The CFTC has approved its final rule on the so-called “end-user exception” to the Dodd-Frank Act’s mandatory clearing requirement applicable to swaps required to be cleared (roughly, standardized swaps). Under the exception, as provided by the Act, a swap counterparty may elect not to clear a swap if the counterparty:
- Is not a “financial entity” (e.g., swap dealer, major swap participant, commodity pool, investment fund, bank, or pension plan);
- Is using the swap to “hedge or mitigate commercial risk,” as further defined; and
- Provides certain information along with the swap to a swap data repository or the CFTC.
If the party electing to not clear the swap is a public company (defined as having securities registered under Section 12 of the Exchange Act or being required to file reports under Section 15(d) of the Exchange Act), the public company must provide the following additional information:
- The relevant SEC Central Key Index number; and
- Whether an appropriate committee of the public company has reviewed and approved the decision to enter into swaps that are exempt from the requirements of Sections 2(h)(1) (referring to clearing requirements) and 2(h)(8) (referring to designated contract markets, referred to as a DCM, and swap execution facilities, referred to as an SEF) of the Commodity Exchange Act.
The rule also goes on to provide that an entity that qualified for an exemption from the clearing requirement may report the information annually in anticipation of electing the exception for one or more swaps. Such reporting is effective for 365 days following the date of the reporting. The electing entity must amend the information as necessary to reflect any material changes to the information reported.
In addition, the adopting release states:
- The public company board or committee must not only approve the decision to enter into an uncleared swap but also not to execute the trade on a DCM or SEF;
- The CFTC expects the public company board or committee to review the policy at least annually and more often on appropriate triggering events, such as a new hedging strategy that was not contemplated in the original board approval; and
- The CFTC considers a committee to be appropriate if it is specifically authorized to review and approve the public company’s decision to enter into an uncleared swaps.
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.
What type of resolutions should be adopted? This may be a start:
WHEREAS, Rule 39.6 of the Commodity Futures Trading Commission (the “CFTC”) provides that an end-user may elect not to clear a swap in certain circumstances;
WHEREAS, since the Company has a class of securities registered under Section 12 of the Exchange Act [or reference Section 15(d) where appropriate], Rule 39.6 requires the Company to provide a swap data repository, or in certain circumstances, the CFTC, information regarding whether an appropriate committee of the Company’s Board of Directors has reviewed and approved the decision to enter into swaps that are exempt from the requirements of Sections 2(h)(1) and 2(h)(8) of the Commodity Exchange Act;
WHEREAS, the Board of Directors has carefully considered the advantages and disadvantages of entering into uncleared swaps as opposed to cleared swaps, including the strength of the counterparties the Company transacts with and the Company’s risk management objectives, and other matters the Board of Directors deems relevant;
NOW THEREFORE BE IT RESOLVED, that the Company is authorized to enter into swaps that are exempt from the requirements of Sections 2(h)(1) and 2(h)(8) of the Commodity Exchange Act.
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