It couldn’t happen to two nicer guys. Keith Higgins was tapped yesterday to become Corp Fin’s Director – and Acting Director Lona Nallengara was promoted to become SEC Chair White’s Chief of Staff! Keith brings a wealth of knowledge to the job – and quite an entertaining personality. Always a favorite at our proxy disclosure conference. And it’s great to have someone with a disclosure & deal background in the Chief of Staff position.
Survey Results: End-User Exception for Swaps
We have posted our survey results on end-user exception for swaps:
1. When it comes to the end-user exception to the clearing requirement for swaps and board review and approval of the decision to use the exception, our company:
– We have already implemented a board approval policy before the need for the exception arises – 11%
– We have started the process of adopting a board approval policy but have not done so yet – 63%
– We have decided that we don’t anticipate ever needing the exception so we have not adopted a board approval policy – 3%
– We have decided to seek board approval on a swap-by-swap basis rather than annually – 0%
– We have not yet decided what to do – 23%
2. For those companies that plan on relying on the end-user exception, will the company:
– Make an annual filing of the electing counterparty information ahead of the first swap transaction – 27%
– Report the electing counterparty information on a swap-by-swap basis – 6%
– We have not yet decided what to do – 68%
Relief Delayed is Relief Denied: Treasury Subsidiaries of Non-Financial Companies
I recently got this from a member: The frustration of the non-financial corporate community grows regarding the long-hoped-for but still elusive relief from a significant unintended consequence of Dodd-Frank regarding the availability of the very important End User exception from mandatory clearing requirements. Beginning as early as June 2013, certain transactions with bank counterparties such as interest-rate derivatives and credit default swaps may need to be cleared and full collateralized unless the End User exception is available. This important exception provides that a swap does not have to be cleared if one of the parties is a non-financial entity that is using the swap to hedge or mitigate commercial risk, and that party’s reliance on the End User exception has been approved by its board or an appropriate committee.
Background on “Financial Entity” v. “Non-Financial Entity”
Many non-financial companies are planning to rely on the helpful End User Exception. Some of them do not have any problem satisfying the “non-financial entity” requirement, which is determined under a very complicated definition. Under the provision most relevant for non-financial public companies, if 85% or more of the entity’s annual gross revenues is derived from activities that are “financial in nature” (as defined by banking regs) or 85% or more of its consolidated assets are related to activities that are “financial in nature” (same), then the entity is deemed to be a “financial entity” that cannot use the End User exception (there’s a 2 year lookback for each test).
The problem arises for non-financial companies that have separate legal entities for their in-house treasury operations. Even though there’s no legal requirement to use a separate legal entity for treasury operations, many companies have historically taken that approach for a variety of reasons including centralization, i.e., having one group of treasury professionals available to interface with a variety of outside banks. These so-called “treasury subsidiaries” are wholly owned by the parent company. They are often the subsidiaries that non-financial companies use as their bank-facing parties to hedge or mitigate commercial risk for the company and its subsidiaries. Because of the nature of their activities, treasury subsidiaries often fail the 85% test, and therefore are “financial entities” that cannot elect as End Users.
CFTC Aware & Looking for Solutions
On April 10th, CFTC Chairman Gary Gensler gave a speech to the US Chamber of Commerce where he acknowledged the treasury subsidiary issue and suggested that the CFTC may provide some relief. Here’s the relevant excerpt from Gensler’s speech:
“Treasury Affiliates. We’ve received many comments and had many meetings with non-financial end-users that [SIC] about required clearing if they use a treasury affiliate when entering into their market facing swaps. Though I don’t have any announcements today, let me assure you that the staff and Commission are taking a close look at how to appropriately address these issues in the context of the Dodd-Frank Act.”
CFTC, Here’s the Solution!
The CFTC does not need to be concerned about going beyond the Congressional mandate with regard to the scope of the End User exception. Instead, it can provide narrow relief to treasury subsidiaries by relying on certain language in the End User text of Dodd-Frank, specifically in Section 723(a) under clause (i) in “Treatment of Affiliates”.
The reason CFTC relief is needed on this issue despite the clear intention of Congress as evidenced by Section 723(a) to allow affiliates of non-financial companies – which would include treasury subsidiaries – to benefit from the End User exception is solely because that affiliate provision in Section 723(a) has language requiring that the affiliate (in our case, the treasury subsidiary) be acting “as an agent…”
The way the swap world works is that the documentation between the treasury subsidiary and the counterparty bank identifies the treasury subsidiary as principal in the transaction, which means this scenario technically does not fit squarely within the parameters of this exception – despite the clear fact that when they enter into these swap transactions, treasury subsidiaries are, as a practical matter, acting on behalf of one or more non-financial parent company subsidiaries (i.e., hedging their commercial risk) and essentially are “defacto agents” as such.
Non-financial entities should not have to do unnatural contortions to be able to have their treasury subsidiaries benefit from the very significant End User Exception. Those contortions – not prohibited by Dodd-Frank – would include transferring sufficient non-financial assets to the treasury subsidiary so that it no longer is a “financial entity” under the 85% test and therefore can itself elect as an End User (after a two year period) without relying on the Section 723(a) affiliate exception.
Specific Relief Needed: Sooner Rather Than Later
For the reasons above, the CFTC should recognize the practical and economic realities concerning treasury subsidiaries. Specifically, it should issue guidance confirming that so long as a treasury subsidiary is entering into a swap to hedge or mitigate commercial risk for its parent or company affiliates who, in each case, are not financial entities, then the treasury subsidiary is “acting on behalf … and as agent” within the purview of Section 723(a), regardless of whether it may be identified as principal in the swap documentation with the bank.
As an aside, it was disappointing how long it took the CFTC to provide relief from certain reporting requirements that went into effect on April 10, 2013, which would have required, among other things, reporting of transactions between wholly-owned affiliates of non-financial entities. Fortunately, the CFTC provided significant relief from those reporting obligations with regard to these wholly-owned affiliates but not until April 5, 2013. To state the obvious, at the 5 day point before the reporting requirements became effective, companies had already devoted significant time and resources trying to ensure compliance. While the relief provided on April 5 was certainly appreciated, it was far less valuable from a work reduction and resources perspective than it would have been if it had been provided a reasonable amount of time before the compliance date. Let’s hope that the CFTC does not make the same mistake this time around with regard to allowing treasury subsidiaries to use the End User Exception.
– Broc Romanek