Comparing Collateral Segregation Regimes for Uncleared Swap Margin

The proposed margin rules from the CFTC and the prudential regulators, when considered alongside the existing CFTC collateral segregation rules, present the potential for three different collateral segregation regimes applying to initial margin posted to a swap dealer. To compare the differences, we have created a chart of the three collateral segregation regimes, available here.

The Dodd-Frank Act provided the customers of swap dealers the “right” to require segregation of initial margin for uncleared swaps, instead of posting such margin directly with the swap dealer. In November of 2013, the CFTC released the final rules implementing collateral segregation for initial margin on uncleared swaps (the “CFTC Collateral Segregation Rules”). See our prior post for a Q&A on the CFTC Collateral Segregation Rules.

Separately, both the CFTC and the prudential regulators have now proposed rules requiring swap dealers and certain financial end-user counterparties to post collateral as margin for uncleared swaps (the “CFTC Margin Rules” and the “Bank Margin Rules”, respectively, and together the “Margin Rules”). The Bank Margin Rules would apply to uncleared swaps with prudentially regulated swap dealers and the CFTC Margin Rules would apply to uncleared swaps with all other swap dealers. The Margin Rules propose requirements for swap dealers to segregate initial margin posted by counterparties.

See our prior post for more information on the Bank Margin Rules. The CFTC Margin Rules can be found here.

The CFTC Collateral Segregation Rules, CFTC Margin Rules, and Bank Margin Rules, however, each set out somewhat different regimes with respect to the requirements for collateral segregation for initial margin posted to a swap dealer, and each set of rules applies to a different group of swap dealers. Click here for a chart identifying the differences between the collateral segregation regimes.

Overall, the CFTC Collateral Segregation Rules provide for more detailed segregation requirements and are (in some respects) more protective of the counterparty. For example, the CFTC Collateral Segregation Rules require the account to be held for and on behalf of the counterparty and typically provide for joint control of the collateral. Importantly, however, the CFTC Collateral Segregation Rules would allow an affiliate of the swap dealer to be the custodian if it is a separate legal entity where the Margin Rules prohibit swap dealer affiliates from being a custodian.

The CFTC Margin Rules also propose to exclude margin required to be posted by the counterparty under the CFTC Margin Rules from the counterparty’s ability to elect segregation under the CFTC Collateral Segregation Rules. There is no such exclusion for initial margin required by the Bank Margin Rules. More importantly, the CFTC Margin Rules propose to reduce the segregation protections available to counterparties for collateral required to be posted to non-prudentially regulated swap dealers, but without indicating how these rules can be rationalized with the CFTC Collateral Segregation Rules.

It may not be necessary for all three rules to use the same collateral segregation regime, but the rules really should work together, or non-swap dealer counterparties will be unclear as which protections that the law intends them to have. The CFTC Collateral Segregation Rules apply at the election of the counterparty. The Margin Rules could provide for the a basic level of segregation and the CFTC Collateral Segregation Rules would then provide the counterparty the option to elect a more protective regime. As proposed, however, the segregation regimes are inconsistent, and the CFTC Collateral Segregation Rules apply differently depending on whether the collateral is required by the CFTC Margin Rules.

As an aside and final note: Historically parties have not voluntarily segregated collateral for swaps unless required by some other regulation (such as the Investment Company Act of 1940). To date, most counterparties have opted not to require segregation of collateral under the CFTC Collateral Segregation Rules. This is primarily because of the following additional costs—

  • Custodian fees; and
  • The swap dealer’s increase in the swap pricing due to losing the income that it would earn from investing the collateral.

If initial margin is required to be segregated under the Margin Rules, those segregation costs (at least for initial margin) will no longer be additional; custodian fees and the lost ability to invest collateral will already apply. As a result, we expect that more counterparties will be willing to elect the protections under the CFTC Collateral Segregation Rules once the Margin Rules come into effect. But The Swap Report believes the collateral segregation regime imposed by the Dodd-Frank Act rules on swap dealers of all types should be consistent, in any event.

