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PLI: Understanding

Securities Law: Derivatives

July 26, 2013

NY2 721551

2

Title VII Overview • Objectives of Title VII

• Reduce systemic risk posed by the swaps market to the U.S. financial system

• Increase transparency of the swaps market, particularly as to both pre and post

execution pricing

• Enhance the integrity of the swaps market and improve the conduct of major

market participants

3

Title VII Overview (cont’d) • Regulates products

• Swaps

• Security-based swaps (SBSs)

• Regulates entities

• Swaps dealers

• Security-based swap dealers

• Major swap participants (MSPs)

• Major security-based swap participants

• Derivatives Clearing Organizations (DCOs)

• Swap Execution Facilities (SEFs)

• Swap Data Repositories (SDRs)

4

Title VII Overview (cont’d) • Splits regulation between CFTC and SEC

• CFTC regulates swaps, swap dealers and major swap participants

• SEC regulates security-based swaps, security-based swap dealers and major

security-based swap participants

• Most of the provisions of Title VII have been finalized, including:

• Swap dealer and MSP registration

• Swap data recordkeeping

• Swap data reporting

• External and internal business conduct standards

5

• However, a number of important issues must still be addressed, such

as:

• OTC margin requirements

• Additional mandatory clearing designations

• Related matters, like the Volcker rule and the Lincoln amendment

Title VII Overview (cont’d)

6

Swaps and Security-Based Swaps • Swaps are subject to the jurisdiction of the CFTC and include interest

rate swaps, floors, caps and collars, commodity swaps, cross-

currency swaps, total return swaps on broad-based security indices

or two or more loans and credit default swaps on broad-based

security indices.

• Security-based swaps are subject to the jurisdiction of the SEC and

include swaps on a single security, loan, or narrow-based securities

index.

• “Narrow based security index” means, among other things, an index

with nine or fewer components, or in which a component security

comprises more than 30 percent of the index’s weighting

• The SEC and CFTC have adopted joint rules for the regulation of

mixed swaps, which combine characteristics of both swaps and

security-based swaps.

7

Dodd-Frank Treatment of Security-Based

Swaps

• Title VII of Dodd-Frank amended the Securities Act of 1933 (the

“Securities Act”) and the Securities Exchange Act of 1934 (the

“Exchange Act”) to include “security-based swaps” in the definition of

“security” for purposes of those statutes.

• Section 761 of Dodd-Frank amends the definition of “security”

contained in the Exchange Act to include security-based swaps.

• Section 768 of Dodd-Frank amends the definition of “security”

contained in the Securities Act to include security-based swaps.

• Trust Indenture Act of 1939 (the “Trust Indenture Act”) incorporates

the definition of “security” contained in the Securities Act.

• As a result, “security-based swaps” became subject to the provisions

of the Securities Act, the Exchange Act and the Trust Indenture Act,

and the rules and regulations thereunder that are applicable to

“securities.”

8

SEC Final Rules • As of today, relatively few SEC rules have been finalized under Title

VII of Dodd-Frank.

• The finalized rules include:

• Certain rules in relation to risk management procedures, controls and rule

changes for clearing agencies (such as central counterparties, or “CCPs”);

• Further definitions of “Swap,” “Security-Based Swap,” “Security-Based Swap

Agreement”; Mixed Swaps, Security-Based Swap Agreement Recordkeeping

(jointly with CFTC);

• Process of Submissions for Review of Security-Based Swaps for Mandatory

Clearing; and

• Further definitions of “Swap Dealer,” “Security-Based Swap Dealer,” “Major Swap

Participant,” “Major Security-Based Swap Participant” and “Eligible Contract

Participant” (jointly with CFTC).

9

• In addition, the SEC finalized a permanent exemption that applies to

security-based swaps that are cleared by a CCP.

• Under the permanent exemption, subject to conditions, security-

based swaps that are cleared by a CCP are exempt from the

provisions of the Securities Act, the Exchange Act and the Trust

Indenture Act (other than with respect to antifraud provisions).

• The exemption’s conditions include (i) that the CCP’s counterparties

to the relevant security-based swap are eligible contract participants

and (ii) in the case of the exemption from the Securities Act, that the

CCP makes available certain information regarding the swap,

including identification of the underlying asset relating to the security-

based swap in question.

SEC Final Rules (cont’d)

10

Contrast with CFTC’s Approach • CFTC has finalized many more rulemakings than SEC.

• Among the rulemakings that the CFTC has finalized are:

• Swap dealer registration (about 75 swap dealers have registered with CFTC);

• Business conduct;

• Swap data reporting and recordkeeping;

• Mandatory clearing (subject to phase-in);

• End-user exception to mandatory clearing requirement; and

• Affiliate exception to mandatory clearing.

