August 3, 2012
This alert focuses on the recent approval by the Commodity Futures Trading Commission ("CFTC") of the final rules relating to the end-user exception to the mandatory clearing requirements, what the rule means for end-users, and the effects that the final rule has for various swaps and entities. Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act") provided non-financial end-users that use derivatives to hedge or mitigate their commercial risks an exception from the Dodd-Frank Act’s clearing requirements. While Title VII of the Dodd-Frank Act provides and the CFTC’s final rule implements an exception for qualifying non-financial swap end-users with respect to clearing and trading requirements, regulators have not provided definitive guidance with respect to inter-affiliate swaps, centralized hedging units, and margin. Additionally, non-financial end-users will still be responsible for other requirements under the Dodd-Frank Act, including recordkeeping obligations. Gibson Dunn can assist derivatives end-users that want to learn more about the end-user exception and other rules that may affect end-users.
On July 10, 2012, the CFTC unanimously approved the final rules relating to the End-User Exception to the Clearing Requirement for Swaps (the "Final End-User Exception Rule"). Section 2(h)(1)(A) of the Commodity Exchange Act ("CEA") establishes a clearing requirement for swaps by providing that "it shall be unlawful for any person to engage in a swap unless that person submits such swap for clearing to a derivatives clearing organization that is registered under the [CEA] if the swap is required to be cleared." Pursuant to CEA Section 2(h)(7), the clearing requirement established in CEA Section 2(h)(1)(A) shall not apply to a swap if one of the counterparties to the swap: (1) is not a financial entity, as defined in CEA Section 2(h)(7)(C)(i); (2) is using swaps to hedge or mitigate commercial risk; and (3) notifies the CFTC, in a manner set forth by the CFTC, how it generally meets its financial obligations associated with entering into non-cleared swaps.
The Final End-User Exception Rule creates CFTC regulation § 39.6 which describes the requirements for electing this statutory exception by (1) establishing the criteria for determining whether a swap hedges or mitigates commercial risk; (2) specifying the information that counterparties must report to satisfy the notification requirement; and (3) establishing an exemption from the clearing requirement for small financial institutions. The Final End-User Exception Rule also provides rules and discussion relating to the application of the end-user exception to certain types of swaps and entities. While the Final End-User Exception Rule provides rules for certain end-users to elect the end-user exception, it does not sufficiently address exceptions from the clearing requirement with respect to inter-affiliate trades, centralized hedging units and captive finance entities.
The Final End-User Exception Rule becomes effective on September 17, 2012; however, compliance with the rule is not possible until swaps become subject to the clearing requirement. On July 24, 2012, the CFTC approved (1) the proposed clearing determinations for certain credit default swaps and interest rate swaps and (2) the final regulations to phase-in compliance with clearing requirements under the Dodd-Frank Act.
The text of the Final End-User Exception Rule is available here.
All swaps for which the end-user exception may be elected must be executed for the purpose of hedging or mitigating commercial risk. Swaps that are eligible for the end-user exception would include swaps that hedge or mitigate either financial risks or physical commodity risks. The Final End-User Exception Rule’s "hedging or mitigating commercial risk" criteria under CFTC regulation § 39.6(c) is consistent with the criteria applied to the major swap participant ("MSP") determination, which was finalized in CFTC regulation § 1.3(kkk); however, the application of such definition serves similar, but different purposes in the two rules.
A. When does a swap hedge or mitigate commercial risk?
CFTC regulation § 39.6(c) provides that a swap is used to hedge or mitigate commercial risk if:
B. "Commercial" Risk
The CFTC explains in the preamble to the Final End-User Exception Rule that whether the risk that is being mitigated is "commercial" will be based on the underlying activity to which the risk relates and not on the type of entity claiming the end-user exception. The status of the entity claiming the end-user exception does not control the determination of whether such entity is hedging or mitigating commercial risk. Instead, the determination will depend on the nature of the underlying activity to which the risk being hedged mitigates or relates. For example, a non-profit end-user entity may be hedging or mitigating commercial risk even though the non-profit entity itself is not a "commercial" entity.
