Impact and Analysis of the CFTC’s Final Rule Relating to the End-User Exception to the Clearing Requirement for Swaps

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")[1] 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. 

I.   Overview 

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").[2]  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);[3] (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[4] and (2) the final regulations to phase-in compliance with clearing requirements under the Dodd-Frank Act.[5]    

The text of the Final End-User Exception Rule is available here. 

II.   Criteria for Determining Whether a Swap Hedges or Mitigates Commercial Risk (CFTC Regulation § 39.6(c))

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)[6]; however, the application of such definition serves similar, but different purposes in the two rules.[7]  

          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:

• Such swap:
  • Is "economically appropriate" to the reduction of risks in the conduct and management of a commercial enterprise, where risks arise from a:
    • Potential change in the value of:
      • Assets that a person owns, produces, manufactures, processes or merchandises or reasonably anticipates owning, producing, manufacturing, processing or merchandising in the ordinary course of business of the enterprise;
      • Liabilities that a person has incurred or reasonably anticipates incurring in the ordinary course of business of the enterprise;
      • Services that a person provides, purchases or reasonably anticipates providing or purchasing in the ordinary course of business of the enterprise;
      • Assets, services, inputs, products or commodities that a person owns, produces, manufactures, processes, merchandises, leases or sells, or reasonably anticipates owning, manufacturing, processing, merchandising, leasing or selling in the ordinary course of business of the enterprise; or
    • Fluctuation in interest, currency or foreign exchange rate exposures arising from a person’s current or anticipated assets or liabilities; or
  • Qualifies as bona fide hedging for purposes of an exemption from position limits under the CEA; or
  • Qualifies for hedging treatment under Financial Accounting Standards Board (FASB) Accounting Standards Codification Topic 815 or under the Governmental Accounting Standards Board (GASB) Statement 53; and
• Such swap is:
  • Not used for a purpose that is in the nature of speculation, investing, or trading; and
  • Not used to hedge or mitigate the risk of another swap or security-based swap position, unless that other position itself is used to hedge or mitigate commercial risk as defined in this rule.

          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.[8] 

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."[9]  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."[10] 

          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."[11]  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.[12]  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: 

• the swap is used to reduce risks in the conduct and management of a commercial enterprise; and
• the "other swap" itself qualifies for the end-user exception.

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,[13] 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.[14]  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.[15] 

III.   Information that Counterparties Must Report to Satisfy the Notification Requirement (CFTC Regulation § 39.6(b))

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. 

• The following information must be provided by the reporting counterparty (as determined under Part 45 of the CFTC’s regulations) on a swap-by-swap basis:
  • Notice of the election of the exception; and
  • Identity of the electing counterparty to the swap
• The following information must be provided on a swap-by-swap basis by the reporting counterparty, unless the information has been provided by the electing counterparty in a current annual filing:
  • Whether the electing counterparty is a "financial entity" as defined in CEA Section 2(h)(7)(C)(i), and if the electing counterparty is a "financial entity," whether it is:
    • Electing the exception in accordance with CEA Section 2(h)(7)(C)(iii) (i.e., captive finance entity exception) or CEA Section 2(h)(7)(D) (i.e., executed as agent to a non-financial entity eligible for the exception); or
    • Exempt from the definition of financial entity under CEA Section 2(h)(7)(C)(ii) and CFTC regulation § 39.6(d) (i.e., small bank exemption).
  • Whether the swap hedges or mitigates commercial risk (the annual filing will state that the electing counterparty will only elect the end-user exception for swaps that hedge or mitigate commercial risk).
  • How the electing counterparty generally meets its financial obligations associated with entering into non-cleared swaps by identifying one or more of the following categories:
    • A written credit support agreement;
    • Pledged or segregated assets (including posting or receiving margin pursuant to a credit support agreement or otherwise);
    • A written third-party guarantee;
    • The electing counterparty’s available financial resources; or
    • Means other than those described immediately above.
  • Whether the electing counterparty is an entity that is an issuer of securities registered under Section 12 of, or is required to file reports under Section 15(d) of, the Securities Exchange Act of 1934, and if so:
    • The relevant SEC Central Index Key number for that counterparty; and
    • Whether an appropriate committee of that counterparty’s board of directors (or equivalent body) has reviewed and approved the decision to enter into swaps that are exempt from the clearing and execution requirements (i.e., board approval).
      • This requirement does not require board approval of each decision by an SEC Filer to enter into a swap that is exempt from the clearing requirement.  Board approval may occur on a general basis.
      • If the board delegates to a committee, such committee would be considered appropriate if it is specifically authorized to review and approve the SEC Filer’s decision to enter into swaps.