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Mandatory Clearing

• In general:

• Section 2(h)(1)(A) of the CEA makes it unlawful to engage in any swap that the

CFTC requires to be cleared, unless it is submitted to a registered clearing

organization for clearing or an exception is available.

• The CFTC subjects classes or types of swaps to mandatory clearing by describing

them in a clearing determination. To date, there has been only one final clearing

determination.

• Once a final clearing determination has been issued, the related swap types are

subject to mandatory clearing on a phased-in timeline based on type of entity

• (T+90, T+180, T+270)

• Section 2(h)(7)(A) of the CEA provides an exception to the clearing requirement

(the “end-user exception”).

• In the adopting release of the CFTC’s final rules addressing the end-user

exception, the CFTC announced that it intended to look into a possible additional

exception for inter-affiliate swaps.

• A final rule excepting inter-affiliate trades under specified conditions was

adopted in early April 2013

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Mandatory Clearing (cont’d) • Mandatory clearing of standard IRS and CDS products commenced

on March 11, 2013 for Category 1 entities, with Category 2 entities

facing a start date of June 10, 2013. End-users will be required to

clear these swaps (subject to applicable exceptions) starting

September 9, 2013.

• End-user clearing deadline for CDS of iTraxx CDS Indices has been extended to

October 23, 2013.

• To Clear, or Not to Clear?

• Possible that some end-users may prefer to clear

• Some factors end-users may consider when deciding whether to clear:

• Desire to replace dealer credit risk with CCP credit risk

• Depending on final OTC margin requirements and the margin levels dealers

impose, it may not be much more expensive to clear than not (though until

these rules are finalized, hard to make any firm assessment of this).

• Clearing will require new infrastructure and relationships (SEFs, FCMs).

• Clearing will require new documentation

• Some products are not amenable to clearing (i.e., too bespoke and/or illiquid).

13

Mandatory Clearing (cont’d)

• Establishing a clearing relationship

• As swap clearing becomes a reality, additional or modified documentation will be

required by some non-registered entity types (although true corporate end-users

may never need to use them)

• The ISDA Master Agreement may serve a lesser or different role for cleared

swaps

• CFTC regulations place certain constraints on clearing-related documentation

• Clearing firms currently are proposing the following three types of documents:

• Futures Account Agreement (“FAA”)

• Customer agreement for setting up a futures account between an FCM and a

customer

• Cleared OTC Derivatives Addendum to FAA

• Necessary because FAAs do not address swaps or close-out rights in relation to

cleared swaps

• Execution Agreement

• New documentation must address consequences if a transaction that is expected

to clear is not accepted for clearing

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Mandatory Clearing (cont’d) • FAA

• Sets out the bilateral relationship between the clearing member and its customer

• Not standardized, differs among dealers

• Historically used for trading futures or options on futures

• Sell-side friendly and, in relation to futures, not highly negotiated

• Unilateral hair trigger defaults, with little or no cure period

• Discretion of FCM to charge whatever margin it believes is required to protect

its interests, including over and above what is required by the clearinghouse

• Aggressive cross-collateralization (including other relationships with the FCM

and, frequently, their affiliates)

• Limited FCM liability provisions (e.g., only gross negligence and willful

misconduct)

• Broad indemnification obligations on customer

15

Mandatory Clearing (cont’d) • FAA (cont.)

• In negotiations to clear derivatives under the FAA, customer typically attempts to

make FAA more like an ISDA Master Agreement by:

• limiting defaults against customer;

• including cure periods for defaults; and

• limiting the amount of margin that FCM may require its customer to post (for

example, by requiring FCM to rely on DCO margin calculations).

• In addition, customers frequently attempt to negotiate for a commitment to clear

(with mixed results).

16

Mandatory Clearing (cont’d) • Cleared OTC Derivatives Addendum to FAA

• Addendum makes FAA applicable to cleared swaps

• After an initial draft was released by ISDA and the Futures Industry Association

(“FIA”) in 2011, some dealers determined that they would need legal opinions in

relation to netting for regulatory cap purposes

• The final standardized document was published in August 2012

• As discussed below, the final document resolved the dealers’ netting opinion

concerns by elaborating on close-out of swaps upon termination:

• Some market participants had wanted to follow futures model (menu of broad

rights upon termination, not especially transparent)

• Others wanted to follow an ISDA-like model (market quotation or similar, more

transparent approach)

17


• Cleared OTC Derivatives Addendum to FAA

• In addition to addressing close out rights, Addendum (or other forms that may be

used) will typically:

• Contain representations as to authority, non-reliance language and tax

provisions.

