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

Potential New Clearing Determinations Under Consideration by the CFTC

By Andrew Cross and Tom Watterson

The CFTC is currently reviewing clearing determinations for two new classes of swaps.

The CFTC is currently reviewing what would be the first clearing determination for non-deliverable FX forwards (NDFs). The clearing determination would cover NDFs in USD with the following currencies:

  • Brazilian real (BRL)
  • Russian ruble (RUB)
  • Indian rupee (INR)
  • Chinese yuan (CNY)
  • Chilean peso (CLP)
  • Korean won (KRW)
  • Colombian peso (COP)
  • Indonesian rupiah (IDR)
  • Malaysian ringgit (MYR)
  • Philippines peso (PHP)
  • Taiwanese dollar (TWD)

In addition, the second clearing determination will mandate central clearing (unless an exception to central clearing applies) for fixed-for-floating interest rate swaps denominated in Australian dollars (AUD), Swiss francs (CHF), or Canadian dollars (CAD). Fixed for floating interest rate swaps denominated in US dollars (USD), British pounds (GBP), or Euros (EUR) are already subject to the central clearing mandate.

We expect that the CFTC will use the same implementation phase-in as for the interest rate and credit default index swaps, which was:

Category 1 Swap dealers, security-based swap dealers, major swap participants, major security-based swap participants, or active funds. 90 days after publication of the clearing determination
Category 2 Commodity pools, private funds, and persons predominantly engaged in activities that are in the business of banking, or in activities that are financial in nature (other than third party sub accounts or ERISA plans) 180 days after publication of the clearing determination
Category 3 All other entities not exempt from the clearing requirement 270 days after publication of the clearing determination

We note that nothing is final until we see a release from the CFTC, but we wanted to alert you to the potential requirements on the horizon.

Good day. Good alert. TSR

Seventh Circuit Court of Appeals Reverses District Court, Follows Trend of Applying Bankruptcy Code Safe Harbors Literally and Expansively

By Todd Zerega and Luke Sizemore

INTRODUCTION

On January 24, 2013, we reported that the United States District Court for the Northern District of Illinois (the “District Court”) declined to apply a literal interpretation of the Bankruptcy Code safe harbor provision protecting “settlement payments” and transfers “in connection with a securities contract” from avoidance and, instead, relied upon equitable considerations to determine that cash distributions from an investment advisor or a future commission merchant to its customers from the proceeds of a sale of securities to a third-party buyer may be avoided in bankruptcy. On March 19, 2014, the United Stated Court of Appeals for the Seventh Circuit (the “Appellate Court”) reversed the District Court’s decision, opting to apply the Bankruptcy Code safe harbor provision literally and expansively to protect such cash distributions from avoidance.

FACTUAL BACKGROUND

The debtor was an investment management company that served as a discretionary investment advisor with respect to assets deposited with it by its customers. Customers deposited cash with the debtor and, in exchange, received a pro rata beneficial interest in securities held by the debtor. Immediately prior to filing for bankruptcy, the debtor sold securities beneficially owned by its customers to a third-party buyer and distributed a portion of the sale proceeds to select customers.

PROCEDURAL BACKGROUND

The liquidating trustee filed adversary proceedings against former customers of the debtor seeking, among other things, to avoid and recover the pre-petition cash distribution as an unlawful preference under section 547(b) of the Bankruptcy Code. Based upon equitable considerations, the District Court held that the pre-petition cash distribution from the debtor to its customers of proceeds from the sale of securities between the debtor and a third-party buyer are not protected from avoidance by the Bankruptcy Code safe harbor provisions. In the District Court’s view, the safe harbor was designed to protect the sale of securities from the debtor to the third-party buyer; it was not designed to protect the distribution of the sale proceeds to the debtor’s customers. The District Court believed that shielding the debtor’s cash distribution to select customers would create the very systemic risk that the safe harbor was deigned to alleviate because the apportionment of losses among customers in the event of an investment advisor bankruptcy would be impossible to predict.

APPELLATE COURT’S ANALYSIS

In broad terms, section 546(e) of the Bankruptcy Code provides that a trustee cannot avoid a transfer that is a margin payment or settlement payment made by or to a commodity broker or a transfer made by or to a commodity broker in connection with a securities contract. This section is meant to insulate legitimate securities and commodities transactions from avoidance because of the potential destabilizing effects that unwinding such transactions could have on the broader market. In the instant case, there was no dispute that the defendant customers were “commodity brokers.” The only disputed issues were whether the cash distribution was a “settlement payment” or was made “in connection with a securities contract.” The Appellate Court answered both questions in the affirmative. As a result, the safe harbor protections of section 546(e) apply, and the pre-petition cash distribution to customers cannot be avoided as a preferential transfer.

The Appellate Court found that the cash distribution qualified as a “settlement payment” under section 546(e) because the debtor’s customers were entitled to pro rata shares of the value of the securities in their investment portfolios and, regardless of how the debtor chose to fund customer redemptions, whether by selling securities from the portfolio or paying customers with cash on hand, the redemptions were intended to settle, at least partially, the customers’ securities accounts with the debtor. Similarly, the Appellate Court found that the cash distribution qualified as a transfer made “in connection with a securities contract” because the distribution was made in connection with the customers’ investment agreement, which constituted a contract for the purchase or sale of securities regardless of the fact that customers were entitled to cash rather than the securities themselves.

