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The Dodd-Frank Act:
Practical Advice for End Users
7th Annual Texas Journal of Oil, Gas & Energy Law
Texas Energy Symposium
February 9-10, 2012
Craig R. Enochs
Kevin M. Page
General Overview
• Who does the Dodd-Frank Act impact?
• What must End Users do to comply
with the Act?
• What should End Users be doing now?
• Navigating the unknown: where will the
Dodd-Frank Act end up?
2
I. Who Does Dodd-Frank Impact?
•
Primarily:
– Major Swap Participants
– Swap Dealers
•
But also End Users that use Swaps:
– What is a swap generally?
– What is a “Swap” under the Act?
– Who is an End User?
3
Swaps Generally
• Most common form of “derivative”
• Basic Definition of a Derivative:
– Financial transaction – no physical delivery involved
– The value of the transaction is derived from the price
or value of some other source
• E.g., an index price, a currency rate, a commodity price or an
interest rate
4
Swaps Generally
•
Commodity Swap: Characteristics
–
No physical delivery occurs.
–
Each party agrees to pay a floating or a fixed price
with respect to a notional quantity of a commodity.
–
No “Seller” or “Buyer” – either party may be
obligated to pay under the swap depending on
whether fixed is greater than floating or floating is
greater than fixed.
5
Swaps Generally
•
Commodity Swap: Example
–
–
Fixed Price Payer (“A”) pays fixed gas price of $7/MMBtu
Floating Price Payer (“B”) pay floating gas index price per
MMBtu
Fixed Gas Price
($7)
A
B
Floating Gas Index
Price
–
–
If Index Price is $8: Party B pays Party A $1.
If Index is $5: Party A pays Party B $2.
6
“Swaps” Under Dodd-Frank
• A put, call, or similar option based on:
– The value of rates, currencies or commodities
– The occurrence or non-occurrence of an event or contingency
• An agreement for an exchange of payments based on
the value of rates, currencies or commodities that:
– Transfers financial risk
– Does not transfer ownership
• An agreement that is commonly known (or in the future
becomes commonly known) as a swap.
7
“Swaps” Under Dodd-Frank
• § 721(a)(21): Expressly includes “commodity swaps”
and “energy swaps”
• Forward Contract Exclusion: Forward contracts in nonfinancial commodities are generally excluded from the
definition of “Swap”.
– The parties must intend for the transaction to be physically
settled at the time the parties enter into the transaction.
– Physical bookouts qualify for the forward exclusion if the parties
regularly trade physical commodities in their ordinary course of
business.
8
“Swaps” Under Dodd-Frank
• Proposed by the CFTC as “Swaps”:
– Physical commodity options
• Financial transaction via payment of option premium
• Physical delivery only occurs if option is exercised
– Any transaction willfully structured to evade Title VII
requirements.
– See CFTC Proposed Rules: Further Definition of “Swap” (76
Fed. Reg. 29,818) (May 23, 2011).
• Embedded Options:
– Physical forward contract, but option to adjust price/quantity
– Will the CFTC treat as a “Swap”?
9
Who is an “End User”?
• In the context of CFTC clearing requirements, an “End
User” is:
– A non-Financial Entity
– Using Swaps to hedge or mitigate its commercial
risks
• CFTC Proposed Rule on End-User Exception to
Mandatory Clearing of Swaps (75 Fed. Reg. 80,747)
(12/23/2010).
10
Who is an “End User”?
• “Financial Entity”:
– Laundry list of parties stated in § 723(a)(3).
– Expressly includes Major Swap Participant and Swap
Dealer.
• Thus, a “non-Financial Entity” cannot be either an MSP
or SD.
11
Who is an “End User”?
• Uses Swaps to hedge or mitigate commercial risk:
– Qualify as “bona fide hedges” under CEA rules;
– Qualify for treatment under FASB Statement No. 133; or
– Swaps are “economically appropriate for the reduction of risks in
the conduct and management of a commercial enterprise”.
