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June 12, 2020 |
European Market Infrastructure Regulation for Derivatives End-Users – A Shift in Responsibility for Reporting

Click for PDF EMIR Refit[1] came into force on 17 June 2019 with the aim of amending the European Market Infrastructure Regulation (“EMIR”)[2] to address “disproportionate compliance costs, transparency issues and insufficient access to clearing for certain counterparties[3]. While most of the changes are already in force, further changes will be implemented with effect from 18 June 2020. These changes will shift responsibility and legal liability as between certain counterparties for the timely and accurate reporting of “over the counter” (“OTC”) derivative contracts. With a particular focus on corporate end-users of derivatives (such as corporate treasury functions)[4], this note sets out, and discusses the implications of, these changes for parties to OTC derivative transactions, including the practical steps that should be taken in contemplation of such changes. What is the reporting obligation? Under the reporting requirements set out in Article 9 of EMIR, all financial counterparties (“FCs”) and non-financial counterparties (“NFCs”) to derivative contracts are required to report details of any concluded OTC and exchange traded contracts (including any modifications or termination of such contracts) to a European trade repository, by no later than the next business day. European corporate derivatives end-users (which are not regulated under any of the European sectoral financial services legislation, such as MiFID II[5], AIFMD[6], etc.) fall into the NFC category. Under the current rules, each counterparty is responsible for reporting in relation to each in-scope transaction (i.e., dual-sided reporting)[7]. While reporting can be delegated to the trading counterparty or to a third party service provider, it is not possible for corporate derivative end-users to delegate the regulatory responsibility for the reporting and therefore they remain liable in the event that reporting information is incorrect or transactions are not reported. Consequently, under the current rules it is prudent for end-users to perform periodic monitoring of any reports submitted to a trade repository on their behalf. What is changing from 18 June 2020 for derivatives end-users? From 18 June 2020, NFCs who are not subject to the clearing obligation (each an “NFC-”) will no longer be subject to the reporting obligation in relation to OTC derivative contracts, unless they opt to continue to perform their own derivatives reporting[8]. Where an FC trading counterparty reports on behalf of itself and its NFC- counterparty, the FC will be solely responsible and legally liable for the reporting. For the avoidance of doubt, this applies only in relation to OTC contracts and does not cause a shift in the responsibility for reporting of exchange traded derivatives. To ensure the FC has the data it needs to fulfil its reporting obligation, the NFC- must provide to the FC the details relating to the OTC derivative contracts concluded between them, which the FC cannot be reasonably expected to possess. The NFC- bears the responsibility for ensuring that these details are correct.[9] To facilitate this, FCs are currently reaching out to their clients to request the necessary data and the execution of a new reporting agreement. In addition to this data, we are also seeing FCs requesting a range of other data from their NFC- clients, including:

  • whether the NFC- intends to report for themselves;
  • whether the NFC- will be in scope of EU-EMIR reporting or the on-shored UK-EMIR reporting regime after the transition period ends following the UK’s withdrawal from the EU;
  • the trade repository used by the NFC-; and
  • whether the FC will report lifecycle events on contracts entered into before 18 June 2020.
With respect to specific data required to be reported under Regulation (EU) 2017/104, the NFC- would be expected to provide the following details to its FC counterparties:
  • Field 1.2 (Reporting counterparty ID – e.g., the counterparty’s Legal Entity Identifier (“LEI”));
  • Field 1.6 (Corporate sector of the counterparty);
  • Field 1.7 (Nature of the counterparty);
  • Field 1.8 (Broker ID – if unknown by FC);
  • Field 1.10 (Clearing Member – if unknown by FC);
  • Field 1.11 (Type of ID of the beneficiary – if the beneficiary is different from the NFC-);
  • Field 1.12 (Beneficiary ID – if beneficiary is different from the NFC-);
  • Field 1.13 (Trading capacity);
  • Field 1.15 (Directly linked to commercial activity or treasury financing); and
  • Field 1.16 (Clearing threshold).
It is important to note that while Fields 1.2, 1.6, 1.7 and 1.16 are static fields which can be provided to the FC one time and updated immediately when they change, the other fields are specific to each OTC derivatives contract and therefore must be provided to the FC for each such contract.[10] Importantly, the NFC- will retain the responsibility for ensuring it has a valid LEI at all times and to provide such information to its FC counterparties. If the NFC- has not timely renewed its LEI, the FC will not be able to successfully report the OTC derivatives contract data to the European trade repository on behalf of the NFC-.[11] What happens if my counterparty is not in the EU? Under current rules, where an NFC- trades with a counterparty that is established outside of the EU (i.e., it is a third-country entity) the NFC- is required to take steps to report its side of the transaction to a European trade repository. EMIR Refit establishes a mechanism whereby the NFC- would no longer need to report the transaction itself where certain conditions are fulfilled, including where the legal regime for reporting in the jurisdiction where the trading counterparty is established has been declared equivalent under EMIR.[12] Currently, there are no equivalency decisions related to reporting and therefore when an NFC- transacts with any third-country entity, including a third-country FC, it must continue to report (or delegate reporting to its counterparty or a third party) the data for any OTC derivative contracts (and lifecycle / termination events) to a European trade repository in the same way as it does today. From the perspective of certain NFC-s, the lack of equivalence determinations for reporting is sub-optimal because the NFC- must retain the legal liability for reporting certain transactions beyond 18 June. What happens if my counterparty is not an FC? EMIR Refit’s changes to Article 9 of EMIR only shift the reporting responsibility from an NFC- to an FC. In the event that an NFC- transacts an OTC derivative contract with another NFC (whether established in the EU or a third-country NFC), the NFC- would retain the responsibility and legal liability to report the data for such OTC derivative contract to a European trade repository. In other words, EMIR Refit does not address NFC to NFC transactions and therefore the same EMIR dual-sided reporting rules would continue to apply for OTC derivatives contracts entered into between NFCs. What about transactions entered into before 18 June 2020? The change discussed above not only applies to new OTC derivative transactions concluded between NFC-s and FCs after 18 June 2020, but also to the modifications or terminations of OTC derivative contracts existing before that date (unless the parties contractually agree that the responsibility of the FC will be limited to the new OTC derivative contracts only). This raises some operational difficulties which counterparties to trades will need to work through in advance of 18 June. For example, if two counterparties to a transaction have each reported to a different European trade repository under the current rules, in order for the FC to report lifecycle and termination events, either the NFC- will need to transfer the contract to the FC’s trade repository using the porting mechanism under EMIR Refit or, where operationally feasible, the FC may continue to report to the trade repository used by the NFC-.[13] Use of the porting mechanism has also thrown up certain operational issues. In particular, prior to porting trades between trade repositories, the Unique Trade Identifiers (“UTI”) originally reported by the NFC- and FC for each trade must match. If this is not the case, it will not be possible for the FC to successfully report post-trade events because the existing position will have a UTI that differs from that recognised by the FC. Therefore, where the UTI of existing positions (as reported by the NFC- and FC counterparties) do not match, such positions must be corrected before porting between trade repositories. This is another area where counterparties need to work together. What happens if I change NFC classification? Where an NFC which is above the clearing threshold in one or more asset classes (“NFC+”) becomes an NFC-, its FC counterparties become immediately responsible for reporting on behalf of the NFC- in respect of both new and lifecycle events. However, in order to facilitate the assumption of reporting by the FC, it is incumbent upon the NFC client to inform the FC of its change in classification.[14] Similarly, an NFC- reclassified as an NFC+ would become liable for its own reporting from the date on which the NFC calculates that its classification has changed. There would be no way for the FC to know of the reclassification in the absence of such notification. ________________________    [1]   Regulation (EU) 2019/834.    [2]   Regulation (EU) No 648/2012.    [3]   See Press Release, Capital markets union: Council adopts updated rules for financial derivative products and clearing, available at https://www.consilium.europa.eu/en/press/press-releases/2019/05/14/capital-markets-union-council-adopts-updated-rules-for-financial-derivative-products-and-clearing/    [4]   Given this focus, this bulletin does not provide detail on the prospective transfer in reporting responsibility and liability from alternative investment funds and undertakings for collective investment in transferable securities to their managers.    [5]   Directive 2014/65/EU    [6]   Directive 2011/65/EU    [7]   We note that EMIR’s dual-sided reporting regime differs from the derivatives reporting regimes of other jurisdictions (e.g., CFTC) which maintain a single-reporting regime where the legal liability for reporting lies with only one counterparty to the OTC derivative contract.    [8]   An NFC- might opt to continue to do its own reporting where, for example, it has invested in building a reporting system and ongoing maintenance costs of operating such a system are not significant.    [9]   See Article 9(1a) of EMIR as amended by EMIR Refit. [10]   See ESMA Questions and Answers, Implementation of the Regulation (EU) No 648/2012 on OTC derivatives, central counterparties and trade repositories (EMIR) (updated 28 May 2020) (“ESMA Q&A”), TR Question and Answer 54(a), available at https://www.esma.europa.eu/sites/default/files/library/esma70-1861941480-52_qa_on_emir_implementation.pdf. [11]   See ESMA Q&A, TR Question and Answer 54(b). [12]   Article 9(1a) of EMIR as amended by EMIR Refit provides that the NFC- would not retain the legal liability for reporting under Article 9 of EMIR when transacting with a third-country FC if the following conditions are met: (a) the third-country entity would be an FC if it were established in the EU; (b) the legal reporting regime to which the third-country FC is subject has been declared equivalent pursuant to Article 13 of EMIR; and (c) the third-country FC has reported the information pursuant to the third-country legal regime for reporting to a trade repository that has granted the entities referred to in Article 81(3) of EMIR direct and immediate access to the data. [13]   See ESMA Q&A, TR Question and Answer 54(d). [14]   See ESMA Q&A, TR Question and Answer 54(c).

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments.  Please contact the Gibson Dunn lawyer with whom you usually work in the firm’s Financial Institutions and Derivatives practice groups, or any of the following:

Jeffrey L. Steiner – Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com) Michelle M. Kirschner – London (+44 (0)20 7071 4212, mkirschner@gibsondunn.com) Martin Coombes – London (+44 (0)20 7071 4258, mcoombes@gibsondunn.com) Chris Hickey – London (+44 (0)20 7071 4265, chickey@gibsondunn.com) © 2020 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

March 2, 2020 |
CFTC Issues Proposed Rule on Speculative Position Limits on Derivatives

Click for PDF On January 30, 2020, the Commodity Futures Trading Commission (“CFTC” or “Commission”) approved on a party-line, 3-2 vote,[1] a proposed rule on federal speculative position limits for derivatives (the “2020 Proposal”),[2] to conform to the amendments to the Commodity Exchange Act (“CEA”) resulting from the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”).[3] The 2020 Proposal would establish federal speculative position limits on 25 physically-settled commodity derivatives and their linked cash-settled futures, options on futures, and economically equivalent swaps. In connection with setting the federal position limits, the 2020 Proposal would also establish exemptions from such position limits for certain transactions that qualify as bona fide hedges. Comments on the 2020 Proposal, which asks a number of specific questions, are due by April 29, 2020. The expectation is that this deadline will not be extended, as CFTC Chairman Tarbert has expressed his desire to finalize position limits this year.[4] The 2020 Proposal marks the fifth time over the past decade that the CFTC has proposed rules to implement the position limits provisions resulting from the Dodd-Frank Act’s amendments to the CEA. The CFTC initially issued proposed and final rules on speculative position limits in 2011;[5] however, the 2011 Final Rule was vacated by the U.S. District Court for the District of Columbia in 2012.[6] Following the vacatur of the 2011 Final Rule, the CFTC issued three additional proposed rules regarding speculative position limits in December 2013, June 2016 and December 2016, none of which were ever finalized.[7] This client alert provides a brief overview of the differences between the 2020 Proposal and prior proposals; a summary of the 2020 Proposal; and insights regarding the 2020 Proposal and its potential impacts.

I.  Differences from Prior Proposed Rules

In issuing the 2020 Proposal, the CFTC’s interpretation of Section 737(a)(4) of the Dodd-Frank Act[8] differs from prior proposals in that the CFTC interprets the section to require a finding, before establishing a position limit, that such limit is “necessary” to “diminish, eliminate, or prevent” excessive speculation.[9] The 2020 Proposal notes that the U.S. District Court for the District of Columbia in ISDA identifies that the statutory language allowing the CFTC to regulate excessive speculation is subject to multiple interpretations and is ultimately ambiguous as to whether the CFTC must determine that a position limit is necessary prior to establishing the limit.[10] Rather than providing a definitive statutory interpretation, the court in ISDA directed the CFTC to use its “experience and expertise” to determine whether a necessity finding is required before the CFTC establishes a position limit.[11] Following ISDA, the CFTC’s position, as evidenced by the 2013 and 2016 proposals, was that the standards set forth in CEA Section 4a(a)(1)[12] do not require that it make a particular necessity finding. Moreover, in the 2013 and 2016 proposals, the Commission found that Section 737 of the Dodd-Frank Act required that it impose position limits on “all markets in physical commodities.”[13] Accordingly, the 2020 Proposal differs from prior proposals by reading CEA Section 4a(a)(1) to place the burden on the government to determine what position limits are necessary.[14] The 2020 Proposal seeks to impose speculative position limits on 25 core referenced futures contracts for which it has made a necessity finding.[15] Note, however, that position limits on contracts listed on exchanges (i.e., designated contract markets) would continue to apply at the specific exchanges beyond the 25 required federal limits to the extent specified in the particular exchange rulebooks. Unlike prior proposals, there is no express intent in the 2020 Proposal to expand position limits beyond the 25 core referenced futures contracts to include all commodities at a future date. Any position limits for a new commodity would have to proceed under a similar necessity finding and notice and comment rulemaking. Chairman Tarbert has described this approach to the necessity finding for position limits as a “big picture approach.”[16] Chairman Tarbert explained that the approach takes into account the fact that position limits impose a burden, whether “on parties having to track their positions relative to limits, or potentially the loss of a business opportunity because the risks cannot be hedged” and as such seeks to impose these limits only when necessary.[17]

II.  Contracts Subject to Position Limits

A.  Federal Spot Month Position Limits Would Apply to 25 Core Referenced Futures Contracts (and Linked/Equivalent Contracts)

1.  25 Core Referenced Futures Contracts

The 2020 Proposal establishes position limits on 25 core referenced futures contracts (which are physically-settled futures derivatives contracts) and their linked cash-settled futures, options on futures, and economically equivalent swaps (collectively, the “Referenced Contracts”). Nine of the proposed 25 core referenced futures contracts are currently subject to federal speculative position limits under Part 150 of the CFTC’s regulations. Those nine legacy agricultural contracts are: (1) CBOT Corn; (2) CBOT Oats; (3) CBOT Soybeans; (4) CBOT Wheat; (5) CBOT Soybean Oil; (6) CBOT Soybean Meal; (7) MGEX Hard Red Spring Wheat; (8) ICE Cotton No. 2; and (9) CBOT KC Hard Red Winter Wheat. Of the remaining 16 core referenced futures contracts, seven are agricultural contracts, five are metals contracts, and four are energy contracts. These commodities may appear familiar to those that have followed the CFTC’s actions around federal position limits, as they are the same commodities listed in the CFTC’s 2016 position limits proposals. Those futures contracts are: (1) CME Live Cattle; (2) CBOT Rough Rice; (3) ICE Cocoa; (4) ICE Coffee C; (5) ICE FCOJ-A; (6) ICE U.S. Sugar No. 11; (7) ICE U.S. Sugar No. 16; (8) COMEX Gold; (9) COMEX Silver; (10) COMEX Copper; (11) NYMEX Platinum; (12) NYMEX Palladium; (13) NYMEX Henry Hub Natural Gas; (14) NYMEX Light Sweet Crude Oil; (15) NYMEX New York Harbor ULSD Heating Oil; and (16) NYMEX New York Harbor RBOB Gasoline. Position limit levels are intended to be low enough to protect excessive speculation and price discovery; high enough to ensure sufficient liquidity for bona fide hedgers; within a range of acceptable levels; and to account for differences between markets. The limits set forth in the 2020 Proposal apply to all Referenced Contracts, not only to core referenced futures contracts, such that linked cash-settled futures and options on futures, as well as economically equivalent swaps would need to be aggregated when calculating. Notably, while the definition of Referenced Contracts would include linked contracts (discussed below), the definition would not include: (1) location basis contracts; (2) commodity index contracts; (3) swap guarantees; and (4) trade options that meet the requirements of CFTC Regulation 32.3.[18]

2.  Cash-Settled Futures and Options on Futures

The 2020 Proposal’s definition of Referenced Contract would incorporate cash-settled look-alike futures contracts and related options that are either “(i) directly or indirectly linked, including being partially or fully settled on, or priced at a fixed differential to, the price of that particular core referenced futures contract; or (ii) directly or indirectly linked, including being partially or fully settled on, or priced at a fixed differential to, the price of the same commodity underlying that particular core referenced futures contract for delivery at the same location or locations as specified in that particular core referenced futures contract.”[19] As a result, under the 2020 Proposal federal position limits would apply to all cash-settled futures and options on futures contracts on physical commodities that are linked, whether directly or indirectly, to a physically-settled contract subject to federal position limits. The CFTC views such cash-settled contracts as “generally economically equivalent to physical-delivery contracts in the same commodity” and notes that without federal position limits “in both the physically-delivered and cash-settled contracts [a trader] may have increased ability and incentive to manipulate one contract to the benefit of the other.”[20] It should be noted that there are separate federal spot month position limits for physically-delivered Referenced Contracts compared to cash-settled Referenced Contracts, meaning that during the spot month, such physically-delivered Referenced Contracts are not able to be netted against cash-settled Referenced Contracts.[21] The CFTC notes that it proposes to publish a CFTC Staff Workbook of Commodity Derivative Contracts under Regulations Regarding Position Limits for Derivatives (“CFTC Staff Workbook”) in connection with the 2020 Proposal. The CFTC Staff Workbook would “provide a non-exhaustive list of Referenced Contracts” and would help market participants determine categories of contracts that would fit within the Referenced Contract definition.[22]

3.  Economically Equivalent Swaps

The 2020 Proposal provides for a new definition for economically equivalent swaps, which will be defined as “swaps with ‘identical material’ contractual specifications, terms, and conditions to a referenced contract.”[23] This definition of “economically equivalent swap” is narrower than the definition set forth in the CFTC’s 2016 proposals, meaning that fewer swaps would be subject to federal speculative position limits under the 2020 Proposal than the prior proposals. Swaps in commodities other than natural gas that have identical contractual terms but differences in lot size specifications, notional amounts, or delivery dates diverging by less than one day would be economically equivalent swaps; for natural gas contracts, similar contracts with a two day window would still be determined to be economically equivalent swaps.[24] Such economically-equivalent swaps could be netted against other Referenced Contracts in the commodity for the purpose of determining one’s aggregate positions for federal position limits.

4.  Setting and Calculating of Spot Month Limits

The spot month limits apply to all of the Referenced Contracts. Position limit levels are set at or below 25 percent of deliverable supply, as estimated using recent data supplied by the designated contract market listing the core referenced futures contracts (and as verified by the CFTC). The 25 percent threshold is intended to make it difficult for a participant to corner the market, as “any potential economic gains resulting from the manipulation” of such a percentage ownership “may be insufficient to justify the potential costs, including the costs of acquiring, and ultimate offloading, the positions used to effectuate the manipulation.”[25] This limits the potential for a market participant to use the Referenced Contracts to affect the price of the commodity. The Commission further expects that the 25 percent limit level will not result in a reduction in liquidity for bona fide hedgers in the identified markets. Finally, the Commission cites as a reason for its choice of the 25 percent threshold the fact that that threshold is customarily used by some of the exchanges.[26] The position limits apply separately to physically-settled and cash-settled contracts, meaning that a market participant may not net cash-settled Referenced Contracts against physically-settled Referenced Contracts. Rather, all of a participant’s positions in a physically-settled Referenced Contract, across all exchanges, are netted and subject to the relevant limit, whereas all of a market participant’s positions in cash-settled contracts linked to physically-settled core referenced futures contracts are netted and independently subject to the federal spot month limit for a given commodity.[27] The Commission disallowed netting out of a concern that allowing netting could disrupt “the price discovery function” of the core referenced futures contract or “allow a market participant to manipulate the price of” a core referenced futures contract.[28] The 25 percent deliverable supply based limits are roughly twice as high as existing federal limits. Some have argued that, without a transition period and analysis on how the market will react to these new limits, market disruption may be likely. In his dissent, Commissioner Berkovitz specifically notes that distributing these limits across non-spot months could lessen the potential to disrupt the convergence process and disrupt market signals that large speculative trading may pose.[29] The proposed spot month limits for Referenced Contracts are set forth in Annex A to this alert.

B.  Federal Non-Spot Month Position Limits Would Only Apply to the Nine Legacy Core Referenced Futures Contracts (and Linked/Equivalent Contracts)

The 2020 Proposal also applies position limits outside of the spot month, referred to as the “non-spot month,” to Referenced Contracts based on the nine legacy agricultural commodities currently subject to federal position limits. The remaining 16 Referenced Contracts do not have non-spot month position limits, other than the exchange-set limits and/or position accountability levels. The non-spot month limits are set at 10 percent of open interest for the first 25,000 contracts of open interest, with a marginal increase of 2.5 percent of open interest above 50,000 contracts thereafter. These non-spot limits have been in place for decades, and the Commission believes their removal could result in market disruption. Market participants trading in these contracts requested the Commission maintain the non-spot month limits to promote “market integrity.”[30] While the 2020 Proposal updates these limit levels, as they had not been updated in over a decade, the Commission’s methodology for setting these limits has not changed, except that the 2.5 percent of open interest will be applied above 50,000 contracts, rather than the current level of 20,000 contracts.[31] The Commission explains that this change is meant to accommodate the near doubling of open interest in these markets. While the Commission proposed federal non-spot month limits only for the nine legacy contracts, the Commission also requires the exchanges to establish “exchange-set position limits and/or position accountability levels in the non-spot months” for the remaining core referenced futures contracts, “consistent with Commission standards set forth in [the 2020 Proposal].”[32] Accordingly, market participants would need to continue to monitor the exchange position limits going forward, as they may be different from the federal position limits set forth in the 2020 Proposal. The proposed non-spot month limits for the nine legacy agricultural contracts are set forth in Annex A to this alert.

C.  Exemptions from Federal Position Limits

The 2020 Proposal establishes exemptions from the federal position limits for certain bona fide hedging transactions. The Commission proposes a new definition of bona fide hedges that market participants wishing to request an exemption from position limits must meet. As a corollary to the revised definition, the Commission also lists certain enumerated hedges that are examples of bona fide hedges in Appendix A to Part 150; contracts that qualify as an enumerated hedge are self-effectuating and do not require Commission approval. However, and as explained further below, market participants must still submit applications for exemptions from exchange-set position limits for these contracts, as applicable.