The CFTC makes clear that it does not believe that the end-user exception was intended to apply only to physical commodity hedging and accordingly, the Final End-User Exception Rule provides that "commercial" risk may include financial risks and/or commodity risks. For example, the CFTC explains that "a change in interest rate risk of a non-financial entity’s debt incurred for commercial business operations (e.g., to fund the purchase of inputs or to build a factory for the entity) can constitute commercial risk." However, the CFTC clarifies "that the use by non-financial entities of the end-user exception for financial risk hedging or mitigation must be an incidental part of (i.e., not central to) the electing counterparty’s business and must fully qualify under all other applicable provisions of the CEA and § 39.6."
C. "Economically Appropriate" Standard
The CFTC believes that the "economically appropriate" standard will help interested parties distinguish those swaps that hedge or mitigate commercial risk from those that do not. The CFTC explains that it will apply a "facts and circumstances" test to determine whether or not a swap is hedging or mitigating commercial risk. Specifically, the "facts and circumstances" will determine whether a swap is "economically appropriate" to hedge or mitigate commercial risks. In the Final End-User Exception Rule, the CFTC acknowledges that "this standard leaves room for judgment in its application," but further explains that the CFTC "believes this flexible approach is needed given the wide variety of swaps, potential electing counterparties, and hedging strategies to which the rule applies." Accordingly, swap counterparties should look at the facts and circumstances that exist at the time the swap is executed and should take into account the person’s overall hedging and risk mitigation strategies.
D. Speculation, Investing or Trading
The end-user exception is explicitly prohibited for swaps entered into for the purpose of speculating, investing or trading, as opposed to hedging or mitigating commercial risk. The preamble to the Final End-User Exception Rule explains that "trading" includes a situation where the party is entering and exiting swap positions for purposes that have little or no connection to hedging or mitigating commercial risks incurred in the ordinary course of business. However, "trading" does not include entering and exiting swaps for the purpose of hedging or mitigating commercial risk. The CFTC further notes that there is nothing to prevent an end-user that elects the end-user exception for swaps in which it hedges or mitigates its commercial risk to also enter into swaps for speculation or investment purposes. The end-user exception is analyzed on a swap-by-swap basis.
E. "Matched Book" or "Back-to-Back" Swaps
Matched book or back-to-back swaps that hedge or mitigate commercial risks of other swaps may qualify for the end-user exception if:
Effectively, a chain of back-to-back swaps could qualify for the end-user exception if the first swap qualifies for the end-user exception and each successive swap also qualifies for the end-user exception.
F. Portfolio and Dynamic Hedging and Hedge Effectiveness Testing
The Final End-User Exception Rule does not create a separate exception for portfolio or dynamic hedging, but it does allow for swaps that facilitate portfolio hedging or dynamic hedging to use the end-user exception only if those swaps hedge or mitigate commercial risk. Parties to the swap would need to look at the relevant "facts and circumstances" to determine if portfolio and dynamic hedging is economically appropriate. Parties are not required to demonstrate hedge effectiveness or engage in periodic hedge effectiveness testing since entities need to know whether the swap is eligible for the end-user exception at the time it is executed. Further, the Final End-User Exception Rule does not require entities to document and report the risk being hedged.
In order for the end-user exception to be elected with respect to a swap, certain information must be provided to a swap data repository or, if no swap data repository is available, to the CFTC. The data will be collected via a "check the box" method as described in CFTC regulation § 39.6(b) and summarized below.
Additionally, the CFTC requires, under CFTC regulation §39.6(b)(3), that a reporting counterparty that reports information on behalf of an electing counterparty has a "reasonable basis" to believe that the electing counterparty meets the requirements for the end-user exception. From a practical standpoint, such a requirement will likely require the reporting counterparty to verify such information with the electing counterparty.
