05.13.2011

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Updates

On May 11, 2011, U.S. Commodities Futures Trading Commission ("CFTC") Chairman Gary Gensler addressed managers of private equity funds at the 13th Annual Global Private Equity Conference.  The chairman’s remarks centered around the CFTC’s proposed rulemaking on swap transactions in light of the Dodd-Frank Act.  Although some stakeholders suggest that the Dodd-Frank Act’s requirements over swap transactions are too restrictive or that the CFTC’s interpretation of the Dodd-Frank Act mandate is too narrow, Chairman Gensler confirmed that the CFTC will adhere to its perceived mandate under the Dodd-Frank Act when issuing its new swaps rules on or prior to July 21, 2011.

 

A swap is a financial transaction where a financial instrument or commodity is exchanged (or swapped) for another financial instrument or commodity.  A common example is the airline industry’s use of swap transactions to hedge against the price of crude oil.  In these transactions, the airlines purchase a security that allows them to acquire crude oil at a certain fixed price over a fixed period.  Should the market price of crude exceed the fixed price offered through the swap, the airline can swap the floating price of crude for a fixed price over the period covered by the swap.  Another common example is the financial industry’s use of swaps to hedge against risk in their investments, such as interest rates, currency and credit default swaps, and to seek profits through speculative investments.

 

Chairman Gensler began his remarks by crediting the lack of meaningful regulatory oversight over swaps with “play[ing] a central role” in causing the recent financial crises.  Citing the need for an increased regulatory framework over the swaps market, Chairman Gensler outlined how the CFTC envisions accomplishing its two principal goals in swaps regulation: promoting greater transparency and lowering risk in the swaps market.

 

To accomplish greater transparency in the swaps market, the CFTC intends to implement regulations across each of the following “three phases” of a swaps transaction (1) the pre-trade phase, (2) the post-trade phase, and (3) the lifetime of the swap transaction.  To facilitate transparency during the initial pre-trade time frame, the CFTC will require standardized swaps, those swaps that are cleared and not traded as blocks, to be traded on an exchange or swap execution facility.  The trading of swaps on an exchange, the CFTC argues, facilitates competitiveness in the market resulting in better pricing and open transactions. 

 

During the post-trade phase, or the time period immediately following the entry into a swap transaction, the CFTC intends to promote transparency by requiring the publishing of pricing information similar to a last trade publication on a stock exchange.  Lastly, during the lifetime of the swap, the CFTC intends to impose disclosure obligations both on clearinghouses and swap dealers.  Once cleared, a clearinghouse will be required to disclose the pricing of a swap.  Swap dealers, similarly, will be required to share mid-market pricing. 

 

Next Chairman Gensler discussed the two principal regulations that the CFTC believes will lower systemic risk in the swap market.  First, the CFTC intends to require central clearing of swap transactions between financial entities.  Clearing agencies, Chairman Gensler argued, act to ensure that one party’s default does not financially harm its counter-party by guaranteeing the performance of each party’s obligations to its counter-party.  Clearinghouses impose certain financial and other obligations on their customers (i.e., margin requirements) that Chairman Gensler believes will act as a further obstacle to financial firms assuming an unhealthy amount of risk through swaps.  Second, the CFTC intends to enact regulations over swap dealers including capital requirements, business conduct standards and portfolio reconciliation requirements, although Chairman Gensler provided no discrete guidance on such requirements in his address.  The ultimate goal of the CFTC’s rulemaking will be to compartmentalize risk such that one party’s failure does not commence a domino effect throughout the broader financial markets.

End-User Exceptions 

While Chairman Gensler’s comments provide insight into the CFTC’s proposed rulemaking, his comments omitted mention of the end-user exception, as outlined in the Dodd-Frank Act, which may be of particular benefit to his private equity audience.  This exception exempts from the margin and clearing requirements those entities that (1) are not financial entities; (2) use swaps to mitigate commercial risks (e.g., strategic companies using swaps as a hedge against commodity prices) and (3) notify the CFTC of the manner in which they intend to meet their financial obligations.  Chairman Gensler, in his March 31, 2011 address to the Agriculture Committee of the U.S. House of Representatives, showcased the CFTC’s intended approach to the end-user exception stating that “if a non-financial company is using a swap to hedge an asset, liability, input or service that it currently has or uses or anticipates having or using, it would qualify for the end-user exception.” 

Practical Tip

Secure End-User Exceptions for Portfolio Companies

 

Portfolio companies of private equity funds should apply for an end-user exception to relieve themselves of the administrative and cost burden of adhering to the margin and clearing requirements of the Dodd-Frank Act.  As Chairman Gensler intends for swap transactions to be traded on an open exchange, these operating companies can benefit from the transparency and competitive pricing incident to securing swaps on such exchanges while not having to adhere to the burdens of margin and clearing regulatory compliance.  Once the CFTC completes their swaps rulemaking, private equity funds should quickly understand the procedures required to exempt their portfolio companies from the CFTC’s contemplated margin and clearing requirements.

Trap for the Unwary

Analyze the Effect a Swap Transaction By a Private Equity Fund Will Have on Its Portfolio Company’s End-User Exception 

It is not clear whether the CFTC’s intended rules will distinguish between a private equity fund’s swap transactions for its own account versus swap transactions by its operating companies to hedge against commodity pricing.  While an operating company may qualify for an end-user exception as noted above, it is unclear whether a private equity fund’s entrance into a swap as a financial transaction for the fund will invalidate or otherwise affect any end-user exception secured by one of such private equity fund’s portfolio companies.  Chairman Gensler’s address highlighted the benefits of an open swaps market to private equity operating companies but did not touch any control group issues between margin and clearing requirements on a private equity fund on the one hand and the end-user exception on the other hand.  Private equity funds should examine the rules once promulgated to ensure their operating companies can qualify for end-user exceptions independent of any financial transactions by their ownership.


Conclusions

While the CFTC continues to solicit feedback for the rulemaking on swap transactions during its extended notice and comment period, Chairman Gensler provided a strong signal that the CFTC intends to issue rules consistent with its interpretation of its mandate under the Dodd-Frank Act.  As such, it is expected that while an open market for swap transactions may provide pricing competitiveness, the proposed rulemaking will also require many swap participants to set aside greater amounts of capital to cover the creation of internal controls and the necessary coordination with regulatory agencies. 

Additional Information 

Read Chairman Gensler’s complete remarks. 

Read a more detailed analysis on the "Changing Face of Swaps Regulation."

 

© 2011 Perkins Coie LLP 


 

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