1.  Enumerated Hedges

Positions in Referenced Contracts that meet any of the enumerated hedges that are listed in Appendix A to proposed Part 150 would meet the bona fide hedging definition set forth in CEA Section 4a(c)(2)(A) and the proposed definition of bona fide hedging set forth in the 2020 Proposal. Below is a list of the enumerated hedges set forth in the 2020 Proposal:
  1. Hedges of unsold anticipated production;
  2. Hedges of offsetting unfixed-price cash commodity sales and purchases;
  3. Hedges of anticipated mineral royalties;
  4. Hedges of anticipated services;
  5. Cross-commodity hedges;
  6. Hedges of inventory and cash commodity fixed-price purchase contacts;
  7. Hedges of cash commodity fixed-price sales contracts;
  8. Hedges by agents;
  9. Offsets of commodity trade options;
  10. Hedges of unfilled anticipated requirements;
  11. Hedges of anticipated merchandising.
The CFTC provides specific guidance around these enumerated hedges in proposed Appendix A to Part 150 and in the preamble to the 2020 Proposal. Exemptions for positions that qualify as enumerated hedges are self-effectuating for purposes of federal position limits, provided that the market participant complies with exchange requirements by requesting an exemption from exchange-set position limits.[33]

2.  Non-Enumerated Hedges

The 2020 Proposal’s definition of bona fide hedge would require that the position (1) represents a substitute for transactions made at a later time in a physical marketing channel; (2) is economically appropriate to the reduction of price risks in the conduct of a commercial enterprise; and (3) arises from the potential change in value of actual or anticipated (A) assets, (B) liabilities or (C) services a person provides or purchases.[34] Alternatively, a position may qualify as a bona fide hedge where it is a pass-through swap and pass-through swap offset pair, where the pass-through swap offset is a futures, option on a futures, or swap position entered into by the pass-through swap counterparty in the same physical commodity as the pass-through swap, or where the futures, option on futures, or swap position reduces price risks attendant to a previously-entered-into swap position.[35] The 2020 Proposal would require that bona fide hedging transactions or positions in commodities must always (and not just normally) be connected to the production, sale, or use of a physical cash-market commodity.[36] Market participants may request approval for an exemption to the federal position limits for bona fide hedges that are not listed in the enumerated list in proposed Appendix A to Part 150 by demonstrating that they meet the definition of a bona fide hedge. Unlike the enumerated exemptions, these exemptions are not self-effectuating and the 2020 Proposal would require a market participant to request the non-enumerated hedge in one of two ways: (1) apply directly to the Commission (and also to the exchange) or (2) use a new streamlined process by requesting only through the exchange. Under the new proposed streamlined process for requesting a bona fide hedge exemption set forth in the 2020 Proposal, a market participant may request an exemption from federal and exchange-level position limits by filing a single application to an exchange, pursuant to the exchange rules. This proposed streamlined process delegates the initial authority for approving an application for a non-enumerated hedge to the exchange, where the exchange maintains Commission-approved standards for such applications; if an exchange authorizes a non-enumerated hedge for a market participant, it must notify the CFTC of its determination. Upon notice of the exchange’s authorization of such an application, the CFTC will have a 10-day review period (or two days where sudden or unforeseen needs exist) during which it can object to such authorization. So long as the Commission does not object to the exchange determination, the request is deemed approved upon expiration of such 10-day period. The 2020 Proposal asks whether this 10 day (or two day) period may be too short (or too long). Commissioner Stump noted in her statement that the “10/2-day rule” is impracticable, in that it is too long from a market participant’s perspective to make hedging decisions quickly, and too short a time period for the Commission to determine whether the position is a bona fide hedge. Commissioner Stump expressed a preference that non-enumerated hedges be approved at the exchange level, given their familiarity with the hedging practices in their markets.[37] The 2020 Proposal outlines what must be included in the market participant’s application to an exchange for recognition of an exemption.[38] While the 2020 Proposal does not dictate timelines for exchanges to review exemption applications that are submitted by market participants, it does provide that an exchange may adopt rules to allow a market participant to submit for approval a bona fide hedging application within five days after federal position limits are exceeded, if such market participant exceeds the limits due to sudden or unforeseen circumstances and can provide materials to demonstrate such circumstances.[39] The Commission notes that applications submitted after a person exceeds the federal speculative limit should not be habitual and that if it were to find that the position does not qualify as a bona fide hedge, the applicant would need to bring its position into compliance within a commercially reasonable time.

3.  Risk Management Exemption Removed

This revised definition removes the risk management exemption, which had enabled market participants to treat a position entered into for “risk management purposes” as a bona fide hedge, unless the position otherwise satisfies the requirements of the pass-through provisions for a pass-through swap.[40] This is because the proposal modified the “temporary substitute test” to require that a bona fide hedging transaction or position in a physical commodity must “always,” and not “normally,” be connected to the production, sale, or use of a “physical cash-market commodity.”

4.  Carve Outs Contained in CFTC Regulation 150.3

Other exemptions from federal position limits include certain spread positions (such as calendar spreads and energy crack processing spreads),[41] certain financial distress positions, certain natural gas positions held during the spot month, and pre-Dodd-Frank enactment and transition period swaps. These exemptions, however, are listed in proposed CFTC Regulation 150.3, and not proposed Appendix A to Part 150.

D.  Exemptions from Exchange-Level Position Limits and Certain Reporting Requirements

In addition to the federal position limits, market participants will remain responsible for complying with all exchange-level position limits for products listed on a particular exchange and must apply for exemptions from such exchange-level limits for both enumerated and non-enumerated hedges in accordance with the exchange rules. While the list of enumerated hedges in Appendix A to Part 150 is self-effectuating for federal purposes, the market participant will still be required to follow exchange rules to claim the exemption. For example, in CME Rulebook Rule 559 “[a] person seeking an exemption from position limits must apply to the Market Regulation Department on forms provided by the Exchange.”[42] Those requirements will remain in effect even after a final federal position limits rule is implemented. In addition, the 2020 Proposal will eliminate certain reporting requirements, including removing the reporting obligations associated with Form 204[43] and Parts I and II of Form 304.[44] Instead of requiring these forms to be submitted, the CFTC will instead rely upon the cash positions report from the exchanges. This new system will place a greater focus on the data reported to exchanges. For example, under the 2020 Proposal, an energy trader that trades NYMEX natural gas and also the look-alike contract on ICE would have to report his/her cash positions to both exchanges (including equivalent cash positions). This outcome may prove to be more burdensome for market participants than submitting a single report to the CFTC.

E.  Aggregation and Netting

Under CFTC Regulation 150.4, which was amended in 2016 by the CFTC’s Final Rule on Aggregation, positions a person holds must be aggregated with positions for which the person controls trading or holds a ten percent or greater ownership interest.[45] Long positions across exchanges and short positions across exchanges must be netted, and that net value is subject to federal position limits. A person that holds more than one account or pool with substantially identical trading strategies must aggregate all such positions with all other positions held by that person and their affiliates. Economically equivalent swaps must be added to, and netted against, other Referenced Contracts in the same commodity for the purpose of determining the aggregate position. The 2020 Proposal also provides a new definition of “Eligible Affiliates” that would make clear that an eligible affiliate may aggregate its positions even though it is eligible to disaggregate positions.[46] Several exemptions to the requirement to aggregate are contained in the existing rule, including for futures commission merchants and certain independent trading strategies, among others. As discussed above, positions in physically-settled contracts may not be netted with positions in linked cash-settled contracts when calculating for position limits. This means that (1) all of a trader’s long and short positions in a particular physically-settled Referenced Contract (executed across all exchanges and OTC, as applicable) are netted and (2) all of a trader’s long and short positions in any cash-settled Referenced Contracts (executed across all exchanges and OTC, as applicable) linked to such physically-settled core referenced futures contract are netted independently (rather than collectively along with the physically settled positions) subject to the federal spot month limit for that commodity.[47] Non-Referenced Contracts cannot be used to net against Referenced Contracts.

ANNEX A

Below are the nine “legacy” contracts along with the 2020 Proposal’s spot month and non-spot-month limits for those contracts:

Legacy Agricultural Contracts

2020 Proposal’s Spot Month Limit

2020 Proposal’s Single Month and All-Months Combined Limit

CBOT Corn (C)

1,200

57,800

CBOT Oats (O)

600

2,000

CBOT Soybeans (S)

1,200

27,300

CBOT Wheat (W)

1,200

16,900

CBOT Soybean Oil (SO)

1,100

17,400

CBOT Soybean Meal (SM)

1,500

19,300

MGEX Hard Red Spring Wheat (MWE)

1,200

12,000

ICE Cotton No. 2 (CT)

1,800

12,000

CBOT KC Hard Red Winter Wheat (KW)

1,200

11,900

Below are the additional 16 core referenced futures contracts and the proposed spot month limits set forth in the 2020 Proposal:

Agriculture

2020 Proposal

Metals

2020 Proposal

Energy

2020 Proposal

CBOT Rough Rice (RR)

800

COMEX Gold (GC)

6,000

NYMEX Henry Hub Natural Gas (NG)

2,000

ICE Cocoa (CC)

4,900

COMEX Silver (SI)

3,000

NYMEX Light Sweet Crude Oil (CL)

6,000/5,000/4,000[48]

ICE Coffee C (KC)

1,700

COMEX Copper (HG)

1,000

NYMEX New York Harbor ULSD Heating Oil (HO)

2,000

ICE FCOJ-A (OJ)

2,200

NYMEX Platinum (PL)

500

NYMEX New York Harbor RBOB Gasoline (RB)

2,000

ICE U.S. Sugar No. 11 (SB)

25,800

NYMEX Palladium (PA)

50

ICE U.S. Sugar No. 16 (SF)

6,400

CME Live Cattle (LC)

600/300/200[49]

_________________________    [1]   CFTC Commissioners Dan Berkovitz and Rostin Behnam dissented.    [2]   Position Limits for Derivatives, 85 Fed. Reg. 11,596 (Feb. 27, 2020).    [3]   Dodd-Frank Wall Street Reform and Consumer Protection Act, § 737(a)(4), Pub. L. No. 111-203, 124 Stat. 1376, 1723 (July 21, 2010).    [4]   Chris Clayton, “CFTC Chair Keeps Focus on Ag,” Progressive Farmer (Nov. 18, 2019), available at https://www.dtnpf.com/agriculture/web/ag/news/business-inputs/article/2019/11/18/commission-preparing-release-new.    [5]   See Position Limits for Derivatives, 76 Fed. Reg. 4752 (Jan. 26, 2011); Position Limits for Futures and Swaps, 76 Fed. Reg. 71,626 (Nov. 18, 2011) (the “2011 Final Rule”).    [6]   Int’l Swaps & Derivatives Ass’n v. U.S. Commodity Futures Trading Comm’n, 887 F. Supp. 2d 259 (D.D.C. 2012) (“ISDA”).    [7]   See Position Limits for Derivatives, 78 Fed. Reg. 75,680 (Dec. 12, 2013); Position Limits for Derivatives; Certain Exemptions and Guidance, 81 Fed. Reg. 38,458 (June 13, 2016); Position Limits for Derivatives, 81 Fed. Reg. 96,704 (Dec. 30, 2016).    [8]   7 U.S.C. 6a(a)(2)(A).    [9]   7 U.S.C. 6a(a)(1). [10]   887 F. Supp. 2d 259, 267 (D.D.C. 2012). [11]   Id. at 270. [12]   7 U.S.C. § 6a(a)(1). [13]   2020 Proposal at 11,665. [14]   Statement of Commissioner Tarbert, (Jan. 30, 2020), available at https://www.cftc.gov/PressRoom/SpeechesTestimony/tarbertstatement013020. [15]   In particular, with respect to the 25 core referenced futures contracts, the CFTC identified their particular importance “in the price discovery process for their respective underlying commodities”; that “physical delivery of the underlying commodity” is required; and that in certain instances “especially acute economic burdens . . . would raise from excessive speculation causing sudden or unreasonable fluctuations or unwanted changes in the price of the commodities underlying these contracts.” 2020 Proposal at 11,603. [16]   Statement of Commissioner Tarbert (Jan. 30, 2020), available at https://www.cftc.gov/PressRoom/SpeechesTestimony/tarbertstatement013020. [17]   Id. [18]   Id. at 11,620-11,621. In the final trade options rule, the CFTC explained that federal position limits should not apply to trade options and that it would address trade options in the context of any final rulemaking for federal position limits. See Trade Options, 81 Fed. Reg. 14,971 (Mar. 21, 2016). [19]   2020 Proposal at 11,615. [20]   2020 Proposal at 11,620. [21]   Id. at 11,635-11,637. [22]   Id. at 11,621. [23]   Id. at 11,599. [24]   2020 Proposal at 11,599. [25]   Id.at 11,626. [26]   Id. [27]   Id.at 11,636. [28]   Id. [29]   Dissenting Statement of Commissioner Berkovitz (Jan. 30, 2020), available at https://www.cftc.gov/PressRoom/SpeechesTestimony/berkovitzstatement013020b. [30]   2020 Proposal at 11,628. [31]   Id. at 11,630. [32]   Id. at 11,598. [33]   Id. at 11,601. [34]   Id. at 11,600. With respect to assets, the Commission notes that it would include “assets which a person owns, produces, manufactures, processes, or merchandises or anticipates owning, producing, manufacturing, processing, or merchandising.” Id. at 11,717. [35]   2020 Proposal at 11,717. [36]   Id. at 11,601. [37]   Statement of Commissioner Stump (Jan. 30, 2020), available at https://www.cftc.gov/PressRoom/SpeechesTestimony/stumpstatement013020. [38]   2020 Proposal at 11,652. [39]   Id. at 11,653. [40]   Id. at 11,641. [41]   If a spread strategy is not covered under the definition of “spread transaction” in proposed CFTC Regulation 150.3, then a market participant would need to petition the CFTC for such spread exemption. [42]   See CME Rulebook, Section 559, available at https://www.cmegroup.com/content/dam/cmegroup/rulebook/CME/I/5/5.pdf. [43]   Form 204 is a monthly report of cash positions in grains, soybeans, soybean oil, and soybean meal. [44]   Form 304 is a statement of cash positions in cotton. [45]   17 CFR § 150.4(a)(1); Aggregation of Positions: Final Rule, 81 Fed. Reg. 91,454 (Dec. 16, 2016). [46]   2020 Proposal at 11,636. Under the proposed definition, an “eligible affiliate” includes certain entities that, among other things, are required to aggregate their positions under CFTC Regulation 150.4 and that do not claim an exemption from aggregation. [47]   Id. at 11,635-11,636. [48]   The proposed spot month limit for Light Sweet Crude Oil is subject to a step-down limit: (1) for contracts as of the close of trading three business days prior to the last trading day of the contract; (2) for contracts as of the close of trading two business days prior to the last trading day of the contract; and (3) for contracts as of the close of trading one business day prior to the last trading day of the contract. 2020 Proposal at 11,599. [49]   The Live Cattle federal spot month limit is subject to a step-down (1) at the close of trading on the first business day following the first Friday of the contract month; (2) at the close of trading on the business day prior to the last five trading days of the contract month; and (3) at the close of trading on the business day prior to the last two trading days of the contract month. 2020 Proposal at 11,599.
The following Gibson Dunn lawyers assisted in preparing this client update: Jeffrey Steiner, Jennifer Mansh and Chelsea Gunter. Gibson Dunn's lawyers are available to assist in addressing any questions you may have regarding these developments.  Please contact the Gibson Dunn lawyer with whom you usually work in the firm's Financial Institutions, Derivatives or Energy, Regulation and Litigation practice groups, or any of the following: Financial Institutions / Derivatives Groups: Matthew L. Biben - New York (+1 212-351-6300, mbiben@gibsondunn.com) Michael D. Bopp - Washington, D.C. (+1 202-955-8256, mbopp@gibsondunn.com) Stephanie Brooker - Washington, D.C. (+1 202-887-3502, sbrooker@gibsondunn.com) Arthur S. Long - New York (+1 212-351-2426, along@gibsondunn.com) Jeffrey L. Steiner - Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com) Energy, Regulation and Litigation Group: William S. Scherman - Washington, D.C. (+1 202-887-3510, wscherman@gibsondunn.com) Jeffrey M. Jakubiak - New York (+1 212-351-2498, jjakubiak@gibsondunn.com) © 2020 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

January 14, 2020 |
CFTC Divisions Release No-Action Relief Related to LIBOR Transition: Summary and Analysis

Click for PDF On December 18, 2019, the staffs of the Division of Swap Dealer and Intermediary Oversight (“DSIO”),[1] the Division of Market Oversight (“DMO”)[2], and the Division of Clearing and Risk (“DCR”)[3] of the Commodity Futures Trading Commission (“CFTC”) each released no-action letters (collectively, the “CFTC Letters”) that provide relief to market participants in connection with the industry-wide initiative to transition swaps that reference the London Interbank Offered Rate (“LIBOR”) and other interbank offered rates (“IBORs”) to swaps that reference alternative risk-free reference rates.[4] The CFTC Letters respond to a request by the Alternative Reference Rates Committee (“ARRC”)[5] on behalf of its members subject to certain CFTC regulations to address issues that will result from amendments made by market participants to their swap documentation to either (i) include fallback language to address what will happen when LIBOR or another IBOR ceases to exist (or is deemed to be non-representative by the benchmark administrator or relevant authority in a jurisdiction) (“Fallback Amendment”) or (ii) convert LIBOR and other IBOR-linked uncleared swaps to an alternative reference rate, like SOFR, prior to the cessation of such IBORs (“Replacement Rate Amendment”).[6] The amendments to swap documentation would likely be viewed as material amendments that would trigger the same requirements as “new” swaps, meaning that each swap may trigger uncleared margin, clearing, business conduct and other requirements and should be analyzed accordingly. The ARRC sought clarification and relief from such requirements so that market participants could make such amendments without facing costly and onerous requirements applied to their existing swaps. The CFTC Letters provide helpful relief to swap market participants with respect to the LIBOR transition in connection with several areas, including the swap dealer de minimis exception, uncleared swap margin, swap dealer business conduct standards, swap trading relationship documentation, portfolio reconciliation, confirmations, eligible contract participants (“ECPs”), the end-user clearing exception, clearing and trade execution requirements; however, the relief in the CFTC Letters does not cover certain requirements (e.g., there is no relief for reporting requirements),[7] and there are some areas of uncertainty that remain and are likely to impact certain swap market participants. In this alert we discuss, for the relief granted in each of the CFTC Letters, the issue, no-action relief position, as well as the impacts and remaining areas of concern and uncertainty that may require further consideration and analysis.

