Final rules relating to the commercial end-user exception to the clearing requirements of the Dodd-Frank Act clarify who can take advantage of the exception and the requirements for doing so.
Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Act) contains significant changes to the ways in which over-the-counter derivatives are regulated. Transactions identified as "swaps" and "security-based swaps" will be regulated under the Act, and the definitions of those terms are broad enough to encompass most over-the-counter derivatives. Most standardized swap transactions likely will be subject to central clearing and exchange-style trading requirements, and certain parties to those transactions will be subject to capital, margin, registration, reporting, recordkeeping, and business conduct requirements.
Under the Act, the Commodity Futures Trading Commission (CFTC) is given authority to regulate swaps and the Securities and Exchange Commission (SEC) is given authority to regulate security-based swaps. These regulators have broad authority to promulgate rules implementing the legislation. The two agencies are required to coordinate and harmonize their respective regulation and, in certain cases, are required to engage in joint rulemaking.
The CFTC and SEC are required to adopt rules under the Act establishing criteria for determining those swaps and security-based swaps that are required to be cleared through a central clearing organization. Generally, the Act makes it unlawful to enter into a swap or security-based swap that is required to be cleared, unless the swap or security-based swap is submitted for clearing. Recognizing that the reforms contemplated by the Act may result in a hardship to commercial (as opposed to financial) enterprises, Congress included an exception to the clearing requirements of the Act for certain commercial enterprises that utilize swaps and security-based swaps. This exception is commonly known as the "commercial end-user exception."
Under the Act, if one party to a swap or security-based swap is not a "financial entity" (a term that includes swap dealers, security-based swap dealers, major swap participants, major security-based swap participants, commodity pools, private funds, employee benefit plans, and banking entities), and that party (a commercial end-user) is using the swap or security-based swap to hedge or mitigate commercial risk and notifies the relevant commission how it generally meets its financial obligations associated with noncleared swaps and security-based swaps, then such swap or security-based swap does not have to be cleared. The commercial end-user may, however, still choose to clear the swap or security-based swap, and if so, may also choose the clearing organization at which to clear the transaction. If the commercial end-user is a public company, an appropriate committee of the board of directors must approve any election not to clear the swap or security-based swap.
Final Rules Address Exception Requirements
In furtherance of its statutory mandate, the CFTC has adopted final rules that address the requirements of the commercial end-user exception. These final rules were published in the Federal Register on July 19, 2012, and will become effective September 17, 2012. However, compliance will not be necessary or possible until swaps become subject to the clearing requirement of the Act, which is now expected to be implemented in stages starting at the end of this year. The SEC has not yet adopted final rules in this area.
The final rules are contained in Part 39.6 of the CFTC regulations and largely parallel the statutory mandate. In order to take advantage of the commercial end-user exception, the party electing the exception
The information required to be reported consists of the following:
A swap is used to hedge or mitigate commercial risk if the swap
Use of the commercial end-user exception will enable entities that are not financial entities to customize their derivative transactions and avoid the standardized margining regime associated with cleared products. However, compliance with the various elements of the end-user exception is determined on a swap-by-swap basis, which requires a careful analysis of the exception and related CFTC commentary. For example, a nonfinancial entity's swaps that do not hedge or mitigate commercial risk and that are subject to the mandatory clearing requirement will need to be cleared even if the nonfinancial entity qualifies for the end-user exception for its other swaps. Parties considering using the commercial end-user exception should begin to familiarize themselves with the exception prior to the time it becomes effective.
Michael M. Philipp
Mark R. Haskell