Although acknowledging the District Court’s equitable goal of a fair distribution to all customers, the Appellate Court determined that the District Court’s reasoning runs directly contrary to the broad language of section 546(e) of the Bankruptcy Code. The Appellate Court explained that, by enacting section 546(e), Congress chose finality over equity for most pre-petition transfers in the securities industry. The safe harbor reflects Congress’s policy judgment that allowing some otherwise avoidable pre-petition transfers in the securities industry to stand is preferable to the uncertainty caused by putting every settlement payment made in the 90 days prior to bankruptcy at risk of being unwound by a bankruptcy court.

The case may be found here.

 Good day. Good distributions. TSR
 

CFTC Collateral Segregation Rules -- Q&A on Upcoming Collateral Segregation Notices

By Andrew Cross and Tom Watterson

Swap dealers have started to send out the first “Notification of Right to Segregation of Initial Margin posted in Respect of Uncleared Swaps” (the ISDA form notification is here). We have prepared the Q&A to cover some common questions arising from the Collateral Segregation rules. The Q&A does not cover every aspect of collateral segregation, but should help to cover the basics.

Q: Wait! I thought the margin rules were not final- Do I have to post initial margin now?
A: These notices do not mean that swap dealers must now collect initial margin, those rules are still in proposed form; but, we expect the CFTC to publish final rules this year.

Q: Why will I be getting these notices?
A: The Dodd Frank Act provided the customers of swap dealers the “right” to segregate initial margin for uncleared swaps, instead of posting such margin directly with the swap dealer. In November, the CFTC released the final rules implementing collateral segregation for initial margin on uncleared swaps. CFTC Rule 23.701 requires that swap dealers send out notifications to their counterparties informing them of the right to segregate initial margin with an independent third party.

Q: What is the “right” to segregation initial margin?
A: At a counterparty’s option, the counterparty’s “initial margin” must be segregated with an independent third-party pursuant to a custodial arrangement. Generally, CFTC Rule 23.700 defines “initial margin” as margin posted by the counterparty in excess of its swap obligations. By way of example, such margin would include the Independent Amount under the ISDA 1994 New York Law Credit Support Annex.

Q: Who can be a custodian?
A: Although the custodian must be a legal entity separate from the swap dealer, it may be an affiliate of the swap dealer. The swap dealer’s notice must identify at least one potential custodian that is creditworthy and not affiliated with the swap dealer.

Q: Why would I want to segregate initial margin?
A: Under US insolvency laws, typically, margin posted by a swap counterparty can be netted against outstanding swap obligations (without permission from the bankruptcy court or a bankruptcy official). Margin in excess of those swap obligations posted directly to a swap dealer, however, may be at risk upon the dealer’s insolvency. The purpose of segregation initial margin is to protect the counterparty’s rights with respect to that margin in the event of a swap dealer's insolvency.

*** As a caution and a brief aside, we note that in a Lehman SIPC proceeding, the collateral (including excess margin) held in a tri-party account with an independent custodian became Customer Property under SIPA (See the Fifth Third decision here).

Q: Why would I not want to segregate margin?
A: Generally, we would expect there to be a cost to the segregation. If you are using a custodian, then they will charge fees for their services. Additionally, we expect that swap dealers would also price the swap higher, because they would not be able earn income by investing or rehypothecating the segregated margin.

Q: I am a mutual fund or already use tri-party accounts for my margin requirements, do I have to renegotiate all of my control agreements?
A: No. Just as a counterparty can elect not to segregate initial margin, a mutual fund can continue to use its existing control agreement arrangements. We would expect that many funds will want to keep their existing control agreements (which cover both initial and variation margin) in place. However, the right to segregate initial margin subject to the CFTC rules may provide an opportunity to update control agreements, because the CFTC rules have a few requirements that depart from current market practice (see below).

Q: What are the CFTC requirements on segregation, if chosen?
A:

  • The segregation must be in an account segregated for and on behalf of the counterparty, and designated as such; 
  • The agreement for the account must be in writing;
  • If either the swap dealer or the counterparty is entitled to control of the margin pursuant to a swap agreement, then that party may issue a written notice to the custodian to take control of the margin;
  • Any such notice of control must be made under penalty of perjury;
  • Before any such notice of control, withdrawals of margin may only be made by joint instructions; and
  • Margin segregated may only be invested in accordance with CFTC Rule 1.25.

Q: What steps would I have to take to segregate initial margin?
A: After notifying your swap dealer of the election, you would have to set up an account at a custodian. Then, you would enter into an account control agreement with the swap dealer and the independant custodian in order to perfect the swap dealer's security interest in the account and the margin. We note that the CFTC requirements (see above) differ in some respects from what has become standard in most current account control agreements (such as those for mutual funds). For instance, the ability for the counterparty to access the collateral is a counterparty right that is only recently gaining traction. To this extent, ISDA has prepared a standard account control agreement form, located here, where you can see what such an agreement would entail. However, we note that control agreements are typically negotiated among the three parties and custodians may have existing forms that they will use.

Good day. Good notices. TSR