I. DSIO Letter

A. Scope of Relief The DSIO Letter applies to the amendment of uncleared swaps that reference USD LIBOR, another IBOR or other reference rates that are phased-out or become impaired[8] (collectively, “Impaired Reference Rates” or “IRRs”). DSIO notes that defining IRRs in this manner will permit a market participant to make more than one amendment to the same swap or portfolio of swaps before settling on “an alternative benchmark that adequately meets the counterparties’ commercial needs.”[9] The amendments may be achieved by (i) adherence to a protocol issued by the International Swaps and Derivatives Association (“ISDA”), (ii) contractual amendment between counterparties or (iii) execution of new contracts in replacement of and immediately upon termination of existing contract(s) (i.e., “contract tear-ups”). DSIO limits the scope of relief to amendments of legacy uncleared swaps that reference an IRR solely to “(i) include new fallbacks to alternative reference rates triggered only by permanent discontinuation of an IRR or determination that an IRR is non-representative by the benchmark administrator or the relevant authority in a jurisdiction; or (ii) accommodate the replacement of an IRR” (each, a “Qualifying Amendment”); however, a Qualifying Amendment does not include any amendment that (i) extends the maximum maturity of a swap or portfolio of swaps, or (ii) increases the total effective notional amount of a swap or the aggregate total effective notional amount of a portfolio of swaps.[10] DSIO recognizes that Qualifying Amendments may require a number of ancillary changes to existing trade terms to conform to different market conventions used for the alternative reference rate (e.g., reset dates, fixed/floating leg payment dates, day count fractions, etc.). B. No-Action Positions, Potential Concerns and Other Considerations 1) Swap Dealer De Minimis Calculation Issue: Entities that actively manage their swap dealing activities to stay below the swap dealer de minimis threshold of $8 billion may be reluctant to transition away from IRRs voluntarily and early if amendments and modifications made to accommodate either a Fallback Amendment or a Reference Rate Amendment will need to be included in the calculation. No-action position: DSIO provides no-action relief to any person that excludes a swap from the swap dealer de minimis calculation that references an IRR solely to the extent that such swap would be included as a consequence of a Qualifying Amendment.[11] Potential concerns and other considerations: Non-swap dealers that engage in swap dealing activities will need to (i) rely on the no-action relief provided in the DSIO Letter in order to preclude such swaps from being counted and (ii) modify their swap dealer de minimis calculation methodology accordingly to account for this subset of swaps that will not be counted. 2) CFTC Uncleared Swap Margin Requirements Issue: Uncleared swaps entered into prior to the relevant compliance date of the CFTC Margin Rule (set forth in CFTC regulation 23.161) (“CFTC Margin Rule Legacy Swaps”) are not subject to the provisions of the CFTC Margin Rule. However, if a CFTC Margin Rule Legacy Swap is amended after the compliance date applicable to a swap dealer and its counterparty, it would cause such CFTC Margin Rule Legacy Swaps to be brought into compliance with the CFTC Margin Rule which would likely have a materially adverse effect to the parties of the swap. No-action position: DSIO provides no-action relief to swap dealers for a failure to comply with the CFTC Margin Rule[12] solely to the extent such compliance would be required as a consequence of a Qualifying Amendment CFTC Margin Rule Legacy Swaps. Additionally, DSIO provided no-action relief for those swap dealers that use basis swaps to accomplish the necessary transition rather than amending individual swaps.[13] Potential concerns and other considerations: As discussed above, this no-action position regarding uncleared swaps is necessary because amendments to CFTC Margin Rule Legacy Swaps after the relevant compliance date would cause such swaps to be brought into scope for purposes of compliance with the CFTC Margin Rule. Further, it aims to be consistent with the Prudential Regulators’ Proposed LIBOR Amendments. 3) Swap Dealer Business Conduct Requirements Issue: Swap dealers are subject to numerous business conduct standards when dealing with their counterparties (“Counterparty BCS”).[14] To the extent that a swap dealer’s existing swap is amended as a result of a Fallback Amendment or a Reference Rate Amendment, it would be treated as if it were a new swap and therefore the swap dealer would need to comply with all Counterparty BCS for that swap.[15] No-action position: DSIO provides no-action relief to swap dealers for a failure to comply with the Counterparty BCS (other than requirements to disclose material information concerning risks and characteristics of a swap pursuant to CFTC regulation 23.431(a)) solely to the extent such compliance would be required as a consequence of a Qualifying Amendment to an uncleared swap. Potential concerns and other considerations: Risk Disclosures and Provision of Material Information: DSIO makes clear that there is no relief provided with respect to CFTC Regulation 23.431(a) and that swap dealers must provide material information concerning risks and characteristics of a swap to their counterparties “at a reasonably sufficient time prior to entering into the swap.”[16] In this regard, DSIO notes that pursuant to the IRR transition, counterparties to swap dealers will be moving from familiar reference rates to newly created alternative reference rates. Accordingly, DSIO explains that swap dealers “should be required to provide material information about such new rates in order for counterparties to better understand what they are stepping into.”[17] As a result, questions arise relating to what swap dealers should include in such disclosures to their counterparties and the timing of such disclosures (e.g., the determination of “reasonably sufficient time”). With respect to the timing, any such disclosures would likely need to occur in advance of the swap dealer agreeing to a Fallback Amendment or Reference Rate Amendment with a counterparty, including adhering to a multilateral protocol (e.g., an ISDA protocol). ECP Status: The DSIO Letter provides relief from a swap dealer’s obligation under CFTC regulation 23.430 to verify a counterparty’s ECP status. However, pursuant to Commodity Exchange Act (“CEA”) Section 2(e) it is unlawful for “any person … to enter into a swap” (other than a swap entered into on a designated contract market) that is not an ECP. None of the CFTC Letters provide any relief from this requirement under CEA Section 2(e) and, as a result, there would be a potential violation of CEA Section 2(e) for the counterparty and increased contractual risk in the event that a counterparty that was an ECP when a swap was originally entered into, is no longer an ECP when a Fallback Amendment or Replacement Rate Amendment occurs.[18] 4) Swap Confirmation Requirements Issue: Swap dealers are required to confirm amendments to swaps within certain timeframes; however, it is expected that most market participants will adhere to a multilateral protocol (e.g., an ISDA protocol) which enables multiple swaps to be legally amended and confirmed simultaneously. However, there is uncertainty under CFTC regulation as to whether a swap dealer would need to issue new confirmations that are amended via such multilateral protocol. No-action position: DSIO provides no-action relief to swap dealers for a failure to comply with the CFTC’s confirmation requirements under CFTC regulation 23.501 provided that the Qualifying Amendment is accomplished pursuant to a multilateral protocol (i.e., not a bilateral amendment between counterparties) and solely to the extent that such compliance would be required as a result of a Qualifying Amendment to an uncleared swap. Potential concerns and other considerations: Limited to amendment by multilateral protocol: DSIO makes clear that relief from the confirmation requirements is only available to a swap dealer’s uncleared swaps that are amended pursuant to a multilateral protocol. Accordingly, swap dealers will need to ensure that any bilateral amendment for a Fallback Amendment or a Reference Rate Amendment with a counterparty satisfies the requirements of CFTC regulation 23.501. 5) Swap Trading Relationship Documentation (“STRD”) Issue: CFTC regulation 23.504(a)(2) requires that swap dealers enter into STRD prior to entering into any “swap transaction” which includes amendments to uncleared swaps entered into prior to the date a swap dealer was required to be in compliance with the STRD rule (“STRD Legacy Swaps”). Accordingly, a Fallback Amendment or a Reference Rate Amendment would cause an STRD Legacy Swap to lose its status as such and would require a swap dealer to enter into documentation to comply with the STRD requirements. No-action position: DSIO provides no-action relief to swap dealers for a failure to comply with the STRD requirements under CFTC regulation 23.504 solely to the extent such compliance would be required as a consequence of a Qualifying Amendment to STRD Legacy Swaps. 6) Reconciliation Issue: The CFTC’s portfolio reconciliation rules require swap dealers to resolve discrepancies of material terms of their swaps with other swap dealers “immediately”[19] and with non-swap dealer counterparties “in a timely fashion.”[20] Since swap dealers and their counterparties may book Fallback Amendments and Reference Rate Amendments at different times and these timeframes may not be met during the transition, notwithstanding that the counterparties are engaging in reconciliation in good faith. No-action position: DSIO provides no-action relief to swap dealers for a failure to comply with the discrepancy resolution timing requirements under CFTC regulations 23.502(a)(4) and (b)(4) solely to the extent such compliance would be required as a consequence of a Qualifying Amendment to an uncleared swap. 7) End-User Exceptions and Exemptions from the CFTC Margin Rule Issue: Some end-user counterparties may question whether a swap still qualifies as an instrument “used to hedge or mitigate commercial risk as prescribed in [CFTC] regulations 50.50(c) and 50.51(b)(2)” in the event that the reference rate on the swap for which the exception or exemption is elected is different from the rate on the underlying loan, debt instrument or other agreement or commercial arrangement.[21]   Because a Fallback Amendment or a Reference Rate Amendment would trigger “new” swap requirements, the swap would need to be analyzed for its qualification for the end-user exception at the time of such amendment. If a swap was determined not to be used for “hedging or mitigating commercial risk” in light of the rate mismatch with the underlying commercial arrangement, then it would not qualify for the end-user exception from clearing (in CFTC regulation 50.50) or for the exemption for cooperatives (in CFTC Regulation 50.51). End-users that qualify for an exception from clearing will qualify for an exclusion from the CFTC Margin Rule pursuant to CFTC regulation 23.150(b). If an end-user no longer qualifies for an exception from clearing, then it would not be permitted to rely on this exclusion.[22] The language defining “hedging or mitigating commercial risk” in the context of the end-user exception is broad and a swap that references a commercial arrangement with a different reference rate may still qualify under that definition; however, there may be situations where such qualification is uncertain. No-action position: DSIO explains that to “alleviate any question” regarding whether one or more swaps will still qualify as instruments used to “hedge or mitigate commercial risk as prescribed in CFTC regulations 50.50(c) and 50.51(b)(2),”[23] it is providing relief for swap dealers for a failure to comply with the CFTC Margin Rule with respect to a swap entered into with an entity electing an exception or exemption pursuant to the requirements of CFTC regulations 50.50(c) or 50.51(b)(2), if the following three conditions are met:
(i) the swap is an uncleared swap referencing an IRR that qualified as a swap used to hedge or mitigate commercial risk pursuant to CFTC regulation 50.50(c) or 50.51(b)(2) at the time of execution; (ii) compliance with the CFTC Margin Rule would be required solely as a consequence of a Qualifying Amendment to such swap, or, with respect to the commercial arrangement for which the swap qualified as a swap used to hedge or mitigate commercial risk, solely as a consequence of an amendment to such commercial arrangement solely for the purpose of: (a) including new fallbacks to alternative reference rates triggered only by permanent discontinuation of an IRR or determination that an IRR is non-representative by the benchmark administrator or the relevant authority in a jurisdiction; or (b) accommodating the replacement of an IRR; and (iii) such swap or the commercial arrangement for which the swap qualified as a swap used to hedge or mitigate commercial risk is amended prior to December 31, 2021, such that the swap again qualifies as a swap used to hedge or mitigate commercial risk pursuant to CFTC regulation 50.50(c) or 50.51(b)(2).[24]
Potential concerns and other considerations: Relief is Time-Limited: This end-user related relief is only available until December 31, 2021, however, given the uncertainty around the transition and fallback terms of underlying commercial arrangements (e.g., an end-user may have a commercial arrangement with fallback language that uses the last published rate), it is possible that relief may be needed after December 31, 2021. Similar relief not provided by the Prudential Regulators: While DSIO is providing no-action relief to swap dealers with respect to compliance with the CFTC Margin Rule, the Prudential Regulators have not included such a provision in the Prudential Regulators’ Proposed LIBOR Amendments or otherwise. Accordingly, there is question as to how the Prudential Regulators will view the available exclusion from the uncleared swap margin rules for swaps with end-users that qualify for the end-user exception from clearing and that are relying on no-action relief provided under the DSIO Letter and DCR Letter to continue to qualify for the end-user exception during the transition. Financial entity status: While the relief addresses the impact of mismatches between an uncleared swap and an underlying commercial arrangement that may cause a swap to not be considered to “hedge or mitigate commercial risk,” there is no relief granted in the event that a counterparty’s financial entity status changes from a non-financial entity at the time the swap was originally entered into to a financial entity at the time of the Fallback Amendment or Reference Rate Amendment.[25] Without such relief, such legacy swaps may need to be cleared and may be subject to the CFTC Margin Rule when trading with swap dealers. Captive finance and small bank exemptions: No relief is provided in a situation where a captive finance company no longer meets the 90/90 test under CEA Section 2(h)(7)(C)(iii) or where a small bank exceeds the $10 million threshold under CFTC regulation 50.50(d). Without such relief, the legacy swaps of such entities whose status changes may need to be cleared and be subject to the CFTC Margin Rule when trading with swap dealers. 8) ECP Status Issue: Some individuals identify themselves as ECPs because the purposes of their swaps are “to manage the risk associated with an asset or liability owned or incurred or reasonably likely to be owned or incurred” by the individual in the conduct of the individual’s business. In the event that a Fallback Amendment or a Reference Rate Amendment leads to a temporary mismatch, such individuals may question whether they continue to qualify as an ECP. No-Action Position: DSIO explains that to “alleviate any question” it is providing no-action relief to any individual for failure to qualify as an ECP pursuant to CEA Section 1a(18)(A)(xi) which provides that an individual can qualify as an ECP based on a swap’s purpose “to manage the risk associated with an asset or liability owned or incurred” by the individual in the conduct/operation of the individual’s business, solely to the extent such status is relevant as a consequence of a Qualifying Amendment to an uncleared swap.[26] Potential concerns and other considerations: No relief for dollar thresholds of ECP provisions: There is no relief provided by DSIO or the other Divisions in the event that the individual cannot satisfy the dollar thresholds to qualify as an ECP at the time of a Qualifying Amendment. Accordingly, an individual whose amounts invested on a discretionary basis fall below the dollar thresholds in CEA Section 1a(18)(A)(xi) at the time of a Qualifying Amendment may not qualify as an ECP and may therefore be viewed to violate CEA Section 2(e). No relief for entities: While DSIO provides relief for individuals from mismatches that may occur between the rates referenced in an “asset or liability owned or incurred” and the swaps used to hedge that the risk of such asset or liability, neither DSIO nor the other Divisions provide parallel relief for entities from CEA Section 1a(18)(A)(v)(III)(bb). Additionally, DSIO does not provide relief for entities that may fall below the dollar thresholds for entities in the ECP provisions. Accordingly, there may be some question for entities that had been relying on this section to qualify as an ECP at the time of a Qualifying Amendment. 9) End-User Documentation Issue: Swap dealers must obtain documentation from an entity claiming the end-user exception or exemption so that the swap dealer has a reasonable basis to believe the counterparty is hedging or mitigating commercial risk. As a result of a Fallback Amendment or Reference Rate Amendment, a swap dealer may be required to obtain such documentation under CFTC regulation 23.505(a)(4). No-action position: DSIO provides no-action relief to swap dealers for a failure to obtain documentation that an entity is “hedging or mitigating a commercial risk” (as required under CFTC regulation 23.505(a)(4)) from an entity for which it has previously obtained such documentation, solely to the extend such would be required as a consequence of a Qualifying Amendment to an uncleared swap. Potential concerns and other considerations: Other end-user exception documentation requirements: To the extent that a swap dealer has not obtained representations from its counterparty regarding its end-user status either through an annual filing, protocol or other representation, a Fallback Amendment or Reference Rate Amendment could trigger a requirement to once again obtain such information. For example, if there were legacy swaps entered into before clearing requirements became effective, a swap dealer would likely be required to obtain such information from a counterparty prior to entering into a Fallback Amendment or Reference Rate Amendment. End-user exception election: Many swap dealers have received standing end-user exception elections from their end-user counterparties that indicate that for each swap for which the end-user exception is elected. However, for those swaps where there is not a standing end-user exception election in place and a counterparty would need to rely on the end-user exception, pursuant to CFTC regulation 23.505(a)(2), a swap dealer may need to ensure that the counterparty elects not to clear the amended swap prior to the occurrence of a Fallback Amendment or Reference Rate Amendment.

II. DCR Letter

A. Scope The DCR Letter applies to uncleared swaps that would have been subject to the interest rate swap (“IRS”) clearing requirement under CEA Section 2(h)(1)(A) and CFTC regulation 50.4(a) but for the fact that such swaps were entered prior to the date on which the counterparties were required to begin complying with the relevant IRS clearing requirement (“Uncleared Legacy IRS”),[27] that are amended as a result of an amendment of fallback provisions (or addition of contractual terms)[28] “to modify the process for selecting the new floating rate term of an IRS that is not available because the rate is unavailable, permanently discontinued, or determined to be non-representative by the benchmark administrator or the relevant authority in a particular jurisdiction” (a “IRS Fallback Amendment”).[29] The relief in the DCR letter would not be available if the IRS Fallback Amendment (i) extends the maximum maturity of an Uncleared Legacy IRS; or (ii) increases the total effective notional amount of an Uncleared Legacy IRS. The relief granted under the DCR Letter would permit such IRS Fallback Amendments to be achieved through a multilateral protocol or through bilateral amendment. The DCR Letter is limited with respect to Uncleared Legacy IRSs to which it is applicable by specifying the LIBOR rates and risk-free fallback rates to which it applies. In particular, the DCR Letter would permit the following rates and fallback rates that may serve as replacement for the floating LIBOR rates or rates using LIBOR for input:
Currency and IBOR Floating Rate Permissible Risk-Free Reference Fallback Rate
GBP LIBOR SONIA
CHF LIBOR SARON
JPY LIBOR TONA
USD LIBOR SOFR
SGD SOR - VWAP SORA
The DCR Letter does not apply to swaps that have been voluntarily submitted for clearing and does not apply if the original counterparties to the Uncleared Legacy IRS change. The relief under the DCR Letter is also time-limited and will expire on December 31, 2021. B. No-Action Positions, Potential Concerns and Other Considerations (1) Uncleared Legacy Swaps Issue: The execution of an IRS Fallback Amendment to an Uncleared Legacy IRS would cause the counterparties to treat such amendment as a “new” swap and would trigger an analysis to determine whether the swap is required to be cleared or subject to an exception. No-action position: Until December 31, 2021, DCR provides no-action relief for any person that fails to comply with the swap clearing requirements of CEA Section 2(h)(1)(A) and CFTC regulation 50.2 with respect to an Uncleared Legacy IRS that references: USD LIBOR, JPY LIBOR, GBP LIBOR, CHF LIBOR or SGD SOR and is amended by adding a Fallback Amendment for the sole purpose of changing the existing floating rate to: SOFR, TONA, SONIA, SARON or SORA, respectively, in the event that the existing floating rate is unavailable, permanently discontinued or has been determined to be non-representative by the benchmark administrator or relevant authority in a jurisdiction. Further, persons wishing to take advantage of this relief must satisfy the all of the following conditions:
  1. The swap meets the definition of the term “Uncleared Legacy Swaps”[30] as described in the DCR Letter and is not required to be cleared under CEA Section 2(h)(1)(A) and Part 50 of the CFTC’s regulations because it was entered into before an applicable compliance date and has not been voluntarily submitted for clearing to a derivatives clearing organization; and
  2.  Each amended “Uncleared Legacy Swap” must:
    1. Have the same counterparties as the original swap that is amended;
    2. Have the same maximum maturity as the original swap that is amended; and
    3. Be amended for the sole purpose of changing the floating rate fallback provisions.[31]
Potential concerns and other considerations: Scope of risk-free reference fallback rates is limited: The DCR Letter only contemplates the fallback to explicit permissible risk-free reference rates (e.g., for USD LIBOR only SOFR is contemplated). Additional relief will need to be sought from DCR in the event that counterparties wish to switch to another risk-free rate. Relief is Time-Limited: This relief is only available until December 31, 2021, however, given the uncertainty around the transition and fallback terms, relief may be needed after that date. (2) Relief regarding the end-user exception and exemptions Issue: This relief coincides with the relief provided for end-users under the DSIO Letter and described in detail in Section I(B)(7) above. Some end-users may question whether a temporary mismatch between the floating rates referenced in commercial arrangements and the rates referenced in their swaps could cause the swaps to not qualify as hedging or mitigating commercial risk and therefore potentially cause the swaps to not qualify for the end-user exception or exemption from clearing. No-action position: Until December 31, 2021, DCR provides no-action relief for an entity that qualifies for an exception or exemption under CFTC regulations 50.50(c) or 50.51(b)(2) for a failure to clear a swap pursuant to CFTC regulation 50.2 if:
(i) Such swap is an uncleared swap that references a floating rate that qualified as a swap to hedge or mitigate commercial risk as defined in CFTC regulation 50.50(c); (ii) One or more of the following occurs: (a) such swap or relevant commercial agreement is amended by execution of a Fallback Amendment (or similar contractual provision in a commercial agreement); or (b) an existing fallback provision in a commercial agreement is activated because the floating rate is unavailable, permanently discontinued, or has been determined to be non-representative by the benchmark administrator or the relevant authority in a jurisdiction; or (c) a commercial agreement is amended for the sole purpose of changing the existing floating rate to an applicable risk-free rate; and (iii) Prior to December 31, 2021, the commercial arrangement documentation and/or the uncleared swap documentation is amended such that the uncleared swap again qualifies as a swap used to hedge or mitigate the commercial risk of such entity pursuant to CFTC regulation 50.50(c) or 50.51(b)(2).[32]
Potential concerns and other considerations: Please see the discussion in Section I(B)(7) above as those issues and concerns are relevant in the context of the relief provided under the DCR Letter. In addition, the DCR Letter explains that “[w]ith regard to the last condition, DCR notes that because both commercial end-users and cooperatives are subject to an ongoing obligations [sic] under CFTC regulations to maintain eligibility to elect an exception or exemption from the clearing requirement, such entities should plan to amend the reference rate provisions in both swap documentation and commercial documentation so that the rates referenced are aligned again as soon as practical, but no later than December 31, 2021.”[33] This intent of this statement is unclear given that (i) end-users do not have an ongoing obligation with respect to a swap since eligibility for an exception or exemption from clearing is determined at execution and (ii) DCR is specifically referencing the “last condition” which only discusses the “hedge or mitigate commercial risk” requirement under CFTC regulation 50.50(c) and 50.51(b)(2).

III. DMO Letter

A. Scope The DMO Letter applies to all swaps that are amended by a Fallback Amendment or a Replacement Rate Amendment or that are created to transition swaps or swap portfolios from IBOR to a new risk-free rate (“New RFR Swaps”). However, there are some limitations on the risk-free rates that can be included in the amended or new swaps (described below). Notably, the DMO Letter does not place a restrictions on the use of a Fallback Amendment or Replacement Rate Amendment relating to changes to the maturity or notional amount in the same manner as the DSIO Letter and the DCR Letter. The relief under the DMO Letter is also time-limited and will expire on December 31, 2021 B. No-Action Positions, Potential Concerns and Other Considerations Issue: Swaps that are (i) subject to the mandatory clearing requirement and (ii) made available to trade on a swap execution facility (“SEF”), exempt SEF or designated contract market (“DCM”), must be executed on a SEF, exempt SEF or DCM and must be executed pursuant to the CFTC’s regulations regarding SEFs or DCMs. No-action position: Until December 31, 2021, DMO provides no-action relief to any person for failure to comply with the trade execution requirement under CEA Section 2(h)(8) (i.e., the trade execution requirement), with respect to an IBOR-linked swap that is a New RFR Swap or is amended by a Fallback Amendment or Replacement Rate Amendment, for the sole purpose of accommodating the replacement (including ancillary changes) of the applicable IBOR with a risk-free rate that has been identified by a national level committee or working group in response to the Financial Stability Board’s Official Sector Steering Group’s report and recommendation that central banks and supervisory authorities should work together with market participants to identify and implement risk-free rates.[34] Potential concerns and other considerations: Relief is Time-Limited: This relief is only available until December 31, 2021, however, given the uncertainty around the transition and fallback terms, relief may be needed after that date. This relief will work in tandem with the relief in the DCR Letter. ______________________ [1] CFTC Letter No. 19-26, DSIO, “No-Action Positions to Facilitate an Orderly Transition of Swaps from Inter-Bank Offered Rates to Alternative Benchmarks” (Dec. 17, 2019) (“DSIO Letter”). [2] CFTC Letter No. 19-27, DMO, “Staff No-Action Relief from the Trade Execution Requirement to Facilitate an Orderly Transition from Inter-Bank Offered Rates to Alternative Risk-Free Rate” (Dec. 17, 2019) (“DMO Letter”). [3] CFTC Letter No. 19-28, DCR, “Staff No-Action Relief from the Swap Clearing Requirement for Amendments to Legacy Uncleared Swaps to Facilitate Orderly Transition from Inter-Bank Offered Rates to Alternative Risk-Free Rates” (Dec. 17, 2019) (“DCR Letter”). [4] In July 2017, the U.K. Financial Conduct Authority (“FCA”), which regulates the ICE Benchmark Administration Limited, the administrator of ICE LIBOR, announced that it would only seek commitments from banks to continue to contribute to LIBOR through the end of 2021, but that the FCA would not compel or persuade contributions beyond such date. See The Future of LIBOR, Speech by Andrew Bailey, Chief Executive of the UK FCA (July 27, 2017), available at https://www.fca.org.uk/news/speeches/the-future-of-libor. [5] The ARRC is a group of diverse private market participants convened and run by the Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New York to help ensure successful transition from U.S. dollar (“USD”) LIBOR to the recommended alternative Secured Overnight Financing Rate (“SOFR”). More information about the ARRC is available here: https://www.newyorkfed.org/arrc. [6] The CFTC staff’s no-action relief follows proposed regulations and guidance issued by the U.S. Department of Treasury (“Treasury”) regarding tax consequences. Gibson Dunn’s Client Alert regarding Treasury’s proposal is available here: https://www.gibsondunn.com/treasury-releases-guidance-on-transition-from-libor-to-other-reference-rates/. Additionally, the prudential regulators have proposed rules to provide relief from uncleared swap margin rules related to LIBOR cessation. See Margin and Capital Requirements for Covered Swap Entities, 84 Fed. Reg. 59,970 (Nov. 7, 2019) (“Prudential Regulators’ Proposed LIBOR Amendments”). The DSIO Letter aims to harmonize with the relief with respect to uncleared swap margin requirements provided in the Prudential Regulators’ Proposed LIBOR Amendments. [7] The CFTC Letters do not provide relief from reporting requirements under Parts 43 or 45 of the CFTC’s regulations. [8] The relief in the DSIO Letter also applies to other IRRs in addition to IBORs which include “conversions away from (i) any other interest rate that the parties to a swap reasonably expect to be discontinued or reasonably determines has lost its relevance as a reliable benchmark due to a significant impairment; or (ii) any other reference rate that succeeds any of the foregoing (the IBORs and any other rate meeting either of the foregoing criterion ….” DSIO Letter at 3-4. [9] DSIO Letter at 4. [10] DSIO Letter at 8. These limitations are aimed at harmonizing with the Prudential Regulators’ Proposed LIBOR Amendments. [11] DSIO Letter at 9-10. [12] See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 81 Fed. Reg. 636 (Jan. 6, 2016) (the “CFTC Margin Rule”). The CFTC Margin Rule is codified in CFTC regulations 23.151-159 and 23.161. See 17 CFR §§ 23.150-159, 161. [13] With respect to basis swaps, DSIO will not recommend the CFTC take an enforcement action against a swap dealer for failure to comply with the CFTC Margin Rule with respect to a basis swap that: (1) references only one or more CFTC Margin Rule Legacy Swaps; (2) is entered into solely to achieve substantially the same effect as would be obtained by an amendment to the referenced CFTC Margin Rule Legacy Swap(s) to accommodate the replacement of an IRR; and (3) does not have the effect of extending the maximum maturity or increasing the aggregate total effective notional amount of the CFTC Margin Rule Legacy Swaps that are referenced. DSIO Letter at 12. [14] See 17 CFR §§ 23.400 through 23.451, § 23.701. See also, Business Conduct Standards for Swap Dealers and Major Swap Participants with Counterparties, 77 Fed. Reg. 9734 (Feb. 17, 2012). [15] These existing swaps may be swaps that were entered into by a swap dealer before the Counterparty BCS rules were effective or after they were effective. [16] DSIO Letter at 14. [17] DSIO Letter at 14. [18] Swap dealers should also consider if there may be any regulatory risk for “aiding and abetting” a counterparty that is no longer an ECP, particularly in the event that the swap dealer knew or should have known that such counterparty was no longer an ECP. [19] CFTC regulation 23.502(a)(4). [20] CFTC regulation 23.502(b)(4). [21] DSIO Letter at 17. [22] We note that many end-users that are eligible for an exception or exemption from clearing would likely not be considered “financial end users” as defined in CFTC regulation 23.151 and therefore would not be subject to the CFTC Margin Rules in any event. [23] DSIO Letter at 17-18. The use of the phrase “[t]o alleviate any question in this regard” by DSIO (and also by DCR in the DCR Letter) suggests that end-users may determine that the swap still qualifies as hedging or mitigating commercial risk under CFTC regulation 50.50(c) in which case they would not need to rely on this no-action relief. [24] DSIO Letter at 17-18. While this relief in the DSIO Letter is only available for swap dealers from the requirements under CFTC regulation 23.151, comparable relief is provided for end-users with respect to the requirements of CFTC regulations 50.50(c) and 50.5(b)(2) in the DCR Letter. [25] For example, financial entity status could change because an entity’s registration status changes or because they become predominantly involved in activities that are financial in nature pursuant to CEA Section 2(h)(7)(C)(i)(VIII). [26] DSIO Letter at 19. [27] See 2012 IRS Clearing Requirement, 77 Fed. Reg. 74284 (Dec. 13, 2012). Swap dealers, major swap participants and active funds were required to comply beginning on March 11, 2013, while all other financial entities were required to clear beginning on June 10, 2013, except for accounts managed by third-party investment managers, as well as ERISA pension plans, which required to begin clearing on September 9, 2013. [28] The amendment to contractual terms is limited solely to situations where the underlying swap documentation is not based on the 2006 ISDA Definitions, which contains fallback provisions. [29] DCR Letter at 4-5. [30] The DCR Letter states that “Uncleared Legacy Swaps” “refer to uncleared swaps that would have been subject to the IRS clearing requirement under CFTC regulation 50.4(a), but for the fact that such swaps were entered into before the application of the 2012 clearing requirement as set forth under CFTC regulation 50.5[] and relevant implementation phasing dates.” DCR Letter at 8. However DCR does not specifically define the term “Uncleared Legacy Swaps,” yet it does define the term “Uncleared Legacy IRS” as “swaps that were executed prior to the compliance date on which swap counterparties were required to begin centrally clearing interest rate swaps (IRS) pursuant to the CFTC’s swap clearing requirement and thus were not required to be cleared and have not been cleared.” DCR Letter at 1. [31] DCR Letter at 11-12. [32] DCR Letter at 13. [33] Id. [34] DMO Letter at 6.
The following Gibson Dunn lawyers assisted in preparing this client update: Jeffrey Steiner and Erica Cushing. Gibson Dunn's lawyers are available to assist in addressing any questions you may have regarding these developments.  Please contact the Gibson Dunn lawyer with whom you usually work in the firm's Financial Institutions and Derivatives practice groups, or any of the following: Matthew L. Biben - New York (+1 212-351-6300, mbiben@gibsondunn.com) Michael D. Bopp - Washington, D.C. (+1 202-955-8256, mbopp@gibsondunn.com) Stephanie Brooker - Washington, D.C. (+1 202-887-3502, sbrooker@gibsondunn.com) Arthur S. Long - New York (+1 212-351-2426, along@gibsondunn.com) Jeffrey L. Steiner - Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com) Erica N. Cushing - Denver (+1 303-298-5711, ecushing@gibsondunn.com) © 2020 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