Comments on the Bank Margin Rules are due November 24, 2014 and comments on the CFTC Margin Rules are due December 2, 2014. The Swap Report

CFTC Chairman Massad Announces Open Meeting on Three End-User Issues

This afternoon, CFTC Chairman Timothy Massad announced a public meeting of the CFTC to take place on November 3, 2014 at 10:30 am (Eastern). The meeting will address the "further fine-tuning of [the CFTC] rules" with respect to commercial end-users. The meeting is scheduled to consider:

  1. clarification to the rules regarding when forward contracts with volumetric optionality should be classified as "swaps";
  2. whether the CFTC should codify in a rule prior no-action relief with respect to the CFTC Rule 1.35 recordkeeping obligations (see our prior coverage here and some of the letters here and here); and
  3. whether the CFTC should require CFTC action before moving the deadline for FCMs to post "residual interest" to any earlier than 6:00 pm on the next business day after the trade date (this ultimately affects when end-users must post margin with an FCM).

The Press Release regarding the meeting can be found here. Chairman Massad's statement regarding the meeting can be found here.

This meeting marks the latest event in a new trend at the CFTC: the "tweaking" of CFTC rules to address end-user concerns. Earlier instances include:

  • the approval of an amendment to Dodd-Frank Act rules for government-owned electric and natural gas utilities (see our prior post here); and
  • no-action relief (for some funds) from the general solicitation restrictions in CFTC Rule 4.7 and CFTC Rule 4.13(a)(3) to harmonize the CFTC rules with the SEC rule changes arising from the JOBS Act (see our prior post here).

Stay tuned to see if this trend of "tweaking" continues. The Swap Report

Approaching Ambiguities in the Financial Entity Definition

The third installment of our ongoing series on the 2014 CFTC Reauthorization Act covers a potential change to the definition of a "financial entity", which has been a particularly troublesome and confusing definition for end-users, and the banks that enter into swaps with them. In addition, the CFTC may be able to address the confusion through its rule making and interpretations, without the need for a legislative change.

We will start with an overview of the financial entity definition and some background as to its ambiguities. Those familiar with these issues can read ahead and skip to the potential solutions after the jump 

The Ambiguities Within the Financial Entity Definition

A key part of the End-User Exception to the Dodd-Frank Act clearing and trading requirements is that it is not available to a "financial entity" as defined in Section 2(h)(7)(C) of the Commodity Exchange Act. (For more on the End-User Exception, see our prior post, including a walking map to claiming the End-User Exception). Section 2(h)(7)(C) includes all of the following as financial entities:

  • swap dealers and security-based swap dealers;
  • major swap participants and major security-based swap participants;
  • commodity pools;
  • private funds (as defined in Section 202(a) of the Investment Advisers Act of 1940); and
  • employee benefit plans (as defined in paragraphs (3) and (32) of the Employee Retirement Income Security Act of 1974).  

Those descriptions are defined and clear. The Dodd-Frank Act, however, also added a catch-all prong in the financial entity definition which includes: "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 [4(k) of the Bank Holding Company Act ("BHCA")]" (the “Catch-All”).

Congress' intent in the Catch-All was to avoid having a loophole allowing entities to avoid the clearing and trading requirement. However, the Catch-All adds multiple layers of ambiguity onto the definition of a financial entity and the resulting ability to claim the end-user exception. First, the definition of "predominantly" with respect to the Catch-All is never clearly defined, either in Title VII of the Dodd-Frank Act or the CFTC rules. We note that Titles I and II of the Dodd-Frank Act also contain tests using language similar to the Catch-All on the financial entity definition, but in each case, the statute also provides a specific test of what “predominantly engaged” means (i.e., 85% of the consolidated revenues comes from financial activities), but we note that each title has a slightly different test. Title VII of the Dodd-Frank Act provided no such test. In the CFTC’s adopting release for the end-user exception, it described that when financial activities are incidental and not primary activities, the entity is not “predominantly” engaged in financial activities, but CFTC has not provided a clear rule for what constitutes being “predominantly” engaged.

In addition, the use of activities "that are in the business of banking" or "are financial in nature, as defined in section [4(k) of the BHCA]" result in ambiguity and confusion as to the application of the definition.

To understand the confusion, we first have to look at the purpose of the business of banking and Section 4(k) of the BHCA. Banking regulation generally limits the activities of banks and precludes them from engaging in commercial activities (considered to be too risky for a bank). However, over the years, the prudential bank regulators have allowed banks to engage in certain activities that are related or incidental to banking operations or are financial in nature. For example, a bank is permitted to engage in trust services, real estate settlement, and courier services for money or checks. The business of banking and Section 4(k) of the BHCA are permissive regulations that define what activities a bank may engage in. However, the Catch-All refers to those terms to define what activities are financial and those permissive regulations do not cleanly apply to the application of financial entity definition. Moreover, commercial entities (or those entities that people would typically consider commercial) also engage in some of the activities that banks are permitted to engage in. In the adopting release for the end-user exception, the CFTC specifically declined to interpret what activities fall under the business of banking and Section 4(k) of the BHCA because those terms come from statutes interpreted by the Office of the Comptroller of the Currency (the “OCC”) and the Board of Governors of the Federal Reserve (the “Fed”), respectively.

