The Dodd-Frank Act broadly requires that most swaps be cleared through a derivative clearing organization. The Dodd-Frank Act also contains an elective exception, referred to as the “end-user exception,” from the clearing requirement if one party to the swap is not a financial entity, is using swaps to hedge or mitigate risk, and notifies the CFTC of certain matters. The CFTC has recently proposed rules to implement this exception. We believe most public companies will want to rely on this exception, where permitted. We recommend public companies begin to consider the process of how to implement use of the exception when it becomes available.
For public companies, here meaning those companies having a class of securities registered under Section 12 of the Exchange Act or being required to file reports under Section 15(d) of the Exchange Act, the notification must include a statement as to whether or not an appropriate committee of the board of directors has reviewed and approved the decision not to clear the swap. Two questions immediately jump out – how is this accomplished and what must the board or committee consider when making this decision?
The CFTC rule proposal states the approval could take the form of “a board resolution or an amendment to a board committee’s charter could expressly authorize such committee to review and approve decisions of the electing person not to clear the swap being reported. In turn such board committee could adopt policies and procedures to review and approve decisions not to clear swaps, on a periodic basis or subject to other conditions determined to be satisfactory to the board committee.” The statement is a bit muddy as to whether each and every uncleared swap must be specifically approved by the board or a committee. Taken as a whole however, it seems that approval of policies and procedures necessary to enter into uncleared swaps would suffice, as long as they are periodically evaluated. So one key step to consider is what mechanics are going to be used to satisfy this requirement.
What should the board or committee consider? It seems to us that one key component is what benefit is forgone by not using a clearing organization. Essentially, the clearing organization generally acts as a middleman between the parties to a transaction, and assumes the risk should there be a default. When structured and operated appropriately, clearing organizations can provide benefits such as improving the management of counterparty risk and reducing outstanding exposures through multilateral netting of trades.
If the benefit of a cleared swap is to eliminate counterparty risks, then one of the key elements of a decision not use a cleared swap is the financial strength of the counterparty to the uncleared swap. Boards and committees will want to establish appropriate metrics for approved counterparties or limit transactions to a list of specifically named counterparties where the financial strength of the counterparty has been evaluated.
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