December 10, 2019 |
Brexit – Reporting of Derivatives under EMIR

Click for PDF In the event of the United Kingdom leaving the European Union without an agreed deal on 31 January 2020, UK counterparties will need to make changes to their derivatives reporting arrangements in advance of that date to ensure that they comply with the UK’s European Market Infrastructure Regulation (“EMIR”) reporting requirements immediately post-Brexit. This briefing sets out what steps UK counterparties to derivatives transactions should take now in relation to their reporting arrangements to ensure a smooth transition on and after Brexit. EMIR and much of its secondary implementation legislation takes the form of a Regulation and is therefore (before exit) directly applicable in UK law. The European Union (Withdrawal) Act 2018 provides that EU legislation that is directly applicable, such as EU EMIR, will form part of UK law on exit day and gives power to the UK government to amend the legislation so that it operates effectively post-Brexit. Consequently, post-Brexit there will be two versions of EMIR: the original EU version which will continue to apply to EU counterparties to derivatives transactions, EU central counterparties (“CCPs”) and EU trade repositories (“TRs”) (“EU EMIR”); and the UK version incorporating amendments during the onshoring process to ensure the regime continues to operate effectively post-Brexit (“UK EMIR”). UK EMIR will operate parallel to EU EMIR. Both regimes aim to increase the resilience and stability of OTC derivative markets. UK EMIR sets out the regulatory regime relating to OTC derivatives transactions, CCPs and TRs in the UK. Like EU EMIR, UK EMIR imposes a number of requirements on derivatives market participants which include, among other things:

  • The obligation to centrally clear certain standardised OTC derivative contracts;
  • Requirements to reduce the risk arising from non-centrally cleared derivatives contracts through risk mitigation techniques; and
  • The obligation to report derivatives transactions to a TR.
From exit day onwards, UK counterparties to derivatives contracts will need to comply with UK EMIR rather than EU EMIR (assuming that the UK leaves the EU with no transitional arrangements in place), including in relation to the reporting of its derivatives transactions. The UK Financial Conduct Authority (“FCA”) released a statement to explain the changes that will be in store for TRs operating in the UK, UK counterparties and UK CCPs and what is expected with respect to compliance.[1] The UK government has confirmed that, as far as possible, the policy approach set out in the EMIR legislation will not change after the UK has left the EU. This is unsurprising given that much of EMIR derived from commitments made at international level at the G20 in 2009. What should UK counterparties be doing in advance of Brexit?
  • Undertake an audit of the UK EMIR validation rules that will apply to reports submitted on or after Brexit to UK TRs. The UK EMIR validation rules diverge from the EU EMIR validation rules and therefore it is likely that operational changes will be necessary to ensure your UK EMIR reports are compliant post-Brexit.
  • To the extent that a UK counterparty is currently reporting its trades to an EU TR, ensure that the necessary operational changes are made in advance of exit day to ensure that trades can be reported to a UK TR immediately post-Brexit. This may involve entering into new arrangements with a UK TR.
  • For UK counterparties who have engaged a third party or their counterparty to perform their reporting for them (i.e., “delegated” reporting), engage with their third party service provider or counterparty to ensure that they are making any necessary changes to ensure compliance post-Brexit.
  • Any UK counterparties who have accepted a delegation from clients and agreed to report on their behalf, where those clients are based in the EU, reporting will need to be provided to an EU TR post-Brexit and for UK clients, reporting will need to be made to a UK TR for those clients. Ensuring that the necessary operational changes are made will be critical for all firms providing delegated reporting services.
  • As all outstanding derivatives contracts entered into by a UK counterparty on or after 16 August 2012 must be held in a UK TR (whether registered or recognised) on exit day, UK counterparties should engage with their TRs to ensure all relevant trades are identified and to understand the porting process to their UK TR of choice by the date of exit.
What happens to outstanding trades post-Brexit? All outstanding derivative trades entered into by UK counterparties on or after 16 August 2012, must be held in a UK registered, or recognised, TR by 11:00 p.m. UK time on exit day. This will require derivatives transactions of UK counterparties that remain outstanding to be ported to a UK TR in time for exit day and will require the necessary steps to ensure that new derivatives transactions will be reported to a UK TR beginning on exit day. UK counterparties would be well-advised to engage with their TRs to ensure orderly porting to their UK TR of choice by exit day and to ensure that all their relevant trades have been identified. UK counterparties should note that any updates to these trades required after Brexit will need to be made to the UK TR and not to the original EU TR. ______________________    [1]   See FCA statement on the reporting of derivatives under the UK EMIR regime in a no-deal scenario, available at https://www.fca.org.uk/news/statements/fca-statement-reporting-derivatives-under-uk-emir-regime-no-deal-scenario (7 November 2019).
Gibson Dunn's lawyers are available to assist in addressing any questions you may have regarding these developments.  Please contact the Gibson Dunn lawyer with whom you usually work in the firm's Financial Institutions and Derivatives practice groups, or the authors: Michelle M. Kirschner - London (+44 20 7071 4212, mkirschner@gibsondunn.com) Jeffrey L. Steiner - Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com) Please also feel free to contact any of the following practice leaders and members: Europe: Patrick Doris - London (+44 20 7071 4276, pdoris@gibsondunn.com) Amy Kennedy - London (+44 20 7071 4283, akennedy@gibsondunn.com) Michelle M. Kirschner - London (+44 20 7071 4212, mkirschner@gibsondunn.com) Lena Sandberg - Brussels (+32 2 554 72 60, lsandberg@gibsondunn.com) United States: Matthew L. Biben - New York (+1 212-351-6300, mbiben@gibsondunn.com) Michael D. Bopp - Washington, D.C. (+1 202-955-8256, mbopp@gibsondunn.com) Stephanie Brooker - Washington, D.C. (+1 202-887-3502, sbrooker@gibsondunn.com) Arthur S. Long - New York (+1 212-351-2426, along@gibsondunn.com) Jeffrey L. Steiner - Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com) © 2019 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

October 15, 2019 |
Treasury Releases Guidance on the Transition from LIBOR to Other Reference Rates

Click for PDF On October 9, 2019, the Department of the Treasury (“Treasury”) published proposed regulations on the transition from interbank offered rates (“IBORs”) to other reference rates (the “Proposed Regulations”).[1] A broad range of financial instruments are based on the London interbank offered rate (“LIBOR”). LIBOR, however, may be phased out after the end of 2021.[2] The Proposed Regulations address the tax consequences of the transition away from LIBOR in response to concerns raised by the Alternative Reference Rate Committee (“ARRC”).[3] The ARRC’s overarching concern was that modifying a financial instrument to replace LIBOR with another reference rate (e.g., SOFR) might trigger adverse tax consequences for either the issuer or the holder. Without additional guidance, existing tax rules could potentially cause all holders of LIBOR-based instruments to realize gain or loss upon the replacement of LIBOR with another reference rate.[4] To address the concerns of the ARRC regarding the adverse tax implications of modifying a financial instrument to replace LIBOR with an alternative reference rate and to provide much needed clarity, the Proposed Regulations provide that:

  1. Replacing LIBOR with another reference rate or adding a “fallback” provision (e.g., a provision stating that LIBOR will be replaced with another reference rate upon its elimination) to a financial instrument is not a realization event and will not cause recognition of gain or loss.
  2. Replacing LIBOR or adding a fallback provision will not cause recognition of gain or loss under the integrated transaction rules.
  3. Replacing LIBOR or adding a fallback provision will not cause recognition of gain or loss under the hedge accounting rules.
  4. A one-time payment made by one party to a financial instrument to another to account for any difference between LIBOR and the rate replacing it has the same character and source as other payments made by the same party with respect to the instrument.
  5. The existence of a fallback provision will not cause a debt instrument providing for a floating rate to be treated as a contingent payment debt instrument.
  6. Replacing LIBOR or adding a fallback provision in the organizational documents of a REMIC will not cause regular REMIC interests to be reclassified as residual interests.
The deadline to submit comments on the Proposed Regulations is November 25, 2019. Taxpayers can generally choose to apply the Proposed Regulations to modifications of debt instruments and non-debt instruments occurring after October 9, 2019, so long as they apply the Proposed Regulations consistently.[5]

1. Realization of Gain or Loss

Current tax rules provide that gain or loss is realized upon the exchange of property for other property that differs materially in kind or in extent (such an exchange is a “realization event”).[6] In the case of debt instruments, current tax rules also provide that a significant modification of the terms of an instrument is a realization event.[7] These rules further provide that the triggering of an existing “fallback” provision is not a significant modification,[8] since such a modification occurs by the operation of the existing terms of the instrument.[9] It is unclear, however, whether the addition of a fallback provision to an existing debt instrument or the outright substitution of another reference rate for LIBOR would constitute a significant modification. The situation is even more uncertain in the case of non-debt instruments (e.g., derivatives), as current tax rules do not explain when modifications of such instruments constitute realization events and do not, a fortiori, provide that the triggering of an existing fallback provision is not a realization event. And just as in the case of debt instruments, it is unclear whether adding a fallback provision or substituting another reference rate for LIBOR in a non-debt instrument would be a realization event. The Proposed Regulations significantly reduce the uncertainty as to which modifications of financial instruments constitute realization events. The Proposed Regulations provide that, for both debt instruments and non-debt instruments (including derivatives, stocks, insurance contracts, and lease agreements), neither the addition of a fallback provision nor the outright substitution of another reference rate for LIBOR is a realization event,[10] provided that the following conditions are satisfied:
  1. The new reference rate must be a “qualified rate.” Conveniently, Treasury provides a list of such rates, a list which includes SOFR.[11]
  2. The fair market value of the instrument after modification must be “substantially equivalent” to its fair market value before modification.[12] Thankfully, Treasury also provides two safe harbors under which this substantial equivalence condition is deemed satisfied.[13]
  3. The new reference rate must generally be based on transactions conducted in the same currency as the rate it replaces.[14] In the case of USD LIBOR, this means that the new reference rate must be based on transactions conducted in U.S. dollars, as is the case with SOFR.
The Proposed Regulations also provide that modifications of an instrument that are associated with the addition of a fallback provision or the substitution of another qualified rate for LIBOR are not realization events.[15] These modifications, however, are only covered to the extent they are reasonably necessary to effect the addition or substitution.[16] For example, the Proposed Regulations provide that modifying a financial instrument to add the obligation for one party to make a one-time payment to the other is not a realization event, so long as adding such an obligation is reasonably necessary to effect the replacement of LIBOR with another qualified rate.[17] The Proposed Regulations also clarify that financial instruments that were issued before certain dates and are “grandfathered” under certain provisions of the Code, including sections 163(f), 871(m), and 1471, will not lose their grandfathered status as a result of the addition of a fallback provision or the substitution of another reference rate for LIBOR.[18]

2. Integrated Transactions

Issuers of debt instruments often enter into derivative contracts (e.g., interest rate swaps or credit default swaps) to hedge against risk. Under current tax rules, a hedge and the debt instrument to which it relates may be integrated and taxed as a single synthetic debt instrument (“SDI”), instead of being taxed as two separate instruments.[19] The rationale behind this rule is that, if the combined cash flows from a debt instrument and a hedge are substantially equivalent to the cash flows on a single debt instrument, then the debt instrument and its hedge should be taxed just as if they were such an instrument.[20] The holder of an SDI “legs out” of an integrated transaction when it disposes of one (or both) of its components.[21] Legging out causes the integrated transaction to terminate and results in the holder of the defunct SDI being treated as having sold it for fair market value.[22] Absent further guidance, the addition of a fallback provision or the outright substitution of another reference rate for LIBOR in either components of an SDI may have caused a legging out resulting in realization of gain or loss. The Proposed Regulations avoid this result and clarify that the amendment of any of the components of an integrated transaction to replace LIBOR with another reference rate is not a legging out, so long as the transaction, as modified, continues to qualify for integration.[23] Thus, an integrated transaction composed of a LIBOR-based debt instrument and interest rate swap is not terminated by reason of the substitution of SOFR for LIBOR in either the debt instrument or the swap.[24]

3. Hedge Accounting

Under current tax rules, taxpayers using the accrual method of accounting must account for hedging transactions in a way that clearly reflects income.[25] In other words, the method of accounting used must reasonably match the timing of income, deduction, gain, or loss from the hedging transaction with the timing of the income, deduction, gain, or loss of the items being hedged.[26] This general rule applies to hedges of debt instruments.[27] Importantly, a taxpayer who retains a hedge while disposing of the items being hedged is required to match the built-in gain or loss in the former to the gain or loss realized on disposition of the latter.[28] A taxpayer can meet this requirement by marking the hedge to market on the date it disposes of the items being hedged.[29] The Proposed Regulations provide that a modification of the terms of a debt instrument or derivative to replace LIBOR with another reference rate is not treated, for purposes of the hedge accounting rules, as a disposition or termination of either instrument.[30] This means that such a modification will not cause the taxpayer to realize gain or loss. The holder of a LIBOR-based debt instrument who enters into a LIBOR-based interest rate swap as a hedge, for instance, will not be required to mark either instrument to market upon the replacement of LIBOR with another reference rate in either.

4. One-Time Payments

The character of a one-time payment made by one party to a financial instrument to another party to account for the difference between the old rate and the new rate may be ambiguous. It is unclear, for instance, whether current tax rules would treat a one-time payment by a borrower to a lender in relation to the substitution of SOFR for LIBOR in a debt instrument as an interest payment or as a fee. Any ambiguity as to the character of a one-time payment implies an ambiguity as to whether it should be sourced to either the U.S. or another jurisdiction. The Proposed Regulations provide that the character and source of a one-time payment made by a payor in connection with the addition of a fallback provision or the outright substitution of an another reference rate for LIBOR in a financial instrument are the same as the source and character that would otherwise apply to a payment by the same party with respect to the instrument.[31] As a result, a one-time payment by a borrower in relation to the substitution of SOFR for LIBOR in a debt instrument would indeed be treated as an interest payment and would therefore be sourced as such.[32]

5. Original Issue Discount and Qualified Floating Rates

Under current tax rules, debt instruments providing for a floating rate may be classified as either variable rate debt instruments (“VRDIs”) or contingent payment debt instruments (“CPDIs”). VRDIs generally benefit from an advantageous tax treatment compared to CPDIs. For instance, if a VRDI provides for stated interest that is unconditionally payable at least annually at a single qualified floating rate (“QFR”), then all of the stated interest on this VRDI is qualified stated interest.[33] This means that stated interest payments on such an instrument will not create original issue discount (“OID”). In plain English, this means that the holder of a VRDI will not be required to include interest payments in income until it has received them (under its method of accounting).[34] By contrast, the holder of a CPDI may be required to include these payments in income before receiving them.[35] The Proposed Regulations provide that, in the case of a debt instrument including a fallback provision, the LIBOR-based floating rate (provided it is a QFR) and the rate (e.g. a SOFR-based rate) that automatically replaces it upon the occurrence of a triggering event are treated as a single QFR.[36] Additionally, the Proposed Regulations state that the possibility that an IBOR—including LIBOR—will become unavailable is treated as a remote contingency and therefore will not cause a debt instrument containing a fallback provision to be classified as a CPDI.[37] Finally, the Proposed Regulations provide that the occurrence of an event triggering a fallback provision does not qualify as a change in circumstances and does not, as a result, cause the instrument to be treated as retired and reissued.[38] As a result, the triggering of a fallback provision does not cause a realization event.

6. REMICs

A real estate mortgage investment conduit (“REMIC”) is an entity formed for the purpose of holding a fixed pool of mortgages secured by interests in real property. REMICs issue both regular and residual interests. Under current tax rules, a regular interest in a REMIC is treated as a debt instrument.[39] Any REMIC interest that is not a regular interest is a residual interest.[40] The tax treatment of holders of regular interests is generally more advantageous than that of holders of residual interests. For a REMIC interest to be a regular interest, the REMIC’s organizational documents must, on the startup day, irrevocably specify the interest rate (or rates) used to compute any interest payments on the regular interest.[41] The addition of a fallback provision to the terms of a REMIC’s organizational documents or the outright substitution of another reference rate for LIBOR would therefore cause all interests in this REMIC to be residual interests. Similarly, the possible triggering of an existing fallback provision by the elimination of LIBOR is treated by current tax rules as a contingency that prevents an interest in a REMIC from being a regular interest.[42] In both cases, the Proposed Regulations provide relief to taxpayers. First, the Proposed Regulations explain that modifications of the terms of a REMIC’s organizational documents after the startup day to add a fallback provision or substitute another reference rate for LIBOR are disregarded for purposes of determining whether an interest in a REMIC is a regular interest.[43] Second, the Proposed Regulations state that the possibility that LIBOR will be replaced by another reference rate as the result of a fallback provision being triggered is not a contingency that will prevent a REMIC interest from being a regular interest.[44] The Proposed Regulations also provide that parties may agree to reduce the amounts of payments of principal or interest to account for the reasonable costs of replacing LIBOR with another reference rate without thereby jeopardizing the status of REMIC interests as “regular.”[45] ____________________ [1]  Guidance on the Transition From Interbank Offered Rates to Other Reference Rates, 84 Fed. Reg. 54068 (Oct. 9, 2019). [2]  The UK Financial Conduct Authority (“UK FCA”) announced in 2017 that it would not compel or persuade banks to submit to LIBOR and that it would therefore not be necessary for the FCA to sustain LIBOR through its influence or legal powers. See The Future of LIBOR, Speech by Andrew Bailey, Chief Executive of the UK FCA (July 27, 2017), available at https://www.fca.org.uk/news/speeches/the-future-of-libor. [3]  The ARRC is a group of diverse private-market participants convened by the Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New York to help ensure successful transition from U.S. dollar (“USD”) LIBOR to the recommended alternative Secured Overnight Financing Rate (“SOFR”). More information on the ARRC is available at https://www.newyorkfed.org/arrc. [4]  See section 1001 of the Internal Revenue Code and § 1.1001–3(b) of the Treasury Regulations (discussed in detail below). Except where expressly stated otherwise, all section references are to the Internal Revenue Code of 1986, as amended (“I.R.C.”), and the Treasury Regulations (“Treas. Reg.”) promulgated thereunder. [5]  Proposed Treasury Regulations (“Prop. Treas. Reg.”) § 1.1001-6(g). [6]  Treas. Reg. § 1.1001–1(a). [7]  Treas. Reg. § 1.1001–3(b). [8]  Treas. Reg. § 1.1001–3(c)(1)(ii). [9]  Id. [10]  Prop. Treas. Reg. § 1.1001-6(a)(1)-(3). Although the Proposed Regulations do not explicitly say so, they are naturally read as implying that the triggering of an existing fallback provision in a non-debt instrument is not a realization event. [11]  Prop. Treas. Reg. § 1.1001-6(b)(1)(i). [12]  Prop. Treas. Reg. § 1.1001–6(b)(2)(i). [13]  Prop. Treas. Reg. § 1.1001–6(b)(2)(ii). [14]  Prop. Treas. Reg. § 1.1001–6(b)(3). [15]  Prop. Treas. Reg. § 1.1001-6(a). [16]  Prop. Treas. Reg. § 1.1001-6(a)(5). [17]  Id. [18]  Prop. Treas. Reg. § 1.1001-6(e). [19]  Treas. Reg. § 1.1275-6(a) [20]  Id. [21]  Treas. Reg. § 1.1275-6(d)(2)(i)(A). [22]  Treas. Reg. § 1.1275-6(d)(2)(i)(B). [23]  Prop. Treas. Reg. § 1.1001-6(c). [24]  Id. See also 84 Fed. Reg. 54068, 54073 (Oct. 9, 2019). The Proposed Regulations provide similar rules for foreign currency hedges integrated with debt instruments under Treas. Reg. § 1.988–5(a) and interest rate hedges integrated with tax-exempt bonds under Treas. Reg. § 1.148–4(h). [25]  Treas. Reg. § 1.446-4(b). [26]  Id. [27]  Treas. Reg. § 1.446-4(e)(4). [28]  Treas. Reg. § 1.446-4(e)(6). [29]  Id. [30]  Prop. Treas. Reg. § 1.1001-6(c). [31]  Prop. Treas. Reg. § 1.1001-6(d). [32]  Although the proposed regulations do not address the case in which a lender makes a one-time payment to a borrower, Treasury has requested comments on the source and character of such a payment. 84 Fed. Reg. 54068, 54073. [33]  Treas. Reg. § 1.1275-5(e)(2)(i). [34]  Treas. Reg. § 1.1275-5(e). [35]  Treas. Reg. § 1.1275-4. [36]  Prop. Treas. Reg. § 1.1275–2(m)(3). [37]  Prop. Treas. Reg. § 1.1275-2(m)(3). [38]  Prop. Treas. Reg. § 1.1275-2(m)(4), Treas. Reg. section 1.1275-2(h)(6). [39]  I.R.C. § 860G(a)(1). [40]  I.R.C. § 860G(a)(2). [41]  Treas. Reg. § 1.860G–1(a)(4) [42]  Treas. Reg. § 1.860G-1(b)(3). [43]  Prop. Treas. Reg. § 1.860G–1(e)(2). [44]  Prop. Treas. Reg. § 1.860G–1(e)(3). This rule applies so long as the LIBOR-based rate and the fallback rate are each rates permitted under I.R.C. § 860G. [45]  Prop. Treas. Reg. § 1.860G–1(e)(4).
Gibson Dunn's lawyers are available to assist with any questions you may have regarding these developments.  For further information, please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm's Tax or Financial Institutions practice groups, or the following authors: Jeffrey M. Trinklein - London/New York (+44 (0)20 7071 4224 /+1 212-351-2344), jtrinklein@gibsondunn.com) Jeffrey L. Steiner - Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com) Alexandre Marcellesi* - New York (+1 212-351-6222, amarcellesi@gibsondunn.com) Please also feel free to contact any of the following practice leaders and members: Tax Group: Jeffrey M. Trinklein - Co-Chair, London/New York (+44 (0)20 7071 4224 /+1 212-351-2344), jtrinklein@gibsondunn.com) Sandy Bhogal - London (+44 (0)20 7071 4266, sbhogal@gibsondunn.com) Jérôme Delaurière - Paris (+33 (0)1 56 43 13 00, jdelauriere@gibsondunn.com) Hans Martin Schmid - Munich (+49 89 189 33 110, mschmid@gibsondunn.com) David Sinak - Co-Chair, Dallas (+1 214-698-3107, dsinak@gibsondunn.com) James Chenoweth - Houston (+1 346-718-6718, jchenoweth@gibsondunn.com) Brian W. Kniesly - New York (+1 212-351-2379, bkniesly@gibsondunn.com) Eric B. Sloan - New York (+1 212-351-2340, esloan@gibsondunn.com) Edward S. Wei - New York (+1 212-351-3925, ewei@gibsondunn.com) Romina Weiss - New York (+1 212-351-3929, rweiss@gibsondunn.com) Benjamin Rippeon - Washington, D.C. (+1 202-955-8265, brippeon@gibsondunn.com) Daniel A. Zygielbaum - Washington, D.C. (+1 202-887-3768, dzygielbaum@gibsondunn.com) Dora Arash - Los Angeles (+1 213-229-7134, darash@gibsondunn.com) Paul S. Issler - Los Angeles (+1 213-229-7763, pissler@gibsondunn.com) Scott Knutson - Orange County (+1 949-451-3961, sknutson@gibsondunn.com) Financial Institutions Group: Matthew L. Biben - New York (+1 212-351-6300, mbiben@gibsondunn.com) Arthur S. Long - New York (+1 212-351-2426, along@gibsondunn.com) Michael D. Bopp - Washington, D.C. (+1 202-955-8256, mbopp@gibsondunn.com) Jeffrey L. Steiner - Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com) * Mr. Marcellesi is not admitted to practice law in New York. © 2019 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