Importantly, Section 4(k) of the BHCA includes engaging as principal in forward contracts, options, futures, swaps, and similar contracts. However, many commercial manufacturers, producers, shippers, energy firms and others use those exact products to hedge and manage their risks and in an incidental or ancillary role to their commercial activities.

In addition, many corporations are structured so that all of the organization’s treasury, borrowing, and hedging activities are located in one subsidiary (a treasury affiliate). A treasury affiliate would likely be a financial entity under the Catch-All, while the same activities ultimately for the same company, under a different organizational structure, would not be a financial entity

For those readers that have stuck with us this long, we continue with some potential solutions after the jump . . .

Continue Reading...

CFTC Approves Important Rule Amendment for Government-Owned Utilities and Their Swap Counterparties

By Patricia Dondanville and Tom Watterson

On September 17, 2014, at the first Open Meeting of the Commodity Futures Trading Commission chaired by Timothy Massad, the CFTC approved an important amendment to its Dodd-Frank Act rules for government-owned electric and natural gas utilities (“utility special entities,” in the parlance of the Dodd-Frank world) and their swap counterparties. The rule amendment provides a permanent regulatory fix to a serious problem for utility special entities arising out of the CFTC rules published in 2012 defining which entities must register with the CFTC as “swap dealers.”

The CFTC’s fact sheet summarizing the final rule amendment is here, and the CFTC’s Q&A is here. The final rule amendment will be effective when published in the Federal Register. The rule amendment is in response to a Petition originally filed by government-owned utilities in July of 2012 (a copy of the Petition is here), and it codifies a no-action letter issued by the CFTC staff in March of 2014 (a copy of the no-action letter is here).

The CFTC swap dealer rules include two de minimis thresholds which permit an entity to engage in a certain amount of swap dealing activity before the entity is required to register with the CFTC as a swap dealer. For swap dealing transactions in general, the de minimis threshold is currently $8 billion per rolling 12-month period. By contrast, for swap dealing transactions with “special entities,” the CFTC established a much, much lower de minimis threshold -- $25 million. However, the operations-related swaps used by a utility special entity to hedge the ongoing risks of its utility business have relatively large notional amounts, due to the utilities’ customer service obligations, the weather fluctuations and commodity price volatility in certain regional markets (especially during times of market stress like a winter “polar vortex”), and the long-term nature of utility hedging swaps. If a non-registered swap dealer counterparty entered into one swap with one utility special entity, that counterparty might decide not to offer any more swaps to utility special entities for 12 months. As a result, the $25 million threshold was severely limiting utility special entities’ ability to cost-effectively hedge their (and their utility customers’) commercial risks.

In the rule amendment, the CFTC was responsive to both the utility special entities’ 2012 Petition, as well as to public comments on the proposed rule amendment issued in June of 2014. In remarks at the Open Meeting, Chairman Massad and each of the other Commissioners noted that this rule amendment is an example of the need for the Commission to “tweak” or “fine-tune” the complex web of swaps rules, to accommodate the needs and concerns of commercial end-users who depend on the derivatives markets to cost-effectively hedge their ongoing business risks – particularly commercial end-users in the energy industry.

Different end-user groups have asked for clarifications, exemptions and no-action relief from rules and interpretations that simply don’t make sense for commercial enterprises trying to hedge ongoing business operations and commercial risks. The CFTC might also consider suspending the applicability of some of the rules to commercial end-users, until the rules are beta-tested on financial commodities and market professionals. Commercial end-users, including the energy companies and utilities, have been inundated with new CFTC regulatory requirements. The Swap Report is hopeful that the new Chairman and the CFTC will continue to be responsive to end-user concerns, and will propose rule amendments, clarify ambiguous interpretations, and provide exemptive relief, keeping in mind that nonfinancial commodity swaps must remain available, affordable and accessible for commercial businesses seeking to hedge customized business risks.