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.

IV.   Application of the End-User Exception to Certain Swaps and Entities

          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."[16]

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).[17] 

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. 

• If the parent or other corporate entity is entering into swaps "in its own name," then the end-user exception would be analyzed from the perspective of the parent or other corporate entity. 
• If a centralized hedging unit is a separate legal entity that predominantly engages in activities that are financial in nature[18] and such centralized hedging unit executes such swap as an agent to a non-financial affiliate that can elect the end-user exception (i.e., the centralized hedging unit is simply executed on behalf of the non-financial affiliate and the swap is in the name of the non-financial affiliate) the centralized hedging unit would be able to elect the end-user exception for such swaps on behalf of the non-financial affiliate.  
  • However, this affiliate exception will not apply to certain entities, including:
    • Swap dealers;
    • Security-based swap dealers;
    • Major swap participants;
    • Major security-based swap participants;
    • Issuers that would be an investment company under the Investment Company Act of 1940;
    • Commodity pools; or
    • Bank holding companies with over $50 billion in consolidated assets.
• If a centralized hedging unit is a separate legal entity that predominantly engages in activities that are financial in nature and such centralized hedging unit executes such swap on a principal basis (i.e., the swap is in the name of the centralized hedging unit and not the non-financial affiliate for which it is executing the swap) the centralized hedging unit would not be able to elect the end-user exception, even if the affiliate for which it is hedging is a non-financial end-user that can elect the end-user exception. 
• For example: 
  • If a swap that hedges or mitigates commercial risk is executed by ABC Corp. (a non-financial entity) through the ABC Corp. parent entity, ABC Corp. parent entity would likely be deemed not to be predominantly engaged in activities that are financial in nature and could elect to use the end-user exception. 
  • If a swap that hedges or mitigates commercial risk is executed by ABC Corp. Centralized Hedging Unit (a separate legal entity) that engages in treasury activities for ABC Corp., then such entity would likely be predominantly engaged in financial activities and the ABC Corp. Centralized Hedging Unit would be considered a financial entity and therefore:
    • If the market-facing swap is executed in the name of ABC Corp., where ABC Corp. Centralized Hedging Unit is serving as agent, then the end-user exception may be elected.
    • If the market-facing swap is executed in the name of ABC Corp. Centralized Hedging Unit, then the end-user exception could not be elected.

          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:

• First, such person must be in the "primary business" of providing financing of purchases or leases from its parent company or subsidiaries thereof.  The CFTC states that the captive finance company exception can be applied when this financing activity finances the purchase or lease of products sold by the parent company or its subsidiaries in a broad sense, including service, labor component parts, and attachments that are related to the products.
• The person must next comply separately with each of the two prongs set forth in CEA Section 2(h)(7)(C)(iii).  While the CFTC interprets each of the two prongs separately, both prongs must be satisfied to meet the exception eligibility.
  • Prong 1 – 90% or more of the interest rate and foreign currency exposure for which the captive finance company is using derivatives to hedge the related underlying commercial risks arises from financing that "facilitates" the purchase or lease of products; and
    • Financing should be measured on a consolidated basis.
    • The CFTC interprets the word "facilitates" broadly to include financing that may indirectly help to facilitate the purchase or lease of products. 
  • Prong 2 – 90% or more of the products, the purchase or sale of which are being facilitated by the financing, must be "manufactured" by the parent company or its subsidiary.
    • The CFTC requires only that the final product being purchased or sold, regardless of components, be manufactured by the parent company or its subsidiary in order to qualify.

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:

• Is organized as a bank, a savings association, a farm credit system institution or an insured Federal credit union or State-chartered credit union; and
• Has total assets of $10 billion or less on the last day of such person’s most recent fiscal year.

          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.

          G.   Cooperatives

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.[19]  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.

V.   Compliance with the Final End-User Exception Rule

Pursuant to the CFTC’s final implementation schedule for mandatory clearing, which was published in the Federal Register on July 30, 2012[20], 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).