September 9, 2019 |
Dodd-Frank 2.0: U.S. Agencies Revise the Volcker Rule on Proprietary Trading

Click for PDF Since it was enacted in July 2010, the Dodd-Frank Act’s Volcker Rule has challenged banks and their regulators alike.  This is particularly the case with respect to its restrictions on proprietary trading.  It has been one thing for former Federal Reserve Chairman Volcker to state that “you know it when you see it,” quite another to formulate a regulation that accurately defines proprietary trading and implements a broad statutory directive across complex business operations. On August 20, 2019, the Office of the Comptroller of the Currency and the Board of Directors of the Federal Deposit Insurance Corporation, Director Gruenberg dissenting, approved an expected rewrite of the regulation on proprietary trading, along with some minor amendments to the provisions governing private equity funds and hedge funds (Revised Rule).  The preamble stated that a new proposal to revise the funds’ provisions more broadly would be forthcoming.  The other Agencies charged with implementing the Volcker Rule are expected to follow. As with most of the revisions to Dodd-Frank since 2016, the revision – proposed in somewhat different form in June 2018 (2018 Proposal) – is a moderate approach that recalibrates the original regulation (Original Rule) and removes certain unworkable excesses.  This “Volcker 2.0” approach also focuses more intelligently on risk than the Original Rule and is more faithful to the statutory text.  At the same time, it still aligns with the most defensible reason for the Volcker Rule, maintaining the nature of banking institutions as customer-serving businesses.  The result is a pruning of some of the excesses of the Original Rule, while leaving the regulation targeted at banks with the largest trading operations. New Risk-Based Approach The Revised Rule, like the 2018 Proposed Rule, applies the statutory provisions differently depending on the size of a banking entity’s trading assets and liabilities.  It adopts a three-tiered approach, under which compliance obligations under the Rule’s market-making, underwriting, and risk-mitigating hedging exemptions, as well as overall compliance program requirements, differ based on the tier in which tier a banking entity finds itself.

Tier Trading Assets/Liabilities[1]
Significant $20 billion or more
Moderate $1 billion to $20 billion
Limited Less than $1 billion
For non-U.S. banks, the final rule looks to the bank’s combined U.S. operations only, and not its worldwide operations, when determining in which tier to place the non-U.S. bank. The tiering revision alone is a substantial improvement.  The Original Rule deemed a banking entity worthy of heightened compliance obligations based on total asset size, and set that threshold at an irrationally low number – $50 billion.  Being based on amounts of trading assets and liabilities, the new tiers align more closely to the risks posed.  The Agencies raised the threshold of the “Significant” tier from $10 billion in the 2018 Proposal to $20 billion, but they declined to make changes to the other tiers. In addition, under the Economic Growth, Regulatory Relief and Consumer Protection Act of 2018, a banking entity is completely exempt from the proprietary trading restrictions if:
  • It has, and is not controlled by a banking entity that has, total consolidated assets of $10 billion or less; and
  • It has total trading assets and liabilities of 5% or less of total assets.
New Definition of Proprietary Trading – Closer to the Statute The Dodd-Frank Act defined “proprietary trading,” as well as the associated term “trading account,” very obscurely:

“[P]roprietary trading” . . . means engaging as principal for the trading account of the banking entity . . . in any transaction to purchase or sell, or otherwise acquire of dispose of, [Volcker covered financial instruments].

“[T]rading account” means any account used for acquiring or taking positions in [Volcker covered financial instruments] principally for the purpose of selling in the near term (or otherwise with the intent to resell in order to profit from short-term price movements), and any such other accounts [as determined by regulation].[2]

The interpretive issue under these definitions is the concept of the “trading account.”  This is not a recognized term under prior banking law, nor do banking institutions organize their operations around such accounts.  For this reason, the Volcker Agencies originally took considerable leeway with the statutory text in expanding these definitions, with the result that most principal activity in covered financial instruments was brought within the trading prohibition, and then was required to find an exempted “permitted activity” like underwriting or market making to justify itself. Specifically, the Original Rule had three tests for determining what was proprietary trading, and one presumption that was rebuttable in theory, but not in fact:
  • Purpose Test: a purchase and sale is principally for the purpose of short-term resale, benefiting from actual or expected short-term price movements, realizing short-term arbitrage profits, or hedging one or more such positions.
  • Market-Risk Capital Test: the banking entity is subject to the market-risk capital rule and the financial instruments are both market-risk covered positions and trading positions (or hedges thereof).
  • Status Test: the banking entity is licensed/registered as a dealer, swap dealer or security-based swap dealer, or the banking entity engages in any such business outside the U.S.; and the covered financial instrument is purchased and sold in connection with such activities.
  • Rebuttable presumption that a short-term resale purpose exists if an instrument is held for fewer than 60 days, or its risk is substantially transferred within 60 days.
The Revised Rule, by contrast, has two principal tests that will bind most institutions subject to the Revised Rule – the Market-Risk Capital Test and the Status Test.  The former has been slightly modified so as not to apply to a banking entity that is not consolidated with an affiliate that calculates risk-based capital ratios under the market risk capital rule for regulatory reporting purposes; the latter was substantively unchanged.  The Purpose Test is retained for those institutions that are not required to calculate market-risk capital, and do not elect to do so for Volcker purposes.  (Such an election must be for a banking entity and all its wholly-owned subsidiaries.)  The Revised Rule also reverses the Original Rule’s presumption so that, with respect to the Purpose Test, a position that is held for 60 days or more and where the risk is not substantially transferred within 60 days is presumed not to be proprietary trading. This simplification of the Original Rule is welcome and is a more reasonable construction of the statute.  First, the Purpose Test – which looked to a banking institution’s intent in purchasing and selling a Volcker instrument – is in many cases duplicative of the Market-Risk Capital Test.  It was also not unreasonably characterized by JPMorgan Chief Executive Officer Jamie Dimon as requiring “a lawyer and a psychiatrist” to analyze every trade.  Second, the Volcker Agencies never had enough staff to engage with banks on rebutting the 60-day presumption – this avenue of compliance was thus effectively read out of the Original Rule.  Finally, for reasons that were never persuasive, the Original Rule did not provide any indication of what period of time would suffice for a banking entity to have certainty that it was not proprietary trading. Expanded Exclusions from Proprietary Trading Certain purchase and sale transactions are wholly outside the Volcker Rule, some statutorily, some under the Original Rule.  The Revised Rule expands the number of regulatory exclusions to include:
  • Purchases and sales of foreign exchange swaps and forwards, and cross-currency swaps (including nondeliverable cross-currency swaps), under the Liquidity Management Plan exclusion.
  • Purchases and sales to correct bona fide trade errors; unlike the 2018 Proposal, there is no requirement that instruments bought or sold in such transactions be transferred to a special “trading error” account.
  • For banking entities that are not dealers, swap dealers or security-based swap dealers, matched swap transactions entered into in connection with customer-driven swaps, such as a back-to-back swap entered into at the same time as a fixed-to-floating interest rate swap with a customer.
  • Hedges of mortgage servicing rights or assets in connection with a documented hedging strategy.
  • Purchases and sales of instruments that are not “trading assets” or “trading liabilities” under regulatory reporting forms.
Revised Definition of “Trading Desk” For purposes of the conditions to the permitted activities of market-making and underwriting, the Original Rule included a definition of “trading desk,” the place where many of the conditions were measured.  In keeping with interpreting the statute’s restrictions broadly, the Original Rule defined the term as “the smallest discrete unit of organization of a banking entity that purchases or sells financial instruments for the trading account of the banking entity or an affiliate thereof.”[3]  This definition did not align with the manner in which banking entities generally organized their businesses for operational, management or compliance purposes. The Revised Rule adopts a more flexible definition, which should align better with banks’ organizational structures and result in fewer compliance costs:
  • “A unit of organization of a banking entity that purchases or sells financial instruments for the trading account of the banking entity or an affiliate thereof” that is either:
    • Structured to implement a well-defined business strategy, organized to ensure appropriate setting, monitoring, and review of the desk’s limits, loss exposures and strategies, and characterized by a clearly defined unit that engages in coordinated trading activity with a unified approach to its key elements; operates subject to a common and calibrated set of risk metrics, risk levels and joint trading limits; submits compliance reports and other information as a unit for monitoring by management; and books its trades together; or
    • For a banking entity that calculates risk-based capital ratios under the market risk capital rule, or a consolidated affiliate for regulatory reporting purposes of such a banking entity, established by the banking entity or its affiliate for purposes of market risk capital calculations under the market risk capital rule.
Underwriting and Market-Making: RENTD Compliance Through Internal Limits The Volcker statute distinguishes permitted underwriting and market-making activities from impermissible proprietary trading in that the former are “designed not to exceed the reasonably expected near term demands of clients, customers, or counterparties” (RENTD).[4]  The Original Rule required “demonstrable analysis” of complex and opaque conditions as a means of satisfying the RENTD requirement, and in so doing, imposed considerable compliance obligations on banking entities.  In addition, studies since the enactment of the Volcker Rule found that liquidity in certain financial markets had been constrained[5] – itself a cause of supervisory concern. The Revised Rule seeks to reduce these obligations and increase market liquidity by permitting banking entities to make use of their own risk limits in showing compliance with the RENTD condition.  It therefore contains a rebuttable presumption of compliance with the Rule if a banking entity has established and implements, maintains, and enforces internal limits for the relevant trading desk designed to not to exceed RENTD.  The relevant supervisor may rebut the presumption of compliance if it believes that a banking entity’s trading desk is exceeding RENTD, after notice to the banking entity. With respect to underwriting, the internal limits must address, based on the nature and amount of the trading desk’s underwriting activities:
  • the amount, types, and risk of its underwriting position;
  • the level of exposures to relevant risk factors arising from its underwriting position;
  • the period of time a security may be held; and
  • the liquidity, maturity, and depth of the market for the relevant types of securities.
With respect to market making, the internal limits must address:
  • the amount, types, and risks of the trading desk’s market-maker positions;
  • the amount, types, and risks of the products, instruments, and exposures the trading desk may use for risk management purposes;
  • the level of exposures to relevant risk factors arising from its financial exposure;
  • the period of time a financial instrument may be held; and
  • the liquidity, maturity, and depth of the market for the relevant types of financial instruments.
These limits are not required to be approved in advance, but they are subject to supervisory review and oversight on an ongoing basis.  Unlike the 2018 Proposal, the Revised Rule does not require banking entities to report limit breaches, but they must maintain and make available to their supervisors on request records regarding any limit that is exceeded and any temporary or permanent increase to a limit. If a banking entity breaches or increases a limit, the presumption of compliance will continue to be available only if the banking entity takes action as promptly as possible after a breach to bring the trading desk into compliance, and follows established written authorization procedures regarding the breach or increase, including demonstrable analysis of the basis for any temporary or permanent increase to a trading desk’s limit. In addition, the Revised Rule eliminates the specific compliance program requirements for the underwriting and market-making exemptions for banking entities that do not have significant trading assets and liabilities. Simplification of Hedging Permitted Activity; Risk-Tailored Compliance Like underwriting and market making, risk-mitgating hedging is an activity permitted by the statute even if it involves a purchase and sale of an instrument in the short term.  The Original Rule imposed substantial conditions on this activity, however, in an effort to guard against abuse.  These original conditions imposed a significant compliance burden and were not easily monitored in practice.  In particular, the requirements that the banking entity conduct a correlation analysis and continuously show that the hedge was demonstrably reducing or significantly mitigating identifiable risks was a significant challenge. The Revised Rule simplifies the conditions to risk-mitigating hedging and gives banking entities more flexibility in demonstrating compliance.  It removes the Original Rule’s requirements that a banking entity undertake a correlation analysis and show that the hedge was demonstrably reducing or significantly mitigating identifiable risks.  Instead, and more closely following the statute, the hedging must be “designed to reduce or otherwise significantly mitigate one or more specific, identifiable risks” being hedged and be “subject, as appropriate, to ongoing calibration” to ensure that the hedging does not become prohibited trading. In addition, for banking entities that have only moderate trading activities (greater than $1 billion in trading assets/liabilities but less than $20 billion), the Revised Rule reduces the scope of the required compliance program.  For such firms, the requirement for a separate internal compliance program for hedging has been eliminated, as well as certain specific requirements,[6] limits on compensation arrangements for persons performing risk-mitigating activities, and documentation requirements. For banking entities that have significant trading activities, the Revised Rule moderates the Original Rule’s requirement for maintaining additional documentation for hedges and hedging techniques not established by a trading desk’s policies and procedures.  The requirement does not apply to purchases and sales of financial instruments for hedging activities that are identified on a written list of financial instruments pre-approved by the banking entity that are commonly used by the trading desk for the specific types of hedging activity, if the banking entity complies with appropriate pre-approved limits for the trading desk when doing the hedging. Relaxation of Trading Outside the United States (TOTUS) Requirements Unlike many statutes, the Bank Holding Company Act of which the Volcker Rule is a part applies extraterritorially, subject to specific exemptions for non-U.S. banking organizations.  The Revised Rule relaxes the conditions that the Original Rule applied to the permitted activity of a non-U.S. bank trading “outside the United States,” the so-called TOTUS permitted activity.  In so doing, the Revised Rule focuses more clearly on potential risks to the United States caused by TOTUS activity. Under the new conditions, a trade qualifies for TOTUS if:
  • the banking entity engaging as principal in the purchase or sale (including relevant personnel) is not located in the United States or organized under the laws of the United States or of any State;
  • the banking entity (including relevant personnel) that makes the decision to purchase or sell as principal is not located in the United States or organized under the laws of the United States or of any State; and
  • the purchase or sale, including any transaction arising from risk-mitigating hedging related to the instruments purchased or sold, is not accounted for as principal directly or on a consolidated basis by any branch or affiliate that is located in the United States or organized under the laws of the United States or of any State.
Unlike the Original Rule, the trade can be with a U.S. counterparty and financing for the trade can be provided by the U.S. offices of the non-U.S. banking entity.  A non-U.S. banking entity may also use a non-affiliated U.S. investment adviser in the trade as long as the actions and decisions of the banking entity as principal occur outside of the United States. Modest Revisions to Covered Fund Provisions The Revised Rule makes only minor revisions to the Volcker funds restriction; the preamble states a new proposal on this subpart will be forthcoming.  In particular, the thorny question of whether a foreign excluded fund should be exempted from the definition of “banking entity” is left for another day, with some indication that the Agencies may still believe this is a question for Congress.[7]  The only amendments are the following:
  • The Revised Rule removes the Original Rule’s requirement that banking entities include for purposes of the aggregate fund limit and capital deduction the value of any ownership interests of a third-party covered fund (i.e., covered funds that the banking entity does not advise or organize and offer) acquired or retained in accordance with the underwriting or market-making exemptions.
  • The Revised Rule permits a banking entity to acquire or retain an ownership interest in a covered fund as a hedge when acting as intermediary on behalf of a customer that is not itself a banking entity to facilitate the exposure by the customer to the profits and losses of the covered fund (as in a fund-linked note). The Original Rule’s prohibition of such activities had no clear statutory basis.
  • The Revised Rule removes the Original Rule’s condition to the SOTUS fund exemption that no financing be provided by U.S. offices.
  • The Revised Rule codifies the Agency staff interpretation that the SOTUS marketing restriction applies only to funds sponsored by – and not to third-party funds invested in – by non-U.S. banking entities.[8]
Tiered, Risk-Base Compliance Regime Consistent with its approach to risk, the Revised Rule substantially modifies the required compliance regime for banking entities with moderate and limited trading assets and liabilities.  Significantly, the CEO certification, which the Original Rule had required for banking entities with $50 billion or greater in total consolidated assets, is eliminated for all such banking entities.  This in itself is significant regulatory relief.  In addition, the six-pillar compliance regime of the Original Rule applies only to banking entities with significant trading assets and liabilities.  Banking entities with only moderate trading assets and liabilities may include in their existing compliance policies and procedures appropriate references to the Volcker Rule and its implementing regulation, with adjustments as appropriate given the activities, size, scope, and complexity of the banking entity.  Entities with limited trading assets and liabilities benefit from a rebuttable presumption of compliance with the Volcker Rule. Effective Date The Revised Rule will be effective on January 1, 2020.  In order to give banking entities a sufficient amount of time to comply with the changes adopted, banking entities will not be required to comply with the Revised Rule until January 1, 2021.  Because the Revised Rule relaxes the Original Rule’s requirements, the Agencies are permitting banking entities to comply voluntarily, in whole or in part, with the Revised Rule prior to January 1, 2021, subject to the Agencies’ completion of necessary technical changes, principally with respect to metrics reporting.[9] Conclusion Ultimately, the fundamental issue with the Volcker Rule is the statute Congress passed.  In an effort to cover every activity that could be proprietary trading, while at the same time using opaque and imprecise language, Congress ensured a “hard slog” for both banking entities and their supervisors.  The Original Rule compounded this problem by interpreting the statute to expand its reach in virtually all close cases.  The Revised Rule appropriately takes a different approach, focusing on what is the overall purpose of Dodd-Frank:  the reduction of risk to banking entities and the financial system more broadly.  By streamlining overall requirements, and focusing most stringently on the banking entities with the largest trading portfolios, “Volcker 2.0” provides better guidance to banking entities and will be easier for regulators to enforce.
[1]   For purposes of these thresholds, the amount of trading assets and liabilities are calculated as the “average gross sum” of assets and liabilities on a trailing 4-quarter basis, and the following obligations are excluded:  U.S. government- and U.S. government agency-issued and -guaranteed securities, and securities issued or guaranteed by certain government-sponsored enterprises. [2]   12 U.S.C. §§ 1851(h)(4), (h)(6). [3]   12 C.F.R. § 248.3(e)(13). [4]   12 U.S.C. § 1851(d)(1)(B). [5]   See, e.g., J. Bao, M. O’Hara & A. Zhou, “The Volcker Rule and Market-Making in Times of Stress,” Finance and Economics Discussion Series 2016-102, Washington: Board of Governors of the Federal Reserve System, https://doi.org/10.17016/FEDS.2016.102, at 3 (“Our results show that bond liquidity deterioration around rating downgrades has worsened following the implementation of the Volcker Rule. We find such adverse effects whether we benchmark to the pre-crisis period or to the period just before the Volcker Rule was enacted, and we find that the relative deterioration in liquidity around these stress events is as high during the post-Volcker period as during the Financial Crisis. Given how badly liquidity deteriorated during the Financial Crisis, this finding suggests that the Volcker Rule may have serious consequences for corporate bond market functioning in stress times.”). [6]   These requirements include the requirements that at inception, the hedging position not give rise to significant new or additional risk that is not hedged contemporaneously and that hedging activity be subject to continuous review, monitoring and management. [7]   Stating that “[c]ertain concerns raised by commenters may need to be addressed through amendments to section 13 of the BHC Act,” the preamble notes how community banks were statutorily excluded from the definition of “banking entity” in 2018. [8]   The Revised Rule also clarifies that the SOTUS exemption does not preclude a non-U.S. banking entity from engaging a non-affiliated U.S. investment adviser as long as the actions and decisions of the banking entity to invest in a fund occur outside of the United States. [9]   In a formal acknowledgment of what Agency staff had previously unofficially stated, the Revised Rule relaxes the metrics that banking entities with significant trading assets and liabilities have to report.
Gibson Dunn's lawyers are available to assist in addressing any questions you may have regarding these developments.  Please contact the Gibson Dunn lawyer with whom you usually work in the firm's Financial Institutions practice group, or the following: Matthew L. Biben - New York (+1 212-351-6300, mbiben@gibsondunn.com) Arthur S. Long - New York (+1 212-351-2426, along@gibsondunn.com) Michael D. Bopp - Washington, D.C. (+1 202-955-8256, mbopp@gibsondunn.com) Jeffrey L. Steiner - Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com) James O. Springer - New York (+1 202-887-3516, jspringer@gibsondunn.com) © 2019 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

June 5, 2019 |
EMIR Refit Enters into Force on June 17, 2019 – Impacts and Action Items for End-Users