A. Inter-affiliate Trades
The CFTC explains in the preamble that an inter-affiliate swap in which one party is a non-financial entity and in which such swap is hedging or mitigating commercial risk can elect to use the end-user exception in the same manner as it would elect for its market-facing swap. The CFTC explains that clearing relief for inter-affiliate swaps is outside the scope of this rulemaking:
"As a general matter, the Commission notes that Congress did not treat inter-affiliate swaps differently from other swaps in Section 2(h)(7) of the CEA. Accordingly, the fact that a swap is between two affiliates would not change the analysis of whether one of the parties to the swap can elect the end-user exception. If one of the affiliates is not a financial entity and is using the swap to hedge or mitigate commercial risk, even if the other affiliate is a financial entity, the non-financial entity affiliate may elect the end-user exception and neither affiliate needs to clear the swap. However, whether the Commission should provide general clearing relief for inter-affiliate swaps for which the statutory requirements of the end-user exception are not satisfied is outside the scope of this rulemaking. Notwithstanding the foregoing, the Commission acknowledges that commenters have raised issues regarding inter-affiliate swaps that warrant further review and the Commission is considering other options regarding these issues."
Additionally, reporting counterparties and electing counterparties would be required to report information relating to inter-affiliate swaps that elect to use the end-user exception in the same manner as they would be required to report for market facing swaps, as described in § 39.6(b).
The CFTC’s position on inter-affiliate swaps in the Final End-User Exception Rule would permit non-financial end-users to use the end-user exception for inter-affiliate swaps in which at least one party is a non-financial end-user and the swap hedges or mitigates commercial risk; however, financial end-users that use a centralized hedging unit model for executing market-facing swaps and inter-affiliate swaps would not be able to elect to use the end-user exception for their inter-affiliate swaps that hedge or mitigate commercial risk. Under this approach, the CFTC effectively treats financial end-users in the same manner that it treats swap dealers with respect to inter-affiliate swaps.
The CFTC has indicated that it intends to propose a rule in the next few weeks to address the clearing of inter-affiliate swaps; however, the scope of the proposal is not clear at this time. It is expected that the inter-affiliate proposal will have a 60-day public comment period.
B. Centralized Hedging Units
The Final End-User Exception Rule distinguishes between (1) where the treasury function operates in the corporate structure and (2) whether or not a market-facing swap is executed on an agent or principal basis.
C. Captive Finance Entities
The CFTC relies on the plain language of CEA Section 2(h)(7)(C)(iii) when interpreting the captive finance company exception. Any entity that meets the definition in CEA Section 2(h)(7)(C)(iii) would not be included in the definition of "financial entity" and would be eligible to elect the end-user exception. Accordingly, an entity is a "captive finance company" if it has the following elements:
As written, the captive finance exception would not apply when a captive provides financing to its member-owners to support their general business activities, rather than to finance purchases from its member-owners. Additionally, certain captives may finance products that fall outside the scope of the CFTC’s interpretation of "manufactured."
D. Small Financial Institutions Exemption (CFTC Regulation § 39.6(d))
If an entity is considered a financial entity solely because it is predominantly engaged in activities that are in the business of banking, or financial in nature, as described in CEA Section 2(h)(7)(C)(i)(VIII), then it shall be exempt from the definition of "financial entity" if such person:
E. Foreign Governments, Foreign Central Banks and International Financial Institutions
The Final End-User Exception Rule clarifies that such entities are not subject to the clearing requirement; however, if such entity enters into a transaction with a counterparty that is subject to the CEA and CFTC regulations with respect to that swap transaction, then the counterparty must still comply with the CEA and CFTC regulations as they pertain to non-cleared swaps.
F. State and Local Governments
State and local governments are not expressly excluded from the clearing requirement; however, the CFTC cites that most state and local government entities are not likely to be "financial entities" under CEA section 2(h)(7)(C)(i)(VIII), because they are not predominantly engaged in activities that are in the business of banking, or financial in nature.