We welcome this tweaking of the Dodd-Frank Act rules for swaps and we hope further “tweaks” are on their way. The Swap Report
 

CFTC Staff Provides JOBS Act Harmonization Exemptive Relief

Attention hedge funds, private equity funds, venture capital funds, and other private funds (collectively, "private funds"). This evening (September 9, 2014) , the CFTC Division of Swap Dealer and Intermediary Oversight (“DSIO”) issued CFTC Letter 14-116 providing exemptive relief (for some funds) from the general solicitation restrictions in CFTC Rule 4.7 and CFTC Rule 4.13(a)(3) to harmonize the CFTC rules with the SEC rule changes arising from the Jumpstart Our Business Startups Act (the “JOBS Act”).

CFTC Letter 14-116 is available here.

Until now, many private funds have been unable to take advantage of provisions in the JOBS Act permitting general solicitation investors due to restrictions in CFTC Rule 4.7 and CFTC Rule 4.13(a)(3). Those readers familiar with the JOBS Act and CFTC Rule 4.13(a)(3) and CFTC Rule 4.7 can skip the next three paragraphs and move straight to the exemptive relief.

Private funds generally rely on the safe harbor for private offerings of securities in Regulation D of the SEC Rules. Previously, Regulation D precluded private funds relying on that safe harbor from offering or selling its securities by any form of general solicitation or general advertising. Congress enacted the JOBS Act in 2012. In July, 2013, the SEC amended Regulation D to implement section 201(a) of JOBS Act. The amendment added SEC Rule 506(c), which permits issuers such as private funds to engage in general solicitation or general advertising in offering and selling securities pursuant to SEC Rule 506, provided that all purchasers of the securities are accredited investors, and issuers take reasonable steps to verify that such purchasers are accredited investors. (For additional information on the JOBS Act and private funds, see a previous Client alert, SEC Lifts Ban on General Solicitation by Private Funds, by Justine Patrick and Thao Ngo).

However, the operator (most often the investment manager) of any private fund using derivatives regulated by the CFTC would have to either register as a commodity pool operator ("CPO") or claim an exemption from registration as such. Private funds typically rely on either:

  • CFTC Rule 4.13(a)(3)--providing an exemption from CPO registration with respect to pools with a de minimis amount of derivatives and where investors are sophisticated; or
  • CFTC Rule 4.7--providing an exemption from certain CFTC rules for CPOs with respect to pool offerings limited to qualified eligible persons.

Both CFTC Rule 4.7(b) and CFTC Rule 4.13(a)(3) include restrictions on marketing the pool to the public or offering the pool securities to the public. As a result, although the Jobs Act removed general advertising and solicitation restrictions for private funds (so long as only accredited investors purchased the securities), if those private funds relied on CFTC Rule 4.7 or CFTC Rule 4.13(a)(3), then the CPO was still precluded from generally soliciting investors.

Enter CFTC Letter 14-116. CFTC Letter 14-116 provides relief to certain CPOs from the requirements in (i) CFTC Rule 4.13(a)(3)(i) that securities be “offered and sold without marketing to the public"; and  (ii) CFTC Rule 4.7(b) that an offering be exempt pursuant to section 4(a)(2) of the 33 Act and be offered solely to qualified eligible persons. The exemptive relief is subject to conditions.

First, only CPOs of issuers relying on SEC Rule 506(c) under Regulation D or using resellers under SEC Rule 144A may qualify for the exemptive relief in CFTC Letter 14-116.

Second, CPOs claiming the exemptive relief must file a notice with the DSIO.

Third, the CPO must represent that it meets all of the remaining provisions of the applicable exemption. The pool securities offered generally may not be actually sold to the public. Additionally, a CPO relying on CFTC Rule 4.13(a)(3) could not market the pool as a vehicle for commodity futures or options trading.

 A long awaited harmonization for private funds. The Swap Report

Bank Regulators Re-Propose Rule for Margin on Uncleared Swaps

This afternoon, the Federal Reserve, Federal Deposit Insurance Corp, Office of the Comptroller of the Currency, Farm Credit Administration, and the Federal Housing Finance Agency (the "Prudential Regulators") released re-proposed rules requiring swap dealers and major swap participants* to hold margin for uncleared swaps (the "Re-Proposed Margin Rules"). The Re-Proposed Margin Rules are available here. The Federal Reserve press release on the Re-Proposed Margin Rules is available here.

The Re-Proposed Margin Rules, if adopted, would apply to swap dealers and major swap participants that are regulated by a Prudential Regulator. The CFTC has released proposed margin rules for swap dealers not regulated by a Prudential Regulator and it is unknown at this time whether the CFTC will finalize those margin rules or re-propose new margin rules.