• CFTC Proposed Rule on End-User Exception to
Mandatory Clearing of Swaps (75 Fed. Reg. 80,747)
(12/23/2010).
12
Who is an “End User”?
• Dodd-Lincoln Letter: Letter from Senators Dodd and
Lincoln to Representatives Frank and Peterson dated
June 30, 2010:
– “End Users should not be treated as Swap Dealers
simply because they regularly use Swaps to hedge
risk.”
– The term “End User” should include any End User of
the commodity being hedged, including energy
producers, power retailers, airlines and those
financing routine business activities.
13
Who is an “End User”?
• Many industries have lobbied to Congress.
– Who will win?
– Airlines, brewers, farmers, utilities, etc.
• Probably will include most entities we think should be
End Users.
14
II. What Must End Users Do?
• “Nothing” is incorrect
• The Act still applies to End Users:
– Pre-enactment and transition swap reporting (§ 723)
– Opt-out of clearing requirements and elective clearing (§ 723)
– Real-time public reporting of Swap data (§ 727)
– Reporting of Swap data for use by regulators (§ 729)
– Swap Confirmation and documentation standards (§ 731)
– Credit support requirements for uncleared Swaps (§ 731)
15
II. What Must End Users Do?
• “Pre-enactment Swap” and “Transition Swap” Reporting:
– “Pre-Enactment Swaps”: entered into prior to enactment of
Dodd-Frank on July 21, 2010 and not yet expired as of such
date.
– “Transition Swaps”: entered into on or after effective date of
Dodd-Frank, but prior to the effective date of CFTC’s final Swap
data reporting rules.
16
II. What Must End Users Do?
• “Pre-enactment Swap” and “Transition Swap” Reporting:
– General Rule: Data for pre-enactment Swaps and transition
Swaps must be reported to a Swap Data Repository (“SDR”) or
the CFTC.
– If pre-enactment and transition Swap data is timely reported,
such Swaps are exempt from further clearing requirements.
– A counterparty must maintain records of its pre-enactment and
transition Swaps for the duration of the Swap plus 5 years.
– See Proposed Rule on Swap Recordkeeping and Reporting
Requirements: Pre-Enactment and Transition Swaps (76 Fed.
Reg. 22,833) (April 25, 2011).
17
II. What Must End Users Do?
• Clearing Requirements:
– Must opt-out of mandatory clearing by notifying the CFTC of how
it generally meets its financial obligations associated with
entering into non-cleared Swaps.
• CFTC Proposed Rule on End-User Exception to Mandatory
Clearing of Swaps (75 Fed. Reg. 80,747) (12/23/2010).
– Submission is made through a Swap Data Repository (“SDR”)
upon execution of a Swap.
18
II. What Must End Users Do?
• Clearing Requirements:
– Even if a Swap is not required to be cleared, the End User has
the right to:
• Require that the parties clear the Swap; and
• Select the Derivatives Clearing Organization (“DCO”) for
clearing.
– Practice Points:
• End Users must interact with SDRs and the CFTC to avoid
clearing
• End Users can opt-in for clearing.
19
II. What Must End Users Do?
• Real-Time Public Reporting of Swap Data:
– Certain data for “Publicly Reportable Swap Transactions”
(whether cleared or not) must be made publicly available “as
soon as technologically practicable” after the Swap has been
“executed”.
– “Publicly Reportable Swap Transaction”:
• Any Swap that is an arm’s-length transaction between 2 parties that
results in changes to each party’s market risk position; or
• Any termination, assignment, novation, exchange, transfer,
amendment, conveyance or extinguishment of rights or obligations
of a Swap that changes the pricing of the Swap.
20
II. What Must End Users Do?
• Real-Time Public Reporting of Swap Data:
– Off-facility “Publicly Reportable Swap Transactions” between
End Users will need to be reported by one of the End User
parties.
– Reported information must not identify the parties to the Swap
transaction.
– Reporting party sends information to an SDR, which makes
reported categories of information publicly available.
21
II. What Must End Users Do?
• Real-Time Public Reporting of Swap Data: What
information must be reported and made public?