Click for PDF On May 28, 2019, final text was published in the Official Journal of the European Union (“OJEU”) for substantive amendments to the European Market Infrastructure Regulation (“EMIR”)[1] relating to the clearing obligation, the suspension of the clearing obligation, the reporting requirements, the risk-mitigation techniques for uncleared OTC derivatives contracts, the registration and supervision of trade repositories, and the requirements for trade repositories (“EMIR Refit”).[2]  EMIR Refit becomes effective on June 17, 2019 (20 days after publication in the OJEU)[3], and most of its provisions will begin applying on that date, while others will be phased in. Many of the changes of EMIR Refit aim to reduce compliance costs for end-user counterparties that are non-financial counterparties (“NFCs”) and smaller financial counterparties (“FCs”).  Some of these changes include (i) an exemption from the reporting of intragroup transactions; (ii) an exemption for small FCs from the clearing obligation, (iii) removal of the obligation and legal liability for reporting when an NFC transacts with an FC, and (iv) a determination of the NFC clearing obligation on an asset-class-by-asset-class basis.  While these amendments provide relief, end-users should be keenly aware of the nuances of the text of EMIR Refit, the extent to which relief applies, the timing and steps involved in these changes and any notifications which must be filed.  In particular, with the fast-approaching June 17, 2019 implementation date for EMIR Refit, end-users should take note of two immediate action items.  The first relates to an end-user’s requirement to perform a new calculation to determine whether or not it exceeds the clearing threshold, while the second requires an end-user to file a notification with the relevant national competent authorities (“NCAs”) in order to take advantage of an exemption for the reporting of intragroup transactions. In this alert, we outline some of the key impacts of EMIR Refit on end-users, including the changes to the clearing threshold calculations, the intragroup exemption from reporting and the relief provided to shift responsibility of the reporting obligation from NFCs below the clearing threshold to FCs, as well as the action items resulting from these changes.[4]

I.  Changes to Clearing Threshold Calculation – Immediate Action Required

EMIR Refit creates a new regime to determine when an NFC and an FC are subject to the clearing obligation.  These determinations will be based on whether the position of an NFC or an FC, as applicable, exceeds the requisite clearing thresholds.  In particular, the NFCs and FCs must determine whether their aggregate month-end average position for the previous 12 months across the entire group exceeds any of the thresholds for a particular asset class.  If an NFC or FC does not make this calculation by June 17, 2019, or if it exceeds the calculation, it must notify the European Securities and Markets Authority (“ESMA”) and the relevant NCA immediately and such NFC or FC will become subject to the clearing obligation beginning four months following such notifications.[5]  Further, NFCs and FCs that are currently subject to the clearing obligation and that remain subject to the clearing obligation under EMIR Refit must still provide notifications to ESMA and the relevant NCA. A.  Impacts on and Action Items for NFCs Under EMIR Refit, whether an NFC is subject to the clearing obligation is separately determined for each particular asset class for which the clearing threshold is exceeded.  Previously, EMIR required that if an NFC exceeded the clearing threshold in one asset class, then all of its OTC derivatives would be subject to the clearing obligation (to the extent the clearing obligation was applicable); however, EMIR Refit modifies this “all or nothing” requirement for NFCs.  Instead, the clearing obligation under EMIR Refit is determined on an asset-class-by-asset-class basis such that an NFC may exceed the clearing threshold for one asset class and be subject to the clearing obligation for that asset class, but may not be subject to the clearing obligation for other asset classes where the NFC does not exceed the clearing threshold.  If an NFC exceeds the clearing obligation in one asset class, it is nonetheless subject to margin requirements for all of its OTC derivatives transactions as the NFC exemption from margin for OTC derivatives remains an “all or nothing” determination.[6] EMIR Refit changes the way in which the entities calculate their positions by replacing Articles 10(1) and (2) of EMIR (which provided that NFCs are required to determine whether their rolling average position over 30 working days) with new provisions that provide that NFCs may calculate, every 12 months, their aggregate month-end average OTC derivatives positions for the previous 12 months across their entire worldwide group and for each asset class.[7]  NFCs would exclude from the calculation transactions that are “objectively measurable as reducing risks related to commercial activity or treasury financing activity” of the NFC or the NFC group (e.g., hedging transactions do not count towards the clearing threshold calculation) but would include intragroup transactions in the calculation.[8]  This average position in each asset class must then be compared against the following clearing thresholds[9]:
Asset class Gross Notional Threshold
Credit Derivatives €1 billion
Equity Derivatives €1 billion
Interest Rate Derivatives €3 billion
Foreign Exchange Derivatives €3 billion
Commodity and Other Derivatives €3 billion
The first calculation must be performed by June 17, 2019 and once a year thereafter.  As mentioned above, if an NFC does not calculate its positions it will by default become subject to the clearing obligation in all asset classes.  We note that NFCs that make the calculation and determine that they fall below the clearing threshold in all asset classes, while not required to notify ESMA or their NCA, will nonetheless be required to notify their counterparties.  Indeed, ESMA recently updated its EMIR Q&A to explain that a “counterparty should obtain representations from its counterparties detailing their status” and noted that if a representation is not obtained from a counterparty it must be assumed that the counterparty is subject to the clearing obligation.[10] Four Key Action Items for NFCs
  1. Collect the necessary data and calculate OTC derivatives positions by asset class by June 17, 2019 and compare against the clearing thresholds (failure to do so will render the NFC subject to the clearing obligation and margin requirements).  NFCs should make such calculation in accordance with the requirements under EMIR Refit and should maintain appropriate documentation of such calculation for audit purposes.
  2. Notify ESMA and the relevant NCA (i) if the clearing threshold is breached in one or more asset classes or (ii) if no calculation is performed.  In the event the notifying NFC is subject to the clearing obligation, such NFC is required to establish clearing arrangements within four months of the notification.
  3. Notify counterparties of clearing status (i.e., whether above or below the threshold) and make any relevant changes to existing documentation.
  4. Ensure that reporting fields are consistent with any changes to the NFC’s clearing requirements.
Impacts on and Action Items for Small FCs EMIR Refit enables certain FCs with limited OTC derivatives activities to be excluded from the clearing obligation.  Previously, EMIR required all FCs to comply with the relevant clearing requirements regardless of the amount of their activities such that every FC was subject to the clearing obligation.  By comparison, the exclusion for FCs is much more limited than the exclusion for NFCs; unlike NFCs, FCs are required to include all OTC derivatives activities in their clearing threshold calculation, including hedging transactions, and FCs maintain the “all or nothing” calculation and do not benefit from the more nuanced asset-class-by-asset-class determination.[11]  In all cases, FCs will remain subject to margin requirements on OTC derivatives.[12] Under EMIR Refit, FCs may calculate, every 12 months, their aggregate month-end average OTC derivatives positions for the previous 12 months across their entire worldwide group and for each asset class.  FCs would not exclude any OTC derivatives transactions from these calculations and would include hedging and intragroup transactions for other entities within the FC’s group.  This average position in each asset class must then be compared against the same clearing thresholds described above for NFCs. Just like NFCs, FCs must make their first calculation by June 17, 2019 and then each year thereafter.  Those FCs that do not make the calculation or that exceed the clearing threshold in one asset class would be subject to the clearing obligations in all asset classes and must notify ESMA and the relevant NCA immediately.  Further, even those FCs that fall below the clearing threshold will be required to notify by their counterparties of their status. Four Key Action Items for FCs
  1. Collect the necessary data and calculate OTC derivatives positions by asset class by June 17, 2019 and annually thereafter (failure to do so will render the FC subject to the clearing obligation).  FCs should make such calculation in accordance with the requirements under EMIR Refit and should maintain appropriate documentation of such calculation for audit purposes.
  2. Notify ESMA and relevant NCA (i) if the clearing threshold is breached in one or more asset classes or (ii) if no calculation is performed.  In the event the notifying FC is subject to the clearing obligation, such FC is required to establish clearing arrangements within four months of the notification.
  3. Notify counterparties of clearing status (i.e., whether above or below the threshold) and make any relevant changes to existing documentation.
  4. Ensure that reporting fields are consistent with any changes to the FC’s clearing requirements.

II.  Exemption from Intragroup Transaction Reporting – Immediate Action Required

Under the current reporting requirements in Article 9 of EMIR, all counterparties subject to EMIR are required to report their intragroup transactions (i.e., inter-affiliate transactions) to a trade repository.  However, effective June 17, 2019, EMIR Refit provides relief to NFCs from the requirement to report these intragroup transactions in certain circumstances.  Specifically, EMIR Refit provides an exemption from the reporting of derivatives contracts “within the same group where at least one of the counterparties is [an NFC] or would be qualified as [an NFC] if it were established in the [EU]” subject to the following criteria:
  1. Both counterparties are included in the same consolidation on a full basis;
  2. Both counterparties are subject to appropriate centralized risk evaluation, measurement and control procedures; and
  3. The parent undertaking is not an FC.[13]
While this intragroup exemption from reporting is likely to provide significant relief to NFCs (particularly the global nature of the exemption), it is important to note that the exemption is not self-executing and that notification to the relevant NCA is required.  Specifically, the text requires counterparties wishing to take advantage of the exemption to “notify their competent authorities of their intention to apply the exemption.”[14]  The text further explains that “[t]he exemption shall be valid unless the notified competent authorities do not agree upon the fulfilment of the conditions [of such exemption] within three months of the date of notification.”[15] The language as drafted lacks some clarity as to how such notification to an NCA may be achieved in order to perfect this intragroup exemption.  For example, it is not clear what form the notification must take, whether it can cover multiple entities and whether a notification for one jurisdiction on behalf of the group may be recognized in another jurisdiction.  Further, while EMIR Refit creates a notification requirement and not an “approval” requirement, market participants must determine whether they seek to take advantage of the intragroup exemption upon notification to the NCA(s) or choose to wait until the three-month NCA response period lapses. NCAs may have different views and requirements with respect to what is required of this notification, but a multinational corporation with affiliates in multiple EU countries may be required to notify the NCA of each jurisdiction in which an affiliate seeking to rely on the intragroup exemption is located.  Accordingly, any counterparty seeking to take advantage of the intragroup exemption should review whether its NCA has provided guidance regarding the notification and/or reach out to its NCA to review with the applicable notification requirements for purposes of claiming the intragroup exemption.[16] Key Action Item for NFCs
Those NFCs that wish to rely on the intragroup exemption from reporting must notify their relevant NCAs that they intend to rely on the exemption in order for such exemption to be available (following such notification(s), the intragroup exemption will apply unless the NCA responds three months to inform the NCA that it does not agree that the conditions for the intragroup exemption are met).

III.  Changes to Reporting Obligation for NFCs Below the Clearing Threshold (“NFC-s”)

Article 9 of EMIR currently provides a dual-sided reporting regime where all parties subject to EMIR must report the details of their OTC derivatives to a trade repository.  EMIR Refit seeks to ease these reporting burdens for NFC-s by providing that FCs will be “solely responsible and legally liable” for reporting contracts concluded with an NFC- on behalf of both counterparties, as well as for ensuring the accuracy of the details so reported.[17]  In other words, EMIR Refit does not create a single-sided reporting regime, but rather modifies its existing dual-sided reporting regime such that the FC will be responsible for reporting data for itself and for the NFC- where the NFC- retains no legal liability for the reporting of such data or the accuracy of the details of such data.[18]  NFC-s are responsible for providing the FC that is reporting the data with the details of the contracts that the FC “cannot be reasonably expected to possess” and the NFC- will remain responsible for the accuracy of that information.[19] EMIR Refit notably does not extend this reporting relief to OTC derivatives between an NFC- and a third-country counterparty that would be an FC if established in the EU (a “third-country FC”), unless the third-country reporting regime has been deemed equivalent and the third-country FC has reported the relevant transactions under such equivalent regime.  These restrictions on third-country FCs are particularly important given that the United States has not been deemed an equivalent regime and counterparties domiciled in the United Kingdom will become third-country FCs following the United Kingdom’s expected exit from the EU later this year.[20] Additionally, EMIR Refit provides NFC-s that have already invested in a reporting system with the option to opt out of this new regime and continue to report the details of their contracts that have been executed with FCs in the same manner as they report under EMIR, rather than having the FC counterparty report on behalf of the NFC-, by informing the FC that they would like to do so.[21] Unlike the intragroup exemption and the changes to the clearing obligation, these changes to the reporting obligation do not come into force until June 18, 2020. Three Key Action Items for NFC-s
  1. NFC-s should identify which of their counterparties are FCs in order to determine the counterparty relationships that will benefit from this relief and those where the NFC- will retain the reporting obligation (this will help to identify where delegated reporting agreements can be terminated and where they should remain in place).
  2. Provide information to FC counterparties that they cannot reasonably be expected to possess (FCs will likely reach out for this information (e.g., whether a transactions is a hedging transaction)).
  3. NFC-s that wish to opt out of the new reporting regime and continue to report the details of their OTC derivatives should notify their FC counterparties as soon as possible.

   [1]   Regulation (EU) No 648/2012 of the European Parliament and Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories.
   [2]   Regulation (EU) No 2019/834 of the European Parliament and Council of 20 May 2019 amending Regulation (EU) No 648/2012 as regards the clearing obligation, the suspension of the clearing obligation, the reporting requirements, the risk-mitigation techniques for OTC derivatives contracts not cleared by a central counterparty, the registration and supervision of trade repositories and the requirements for trade repositories.
   [3]   In 2015, the European Commission conducted a comprehensive review of the EMIR to help to reduce disproportionate costs and burdens imposed by EMIR and simplify rules without putting financial stability at risk.  This review included, among other things, the European Commission’s Public Consultation on the Regulation (EU) No 648/2012 on OTC derivatives, central counterparties and trade repositories and their broader Call for Evidence on the European Union (“EU”) regulatory framework for financial services.  See Public Consultation on Regulation (EU) No 648/2012 on OTC Derivatives, Central Counterparties and Trade Repositories; see also Call for Evidence, EU Regulatory Framework for Financial Services.  Following this review, on May 4, 2017, the European Commission proposed amendments to EMIR in the context of its Regulatory Fitness and Performance (Refit) program.  The EU Council published its compromise text on December 11, 2017 and ECON Committee report was adopted by EU Parliament on May 16, 2018.  The EU Council and EU Parliament reached political agreement on EMIR Refit on February 5, 2019.  Following that, Parliament’s ECON Committee approved the text, it was approved in plenary, adopted by EU Council and ultimately signed on May 20, 2019.
   [4]   EMIR Refit also (i) extends the definition of “financial counterparties” to include EU alternative investment funds (AIFs) and their EU alternative investment fund managers (AIFMs); (ii) ends the frontloading requirement; (iii) ends the backloading requirement; (iv) provides power for ESMA and the European Commission to suspend the clearing and derivatives trading obligation; (v) extends the clearing exemption for risk-reducing transactions of pension schemes for two additional years with the ability to extend further; (vi) creates an obligation to provide clearing services on fair, reasonable, non-discriminatory and transparent terms (FRANDT); and (vii) requires regulators to validate risk management procedures for the exchange of collateral.
   [5]   See ESMA Public Statement, Implementation of the new EMIR Refit regime for the clearing obligation for financial and non-financial counterparties, March 28, 2019, available at https://www.esma.europa.eu/sites/default/files/library/esma70-151-2181_public_statement_on_refit_implementation_of_co_regime_for_fcs_and_nfcs.pdf.
   [6]   Recital (8) of EMIR Refit explains that “[NFCs] should nonetheless remain subject to the requirement to exchange collateral where any of the clearing thresholds is exceeded.”
   [7]   Article 1(8)(a) of EMIR Refit.
   [8]   Article 10(1) of Commission Delegated Regulation (EU) No 149/2013.
   [9]   The clearing thresholds are defined under Article 11 of Commission Delegated Regulation (EU) No 149/2013.
[10]   ESMA, Questions and Answers, Implementation of the Regulation (EU) No 648/2012 on OTC derivatives, central counterparties and trade repositories (EMIR), pp. 21-22 (May 28, 2019).
[11]   Article 1(3) of EMIR Refit.
[12]   Recital (7) of EMIR Refit explains that “small financial counterparties should be exempted from the clearing obligation, but they should remain subject to the requirement to exchange collateral to mitigate any systemic risk.”
[13]   Article 1(7)(a) of EMIR Refit.
[14]   Id.
[15]   Id.
[16]   We note that some NCAs have provided guidance or forms on how notification of the reliance on the intragroup exemption should be submitted while others have not.  See, e.g., EMIR: FCA Notification for an Intragroup Exemption from Reporting, available at https://www.fca.org.uk/publication/forms/emir-reporting-exemption-form.pdf.
[17]   Article 1(7)(b) of EMIR Refit.
[18]   While many NFC-s currently delegate the reporting responsibility to their counterparties, under EMIR delegated reporting the NFC-s retain the legal liability to report and for the accuracy of the data that is reported by the counterparties on the NFC-’s behalf.
[19]   Id.
[20]   For example, if an NFC- were to transact with an EU bank, the NFC- would no longer have a reporting obligation; however, if the NFC- were to transact with a US-based bank, the NFC- would retain the reporting obligation and delegated reporting would likely be desired.
[21]   It should be noted that if an NFC- decides to opt-out of the new EMIR Refit reporting regime, it will retain the legal liability for reporting the OTC derivatives data as well as the liability for ensuring the accuracy of such data.

The following Gibson Dunn lawyers assisted in preparing this client update: Jeffrey Steiner and Erica Cushing. Gibson Dunn's lawyers are available to assist in addressing any questions you may have regarding these developments.  Please contact the Gibson Dunn lawyer with whom you usually work in the firm's Financial Institutions and Derivatives practice groups, or any of the following: Europe: Patrick Doris - London (+44 20 7071 4276, pdoris@gibsondunn.com) Amy Kennedy - London (+44 20 7071 4283, akennedy@gibsondunn.com) Lena Sandberg - Brussels (+32 2 554 72 60, lsandberg@gibsondunn.com) United States: Michael D. Bopp - Washington, D.C. (+1 202-955-8256, mbopp@gibsondunn.com) Arthur S. Long - New York (+1 212-351-2426, along@gibsondunn.com) Jeffrey L. Steiner - Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com) Erica N. Cushing - Denver (+1 303-298-5711, ecushing@gibsondunn.com)
© 2019 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

May 16, 2019 |
Impact of CFTC’s Proposed Amendments to Swap Data Reporting Requirements on Reporting and Non-Reporting Counterparties

Click for PDF On May 13, 2019, the Commodity Futures Trading Commission (the “Commission” or the “CFTC”) published a notice of proposed rulemaking titled Proposed Amendments to the Commission’s Regulations Relating to Certain Swap Data Repository and Data Reporting Requirements (the “Proposal”).[1]  The Proposal seeks to modify existing swap data reporting requirements in Part 23 of the Commission’s regulations for swap dealers (“SDs”) and major swap participants (“MSPs”), Parts 43 and 45 of the Commission’s regulations for “reporting parties” and “reporting counterparties” (as such terms are defined in the Commission’s regulations),[2] and Part 49 of the Commission’s regulations for swap data repositories (“SDRs”).  The Proposal is the first rulemaking adopted by the CFTC following its Division of Market Oversight’s (the “Division”) July 2017 comprehensive analysis of the CFTC’s swap data reporting regulations, which was titled the Roadmap to Achieve High Quality Swaps Data (the “Roadmap”).[3]  In the Roadmap, the Division solicited public feedback on potential improvements to the CFTC’s swap data reporting regime in a manner that would achieve the CFTC’s regulatory goals of swap data transparency under the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”)[4] without imposing unnecessary burdens on market participants. Consistent with the Roadmap’s goals, the CFTC’s expressed objectives in adopting the Proposal are to “improve the accuracy of data reported to, and maintained by, SDRs,” “require reporting counterparties to verify the accuracy of swap data pursuant to […] SDR procedures,” and “provide enhanced and streamlined oversight over SDRs and data reporting generally.”[5]  The CFTC notes that the Proposal is the first of three planned rulemakings as described in the Roadmap.[6]  While most of the Proposal’s amendments are intended to modify Part 49 of the Commission’s regulations, which covers SDR registration requirements, SDR operational duties, and the CFTC’s oversight over SDRs generally, the Proposal also would make certain substantive amendments to the swap data reporting requirements for SDs and MSPs under Part 23 and reporting counterparties (and non-reporting counterparties) under Parts 43 and 45 (the “Counterparty Reporting Rules”).[7]  This Client Alert focuses on the Proposal’s modifications to the Counterparty Reporting Rules.  With respect to the Counterparty Reporting Rules, the Proposal notes that current swap data that is available to the CFTC lacks accuracy.  This view has been specifically echoed by CFTC Chairman J. Christopher Giancarlo and several other past and current CFTC Commissioners.[8] To address these concerns regarding accuracy and data quality, the Proposal includes specific amendments to the Counterparty Reporting Rules.  In particular, the Proposal, if adopted, would establish:  (1) new swap data accuracy verification requirements for reporting counterparties within certain timeframes depending on the type of reporting counterparty (i.e., different requirements for SDs/MSPs versus non-SDs/MSPs); (2) revisions to existing swap data error and omission rules for reporting counterparties; and (3) enhanced requirements for SDs and MSPs in terms of their written policies and procedures for swap data reporting under Parts 43 and 45 of the Commission’s regulations.  In the sections below, we have summarized each of these three proposed amendments to the Counterparty Reporting Rules and its impact on the reporting counterparties. The Proposal’s comment period deadline is July 29, 2019.  Since the Proposal and two anticipated proposed rulemakings that are expected to follow will address interconnected issues, the CFTC plans to re-open the comment period for the Proposal at the same time it issues each anticipated rulemaking so that commenters can provide comments on the three rulemakings altogether. Please contact a member of Gibson Dunn’s Derivatives Team if you have any questions regarding the Proposal.

1.    Swap Data Verification

The Proposal, if adopted, would establish new swap data accuracy verification requirements for reporting counterparties within certain timeframes depending on the type of reporting counterparty.  The Proposal’s amendments relating to data verification fall under Part 45 of the Commission’s regulations, which generally focuses on the duties of reporting counterparties to report swap data to SDRs for regulatory purposes.  The current Counterparty Reporting Rules do not explicitly require reporting counterparties to verify the data reported with the relevant SDR.  However, the Proposal would create a mandate that all reporting counterparties must verify their swap data for accuracy and completeness with reports provided by the SDR.[9]  Effectively, the Proposal would require a reporting counterparty to reconcile their internal books and records for each open swap against any and all open swaps reflected in an open swap report received from an SDR.[10]  Further, reporting counterparties would be required to conform to any swap data verification policies and procedures enacted by an SDR.[11] The Proposal includes specific timing requirements for reporting counterparty data verification as well as the timing of the frequency of the open swaps reports to be distributed by the SDR.  The open swaps reports must be distributed by the SDR to SD, MSP and DCO reporting counterparties on a weekly basis and to non-SD and non-MSP reporting counterparties on a monthly basis.[12]  Upon receipt and review of the open swaps report, reporting counterparties must submit either a (i) verification of data accuracy[13] or (ii) notice of discrepancy in response to every open swaps report received from an SDR within the following timeframes:  (a) 48 hours of the SDR’s providing the open swaps report if the reporting counterparty is a SD or MSP; or (b) 96 hours of the SDR’s providing the open swaps report for non-SD/MSP reporting counterparties.[14]  In the event that the reporting counterparty finds no discrepancies between its books and records and the data in the SDR’s open swap report, the reporting counterparty must nonetheless submit a verification of data accuracy indicating that the swap data is complete and accurate to the SDR in accordance with the aforementioned timing requirements.[15]  If, however, the reporting counterparty finds a discrepancy in the swap data (i.e., over-reporting or under-reporting), the reporting counterparty must submit a notice of discrepancy to the SDR in accordance with the timing outlined above.[16] The Commission explains that the Proposal’s swap data verification rules aim to improve swap data quality by facilitating the swift resolution of any discrepancies between the swap data maintained by an SDR and the information on record with a reporting counterparty.  However, the data verification requirements of the Proposal would impose new and notable obligations on all reporting counterparties (including smaller, non-SD/non-MSP reporting counterparties) that are not in existence under today’s reporting rules.  In particular, the Proposal would require reporting counterparties to review the SDR’s policies and procedures around the verification process, to build comprehensive systems to verify the swap data reported to the SDR by comparing its internal records against open swaps reports received from the SDR, and to send verification or discrepancy notices to the SDR within relatively short timeframes.  As reporting counterparties already report information to SDRs under the Counterparty Reporting Rules, the Commission expressed its belief that SDRs and reporting counterparties would coordinate with one another to implement a system which is efficient and convenient for both parties, with particular attention to not be unnecessarily burdensome to non-SD/MSP and non-derivatives clearing organization reporting counterparties.[17]  Further, many reporting counterparties report swap data to more than one SDR and given that each SDR will have its own unique policies and procedures, the verification process will differ between SDRs.