The Prudential Regulators initially released proposed rules on requiring swap dealers to hold margin for uncleared swaps in 2011 (the "Initial Margin Rules") under the Dodd-Frank Act provisions regarding swap dealer regulation, but the rules were never finalized. Since the release of the Initial Margin Rules, the Basel Committee on Banking Supervision and the International Organization of Securities Commissions produced a framework for margin requirements on uncleared swaps, which the Re-Proposed Margin Rules generally follow.

Comments on the Re-Proposed Margin Rules will be due within 60 days after the proposal is published in the Federal Register.

Stay tuned for further updates on margin rules for uncleared swaps. The Swap Report

* These also apply to security-based swap dealers and major swap participants, but for ease of reference, we only refer to swap dealers in this post

Attention Mutual Funds--Potential Relief for CPO and CTA Regulation in the 2014 CFTC Reauthorization Act

By Tom Watterson and Crystal Travanti

As the second part of our ongoing series on the 2014 CFTC Reauthorization Act, we wanted to highlight what could become important relief for mutual funds and their investment advisers with respect to registration as commodity pool operators ("CPOs") or commodity trading advisers ("CTAs").

In a late addition to the proposed 2014 CFTC Reauthorization Act, the House added a section 361, "Treatment of certain funds", amending the definitions of a CPO and CTA in the Commodity Exchange Act to exclude investment advisers of mutual funds (registered investment companies) in certain circumstances. Section 361, as passed by the House, excludes from the definition of a CPO, investment advisers that provide advice to mutual funds where the only "commodity interests", or CFTC regulated products, that the mutual fund invests in are "financial commodity interests." Similarly, section 361 excludes from the definition of a CTA, investment advisers who provide advice to mutual funds where the adviser provides advice on commodity interests only in relation to "financial commodity interests."

Section 361 would define "financial commodity interests" as "a futures contract, an option on a futures contract, or a swap, involving a commodity that is not an exempt commodity or an agricultural commodity." Practically, a financial commodity interest would be a swap or future on interest rates, credit, foreign exchange, stock indices, indices based on rates or prices. For example, an adviser of a mutual fund using treasury futures to manage its duration, or using credit default swaps to gain credit exposure to certain entities would be covered by the exclusion in section 361. The exclusion would not apply to advisers of mutual funds that use futures or swaps on agricultural or energy products.

Prior to 2012, CFTC Rule 4.5 excluded investment advisers to mutual funds from the definitions of a CPO or CTA. In February of 2012, the CFTC released final rules amending CFTC Rule 4.5 to add a requirement that mutual funds relying on the exclusion limit futures and commodity option positions other than bona fide hedging positions to a de minimis level of the funds total assets. At the same time, the Dodd-Frank Act included an expanded definition of a "swap" and included swaps as "commodity interests". Together with the amendments to CFTC Rule 4.5, these change resulted in a significant number of mutual funds becoming subject to the dual regulatory regimes of the SEC and the CFTC. In addition, even if not subject to full CFTC regulation, mutual funds now have an additional compliance burden to track their commodity interest exposure with respect to the Rule 4.5 limits.

Although the CFTC released rules harmonizing the disclosure rules for mutual funds subject to SEC regulation, investment advisers to mutual funds that must register as CPOs still undergo an increased regulatory burden. Section 361 of the 2014 CFTC Reauthorization Act seeks to remove the additional burdens added by the 2012 revisions of CFTC Rule 4.5 for advisers to those mutual funds that only trade "financial" CFTC regulated products.

The House bill on the 2014 CFTC Reauthorization Act is available here.

Mutual funds will want to keep up-to-date with this section of the 2014 CFTC Reauthorization Act as the bill progresses. The Swap Report

Special thanks to Renold Sossong for his assistance with this post

The 2014 CFTC Reauthorization Act: An Ongoing Series

By Tom Watterson and Crystal Travanti

In late June, the U.S. House of Representatives passed a bill to reauthorize the CFTC, HR 4413, located here (the “2014 CFTC Reauthorization Act”), which includes a number of revisions to the Dodd-Frank Act and CFTC regulations. Most of these proposed changes are an attempt to limit some of the added regulatory burden for various swap end-users. We are beginning a series of posts that will further analyze the 2014 CFTC Reauthorization Act. The remainder of this post will provide a background on the reauthorization process.