• A Few Examples:
–
–
–
–
–
–
–
–
Execution timestamp
Whether the Swap is cleared or uncleared
If uncleared, an indication of how the Swap is collateralized
Whether the End-User exception applies to the Swap
Effective Date and End Date
Asset Class (e.g., interest rate, commodity, FX, etc.)
Price
Payment frequency
22
II. What Must End Users Do?
• Real-Time Public Reporting of Swap Data:
– “As soon as technologically practicable”: “As soon as possible,
taking into consideration the prevalence, implementation and
use of technology by comparable market participants”.
• CFTC recognizes that this standard will vary based on the type of
market participant reporting the information.
• Permitted time delays for block trades and large notional swaps
– “Execution” = agreement by the parties (whether orally or in
writing) that legally binds the parties.
• Occurs simultaneously with (or immediately following)
affirmation of a Swap’s primary economic terms.
• Not the same as signing a Confirmation.
23
II. What Must End Users Do?
• Real-Time Public Reporting of Swap Data: EXCEPTION-Certain Commodity Transactions
– Only the following “Publicly Reportable Swap Transactions” in
commodities are required to be publicly disseminated:
• On-Facility Transactions (i.e., executed on a DCM or SEF); or
• Commodity swaps based on the following:
–
–
–
–
NYMEX Light Sweet Crude Oil
NYMEX New York Harbor Gasoline Blendstock
NYMEX Henry Hub Natural Gas
NYMEX New York Harbor Heating Oil
– See Real Time Public Reporting of Swap Transaction Data (77
Fed. Reg. 1,182) (01/09/12).
24
II. What Must End Users Do?
• Real-Time Public Reporting of Swap Data:
– Practice Points:
• Be aware that End Users still may have to report. Are your
internal operations/systems ready?
• Reporting is required upon “execution”. How does this align
with your internal Confirmation procedures?
• Do you need to update confidentiality provisions in your
contracts?
• Even if you are not the reporting party, note that information
about your gas/power Swaps will be made public.
• Exception for commodity swaps—will the CFTC expand
reporting requirements in the future?
25
II. What Must End Users Do?
• Reporting to SDRs and Recordkeeping:
– While § 727 relates to real-time public reporting, § 729 relates to
records/reports for use by regulators.
– Initial Swap creation data and ongoing Swap continuation data
must be reported.
– Depending on whether a Swap is cleared and/or executed on an
exchange, an End User may have to report.
– See Proposed Rule on Swap Data Recordkeeping and Reporting (75
Fed. Reg. 76,573) (12/8/2010).
– See also Final Rule - Swap Data Recordkeeping and Reporting
Requirements (77 Fed. Reg. 2,136) (01/13/12).
26
II. What Must End Users Do?
• Reporting to SDRs and Recordkeeping: When do End
Users have to report?
– General Rule: An End User only has to report data when both
counterparties are End Users
– Swap Creation Data:
• If executed on-exchange, the SEF or DCM reports
• If executed off-exchange, the DCO reports (if cleared) or the
“reporting counterparty” reports (if not cleared)
– Swap Continuation Data:
• If the Swap is cleared, the DCO reports
• If the Swap is not cleared, the “reporting counterparty” reports
27
II. What Must End Users Do?
• Reporting to SDRs and Recordkeeping:
– For SDs/MSPs, records must be “readily accessible”:
• Throughout the life of a Swap; and
• For 2 years following termination or expiration.
– For all entities (including End Users), records must be kept:
• Throughout the life of a Swap; and
• For 5 years following termination or expiration.
– Retrieval of Data:
• MSPs/SDs: After the “readily accessible” period, data must be
retrievable within 3 business days.
• End Users: At all times during the 5-year period, data must be
retrievable within 5 business days
28
II. What Must End Users Do?
• Reporting to SDRs and Recordkeeping:
– Practice Points:
• System/Operations issues:
– Monitor and initially report Swap creation data.
– Continue to report Swap continuation data.