• Require a clearing member to transfer (“port”) the customer’s trades to

another clearing member upon client’s request in accordance with National

Futures Association rules.

• Many market participants will need to negotiate the Cleared OTC Swaps

Addendum

• Some have already negotiated and agreed to the prior version and will likely

need to renegotiate based on the final version

18


• Cleared OTC Derivatives Addendum to FAA (cont.)

• As compared to its earlier version, the newly published Cleared OTC Swaps

Addendum has the following significant features:

• Covers all derivatives transactions amenable to clearing (including forwards

and options), not just swaps

• Liquidation provision (Section 7):

• Provides detailed liquidation and close out methodology for clearing members

• Following a “Close-out Event” a clearing member may execute “Close-out

Transactions”, but also may execute “Risk-reducing Transactions” and “Mitigation

Transactions”

• All such close out activity is to occur in accordance with a defined Liquidation

Standard that is based on good faith and commercially reasonable procedures,

though it is also recognized that a clearing member may have to effect a close out

in circumstances where no prevailing market prices or bona fide quotations are

available

• However, if despite its commercially reasonable efforts, a clearing member

determines it cannot satisfy the Liquidation Standard based on quotations, prices

and other market data, then it may base its valuation on internal sources

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• Cleared OTC Derivatives Addendum to FAA (cont.)

• Another significant feature of the Addendum is an expanded set of tax provisions

(Section 8), including:

• references to FATCA;

• gross up and indemnity provisions;

• tax liquidation event provisions; and

• tax documentation requirements.

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• Cleared Swaps Execution Agreement

• This agreement sets out the procedure for trade affirmation or rejection and states

what happens if a transaction that is expected to clear is not accepted for clearing

• Each of the parties to the original transaction (dealer and client) represents that it

has a clearing agreement with a clearing member

• Once a transaction is accepted for clearing, neither dealer nor client has any

obligation to the other (DCO becomes a party to both sides of transaction)

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• If a trade does not clear, then unless otherwise agreed, at the option of the dealer:

• The dealer (if it is a clearing member) may elect to accept the transaction in

its capacity as clearing member, or have a clearing member affiliate do so;

• If the transaction is not legally required to be cleared, the dealer may enter

into the transaction on a bilateral (uncleared) basis; or

• The transaction may be terminated

• at the dealer’s side of the market if the transaction’s failure to clear is caused

by the customer or its clearing member (including the customer’s clearing

member breaching a position limit imposed by the relevant DCO)

• at the customer’s side of the market if the transaction’s failure to clear is

caused by the dealer or its clearing member (including the dealer’s clearing

member breaching a position limit imposed by the relevant DCO)

• at mid-market in certain no-fault scenarios

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• In accordance with recent CFTC rules, each Execution Agreement can only be

bilateral, between dealer and customer

• As previously proposed by FIA and ISDA, the Execution Agreement would have

been trilateral, with optional annexes under which either party’s clearing member

could become a party to the agreement

• Trilateral arrangement was a major point of contention with the buy-side, which

was concerned that clearing members would steer trades to their own affiliates

and restrict the dealers with which the buy-side could transact

• Market consensus that CFTC final rules effectively prohibit a trilateral agreement

23

Mandatory Clearing/End-User Exception

• Clearing exception for end-users

• An end-user may be eligible for an exception from the clearing and trade

execution requirements under CEA Section 2(h)(7) and CFTC Rule 50.50

(formerly Rule 39.6)

• In order to qualify for the end-user exception, an end-user:

• Cannot be a “financial entity” (with limited exceptions);

• Must use swap to “hedge or mitigate commercial risk”; and

• Must notify the CFTC of how the entity “meets its financial obligations

associated with entering into non-cleared swaps”

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(cont’d) • A financial entity includes:

• SDs, MSPs;

• Commodity pool operators;

• Private funds;

• ERISA plans; or

• Persons “predominantly engaged” in activities that are in the business of banking, or in

activities that are “financial in nature” (defined under Section 4(k) of the Bank Holding

Company Act), including securities underwriting and dealing, investment advisory activities,

insurance agency or brokerage, and extending credit.

• On May 16, 2013, the American Securitization Forum (ASF) submitted a no-

action request to the CFTC seeking an explicit exemption for securitization

swaps from mandatory clearing requirements • ASF states that the relief it is seeking is confirmation that “swaps used in securitizations that

include special provisions to support their legal structures and/or credit ratings are NOT

subject to the clearing mandate if no derivatives clearing organization clears swaps with such

provisions.”