Unlike many federal agencies, the CFTC, since its inception, has been authorized with 5 year sunset provisions (however this period often extends to longer than five years). As a result, every five years, Congress must reauthorize the existence of the CFTC. This requirement for reauthorization creates “built-in” opportunity for legislative changes and provides the means for a regular review of the CFTC and the Commodity Exchange Act.

The CFTC was most recently reauthorized in 2008 as part of the 2008 Farm Bill and the CFTC’s statutory authority lapsed in the Fall of 2013 (note that prior to the 2008 reauthorization, the CFTC’s authority had lapsed in 2005, so some delay can occur between a lapse and reauthorization). The 2014 CFTC Reauthorization Act will now be considered by the Senate and will need to be passed by the Senate and signed by the President prior to enactment.

To keep in touch with our periodic updates, keep checking this post, or subscribe to our automatic email updates at www.theswapreport.com (on the left side of the screen). The Swap Report

Breaking: ISDA Announces Credit Event for Argentina

Breaking--ISDA just announced that its Determination Committee decided that a "failure to pay" Credit Event has occurred with respect to the Argentine Republic.

The date of the Credit Event is July 30, 2014.

The ISDA Press Release can be found here, and the Determination Committee Decision can be found here.

The Swap Report

CFTC No-Action Relief from Potentially Burdensome Requirement for Automated Form 40S Response to CFTC 'Special Calls'

On July 23, the CFTC staff issued No-Action Letter 14-95 (available here) extending the compliance date from August 15, 2014 to February 11, 2016 for use of new Forms 40/40S—reports solicited from market participants by "special call" of the CFTC—and the CFTC’s automated filing interface for such Forms.

We published a recent Client Alert, here, with a discussion of the No-Action Letter and a background on the new Form 40/40S. We also provide a summary below.

Under the CFTC Rules regarding large trader reporting, futures commission merchants , and certain other intermediaries, make periodic reports to the CFTC regarding accounts of customers that hold large positions in exchange traded futures and options. Once an account reaches a reportable size, the CFTC may then contact the customer directly and require that the trader file a Form 40 with more detailed information.

In 2011, the CFTC revised its Large Trader Reporting Rules to solicit information about certain swap positions. The CFTC then began receiving reports from swap dealers that identify the swap dealers’ counterparties to swaps that are linked to certain commodity futures contracts or the physical commodities underlying those contracts. The CFTC may then contact the swap counterparty directly and require that the counterparty file a "Form 40S," the swap version of Form 40. The CFTC requirement for a company to file a Form 40 or Form 40S is called a "special call."

In November 2013, the CFTC published its final new Large Trader Reporting FORMS—including new Form 40/40S to be used for its special call authority in respect of “swaps.” The new Form 40/40S requirements differ in several ways from the prior Form 40 rules. For example, once effective, the new CFTC rules will require Form 40/40S to be submitted electronically to the CFTC via an automated web interface. The new Form 40/40S rules also require the commercial entity that receives such a special call once to CONTINUE TO SUPPLEMENT AND UPDATE its Form 40S, whether or not the entity receives another periodic special call from the CFTC.

The CFTC has not yet developed the necessary automated web interface and as a result has extended the compliance date for the use of the new Form 40/40S to February 11, 2016. Note that if a company receives a special call, it stil must comply through the use of the old Form 40 or otherwise following the CFTC directions in the special call.

The Swap Report

Commissioner Scott O'Malia to Become CEO of ISDA - Will ISDA Increase its Focus on the Energy Industry, Commercial Market Participants and Physical Commodity Markets?

By Patty Dondanville and Tom Watterson

Following the CFTC announcement that Commissioner Scott O’Malia has resigned his position effective August 8th (see our prior post about that announcement here), ISDA has now announced that O’Malia will become its CEO effective August 18th. ISDA’s Press Release is available here.

O’Malia’s leadership of ISDA could be a particularly important development for those in the energy industry and other commercial market participants, including “end-users.” O’Malia takes over the helm at ISDA from long-time financial industry stalwart Robert Pickel, and O’Malia brings his perspectives and background in the energy industry with him. With O’Malia on board, ISDA may increase its focus on the energy and physical commodity markets, and how those markets and commercial hedgers are impacted by increasingly complex global regulation.

O’Malia could expand ISDA’s traditional perspective from the financial trading and investment markets, where “sell-side” dealers provide products and the “buy-side” makes investments in those products to focus on the complex ways in which commercial enterprises use energy and other physical commodity derivatives to hedge global and dynamic commercial risks that arise from ongoing business operations.