While the Final End-User Exception Rule did not address cooperatives, on July 10, 2012 the CFTC unanimously approved a proposed rule what would enable certain cooperatives, whose members are eligible for the end-user exception, to elect not to clear swaps in connection with such activities. The exemption is being proposed since certain cooperatives that execute swaps on behalf of their members for the benefit of their members may be considered "financial entities" with assets greater than $10 billion. While the cooperative members could individually qualify for the end-user exception, the cooperatives could not. Accordingly, the proposed rule would enable cooperative members to continue to access the financial markets through the cooperative and still receive the benefits of the end-user exception.
The text of the proposed rule exempting certain cooperatives can be found here.
Pursuant to the CFTC’s final implementation schedule for mandatory clearing, which was published in the Federal Register on July 30, 2012, a non-financial end-user would not be subject to the mandatory clearing requirements until 270 days after mandatory clearing determinations are effective. This would be the compliance date even if the non-financial end-user’s counterparty is a swap dealer (i.e., in determining if the swap is subject to the clearing mandate, always look to the counterparty with the latest compliance date). Accordingly, such non-financial end-users would not need to elect or comply with the end-user exception rules in § 39.6 until such entities are required to comply with the mandatory clearing requirements (i.e., 270 days after the effective date of the mandatory clearing determinations).
 Public Law 111-203, 124 Stat. 1376 (2010). Pursuant to Section 701 of the Dodd-Frank Act, Title VII may be cited as the "Wall Street Transparency and Accountability Act of 2010."
 See 77 Fed. Reg. 42560 (July 19, 2012).
 CEA Section 2(h)(7)(C)(i) defines the term "financial entity" to mean: (i) a swap dealer; (ii) a security-based swap dealer; (iii) a major swap participant; (iv) a major security-based swap participant; (v) a commodity pool; (vi) a private fund as defined in section 80b–2 (a) of title 15; (vii) an employee benefit plan as defined in paragraphs (3) and (32) of section 1002 of title 29; (viii) a person predominantly engaged in activities that are in the business of banking, or in activities that are financial in nature, as defined in section 1843 (k) of title 12.
 This proposal has not yet been published in the Federal Register, but the text of the proposal can be accessed here.
 See 77 Fed. Reg. 44441 (July 30, 2012). The text of this final rule is available here.
 See 77 Fed. Reg. 30596 (May 23, 2012); see also 77 Fed. Reg. 39626 (July 5, 2012) (correction to final rule).
 While the criteria in the two rules are consistent, it should be noted that while the MSP definition of hedging or mitigating commercial risk allows for application of the criteria to financial entities, the end-user exception does not. See 77 Fed. Reg. at 42577.
 It should be noted that if an entity is considered a "financial entity," as defined in CEA section 2(h)(7)(C)(i), it would not be eligible to elect to use the end-user exception, even if it is hedging or mitigating commercial risk.
 See 77 Fed. Reg. at 42573 – 42574.
 Portfolio hedging refers to hedging or mitigating the net risk of an overall portfolio of products that could include both financial and physical positions. Dynamic hedging refers to the ongoing modification of a hedging structure based on the optimization of the value of underlying physical assets based on pricing relationships or other market factors.
 See 77 Fed. Reg. at 42575.
 However, the Commission explains that it intends to monitor the use of the end-user exception for abuse of the end-user exception and if such abuse becomes prevalent, it may impose appropriate hedge identification and/or hedge effectiveness testing or reporting requirements. See 77 Fed. Reg. at 42576.
 Similarly, end-users would also be required to comply with recordkeeping and reporting requirements with respect to inter-affiliate swaps as required under Part 45 and Part 46 of the CFTC’s regulations.
 CEA Section 2(h)(7)(C)(i)(VIII) explains that activities that are "financial in nature" are those activities described as such in section 4(k) of the Bank Holding Company Act of 1956.
 See 77 Fed. Reg. 41940 (July 17, 2012).
Gibson, Dunn & Crutcher’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 work or the following:
Michael Bopp – Chair, Financial Markets Crisis Group, Washington, D.C. (202-955-8256, email@example.com)
Jeffrey L. Steiner - Washington, D.C. (202-887-3632, firstname.lastname@example.org)
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