• Data retention and storage policies to comply with
CFTC recordkeeping requirements.
29
II. What Must End Users Do?
• Confirmation and Documentation Standards:
– The Act imposes significant documentation standards on MSPs
and SDs when dealing with End Users:
• Strict timing requirements for executing and confirming
Swaps.
• Procedures for terminating offsetting Swaps with End Users.
– See Proposed Rule on Swap Trading Relationship Documentation
Requirements for Swap Dealers and Major Swap Participants (76 Fed.
Reg. 6715) (Feb. 8, 2011)
– Practice Point:
• Changes are coming that impact how Swaps are
documented.
30
II. What Must End Users Do?
• Credit Support for Uncleared Swaps:
– If an MSP or SD enters into an uncleared Swap with an End
User, initial and variation margin is not expressly required by the
CFTC.
– However, the parties must enter into a credit support
arrangement (which may contain margin requirements).
• See Proposed Rule Regarding Margin Requirements for Uncleared
Swaps for Swap Dealers and Major Swap Participants (76 Fed.
Reg. 23,732) (April 28, 2011).
– Practice Point: End Users will need to enter into credit
arrangements to comply with CFTC regulations.
31
II. What Must End Users Do?
• Trickle-down effect of MSP & SD regulations: Two
Examples-– Margin requirements (§ 731): increased margin and
collateral costs required by the CFTC likely will be
passed through to End Users.
– Clearing requirements (§ 723): general cost of
clearing transactions may be reflected in higher prices
to End Users.
32
III. What Should End Users
Be Doing Now?
•
Evaluate internal systems, processes, and
personnel
–
–
•
Who is responsible for reporting, recordkeeping, and ensuring
compliance?
What systems need to be updated?
Analyze the cost of compliance
–
Use of consultants may be necessary to fully analyze the scope of
compliance and to take next steps ensuring compliance.
33
III. What Should End Users
Be Doing Now?
•
Analyze the cost of alternatives to compliance
– Moving all of your business to physical instead of financial?
•
Does the use of only physical transactions make sense for your
business?
•
If you intentionally move all financial transactions to physical to
avoid Dodd-Frank requirements, are you “willfully evading” the
Act?
– Change business models altogether to avoid Dodd-Frank
compliance costs?
34
IV. Where Will We End Up?
•
New Lawsuit Strategy?
– Scalia the Younger
– SEC’s “proxy-access rule” under Dodd-Frank struck down by
federal court of appeals in July 2011.
• Basis: 1996 law requiring the SEC to promote “efficiency,
competition and capital formation”.
– Prompted direct attacks on Dodd-Frank regulations based on
the economic cost of a rule, regardless of its merits.
•
•
Analyze the CFTC’s cost-benefit analysis
Does it pass muster?
35
IV. Where Will We End Up?
•
The Lawsuits Continue: ISDA/SIFMA Sue the CFTC
Over Position Limits
– The Securities Industry and Financial Markets Association
(SIFMA) and ISDA claim that the CFTC “grossly misinterpreted
its authority” in adopting position limit regulations.
– Basis:
•
The Dodd-Frank Act instructs the CFTC to set position limits if
necessary to control speculative trading.
•
ISDA/SIFMA claim the CFTC’s actions are not supported by
sufficient evidence that the benefit of position limits outweighs the
economic burden and cost to industries.
36
IV. Where Will We End Up?
•
The Lawsuits Continue: ISDA/SIFMA Sue the CFTC
Over Position Limits
– January 2012: SIFMA/ISDA requested that the CFTC halt
implementation of position limits until after the lawsuit is
decided.
•
CFTC rejected the request
37
IV. Where Will We End Up?
•
The Lawsuits Continue: ISDA/SIFMA Sue the CFTC
Over Position Limits
– Jan. 20, 2012: U.S. Court of Appeals for D.C. Circuit dismissed
the suit
•
•
Direct appellate review of ISDA/SIFMA’s challenge is not
available
Proper court is the District Court in D.C.
