transactions with the eligible contract participant requirements applicable to all swaps that are not executed on an exchange - CFTC Final Rule issued on August 4, 2011 - Allows agricultural swaps - Regulates agricultural swaps like other swaps - Replaces existing eligible swap participant safe harbor for agricultural swap transactions with the eligible contract participant requirements applicable to all swaps that are not executed on an exchange - Commodity options not addressed to be included in final swap definition rulemaking 9. Position Limits - CFTC Rule issued October 18, 2011 - Applies to futures, options and economically equivalent swaps - Two phases: - Phase 1: - CFTC imposition of existing exchange-imposed spot-month limits - Non-spot month legacy limits for agricultural commodities (based on updated data) - Spot-month limits reset annually (for energy and metal commodities) or every two years (for agricultural commodities) based on deliverable supply - Will take effect 60 days after the effectiveness of the CFTC/SEC definition of "swap" (not expected until 2012) - Phase 2: - Non-spot month limits - Reset every two years based on open interest
- Will not take effect until CFTC has obtained one year's worth of swap data (not expected until the beginning of 2013) - Will be issued by CFTC Order - Aggregation Requirements - Based on ownership and control, with certain exceptions - Hedging Exemption - Includes anticipatory hedging but is not as broad as hedging requirement for end-user exemptions from clearing under the Dodd-Frank Act 10. Uncertainty - Majority of Proposed Rules remain to be finalized, including those pertaining to key topics: - Definition of Swap - Capital and Margin Requirements - Protection of Customer Collateral - Entity Definitions - Effective Dates for the CFTC s finalized rules are still uncertain - On September 8, 2011, the CFTC issued two Proposed Rules pertaining to the implementation of: - The mandatory clearing and trade execution requirements; and - The CFTC s proposed trade documentation and margin requirements for uncleared swaps Compliance with the Dodd-Frank Act s clearing requirement would be phased in based on the following entity categories: Category 1 entities I.e., swap dealers, security-based swap dealers, major swap participants, major security-based swap participants and active funds Category 2 entities I.e., commodity pools, private funds (as defined by Section 202(a) of the 1940 Act, other than active funds), employee benefit plans, or persons predominantly engaged in activities that are financial in nature or in the business of banking (not including third-party subaccounts) Category 3 entities I.e., all other market participants --> --> --> Within 90 days of the CFTC s issuance of a mandatory clearing determination Within 180 days of the CFTC s issuance of a mandatory clearing determination Within 270 days of the CFTC s issuance of a mandatory clearing determination Trade execution requirements would take effect on the later of (1) the date on which the swap is required to be cleared or (2) 30 days after the swap is made available for trading - The CFTC has similarly proposed to phase in its trade documentation and margin for uncleared swaps requirements using entity categories - The entity categories and time frames for compliance with the CFTC's trade documentation
and margin for uncleared swaps requirements are nearly the same as those for the clearing and trade execution requirements, except that "Category 3" only encompasses those entities whose positions are held as third-party subaccounts, and a "Category 4" is included to encompass all other entities - Publication of several prerequisite final rules serves as the trigger for phased-in compliance - Both Category 3 and Category 4 entities will have 270 days from the publication of the prerequisite final rules to comply - The proposed phase-in time periods are dependent on completion of the following rules, among others: - Mandatory Clearing - End-user Exception - Entity Definitions - Protection of Margin Posted in Connection with Cleared Swaps - Trade Execution - Above-named final rules and rules related to DCMs and SEFs - Swap Trading Relationship Documentation and Margin for Uncleared Swaps - Swap Documentation Rules - Entity Definitions - Protection of Margin Posted in Connection with Uncleared Swaps - Rules Regarding Confirmation of Swap Transactions - Rules regarding SD and MSP Registration Jamie Cain, a member of Sutherland s Corporate Practice Group, has extensive experience with public and private securities offerings by U.S. and foreign companies and with mergers and acquisitions of these companies. He is nationally known for his experience with respect to the use of over-the-counter (OTC) derivatives including interest rate, foreign exchange, equity and commodity transactions, and related collateral arrangements. Jamie also is recognized for his experience advising insurers, banks and broker-dealers in connection with cross-industry acquisitions and in the distribution of their respective products both domestically and internationally. He routinely advises these institutions with respect to compliance with the myriad of federal and state laws applicable to such transactions. www.regulatoryreformtaskforce.com The information in this Top Ten should not be construed as legal advice or legal opinion on specific facts and should not be considered representative of the views of its authors, its sponsors, and/or the ACC. This Top Ten is not intended as a definitive statement on the subject addressed. Rather, it is intended to serve as a tool providing practical advice and references for the busy in-house practitioner and other readers. Reprinted with permission from the Association of Corporate Counsel (ACC) 2011 All Rights Reserved. http://www.acc.com/legalresources/publications/topten/toptenifdu.cfm