As a CFTC commissioner, O’Malia had an open door policy when it came to the energy industry and other commercial groups. In his well documented dissents from some of the Commission’s final rules and other public statements, O’Malia focused attention on:

  1. the international nature of the energy and other physical commodity markets;
  2. the importance of maintaining liquid commodity and derivative trading markets to enable commercial end users to hedge the risks that arise from ongoing business operations; and
  3. the regulatory challenges faced by global commercial business enterprises, as distinguished from financial institutions and investors.

O’Malia also focused on understanding the complex legal structure of the OTC derivatives markets, and the policy implications of regulating the commercial world’s use of commodities and physical commodity-based derivatives. In recent months, O’Malia and former Acting Chairman/now Commissioner Wetjen repeatedly acknowledged the need to fix CFTC rules adopted in haste that are hampering commercial entities’ ability to hedge risks arising from business operations. The two-member commission also called for careful deliberation before moving forward with the important remaining CFTC rules on position limits and margin/collateralization.

We hope “soon-to-be former Commissioner” Scott O’Malia will continue his efforts on behalf of the energy industry and other commercial market participants as CEO of ISDA. The Swap Report

Commissioner O'Malia to Leave CFTC

On Monday, July 21st, the CFTC issued a press release noting that CFTC Commissioner Scott D. O'Malia tendered his letter of resignation, and intends to resign effective August 8th.

The CFTC press release can be found here, and his letter of resignation can be found here.

Commissioner O'Malia's resignation will mark the fourth departure of a CFTC Commissioner in just over a year.

Farewell, Commissioner O'Malia. The Swap Report

Summer Reading: Financial Stability Board Consultative Document on Foreign Exchange Benchmarks

The Financial Stability Board (FSB) released a Consultative Document on Foreign Exchange Benchmarks about potential market abuse on foreign exchange (FX) fixings. You can access the full report here. The report may be of particular interest to currency ETFs, multi-currency funds and portfolios, and corporate entities that seek to execute at the benchmark fix price.

Following the Libor scandal, a number of concerns were raised about the integrity of FX benchmarks, which stemmed from the incentives for potential market abuse linked to the structure of trading around the benchmark fixings. The FSB formed a group to analyze the FX market structure and incentives that may promote certain trading activity around the benchmark fixings. 

The FSB recommends that the FX fixing window be widened from its current width of one minute, and it seeks feedback from market participants as to the appropriate width.
 
The FSB also seeks feedback from market participants as to whether there is a need for alternative benchmark calculations (such as a volume weighted or time weighted benchmark price) calculated over longer time periods of up to and including 24 hours.
 
Enjoy the summer reading. The Swap Report

 

CFTC Extends Comment Period to August 4th for Aggregation and Position Limits Proposals

By Crystal Travanti and Tom Watterson

In the ongoing saga of the CFTC Position Limit Rules, the CFTC extended the comment periods for the Proposed Aggregation Rules and the Proposed Position Limits Rules until August 4, 2014.

The Proposed Position Limits Rules establish speculative position limits for 28 exempt and agricultural commodity futures and options contracts and the physical commodity swaps that are economically equivalent to such contracts. The Proposed Aggregation Rules amend existing regulations setting out the policy for aggregating the positions of affiliated entities under the CFTC position limits regime.  The CFTC extended the comment period to provide interested parties with an opportunity to comment on the issues regarding position limits for physical commodity derivatives, which were discussed at the CFTC Staff’s public roundtable on June 19, 2014.

Good day. Good commenting. TSR

District Court Affirms that Zero Purchase Price Repo Transactions May Be Considered "Repurchase Agreements" Under the Bankruptcy Code

By Todd Zerega and Luke Sizemore

INTRODUCTION

On February 18, 2013, we reported that the United States Bankruptcy Court for the District of Delaware (the “Bankruptcy Court”) found that individual repurchase transactions having a purchase price of zero may fall within the definition of “repurchase agreement” under the Bankruptcy Code provided that the master agreement governing such transactions acknowledges that each transaction constitutes consideration for every other transaction under the master agreement. On March 27, 2014, the United States District Court for the District of Delaware (the “District Court”) affirmed the Bankruptcy Court’s judgment, but disagreed with its rationale. This post examines the differences in the Courts’ logic.