– Feb. 7, 2012: ISDA/SIFMA filed a Motion for Preliminary
Injunction with the D.C. District Court to delay implementation of
position limits until the legal challenge is decided.
38
IV. Where Will We End Up?
•
The Lawsuits Continue: ISDA/SIFMA Sue the CFTC
Over Position Limits
–
“Compliance Efforts will include restructuring of corporate relationships
and divestment—irreversible changes in ownership. These costs are
being incurred now and will continue to rise absent a preliminary
injunction, and they will be impossible to recoup if the rule is
invalidated—as it likely will be.”*
•
–
Eugene Scalia – counsel for ISDA/SIFMA
How will the case be decided? Will other suits be filed?
*Source: Tom Schoenberg, “Wall Street Groups Seek to Delay CFTC Rule Limiting Speculation,” Bloomberg Online
(Feb. 8, 2012).
39
IV. Where Will We End Up?
•
Impact of Legal Challenges on CFTC’s Approach:
– CFTC is rewriting Dodd-Frank rules to more fully analyze the
economic impact on business.
– Commissioner O’Malia: “We’re not there yet.”
•
Cost-benefit analysis must be bolstered for each rule to pass
judicial scrutiny.
– Result: Delays in voting on final regulations.
40
IV. Where Will We End Up?
•
Implementation Delays:
– ROUND ONE: Effective Date for Swap Regulation (76 Fed.
Reg. 42,508) (07/19/11).
•
The effective date for Title VII provisions referencing key
defined terms (e.g., Swap, MSP, SD) was delayed until the
earlier of:
– The date definitional rulemakings become final, or
– December 31, 2011.
•
The repeal of CEA exemptions and exclusions has been
delayed until December 31, 2011.
41
IV. Where Will We End Up?
•
Implementation Delays:
– ROUND TWO: Amendment to July 14, 2011 Order for Swap
Regulation (76 Fed. Reg. 80,233) (12/23/11).
•
The effective date for Title VII provisions referencing key
defined terms (e.g., Swap, MSP, SD) has been further
delayed until the earlier of:
– The date definitional rulemakings become final; or
– July 16, 2012.
•
•
The repeal of CEA exemptions and exclusions has been
delayed until July 16, 2012.
Will there be another round of delays?
42
IV. Where Will We End Up?
•
Proposed Timeline for Final CFTC Rules:
January –
March 2012
•Client clearing documentation
•Commodity Options
•DCMs
•End-User Exception
•Entity Definitions
•External Business Conduct
•Internal Business Conduct
•Product Definitions
•Registration of MSP/SDs
•Reporting of Historical Swaps
•Segregation for Cleared Swaps
April 2012 and
Beyond
•Block Rule
•Capital and Margin
•Conforming Rules
•Disruptive trade practices
•Governance and conflict of interest
•Internal business conduct
•Implementation
•Process for making a Swap
available to trade
•SEFs
•Segregation for Uncleared Swaps
*Source: Chart published on CFTC website as of January 11, 2012.
43
IV. Where Will We End Up?
•
Pushback from Congress:
– Budget Fights in Washington:
•
Senate approved 19% increase of CFTC’s 2012 budget
•
In June, the Republican-controlled House denied Obama’s
request to increase CFTC funding for 2012.
– Passed appropriations bill that decreased the CFTC’s 2012
budget.
•
Will the CFTC, SEC and the Consumer Financial
Protection Bureau (CFPB) have sufficient funds to actually
enforce the Act?
44
IV. Where Will We End Up?
•
Pushback from Congress:
– Legislation to Loosen Dodd-Frank’s Grip: Passed House
Committee; recommended for full vote by the House.
•
•
•
H.R. 2682: Clarifies the End User exemption
H.R. 2586: Concerns the regulation of Swap Execution Facilities
H.R. 2779: Exempts inter-affiliate swaps from Dodd-Frank
– Dodd-Frank = Big Government?
– Tea Party Effect
– Election 2012
45
IV. Where Will We End Up?
•
International Pushback: Overseas Swaps
– How Will Dodd-Frank Impact Overseas Trading?