• Once OTC Margin rules are finalized, would expect follow on no-action request to exempt

securitization vehicles from such rules

• Viability of securitization market will be affected by how CFTC responds to such requests

25

• Financial entity exceptions:

• Captive finance affiliate and the “90% rule”

• Primary business is providing financing;

• Uses derivatives for the purpose of hedging commercial risks related to

interest rate or FX exposure;

• 90 percent or more of which arise from financing that facilitates the purchase

or lease of products; and

• 90 percent or more of such products are manufactured by the parent

company or another subsidiary of the parent company

• Acting as an agent for its non-financial affiliates

• swaps used to hedge or mitigate commercial risk

• Small financial institution

• banks, savings associations, farm credit system institutions, and credit unions

with total assets of $10 billion or less


(cont’d)

26

• To qualify for the end-user exception, a swap must be used to hedge

or mitigate commercial risk, which requires that a swap:

• qualifies as a bona fide hedging under the CEA position limit rules, or

• qualifies for hedging treatment under FASB, or

• be “economically appropriate” to reduce, in the ordinary course of business, risks

arising from a change in: the value of assets that the entity owns, produces,

manufactures, processes or merchandises; the value of liabilities due to

fluctuations in interest, currency or foreign exchange rates, or the interest,

currency or foreign exchange rate exposures arising from a person’s assets,

services or liabilities; and

• not be used for a purpose that is in the nature of speculation, investing or trading

and not be used to hedge or mitigate the risk of another swap, unless that other

swap itself is used to hedge or mitigate commercial risk.


(cont’d)

27

• Actions to be taken by end-users in connection with the end-user

exception:

• Board/Committee approval (public companies only)

• Reporting

• Enter into the ISDA DF Protocol (or similar arrangement)

• Obtain an LEI/CICI

• Evaluate margining arrangements

• Corporate actions to be taken by end-users that are reporting

companies

• Board or an authorized committee must approve decision to rely on end user

exception

• A committee may be authorized by the Board to review the company’s swaps

policies and evaluate the company’s reliance on the end user exception

• Also covers a reporting company’s controlled subs


(cont’d)

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• Reporting for End-Users • Reporting counterparty reports the following data points to an SDR (or the CFTC):

• whether the swap is subject to the end-user exception;

• the identity of the exempt end-user; and

• whether the end-user has filed an annual filing with the SDR (or the CFTC).

• End-user is required to report annually (or, if it chooses, on a trade-by-trade basis) to an

SDR (or the CFTC) containing the following information:

• whether it is a financial entity or a finance affiliate;

• whether the swap hedges or mitigates commercial risk;

• whether it is an SEC reporting company, and, if so, whether the appropriate

committee of its board of directors has reviewed and approved the decision to

enter into swaps that are exempt from clearing; and

• how it generally expects to meet its financial obligations:

• a credit support agreement;

• pledged assets;

• a third-party guarantee;

• its own available financial resources; or

• other means.


(cont’d)

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• The CFTC released final Rule 50.52 on April 1, 2013

• CFTC has made clear it anticipates that the exemption will be used

primarily for trades between affiliated financial entities that are less

likely to be able to use the end-user exception

• The rule allows the eligible affiliate counterparties to a swap to

elect not to clear a swap that would otherwise be subject to

mandatory clearing, subject to the following limitations:

• Only majority-owned affiliates eligible for exemption

• Both counterparties would have to elect not to clear the swap

• Swap trading relationship documentation required between the parties

• Swap must be subject to a centralized risk management program within the group

of affiliated entities that is reasonably designed to monitor and manage the risks

associated with inter-affiliate swaps

Mandatory Clearing/Affiliate Exception

30


(cont’d)

• Eligible Affiliate Counterparties

• one counterparty directly or indirectly holds a majority ownership interest in the

other, or a third party directly or indirectly holds a majority ownership interest in

both counterparties; and

• the financial statements of both counterparties are consolidated under GAAP or

International Financial Reporting Standards.

• Swap Trading Relationship Documentation

• For SDs/MSPs, an agreement that contains all terms governing the trading

relationship between the affiliates, incl. payment obligations, netting of payments,

events of default or other termination events, calculation and netting upon

termination, transfer of rights and obligations, governing law, valuation and dispute

resolution procedures (compliance with business conduct rule § 23.504 satisfies

the rule).

• For non-SDs/MSPs, the terms of the swap must be documented in a written swap

trading relationship document that includes “all terms governing the trading

relationship between the counterparties”.

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• Centralized Risk Management Program

• The adopting release suggests that if a corporate group already has a centralized

risk management program in place that performs this function, that “it is likely that

the program would fulfill the requirements” of the final rule.

