Member Article

On April 1, 2013, the U.S. Commodity Futures Trading Commission (“CFTC”) issued a final rule exempting swaps between certain affiliated entities from the clearing requirement under section 2(h)(1)(A) of the Commodity Exchange Act (“CEA”) and CFTC regulations (“Final Rule”).¹ This alert outlines the rule and raises some questions as to its conditions and impact.

I. Background

The Dodd-Frank Wall Street Reform and Consumer Protection Act² (“Dodd-Frank”) amended the CEA so as to require clearing of certain swaps.³ On November 29, 2012, the CFTC adopted clearing requirements for four classes of interest rate swaps and two classes of credit default swaps.⁴ Pursuant to its exemptive authority under section 4(c)(1) of the CEA, the CFTC issued the Final Rule permitting majority-owned affiliates to elect not to clear a swap on an exchange, subject to certain conditions.⁵

II. The Rule and Conditions

The inter-affiliate swap exemption from required clearing sets forth certain conditions that must be satisfied in order to elect the exemption:⁶

1. Both affiliates must elect not to clear the inter-affiliate swap;
2. Either one affiliate must hold a majority ownership interest in the other or both affiliates must be majority-owned by a common parent and the financial statements of both affiliates (and, if applicable, the common parent) must be reported on a consolidated basis;
3. The swap must be documented in a written swap trading relationship document satisfying certain specified requirements;
4. The swap must be subject to a centralized risk management program;
5. Certain information regarding the swap must be reported to a Swap Data Repository⁷; and
6. both affiliates must meet certain conditions with regard to their “outward-facing swaps” (as defined below).⁸

a. Affiliation Requirements

i. Majority ownership of equity securities

Counterparties can avail themselves of the rule so long as either one counterparty directly or indirectly holds a majority ownership interest in the other, or a third party directly or indirectly holds a majority ownership interest in both counterparties. The rule further provides that majority ownership interest refers to a “majority of the equity securities of an entity, or the right to receive upon dissolution, or the contribution of, a majority of the capital of a partnership.”⁹

The contours of what constitutes “majority ownership” may be unclear in the context of quasi-equity instruments that confer a degree of control but may or may not fall within a narrow definition of “equity securities,” such as convertible debt securities, warrants or preferred stock. For example, holding a sizable stake in convertible debt securities of an entity would give the holder significant leverage and control and may entitle the holder to receive a majority of “equity securities” upon conversion, but prior to conversion, such stake may not be included in the calculation of “majority ownership.”¹⁰ The question thus arises as to whether and under what circumstances the holder might become an affiliate of the issuing entity under the rule, thereby exempting swaps between the two parties (or where one is a common parent of the other as well as another affiliate) from the clearing requirement. Furthermore, it is possible to hold a majority of the “equity securities” but have limited management rights.

Another issue is how “treasury affiliates” or other entities in a corporate group that are used to consolidate and manage group risk that do not otherwise meet the applicable requirements will be treated. The CFTC in its comments said that it would address this issue under a separate action.¹¹

ii. Consolidated financial statements required

Another required condition is that the affiliated entities must report their financial statements on a consolidated basis. The CFTC has said reporting may be made in compliance with either Generally Accepted Accounting Principles (“GAAP”) or International Financial Reporting Standards (“IFRS”),¹²which may facilitate cross-border swaps by allowing foreign subsidiaries to continue operating in the overseas swap markets (subject to the other conditions discussed below as to “comparable and comprehensive” foreign regulations).

b. Documentation of Inter-Affiliate Swaps Required

The exemption requires that “all terms governing the trading relationship” be documented.¹³ There is no materiality requirement, though the CFTC has said that book entry documentation alone is not sufficient, whereas full ISDA master agreement documentation is not required.¹⁴

c. Treatment of Outward-Facing Swaps

In order to prevent extraterritorial abuse of the exemption through the use of swaps entered into by offshore affiliates facing unaffiliated third parties (“outward-facing swaps”), the Final Rule also imposes certain requirements on such outward-facing swaps entered into by affiliates. Where such outward-facing swaps would be subject to mandatory clearing requirements if executed in the U.S., the affiliated swap participants must satisfy one of the following with respect to such outward-facing swaps:

A. Comply with the CFTC clearing requirement;
B. Comply with a foreign jurisdiction’s clearing requirement provided the CFTC has deemed the requirement “comparable and comprehensive” (but not necessarily identical);
C. Comply with an exemption or exception under the CEA or CFTC regulations (such as the end-user exception¹⁵);
D. Comply with a foreign jurisdiction’s exemption or exception to a clearing requirement provided the CFTC has deemed the exemption or exception “comparable and comprehensive” (but not necessarily identical); or
E. Clear such swaps through a registered derivatives clearing organization or a clearing organization that is subject to supervision by appropriate government authorities in the home country of the clearing organization and that has been assessed to be in compliance with the Principles for Financial Market Infrastructures.¹⁶

The CFTC has partly interpreted the “comparable and comprehensive” requirement to mean that the foreign regime covers the same swaps required for clearance under section 2(h) of the CEA, and shares the same objectives as the CEA, as amended by Dodd-Frank.¹⁷

III. Effectiveness and Impact

The exemption takes effect June 10, 2013.¹⁸ Despite important benefits afforded by the exemption, including risk-mitigation, hedging and netting, the CFTC acknowledged the possibility that the delay of the exemption might result in a reduced volume of cleared swaps, which ultimately could have the effect of increasing exchange margin requirements¹⁹ – and presumably pricing. The CFTC stated that it does not consider non-arm’s length or inter-affiliate transactions like those covered by the exemption to contribute to price discovery in the markets.²⁰

Notably, the exemption does not require the posting of initial or variation margin in order for inter-affiliate swaps to fall within the exemption.²¹

All swap market participants should continue to monitor developments in this area. For more information, please contact one of the lawyers listed below.