•
Under the Act, if swaps are not cleared, then MSPs and SDs
generally must comply with capital and margin requirements.
•
In 2008, the Federal Reserve estimated that between 55% and
75% of U.S. banks’ notional derivative exposure was held in nonU.S. operations.*
•
§ 722d: The CFTC may apply its rules to transactions with a
“direct and significant connection with activities in, or effect on,
commerce in the United States.”
*Source: Silla Brush, “Banks Fight to Exempt Half of Swaps Books,” Bloomberg Online (Jan. 29, 2012).
46
IV. Where Will We End Up?
•
International Pushback: Overseas Swaps
– Five major U.S. Banks are aggressively seeking a “foreign
exemption” from the clearing and margin requirements for nonU.S. swaps.
– The exemption is gaining bipartisan support from Congress:
•
Rep. Barney Frank (D-MA) – namesake of the Act has urged the
CFTC to rein in its regulatory reach.
•
Ben Bernanke, Fed Chairman, testified to Congress:
– “If those margin rules for foreign operations are maintained
and Europeans and other foreign jurisdictions do not match it,
that would be a significant competitive disadvantage.”
47
IV. Where Will We End Up?
•
International Pushback: Overseas Swaps
– CFTC’s Chairman Gensler:
•
The CFTC may eventually defer to foreign regulations if
comparable and consistent with Dodd-Frank.
•
What is the metric for deciding that foreign laws are sufficiently
“comparable and consistent” with the Act?
– Dodd-Frank’s impact on U.S. banks’ operations overseas is still
very much up in the air.
•
•
Will increased costs imposed on U.S. banks drive more trading
overseas?
What exactly will finalized CFTC rulemakings require?
48
IV. Where Will We End Up?
•
International Pushback: Volcker Rule
– General Rule: U.S. Banks are not allowed to engage in
“proprietary trading”
•
•
Separates Wall Street risks from Main Street banks
Intended to put a stop to “too-big-to-fail”
– U.S. Banks—and possibly foreign banks that do business in
America—are restricted from trading foreign government bonds.
– ISSUES: Impact on world banking markets
•
•
•
Increased borrowing costs for foreign governments?
Decrease in “market-making” services by U.S. banks overseas?
Creating volatility in already unstable global debt markets?
49
IV. Where Will We End Up?
•
Concentration Risk: The Impact of Clearing
– Decreases risk for individual market participants
– Increases concentration of risk for DCOs and FCMs
–
•
CFTC regulations may not adequately protect against a DCO or
FCM default
•
What if MF Global had been a clearing member of a DCO?
See Protection of Cleared Swaps Customer Contracts and Collateral
(77 Fed. Reg. 6,336) (Feb. 7, 2012)
50
IV. Where Will We End Up?
Financial
Meltdown
Dodd-Frank Act
Protection from
next crisis?
51
IV. Where Will We End Up?
•
Transition to Physical?
– Any migration will be slow
– Unclear how far this will go, especially because of questions
regarding CFTC’s jurisdiction
– Financial transactions are easier
52
IV. Where Will We End Up?
•
New CFTC Director: Division of Swap Dealer and
Intermediary Oversight
– New York derivatives attorney, not banker or politician
– Will this result in a more pragmatic approach?
•
Continued pushback on “End User” definition:
– Everybody wants some
– How about you?
53
V. Conclusion
•
An End User is not exempt from Dodd-Frank simply
because it meets the Act’s definition.
•
Identify the regulations and requirements that apply to
your particular business.
•
Analyze internal systems, operations and processes to
ensure compliance.
•
Monitor CFTC rulemaking updates to avoid surprises.
54
Should you be focused on the
Dodd-Frank Act?
YES!!!
55
Questions?
Craig R. Enochs
[email protected]
Tel: (713) 752-4315
Kevin M. Page
[email protected]
Tel: (713) 752-4227
Jackson Walker L.L.P.
1401 McKinney, Suite 1900
Houston, Texas 77010
56