• If at least one of the eligible affiliate counterparties is an SD or MSP, this

requirement can be satisfied by complying with the requirements of CFTC

Regulation § 23.600.

• Margin

• The final rule does not require marking-to-market or payment of IM or VM (the

proposed rule had required daily marking-to-market and posting of VM for most

trades between affiliated financial entities, except in the case of 100% commonly

owned and commonly guaranteed affiliates where the common guarantor is also

100% commonly owned).


(cont’d)

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• Reporting Requirements

• Reporting counterparty (selected pursuant to Part 45) must provide the following

information to an SDR or, if no SDR exists, to the CFTC:

• Confirmation that both counterparties to the swap are electing not to clear the

swap and that each of the counterparties satisfies the requirements to claim

the exemption (may not be reported annually);

• For each counterparty, how it generally meets its financial obligations

associated with entering into uncleared swaps (may be reported annually);

and

• If a counterparty is a public company, (i) the SEC Central Index Key number

for that counterparty and (ii) acknowledgment that an appropriate committee

of the board of directors of that counterparty has reviewed and approved the

decision not to clear the swap (may be reported annually).


(cont’d)

33

Recordkeeping • Recordkeeping requirements are in effect for all market participants

• Important that even non-registered end-users appreciate that they are subject to

recordkeeping requirements

• For registered entities, recordkeeping requirements are more

extensive and various forms of temporary no-action relief have been

provided by the CFTC • In particular, CFTC in late 2012 provided relief for “Daily Trading Record” requirements

in Rule 23.202

• This rule imposes some of the most challenging technological recording and search

function requirements that swap dealers and MSPs face, including

• Recording pre-execution trade information, including records of all oral and written

communications provided or received concerning quotes, solicitations, bids,

instructions, trading and prices, that lead to the execution of a swap (or lead to the

conclusion of a related cash or forward transaction), whether communicated by

telephone, voicemail, facsimile, instant messaging, chat rooms, electronic mail,

mobile device or other digital or electronic media

• Industry is not yet capable of complying and on March 30, 2013 the CFTC extended its

no-action relief until June 30, 2013

34

Swap Data Reporting

• Full reporting obligations are now in effect for swap dealers and

MSPs, subject only to various forms of no-action relief

• All other market participants faced a starting date of April 10, 2013 for

their reporting obligations.

• CFTC received numerous requests to defer this April 10th start date and provide

other forms of no-action relief

• On April 5, the CFTC provided no-action relief for reporting obligations arising from

certain inter-affiliate transactions

• This relief applies to reporting under Parts 45 and 46, not Part 43 which

already has a limited exception for reporting non-arm’s-length affiliate swaps

• The relief is broader for swaps between wholly-owned affiliates than for

swaps between majority-owned affiliates

• However, many market participants had been hoping that the CFTC would issue

broader temporary relief deferring the general April 10th start date for at least

several months to give non-registered entities additional time to implement the

arrangements and systems required for swap data reporting

35

Swap Data Reporting (cont’d) • On April 9, 2013, the CFTC responded to market concerns with broader

reporting relief for non-registered (i.e., non-SD/non-MSP) entities, as follows:

• For a Financial Entity, for swaps for which it has reporting responsibility:

• under each of Part 43 and Part 45, no relief for new IRS or CDS executed from and after April

10th

• under each of Part 43 and Part 45, new commodity, FX and equity swaps need not be reported

until 12:01 a.m. on May 29, 2013, but must backload and report all data for such swaps

executed between April 10 and May 29 by no later than 12:01 a.m. on June 29, 2013 (to same

extent as required under Part 45 as if no relief granted)

• all historical swaps (any pre-April 10, 2013 swap for which it has reporting responsibility under

Part 46) can be reported by September 30, 2013

• For a non-Financial Entity, for swaps for which it has reporting responsibility:

• under each of Part 43 and Part 45, new IRS and CDS need not be reported until 12:01 a.m. on

July 1, 2013, but must backload and report all data for such swaps executed between April 10

and July 1 by no later than 12:01 a.m. on August 1, 2013 (to same extent as required under

Part 45 as if no relief granted)

• under each of Part 43 and Part 45, new commodity, FX and equity swaps need not be reported

until 12:01 a.m. on August 19, 2013, but must backload and report all data for such swaps

executed between April 10 and August 19 by no later than 12:01 a.m. on September 19, 2013

(to same extent as required under Part 45 as if no relief granted)

• all historical swaps (any pre-April 10, 2013 swap for which it has reporting responsibility under

Part 46) can be reported by 12:01 a.m. on October 31, 2013

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