2.    Changes to Errors and Omissions Reporting

If adopted, the Proposal would also revise the swap data error and omission correction requirements for reporting counterparties.[18]  Currently, the error and omission correction requirements under Part 43 and those under Part 45 have substantive differences from one another.  For example, Part 43 requires a reporting counterparty that “becomes aware of an error or omission in the swap transaction and pricing data” to “promptly notify the other party of the error and/or correction” while Part 45 does not have a similar notification requirement for the reporting counterparty to provide such notice.[19]  The Proposal would seek to fix the gaps between the two rules and would require reporting counterparties to correct any errors and omissions to which they may be aware, including, but not limited to, errors or omissions present in the swap data in the open swaps reports provided as part of the verification process specific in the Proposal.  For example, Proposed regulations 43.3(e)(1) and 45.14(b)(1) provide that to the extent that a reporting counterparty becomes aware of any error or omission in swap data previously reported to an SDR, the reporting counterparty must submit corrected swap data to the SDR.[20]  The error and omissions correction requirements would apply regardless of the state of the swap.  In other words, it would include the correction of live swaps and swaps that are no longer active (i.e., which are commonly referred to as “dead trades”). In addition, the Proposal would establish specific error and correction procedures for reporting counterparties.  In particular, the Proposal would retain the current error and correction procedure in the Counterparty Reporting Rules that requires reporting counterparties to correct swap data “as soon as technologically practicable” following discovery of the errors or omissions.[21]  The Proposal would modify the “as soon as technologically practicable” timing requirement by creating a backstop of three business days after the discovery of the error or omission.[22]  In the event that the reporting counterparty is unable to correct errors or omissions within three business days of discovery, the Proposal would require the reporting counterparty to immediately inform the Director of DMO, or such other CFTC employees whom the Director of DMO may designate, in writing, of the errors or omissions and provide an initial assessment of the scope of the errors or omissions and an initial remediation plan for correcting the errors or omissions.[23]  Proposed regulations 43.3(e)(1)(iii) and 45.14(b)(1)(iii) would require that a reporting counterparty conform to the SDR’s policies and procedures for correction of errors and omissions that the SDRs would be required to create under the Proposal.[24] The Proposal would also establish new requirements for non-reporting counterparties.  Proposed regulations 43.3(e)(2) and 45.14(b)(2) would require a non-reporting counterparty that “by any means becomes aware” of an error or omission in swap data previously reported to an SDR, or the omission of swap data for a swap that was not previously reported to an SDR as required, to notify its counterparty to the swap (i.e., the reporting counterparty) as soon as technologically practicable following discovery of the errors or omissions, but no later than three business days following the discovery of the errors or omissions.[25]  This section of the Proposal also specifies that a non-reporting counterparty that does not know the identity of the reporting counterparty for a swap must notify the SEF or DCM where the swap was executed of the errors or omissions as soon as technologically practicable following discovery of the errors or omissions, but no later than three business days after the discovery.[26]  In the Proposal, the Commission expressed its hope that the requirement to correct all swap data, regardless of status, would ensure that reporting counterparties establish and maintain properly functioning reporting systems to prevent the reporting of errors or omissions. The Proposal’s modifications to the errors and omissions correction requirements would notably make Parts 43 and 45 of the Commission’s regulations consistent in this regard.  In particular, the Proposal would remove the counterparty notification requirement set forth in current CFTC regulation 43.3(e)(1)(i).  However, the Proposal would create a more definitive timeframes in which reporting counterparties are required to correct errors and omissions and in which non-reporting counterparties are required to notify their counterparties of any such errors or omissions.  With respect to non-reporting counterparties, the current rules require that when a non-reporting counterparty “discovers” an error or omission it must “promptly notify” the reporting counterparty of such error or omission.  The Proposal would create more stringent requirements in this regard such that non-reporting counterparties that merely become “aware” of an error or omission by “any means” must notify the reporting counterparty “as soon as technologically practicable” but no later than three business days.  Further the Proposal clarifies that the non-reporting counterparty’s notification obligation with respect to omissions extends to data that was not reported to an SDR (but that presumably should have been reported).

3.    SD and MSP Requirements

The Proposal would also establish enhanced requirements for SDs and MSPs with respect their written policies and procedures for swap data reporting under parts 23, 43, and 45 of the Commission’s regulations.  Under the current regime, SDs and MSPs are required to report all information and swap data required for swap transactions when they are reporting counterparties for purposes of regulatory and real-time public reporting.[27]  SDs and MSPs are also required to implement electronic systems and procedures necessary to transmit electronically all information and swap data required to be reported in accordance with Part 43 and Part 45.[28]  The Proposal would require each SD and MSP to establish, maintain and enforce written policies and procedures that are reasonably designed to ensure that the SD and MSP comply with all obligations to report swap data to an SDR, which would include any requirements under Part 43 and Part 45, as well as any rules established by the SDR.[29]  The preamble to the Proposal sets forth specific content that would be expected to be included in the SD or MSP’s policies and procedures.[30] The Proposal also would require SDs and MSPs to review their policies and procedures on an annual basis and to update them as needed to reflect the requirements in Part 43 and Part 45.[31]  The Commission believes that the annual review requirement in the Proposal would ensure that SDs’ and MSPs’ policies and procedures remain current and effective over time.  SDs and MSPs are currently expected to establish policies and procedures related to all of their swap market activities, including their swap data reporting obligations.[32]  The Proposal’s amendments to Part 23 would make the expectations around these policies and procedures explicit by creating new obligations and setting forth guidance around content regarding reporting policies and procedures, rather than merely cross-referencing Parts 43 and 45 as we see under the current regulations.

[1]      Certain Swap Data Repository and Data Reporting Requirements, 84 Fed. Reg. 21044 (May 13, 2019).
[2]      See 17 C.F.R. § 43.3(a)(3) (sets forth the determination of which counterparty to a swap transaction is the “reporting party” and has the obligation to report swap data to an SDR for purposes of real-time public reporting); 17 C.F.R. § 45.8 (sets forth the determination of which counterparty to a swap transaction is the “reporting counterparty” and has the obligation to report swap data to an SDR for purposes of regulatory reporting).  For purposes of this Client Alert, the term “reporting counterparty” will refer to both a “reporting party” under Part 43 and a “reporting counterparty” under Part 45.
[3]      Division of Market Oversight, Roadmap to Achieve High Quality Swaps Data, U.S. Commodity Futures Trading Commission, July 10, 2017, available at http://www.cftc.gov/idc/groups/public /@newsroom/documents/file/dmo_swapdataplan071017.pdf.
[4]      Dodd-Frank Wall Street Reform and Consumer Protection Act, 124 Stat. 1376, Pub. Law 111-203 (July 21, 2010), as amended.
[5]      Proposal at 21044.
[6]      Proposal at 21045.
[7]      The Proposal also includes proposed amendments to the reporting requirements for derivatives clearing organizations (“DCOs”), swap execution facilities (“SEFs”), and designated contract markets (“DCMs”) to the extent that these entities are also reporting counterparties.  This Client Alert is focused on the Proposal’s specific impact on the Counterparties and, for that reason, does not discuss the proposed amendments impacting DCOs, SEFs, and DCMs. [8]      Speech by Commissioner J. Christopher Giancarlo, Making Market Reform Work for America (Jan. 18, 2017), available at http://www.cftc.gov/PressRoom/SpeechesTestimony/opagiancarlo-19 (“The CFTC has faced many challenges in optimizing swap data ranging from data field standardization and data validation to analysis automation and cross-border data aggregation and sharing.  Market participants vary significantly in how they report the same data field to SDRs.  Those same SDRs vary in how they report the data to the CFTC”). Statement by Commissioner Scott D. O’Malia, SIFMA Compliance and Legal Society Annual Seminar (Mar. 19, 2013), available at http://www.cftc.gov/PressRoom/SpeechesTestimony/opaomalia-22 (“In a rush to promulgate the reporting rules, the Commission failed to specify the data format reporting parties must use when sending their swaps to SDRs.  In other words, the Commission told the industry what information to report, but didn’t specify which language to use.  This has become a serious problem. . . .  The end result is that even when market participants submit the correct data to SDRs, the language received from each reporting party is different.  In addition, data is being recorded inconsistently from one dealer to another.”). Speech by Commissioner Dan M. Berkovitz, Proposed Amendments to the Commission’s Regulations Relating to Certain Swap Data Repository and Data Reporting Requirements (Apr. 25, 2019), available at https://www.cftc.gov/PressRoom/SpeechesTestimony/berkovitzstatement042519 (“Accurate, complete, and timely information is therefore vital to any successful swap data reporting regime.  These objectives were central to post-crisis reform efforts, and they must remain the primary considerations as the Commission moves to enhance its reporting rules”). [9]    Proposal at 21098.  Proposed § 45.14(a) addresses the verification of swap data accuracy against the SDR’s open swaps report. [10]   Proposal at 21098.  Proposed § 45.14(a)(1) addresses a reporting counterparty’s requirement to verify the accuracy and completeness against the open swap reports from the SDR. [11]   Proposal at 21103.  Proposed § 49.11 would set forth rules around such SDR policies and procedures relating to verification of swap data accuracy and would require the SDR to verify the accuracy of the data with reporting counterparties. [12]   Proposal at 21103.  Proposed §§ 49.11(b)(2) and (3) address the timing obligations for SDRs to distribute open swaps reports to reporting counterparties. [13]   For purposes of clarification, examples of unsatisfactory verification may include:  (i) failure to perform the verification in a timely manner and (ii) providing a verification of data accuracy indicating that the swap data was complete and accurate for swap that was not correct when verified. [14]   Proposal at 21098.  Proposed § 45.14(a)(2) addresses the timing in which such verification against the open swap reports from the SDR must occur.  This proposed requirement would also treat DCO reporting counterparties in the same way it does SD and MSP reporting counterparties. [15]   Proposal at 21098.  Proposed § 45.14(a)(3) addresses the requirement to submit a verification of data accuracy regardless of whether there are discrepancies identified.  Such verification would be required to be submitted in the form and manner required by the SDR’s swap data verification policies and procedures. [16]   Proposal at 21098.  Proposed § 45.14(a)(4) addresses the requirement to submit a notice of discrepancy in the event of any inconsistencies.  Such notice of discrepancy would need to be submitted in the form and manner required by the SDR’s swap data verification policies and procedures. [17]   Proposal at 21068. [18]   Proposal at 21097-21099.  Proposed §§ 43.3(e) and 45.14(b) address the error and omission correction requirements for Parts 43 and 45 of the CFTC’s regulations. [19]   17 C.F.R. § 43.3(e)(1)(i). [20]   Proposal at 21098-21099. [21]   17 C.F.R. §§ 43.3(e)(3), 43.3(e)(4), 45.14(a). [22]   Proposal at 21098-21099.  Proposed §§ 43.3(e)(1)(i) and 45.14(b)(1)(i) address the timing for errors and corrections. [23]   Proposal at 21098-21099.  Proposed §§ 43.3(e)(1)(ii) and 45.14(b)(1)(ii) address the requirement to notify the Director of the Division of Market Oversight if the error correction timing cannot be met. [24]   Proposal at 21098-21099. [25]   Proposal at 21098-21099.  The Proposal makes clear that the non-reporting counterparty is not only responsible for notifying the reporting counterparty of errors or omissions in the data that is reported, but also to notify the reporting counterparty of data that was not reported to an SDR. [26]   Proposal at 21099-21099.  Proposed §§ 43.3(e)(2) and 45.14(b)(2) would also require that if the reporting counterparty, SEF or DCM, as applicable, and the non-reporting counterparty agree that the swap data for a swap is incorrect or incomplete, the reporting counterparty, SEF or DCM, as applicable, must correct the swap data in accordance with proposed § 43.3(e)(1) or § 45.14(b)(1), as applicable. [27]   See 17 C.F.R. §§ 23.204(a), 23.205(a). [28]   See 17 C.F.R. §§ 23.204(b), 23.205(b). [29]   Proposal at 21097. [30]   With respect to Part 45, the Proposal explains that such policies and procedures would include, but not be limited to: (i) the reporting process and designation of responsibility for reporting swap data, (ii) reporting system outages or malfunctions (including the use of back-up systems), (iii) verification of all swap data reported to an SDR, (iv) training programs for employees responsible for reporting under Part 45, (v) control procedures relating to reporting under Part 45 and designation of personnel responsible for testing and verifying such policies and procedures; and (vi) reviewing and assessing the performance and operational capability of any third party that carries out any duty required by Part 45 on behalf of the SD or MSP as well as any rules established by the SDR.  With respect to Part 43, the Proposal explains that such policies and procedures would include, but not be limited to:  (i) the reporting process and designation of responsibility for reporting swap transaction and pricing data, (ii) reporting system outages or malfunctions (including use of back-up systems), (iii) training programs for employees responsible for reporting under Part 43, (iv) control procedures relating to reporting under Part 43 and designation of personnel responsible for testing and verifying such policies and procedures, (v) reviewing and assessing the performance and operational capability of any third party that carries out any duty required by Part 43 on behalf of the SD or MSP; and (vi) the determination of whether a new swap transaction or amendment, cancelation, novation, termination, or other lifecycle event of an existing swap, is subject to the real-time reporting requirements under Part 43.  Proposal at 21073. [31]   Proposal at 21097. [32]   See, e.g., 17 C.F.R. § 3.3(d)(1) (requiring a chief compliance officer to administer each of the registrant’s policies and procedures relating to its business as an SD/MSP that are required to be establish pursuant to the Act and the Commission’s regulations); 17 CFR § 3.2(c)(3)(ii) (requiring the National Futures Association to assess whether an entity’s SD/MSP documentation demonstrates compliance with the Section 4s Implementing Regulation to which it pertains which includes § 23.204 and § 23.205).
The following Gibson Dunn lawyers assisted in preparing this client update: Jeffrey Steiner, Carl Kennedy and Erica Cushing. Gibson Dunn's lawyers are available to assist in addressing any questions you may have regarding these developments.  Please contact the Gibson Dunn lawyer with whom you usually work in the firm's Financial Institutions and Derivatives practice groups, or any of the following: Arthur S. Long - New York (+1 212-351-2426, along@gibsondunn.com) Michael D. Bopp - Washington, D.C. (+1 202-955-8256, mbopp@gibsondunn.com) Jeffrey L. Steiner - Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com) Carl E. Kennedy - New York (+1 212-351-3951, ckennedy@gibsondunn.com) Erica N. Cushing - Denver (+1 303-298-5711, ecushing@gibsondunn.com) © 2019 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

December 7, 2018 |
Derivatives End-User’s Guide to the QFC Resolution Stay Requirements

Click for PDF Last year, the Board of Governors of the Federal Reserve System[1], the Federal Deposit Insurance Corporation ("FDIC")[2], and the Office of the Comptroller of the Currency[3] issued final rules (collectively, the "U.S. Rules") requiring globally systematic banking organizations ("G-SIBs") in the United States and their subsidiaries, as well as all U.S. operations of non-U.S. G-SIBs (each, a "Covered Entity")[4]  to include in their qualified financial contracts ("QFCs")[5] language that provides for contractual stays on early termination rights.  By now, most buy-side counterparties to QFCs, including corporates and other non-financial end-users (collectively, "End-User Counterparties") have been contacted by their Covered Entity counterparties with a request to amend their QFCs by January 1, 2019 to include contractual language so that the Covered Entities can comply with the U.S. Rules. This Alert provides a brief background on the U.S. Rules from an End-User Counterparty's perspective, reviews the impacts of the U.S. Rules on End-User Counterparties and highlights practical considerations for End-User Counterparties. If you have any questions regarding this Gibson Dunn Alert, please contact a member of the Derivatives Team.[6]         I.   Background The economic dislocation in 2008, and in particular the Lehman Brothers failure, highlighted the interconnectedness of the world's financial systems.  As a result, the Financial Stability Board and home country regulators focused on ways to minimize the impact of a G-SIB failure on the global financial system.  Regulators in the world's financial centers urged G-SIBs to adopt modifications to their existing and future derivatives (and similar) contracts that would limit End-User Counterparty termination rights (e.g., cross-default and direct default rights) in the event of a resolution or bankruptcy of the G-SIB or one of its affiliates.  Regulators believe that unfettered early termination rights make it more difficult for a G-SIB to pass through a bankruptcy or resolution proceeding, as a rush to terminate in the event of failure has significant knock-on complications. Titles I and II of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the "Dodd-Frank Act")[7] provided U.S. regulators with new tools to effect the orderly resolution of G-SIBs.  One of those tools requires each G-SIB to prepare and submit to U.S. regulators a resolution plan commonly referred to as a "living will" that outlines the steps it would take for a rapid and orderly resolution of the G-SIB under the U.S. Bankruptcy Code in the event of material financial distress or failure.  Title II of the Dodd-Frank Act enacted a special resolution regime, known as the Orderly Liquidation Authority ("OLA"), which authorizes the appointment of the FDIC as a receiver to carry out the liquidation of large and complex financial institutions should an orderly resolution under the U.S. Bankruptcy Code not be feasible (the "U.S. Special Resolution Regime"). For more than 25 years, market participants have used ISDA Master Agreements to memorialize and govern the rights and responsibilities for their over-the-counter derivatives transactions.  Under these standardized agreements, non-defaulting parties have generally had a right to designate an "Early Termination Date" in respect of an "Event of Default" by the other party or by other "Specified Entities,"[8] which typically includes affiliates who may or may not be "Credit Enhancement Providers."[9]  An Event of Default thus includes a bankruptcy or resolution of the direct counterparty (i.e., a direct default) and also the bankruptcy or resolution of any of the "Specified Entities" or "Affiliates" (i.e., a cross-default).[10] Such early termination rights generally provide the non-defaulting party with the ability to close out its relationship with the defaulting counterparty as well as its relationship with any affiliates of the defaulting counterparty.  Following an Event of Default, and the occurrence of an Early Termination Date, either automatically or by designation by the non-defaulting party, the obligation to make further payments or deliveries in respect to the transactions governed by the ISDA Master Agreement will end.  Instead, there will be an obligation to pay a close-out amount, calculated as provided in the ISDA Master Agreement. A filing under the U.S. Bankruptcy Code generally does not impact the ability to exercise early termination and close-out rights.  The U.S. Bankruptcy Code generally exempts QFCs (which term includes ISDA Master Agreements) from application of the automatic stay; this means that non-defaulting parties can, notwithstanding the filing of a case under the U.S. Bankruptcy Code by the defaulting counterparty or one of its Specified Affiliates, enforce an Event of Default and exercise close-out rights without the requirement to obtain any approval from the bankruptcy court. By contrast, the U.S. Special Resolution Regime does not incorporate such provisions—non-defaulting counterparties are subject to a stay period before enforcing termination rights, or exercising close-out rights, arising from the insolvency of a Covered Entity or a specified affiliate and, if certain conditions are satisfied, they may be permanently prevented from exercising such rights.