FACTUAL BACKGROUND

In 2005, the debtor entered into a global master repurchase agreement (the “Master Agreement”) with a counterparty. The Master Agreement acknowledged that all individual transactions entered into thereunder constituted a single business transaction. The Master Agreement also provided that any payments, deliveries, and other transfers made by either of the parties in respect of any transaction shall be deemed to have been made in consideration of payments, deliveries and other transfers in respect of any other transactions entered into under the Master Agreement.

The debtor and its counterparty entered into numerous repurchase transactions under the Master Agreement. The written confirmations for certain, but not all, of these transactions showed a purchase price of zero (“Zero Price Repos”). Immediately prior to filing for bankruptcy, the debtor failed to pay the aggregate repurchase price on the date due, and the counterparty issued formal notices of default. An aggregate repurchase amount was owed because not all of the subject transactions were Zero Price Repos. Following the bankruptcy filing and the imposition of the automatic stay, the counterparty liquidated the securities subject to the Master Agreement, including but not limited to the Zero Price Repos, by auction, and used the auction proceeds to set off against the debtor’s aggregate unpaid repurchase amount.

BANKRUPTCY COURT PROCEEDINGS

Pursuant to the safe harbor provision of section 559 of the Bankruptcy Code, the counterparty to a “repurchase agreement” with the debtor may liquidate, terminate, or accelerate the repurchase agreement notwithstanding the imposition of the automatic stay. In the instant case, the counterparty believed that the Zero Price Repos qualified for these protections and, relying upon section 559, liquidated the securities without first seeking approval from the Bankruptcy Court. To the contrary, the debtor argued that the Zero Price Repos do not constitute “repurchase agreements,” as that term is defined in the Bankruptcy Code, and, as a result, the counterparty’s reliance on the safe harbor provision of section 559 was misplaced.

The term “repurchase agreement” is defined in the Bankruptcy Code, in part, as an agreement that provides for the transfer of one or more mortgage related securities against the transfer of funds by the transferee of such securities, with a simultaneous agreement by such transferee to transfer to the transferor thereof securities at a date not later than one year after such transfer or on demand, against the transfer of funds. 11 U.S.C. § 101(47)(A)(i) (emphasis added). There also is a “catchall provision” providing that the term “repurchase agreement” includes any security agreement or arrangement or other credit enhancement related to any agreement or transaction described above. 11 U.S.C. § 101(47)(A)(v).

The debtor argued that the Zero Price Repos cannot be “repurchase agreements” because the corresponding confirmations noted a zero purchase price, meaning that the securities were not transferred to the counterparty “against the transfer of funds.” The Bankruptcy Court disagreed. Relying upon the acknowledgment contained in the Master Agreements that each transaction thereunder constituted consideration for every other transaction, the Bankruptcy Court held that any transaction under the Master Agreements with a purchase price greater than zero provided sufficient consideration to satisfy the “transfer of funds” requirement with respect to the Zero Price Repos. Because the Zero Price Repos constituted “repurchase agreements” under the Bankruptcy Code, the Bankruptcy Court held that such transactions were entitled to the benefits provided to repurchase agreements under the safe harbor of section 559.

DISTRICT COURT’S ANALYSIS

The District Court agreed with this result, but not the Bankruptcy Court’s rationale. As a threshold matter, the District Court agreed that the acknowledgments in the Master Agreement make the Zero Price Repos part of a larger package for which there was consideration. However, citing to statements in the record, and without any analysis, the District Court found that the Zero Price Repos “could have been transferred back . . . without being ‘against the transfer of funds.’” Because of this possibility—that the Zero Price Repos could have been transferred back without consideration—the District Court concluded that the Zero Price Repos did not fall within the plain meaning of “repurchase agreement” under section 101(47)(A)(i) of the Bankruptcy Code.

The District Court then examined the “catchall provision” of section 101(47)(A)(v) and observed that there is no question that the Zero Price Repos were part and parcel of the Master Agreement. Consequently, the extra securities held by the counterparty in connection with the Zero Price Repos were within the umbrella of “credit enhancements” for the other undisputed repurchase transactions under the Master Agreement. As “credit enhancements,” the Zero Price Repos fall within the meaning of “repurchase agreement” under the catchall provision of section 101(47)(A)(v) of the Bankruptcy Code. Although the District Court’s rationale differs, the result is the same: liquidation of the securities associated with the Zero Price Repos was permitted by the safe harbor of section 559 of the Bankruptcy Code

The case may be found here.

Good day. Good liquidation. TSR