a.   The U.S. Rules
The primary objectives of the U.S. Rules are to address the threat to financial stability posed by existing default rights under QFCs and to enable the resolution of G-SIBs in a controlled manner.  The U.S. Rules seek to accomplish these objectives by requiring two amendments (discussed below) to the QFCs between a Covered Entity or any of a Covered Entity's affiliates that are also Covered Entities (collectively, a "Covered Entity Group") and an End-User Counterparty or any of the End-User Counterparty's consolidated affiliates (collectively, an "End-User Group").  Under the U.S. Rules, a Covered Entity will no longer be able to execute a QFC with an End-User Counterparty without violating those rules unless all QFCs between each entity in the Covered Entity Group and all relevant entities in the End-User Group are amended. The first required amendment under the U.S. Rules addresses the uniformity of treatment between parties that opt-in to the relevant provisions of a resolution regime and parties that are subject to the law of the jurisdiction of the resolution regime because it is the governing law of the contract.  To reduce the risks that courts in foreign jurisdictions would disregard the U.S. Special Resolution Regime provisions that stay an End-User Counterparty's rights under QFCs with Covered Entities due to a foreign governing law provision, the amendment effectively requires the End-User Counterparty to opt in to the U.S. Special Resolution Regime. The opt-in mechanic of this first amendment is similar to what is required under the resolution stay rules that were passed in other jurisdictions (e.g., UK, Switzerland, Japan, Germany, etc.). The second amendment under the U.S. Rules is unique to the United States in that it restricts the ability of End-User Counterparties to exercise certain cross-default rights under QFCs.  Specifically, this amendment subjects an End-User Counterparty's cross-default rights to a mandatory stay where a parent or affiliate acting as Credit Enhancement Provider to a Covered Entity counterparty's obligations under a QFC goes into insolvency proceedings (i.e., under the U.S. Bankruptcy Code), notwithstanding that the Covered Entity counterparty may still able to make payments and perform under the QFC, (i.e., the Covered Entity is not itself insolvent).  Additionally, the second amendment requires an End-User Counterparty to agree that if a Covered Entity affiliate that is not a Credit Enhancement Provider goes into an insolvency, such End-User Counterparty's cross-default rights resulting from that Covered Entity affiliate's insolvency are permanently stayed with respect to the QFC with the direct Covered Entity counterparty.  Effectively, this provides for a full override of the "Specified Entity" defaults in the ISDA Master Agreement.  The goal of this second amendment is to facilitate "the resolution of a large financial entity under the U.S. Bankruptcy Code and other resolution frameworks by ensuring that the counterparties of solvent affiliates of the failed entity cannot unravel their contracts with the solvent affiliate based solely on the failed entity's resolution."[11]
b.   Amending QFCs – Timing
The U.S. Rules mandate that if a Covered Entity enters into a QFC with an End-User Counterparty on or after January 1, 2019 (the "Trigger Date"), then all of the QFCs between the Covered Entity Group and the End-User Group must incorporate the required amendments effective as of the relevant "compliance date."  The U.S. Rules provide staggered compliance dates that determine when the U.S. Rules actually become effective for different types of counterparties as follows:  (a)  for QFCs between Covered Entities – January 1, 2019; (b) for QFCs between Covered Entities and "financial counterparties" – July 1, 2019; and (c) for QFCs between Covered Entities and any other type of counterparty – January 1, 2020.  This means that if an End-User Counterparty's QFCs are fully performed, terminated or otherwise unwound prior to the relevant compliance date for such End-User Counterparty, those QFCs would not be subject to the U.S. Rules and would not need to be amended.  Further, to the extent End-User Counterparties adhere to the ISDA Protocol (discussed below) or agree to a bilateral amendment in advance of the appropriate compliance date, such amendment would likely not become effective until the appropriate compliance date.  Therefore, End-User Counterparties could retain their current default rights under the ISDA Master Agreement until their respective required compliance dates regardless of when such counterparties actually amend their QFCs. From a practical perspective, however, the staggered compliance dates are unlikely to deter Covered Entities from requiring that all relevant amendments to QFCs be put in place between the End-User Group and the Covered Entity Group by no later than January 1, 2019 or the first date thereafter on which the relevant Covered Entity enters into a new QFC with any member of the End-User Group.  In other words, Covered Entities are incentivized to amend all of their QFCs irrespective of the compliance dates because entering into a new QFC after January 1, 2019 without all of the required amendments in place could potentially expose the Covered Entity Group to regulatory and business risks (e.g., the risk that an End-User Counterparty that triggers the U.S. Rules' requirements will not agree to amend its QFCs by the relevant compliance date).  To remove such risks, Covered Entities have been seeking to have all amendments to QFCs in place prior to January 1, 2019, regardless of a particular counterparty's compliance date.
c.   Amending QFCs – Protocol Adherence or Bilateral Amendment?
There are two ways that an End-User Counterparty can amend its QFCs with Covered Entities.  End-User Counterparties can either adhere to the ISDA 2018 U.S. Resolution Stay Protocol as published by the International Swaps and Derivatives Association Inc. (the "ISDA Protocol")[12] or bilaterally amend its QFCs to comply with the U.S. Rules' contractual requirements and restrictions (ISDA has also published forms of bilateral amendments).[13]  The ISDA Protocol is an "all to all" method whereby all of an entity's QFCs with all Covered Entities that have adhered to the ISDA Protocol are amended.  In the case of End-User Counterparties, the ISDA Protocol is essentially a global amendment to the terms of all QFCs between the End-User Counterparty and every Covered Entity that also adheres to the ISDA Protocol.  The ISDA Protocol would require an adhering party to "opt in" to the special resolution regimes of France, Germany, Japan, Switzerland and the United Kingdom (which have all finalized their resolution stay rules) in addition to the U.S. Special Resolution Regime.  Accordingly, the process would make the amendment process easy by allowing the End-User Counterparty to adhere to the ISDA Protocol one time in order to address all requests from all Covered Entities for the End-User Counterparty to amend its QFCs in accordance with the U.S. Rules. In contrast, under a bilateral amendment process, the counterparties can agree (on a group-by-group basis) to amend their QFCs that are affected by the U.S. Rules.  A bilateral amendment would not require  an "opt in" to the special resolution regimes of France, Germany, Japan, Switzerland and the United Kingdom, although counterparties in those jurisdictions will likely request this nonetheless.  Further, under a bilateral amendment, the parties can agree not to amend QFCs that do not need to be amended to be brought into compliance. It is important to note that the ISDA Protocol and the bilateral amendments would only amend QFCs and would only be applicable to the End-User Counterparty that is the adhering party. All affiliates that have entered into QFCs with Covered Entities would each need to separately amend those QFCs.  Further, the ISDA Protocol only becomes effective upon the appropriate compliance date for the adhering party (notwithstanding when the entity actually adheres to the ISDA Protocol).  Bilateral amendments would need to be reviewed and negotiated to ensure the scope and timing of compliance are appropriate. Although the ISDA Protocol generally tracks the requirements of the U.S. Rules, there are a few differences relating to creditor enhancement provisions and certain default rights in the ISDA Protocol as compared to a bilateral amendment that would track the U.S. Rules directly.  The ISDA Protocol tracks the terms of the ISDA 2015 Universal Stay Protocol (which was published before the U.S. Rules) and provides a safe harbor from certain of the U.S. Rules.  This variation both aligns with the preference of prudential banking regulators for ISDA Protocol adherence and incentivizes End-User Counterparties to adhere.  In particular, under the ISDA Protocol provides that an End-User Counterparty only waives its rights to exercise remedies under a QFC due to an affiliate of its direct Covered Entity counterparty entering insolvency proceedings under Chapter 7 or 11 of the U.S. Bankruptcy Code or proceedings under the Securities Investor Protection Act, as amended, or Federal Deposit Insurance Act.  However, a bilateral agreement has a much broader scope, because an End-User Counterparty would have to waive such rights if the affiliate of its direct Covered Entity counterparty enters into any insolvency proceeding (including non-U.S. insolvency proceedings). Additionally, under the U.S. Rules and a bilateral amendment approach, if an End-User Counterparty seeks to exercise a default right in respect of a QFC with a Covered Entity counterparty, it must demonstrate by "clear and convincing evidence" or a similar or higher burden of proof that the right to exercise such default right is permitted under the U.S. Rules.  Meeting such a standard could be difficult to prove depending on the facts and circumstances.  The ISDA Protocol similarly requires the stayed party to have the burden of proof to establish by clear and convincing evidence that a default right may be exercised with respect to the QFC; however, the ISDA Protocol, unlike a bilateral amendment, makes clear that default rights related to performance defaults may be exercised without meeting such burden of proof.  For example, under the ISDA Protocol a stayed party could exercise its default rights in the event that its direct counterparty fails to perform (i.e., make payments) at any time; however, under a bilateral amendment, a stayed party would need to establish by clear and convincing evidence that the performance default is not related to an affiliate of the direct party becoming a party to U.S. proceedings, etc.  Accordingly, under the bilateral amendment, there is a broader scope of scenarios where this heightened burden of proof may be applicable compared to the ISDA Protocol.      II.   Impact on End-User Counterparties Below are two examples to illustrate the practical implications of the U.S. Rules for End-User Counterparties. EXAMPLE 1: Bank X (which is a Covered Entity) enters into a QFC with Company A on January 2, 2019.  Entering into this QFC on or after January 1, 2019 triggers the requirements of the U.S. Rules.  As a result, the following QFCs between Bank X and Company A would need to be amended:
i.   the January 2, 2019 QFC between Company A and Bank X; ii.   all existing and future QFCs between Company A and Bank X; iii.   all existing and future QFCs between Company A and any Bank X affiliate that is a Covered Entity; and iv.   all existing and future QFCs entered into by any consolidated affiliate of Company A and Bank X or any Bank X affiliate that is a Covered Entity.
This means that in order to enter into this new QFC with Bank X, Company A and all of Company A's affiliates on the same consolidated financial statements must either:
i.   adhere to the ISDA Protocol; or ii.   bilaterally amend all QFCs with Bank X and all of Bank X's affiliates (since all the Bank X affiliates are Covered Entities).[14]
EXAMPLE 2: Company A enters into a 10-year interest rate swap with Bank X (a U.S. bank) on December 20, 2018.  On January 2, 2019, Company A's affiliate Company B enters into a 5-year interest rate swap with Bank X's affiliate, Broker Dealer Y (a U.S. broker dealer). Company A's entry into the 10-year interest rate swap with Bank X does not trigger the U.S. Rules because it is entered into before January 1, 2019.   If neither Company A nor its affiliates entered into any QFCs with Bank X or its affiliates after January 1, 2019, Company A would, under the U.S. Rules, retain its existing early termination and cross-default rights with respect to the 10-year interest rate swap. However, Company B's entry into the interest rate swap with Broker Dealer Y after January 1, 2019 would trigger the U.S. Rules for all of Company B's consolidated affiliates, including Company A, with respect to all existing and future QFCs with any consolidated Broker Dealer Y affiliate, including Bank X.  Accordingly, it would:
(i) Require Company B either to enter into the ISDA Protocol or enter into a bilateral amendment for all QFCs with Bank X, Broker Dealer Y and all of their consolidated affiliates.  This would subject the Company B interest rate swap and all other QFCs with Broker Dealer Y's affiliates to the contractual stay provisions beginning on July 1, 2019 or January 1, 2020, as appropriate. (ii) Require Company A and all other consolidated affiliates to enter into the ISDA Protocol or enter into a bilateral amendment for all QFCs with Bank X, Broker Dealer Y and all of their consolidated affiliates.  This would subject the Company A 10-year interest rate swap and all other QFCs with Bank X and its affiliates to the contractual stay provisions beginning on July 1, 2019 or January 1, 2020, as appropriate.
  III.   Conclusions and Considerations Although the U.S. Rules do not impose direct obligations on End-User Counterparties to QFCs with Covered Entities, those End-User Counterparties that seek to continue to trade QFCs with Covered Entities will face certain indirect requirements and effects.  Specifically, End-User Counterparties must amend their QFCs with Covered Entities by either (i) adhering to the ISDA Protocol or (ii) negotiating bilateral amendments with their Covered Entity counterparties.  Once effective, these amendments will limit an End-User Counterparty's existing cross-default rights under an ISDA Master Agreement (and other types of QFCs) with Covered Entities. At this time, the consequences of the U.S. Rules on the marketplace are unclear as there is little precedent to assist in interpretation and negotiation.  There appear to be divergent views in the marketplace. While it is true that an End-User Counterparty's cross-default rights are limited under the U.S. Rules, some argue that such limitations on early termination rights will likely protect End-User Counterparties by decreasing the chances of a systemic failure and, given the creditor safeguards, decrease the likelihood that an End-User Counterparty would suffer an unanticipated loss due to the failure of a Covered Entity.  On the other hand, others have argued that the U.S. Rules could cause market participants to shy away from a vulnerable entity thereby further increasing the likelihood of failure of that entity and End-User Counterparties could face potential exposure during the stay period in the event the resolution proceedings do not work out as planned.  In any event, credit, pricing and risk determinations will continue to evolve as the market adapts to the U.S. Rules and a "new normal" will result. In the meantime, End-User Counterparties should be sure to coordinate an approach for amending their QFCs (particularly if the affiliates are controlled by different treasury centers or boards).  Additionally, because adherence to the ISDA Protocol is a universal amendment, End-User Counterparties will want to identify each outstanding QFC to which it is a party with a Covered Entity in order to evaluate the extent to which their default rights may be restricted under those QFCs.

   [1]   12 C.F.R. §§ 252.2, 252.81-88; see also, Restrictions on Qualified Contracts of Systemically Important U.S. Banking Organizations and the U.S. Operations of Systemically Important Foreign Banking Organizations; Revisions to the Definition of Qualifying Master Netting Agreement and Related Definitions, 82 Fed. Reg. 42,882 (Sept. 12, 2017).
   [2]   12 C.F.R. §§ 382.1-7.
   [3]   12 C.F.R. § 47.1-8.
   [4]   The following U.S. banking institutions have been identified as G-SIBs: Bank of America, Bank of New York Mellon, Citigroup, Goldman Sachs, JP Morgan Chase, Morgan Stanley, State Street, and Wells Fargo. The following foreign banking institutions have been identified as G-SIBs: Agricultural Bank of China, Bank of China, Barclays, BNP Paribas, China Construction Bank, Credit Suisse, Deutsche Bank, Groupe BPCE, Groupe Crédit Agricole, Industrial and Commercial Bank of China Limited, HSBC, ING Bank, Mitsubishi UFJ FG, Mizuho FG, Nordea, Royal Bank of Canada, Santander, Société Générale, Standard Chartered, Sumitomo Mitsui FG, UBS, and Unicredit Group.
   [5]   The definition of QFC is expansive and includes a broad range of transactions including, but not limited to, derivatives, repurchase, reverse repurchase and securities lending transactions.  See 12 U.S.. § 5390(c)(8)(D).
   [7]   See Dodd-Frank Wall Street Reform and Consumer Protection Act, Public Law 111–203, 124 Stat. 1376 (2010).
   [8]   The standard terms of Section 6(a) of the 1992 and 2002 ISDA Master Agreement (some of which are capitalized in this alert) provide parties to a derivatives transaction the right to terminate following an "Event of Default" (as such term is defined in the ISDA Master Agreement).  Specifically, this provision notes that if "Automatic Early Termination" has been selected in the ISDA Schedule, then upon the occurrence of certain defaults, including bankruptcy-related events, an "Early Termination Date" is deemed to have automatically occurred immediately before such event.  In other circumstances, an Event of Default gives the non-defaulting party the right to terminate the agreement and trigger the close-out, netting and setoff provisions therein by designating an Early Termination Date.
   [9]   A Credit Enhancement Provider is a party that provides credit enhancement or support in respect of an ISDA Master Agreement entered into by another party.  Credit enhancement or support can take the form, among others, of a guarantee, pledge of collateral, letter of credit, transfer of margin or any similar arrangement, in each case only to the extent such credit enhancement relates to the ISDA Master Agreement.  The definition of "Credit Enhancement Provider" is found in the ISDA Protocol (as defined below).
[10]   See Section 5(a)(vii) of the 1992 or 2002 ISDA Master Agreement.
[11]   82 Fed. Reg. at 42,883.
[12]   The text of the ISDA Protocol is available at https://www.isda.org/a/CIjEE/3431552_40ISDA-2018-U.S.-Protocol-Final.pdf.
[13]   Each affiliate that is a separate legal entity that has QFCs with a covered entity will need to separately adhere to the ISDA Protocol or enter into a bilateral amendment. ISDA has published four different form of bilateral amendments as well as model language that an entity can use to amend its QFCs with respect to a particular covered entity and its affiliates.  The form of bilateral amendments are available at https://www.isda.org/a/vrCEE/US-Stay-Regulations-Bilateral-Amendments.pdf.
[14]   There is no requirement that all of Company X's affiliates amend their QFCs in the same way; however, if some affiliates choose a bilateral amendment while others choose the ISDA Protocol, they could have different rights and be in a different position with respect to their rights against a QFC with the same party.

The following Gibson Dunn lawyers assisted in preparing this client update: Arthur Long, Jeffrey Steiner, Carl Kennedy and Erica Cushing. Gibson Dunn's lawyers are available to assist in addressing any questions you may have regarding these developments.  Please contact the Gibson Dunn lawyer with whom you usually work in the firm's Derivatives or Business Restructuring and Reorganization practice groups, or the following: Derivatives Group: Arthur S. Long - New York (+1 212-351-2426, along@gibsondunn.com) Michael D. Bopp - Washington, D.C. (+1 202-955-8256, mbopp@gibsondunn.com) Carl E. Kennedy - New York (+1 212-351-3951, ckennedy@gibsondunn.com) Jeffrey L. Steiner - Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com) James O. Springer - Washington, D.C. (+1 202-887-3516, jspringer@gibsondunn.com) Erica N. Cushing - Denver (+1 303-298-5711, ecushing@gibsondunn.com) Business Restructuring and Reorganization Group: Michael A. Rosenthal - New York (+1 212-351-3969, mrosenthal@gibsondunn.com) © 2018 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

October 11, 2018 |
Financing Arrangements and Documentation: Considerations Ahead of Brexit

Click for PDF Since the result of the Brexit referendum was announced in June 2016, there has been significant commentary regarding the potential effects of the UK's withdrawal from the EU on the financial services industry. As long as the UK is negotiating its exit terms, a number of conceptual questions facing the sector still remain, such as market regulation and bank passporting. Many commentators have speculated from a 'big picture' perspective what the consequences will be if / when exit terms are agreed.  From a contractual perspective, the situation is nuanced. This article will consider certain areas within English law financing documentation which may or may not need to be addressed. Bank passporting The EU "passporting" regime has been the subject of much commentary since the result of the Brexit referendum.  In short, in some EU member states, lenders are required under domestic legislation to have licences to lend.  Many UK lenders have relied on EU passporting (currently provided for in MiFID II), which allows them to lend into EU member states simply by virtue of being regulated in the UK (and vice versa). The importance for the economy of the passporting regime is clear. Unless appropriate transitional arrangements are put in place to ensure that the underlying principle survives, however, there is a risk that following Brexit passporting could be lost.  Recent materials produced by the UK Government suggest that the loss of passporting may be postponed from March 2019 until the end of 2020, although financial institutions must still consider what will happen after 2020 if no replacement regime is agreed.  The UK Government has committed to legislate (if required) to put in place a temporary recognition regime to allow EU member states to continue their financial services in the UK for a limited time (assuming there is a "no deal" scenario and no agreed transition period). However, there has not to date been a commitment from the EU to agree to a mirror regime. Depending on the outcome of negotiations on passporting, financial institutions will need to consider the regulatory position in relation to the performance of their underlying financial service, whether that is: lending, issuance of letters of credit / guarantees, provision of bank accounts or other financial products, or performing agency / security agency roles. Financial institutions may need to look to transfer their participations to an appropriately licensed affiliate (if possible) or third party, change the branch through which it acts, resign from agency or account bank functions, and/or exit the underlying transaction using the illegality protections (although, determining what is "unlawful" for these purposes in terms of a lender being able to fund or maintain a loan will be a complex legal and factual analysis).  More generally, we expect these provisions to be the subject of increasing scrutiny, although there seems to be limited scope for lenders to move illegality provisions in their favour and away from an actual, objective illegality requirement, owing to long-standing commercial convention. From a documentary perspective, it will be necessary to analyse loan agreements individually to determine whether any provisions are invoked and/or breached, and/or any amendments are required.  For on-going structuring, it may be appropriate for facilities to be tranched – such tranches (to the extent the drawing requirements of international obligor group can be accurately determined ahead of time) being "ring-fenced", with proportions of a facility made available to different members of the borrower group and to be participated in by different lenders – or otherwise structured in an alternative, inventive manner – for example, by "fronting" the facility with a single, adequately regulated lender with back-to-back lending mechanics (e.g. sub-participation) standing behind.  In the same way, we also expect that lenders will exert greater control – for example by requiring all lender consent in all instances - on the accession of additional members of the borrowing group to existing lending arrangements in an attempt to diversify the lending jurisdictions.  Derivatives If passporting rights are lost and transitional relief is not in place, this could have a significant impact on the derivatives markets.  Indeed, without specific transitional or equivalence agreements in place between the EU and the UK, market participants may not be able to use UK clearing houses to clear derivatives subject to mandatory clearing under EMIR.  Additionally, derivatives executed on UK exchanges could be viewed as "OTC derivatives" under EMIR and would therefore be counted towards the clearing thresholds under EMIR.  Further, derivatives lifecycle events (such as novations, amendments and portfolio compressions) could be viewed as regulated activities thereby raising questions about enforceability and additional regulatory restrictions and requirements. In addition to issues arising between EU and UK counterparties, equivalence agreements in the derivatives space between the EU and other jurisdictions, such as the United States, would not carry over to the UK.  Accordingly, the UK must put in place similar equivalence agreements with such jurisdictions or market participants trading with UK firms could be at a disadvantage compared to those trading with EU firms. As a result of the uncertainty around Brexit and the risk that passporting rights are likely to be lost, certain counterparties are considering whether to novate their outstanding derivatives with UK derivatives entities to EU derivatives entities ahead of the exit date.  Novating derivatives portfolios from a UK to an EU counterparty is a significant undertaking involving re-documentation, obtaining consents, reviewing existing documentation, identifying appropriate counterparties, etc. EU legislation and case law Loan agreements often contain references to EU legislation or case law and, therefore, it is necessary to consider whether amendments are required. One particular area to be considered within financing documentation is the inclusion of Article 55 Bail-In language[1].  In the last few years, Bail-In clauses have become common place in financing documentation, although they are only required for documents which are governed by the laws of a non-EEA country and where there is potential liability under that document for an EEA-incorporated credit institution or investment firm and their relevant affiliates, respectively.  Following withdrawal from the EU, the United Kingdom will (subject to any transitional or other agreed arrangements) cease to be a member of the EEA and therefore English law governed contracts containing in-scope liabilities of EU financial institutions may become subject to the requirements of Article 55.  Depending on the status of withdrawal negotiations as we head closer to March 2019, it may be appropriate as a precautionary measure to include Bail-In clauses ahead of time – however, this analysis is very fact specific, and will need to be carefully considered on a case-by-case basis. Governing law and jurisdiction Although EU law is now pervasive throughout the English legal system, English commercial contract law is, for the most part, untouched by EU law and therefore withdrawal from the EU is expected to have little or no impact.  Further, given that EU member states are required to give effect to the parties' choice of law (regardless of whether that law is the law of an EU member state or another state)[2], the courts of EU member states will continue to give effect to English law in the same way they do currently.  Many loan agreements customarily include 'one-way' jurisdiction clauses which limit borrowers/obligors to bringing proceedings in the English courts (rather than having the flexibility to bring proceedings in any court of competent jurisdiction). This allows lenders to benefit from the perceived competency and commerciality of the English courts as regards disputes in the financial sector. Regardless of the outcome of the Brexit negotiations, such clauses  are likely to remain unchanged due to the experience of English judges in handling such disputes and the certainty of the common law system. It is possible that the UK's withdrawal will impact the extent to which a judgement of the English courts will be enforceable in other EU member states.  Currently, an English judgement is enforceable in all other EU member states pursuant to EU legislation[3].  However, depending on the withdrawal terms agreed with the EU, the heart of this regulation may or may not be preserved. In other words, English judgements could be in the same position to that of, for example, judgements of the New York courts, where enforceability is dependent upon the underlying law of the relevant EU member state; or, an agreement could be reached for automatic recognition of English judgements across EU member states.  In the same vein, the UK's withdrawal could also impact the enforcement in the UK of judgements of the courts of the remaining EU member states. Conclusion Just six months ahead of the UK's 29 March 2019 exit date, there remains no agreed legal position as regards the terms of the UK's withdrawal from the EU. It is clear that, for so long as such impasse remains, the contractual ramifications will continue to be fluid and the subject of discussion.  However, what is apparent is that the financial services sector, and financing arrangements more generally, are heavily impacted and it will be incumbent upon contracting parties, and their lawyers, to consider the relevant terms, consequences and solutions at the appropriate time.


[1]   Article 55 of the Bank Resolution and Recovery Directive
[2]   Rome I Regulation
[3]   Brussels I regulation.

Gibson Dunn's lawyers are available to assist in addressing any questions you may have regarding these issues. Please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm's Global Finance practice group, or the authors:

Amy Kennedy - London (+44 (0)20 7071 4283, akennedy@gibsondunn.com) Jeffrey L. Steiner - Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com) Alex Hillback - Dubai (+971 (0)4 318 4626, ahillback@gibsondunn.com) Please also feel free to contact the following leaders and members of the Global Finance and Financial Institutions practice groups: Global Finance Group: Thomas M. Budd - London (+44 (0)20 7071 4234, tbudd@gibsondunn.com) Gregory A. Campbell - London (+44 (0)20 7071 4236, gcampbell@gibsondunn.com) Richard Ernest - Dubai (+971 (0)4 318 4639, ) Jamie Thomas - Singapore (+65 6507 3609, ) Michael Nicklin - Hong Kong (+852 2214 3809, ) Linda L. Curtis - Los Angeles (+1 213 229 7582, lcurtis@gibsondunn.com) Aaron F. Adams - New York (+1 212 351 2494, afadams@gibsondunn.com) Financial Institutions Group: Arthur S. Long - New York (+1 212-351-2426, along@gibsondunn.com) Michael D. Bopp - Washington, D.C. (+1 202-955-8256, mbopp@gibsondunn.com) Jeffrey L. Steiner - Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com) Carl E. Kennedy - New York (+1 212-351-3951, ckennedy@gibsondunn.com) © 2018 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.