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Financial Markets Alert

Derivatives Regulation Reform and Provisions Affecting Governmental Entities in the Dodd-Frank Act

On July 21st, President Obama signed the "Dodd-Frank Wall Street Reform and Consumer Protection Act" (the "Financial Reform"), which was passed by the U.S. Senate on July 15th and the U.S. House of Representatives on June 30th after weeks of reconciliation talks.  The legislation covers a wide variety of topics in an effort to address the causes of the recent turmoil in the financial markets.  Title VII of the Financial Reform is entitled the "Wall Street Transparency and Accountability Act of 2010" (the "Act").  The Act is the culmination of numerous Administration and legislative proposals for derivatives regulation that have been considered since the beginning of the recent financial crisis, which thrust the $615 trillion over-the-counter (OTC) derivatives market into the media and legislative spotlight.  As expected, the Act makes sweeping changes to the regulation of the OTC derivatives market, including certain changes that affect governmental entities active in the derivatives market.[1]

Policies and Objectives of the Act

The primary goals of derivatives reform were to increase pricing transparency and reduce systemic risk by encouraging and, in some cases, requiring derivatives to be traded on registered exchanges and cleared through registered central counterparties and by imposing margin and capital requirements on derivatives.  In drafting the Act, legislators focused much of their attention on determining what types of entities should become subject to registration and other requirements under the Act.  They ultimately decided on the identities of these market participants, called "swap dealers"[2] and "major swap participants."[3]  However, throughout the derivatives regulation overhaul effort, legislators also focused on explicitly providing for protections for governmental and certain other special users of derivatives transactions.

This focus was, at least in part, in reaction to well-publicized recent situations where governmental entities, both in the U.S. and in Europe, incurred large losses on derivatives transactions.[4]  Certain local governmental entities, in particular, discovered derivatives losses—which in some cases were enormous—in connection with transactions that they argued they did not adequately understand or for which they argued they had been overcharged.  This situation led to calls by some for additional protections where public monies were at stake, and even for an outright ban on certain governmental entities entering into derivatives.[5]

Legislators struggled to find an appropriate balance between protecting such "special" counterparties to derivatives and shutting them out of the market entirely.  In fact, the U.S. Senate bill prior to reconciliation with the U.S. House of Representatives bill proposed an approach that would have imposed fiduciary duties on dealers that propose or advise on, or serve as counterparties under, derivatives transactions with state and local governments or pension funds.  Of course, this approach would have been in stark contrast to existing market practice, which is that parties—irrespective of their type—enter into derivatives transactions at "arms'-length."  This market practice is almost always reflected in and reinforced by representations made by the parties that they understand the risks of any transaction entered into, have not relied on the advice of the other party and have made their own investment decision, engaging such experts as they deem appropriate.  Once the U.S. Senate bill was proposed, the market feared that this approach would leave governmental entities largely unable to hedge interest rate risk related to floating rate debt issuances.

Governmental and Other Special Entities

Despite the language in earlier bills, the Act takes a balanced approach.  In particular, it does not impose fiduciary duties on persons who act solely as derivatives counterparties (as opposed to as advisors) to governmental entities; rather, it provides for certain protections to be afforded when "swaps"[6] are offered or entered into by swap dealers and major swap participants and "special entities."[7]

"Special entities" are defined to include federal agencies; States, State agencies, cities, counties, municipalities or other political subdivisions of a State; employee benefit plans and governmental plans under ERISA; and endowments (including organizations described in section 501(c)(3) of the Internal Revenue Code of 1986, as amended).[8]  Generally, the relevant protections under the Act depend on the role a swap dealer or major swap participant has in connection with a swap offered to or entered into with a special entity, i.e., whether such a party acts as an advisor or counterparty to the special entity.

Specific Protections for Special Entities

Specifically, the Act requires that each swap dealer or major swap participant that enters into or offers to enter into a swap with a special entity comply with the following requirements: (i) have a reasonable basis to believe that the special entity has an "independent representative" that has sufficient knowledge to evaluate each transaction and its risks, is not subject to a statutory disqualification, is independent of the swap dealer or major swap participant, undertakes a duty to act in the best interest of the special entity, provides written representations to the special entity regarding fair pricing and the appropriateness of each transaction and (ii) before the initiation of any transaction, disclose to the special entity in writing the capacity in which the swap dealer or major swap participant is acting.

The Act does not appear to provide for any exceptions to the requirement that, in effect, all special entities (irrespective of their size, business or level of sophistication) have a competent independent representative when entering into swaps with swap dealers and major swap participants.  Further, the Act does not provide any specific guidance on who will qualify as an independent representative or how swap dealers and major swap participants will demonstrate that they have made an appropiate determination regarding an independent representative.  Although guidance on these points is expected from the CFTC, in the future, regulated entities likely will request additional, tailored, representations from both governmental entities and their independent advisors and perform more comprehensive due diligence on independent representatives (and maintain detailed records of that due diligence).

The Act also provides that a swap dealer that acts as an advisor to a special entity has a duty to act in the best interest of the entity and must make reasonable efforts to obtain such information as is necessary to make a reasonable determination that a swap it recommends is in the best interests of such entity, including information relating to the entity's financial status, tax status and investment (or financing) objectives.  Moreover, a swap dealer or major swap participant advising a special entity on swaps may not employ schemes or engage in transactions that operate to defraud that entity or engage in any act that is fraudulent, deceptive or manipulative.

As an additional protection, the Act increases the discretionary investment threshold for governmental entities to qualify as "eligible contract participants" (generally, entities permitted to enter into swaps outside of a regulated exchange) under the Commodity Exchange Act of 2000, as amended (the "CEA"), to $50 million from $25 million.[9]  It also requires that the CFTC adopt business conduct requirements that, inter alia, (i) establish a duty for swap dealers and major swap participants to verify that any counterparty meets the eligibility standards for an eligible contract participant and (ii) require swap dealers and major swap participants to (a) disclose information about the material risks and characteristics of a swap, any material incentives or conflicts of interest they have in connection with a swap and (b) provide counterparties with daily marks for swaps.  Swap dealers and major swap participants also must communicate in a fair and balanced manner based on principles of fair dealing and good faith.

Central Clearing Requirements

The Act makes it unlawful for any person to engage in a swap that the CFTC determines should be required to be cleared unless that person submits the swap for clearing to a registered or exempt derivatives clearing organization (DCO). An important exemption to the clearing requirement of the Act exists if one counterparty to a swap (i) is not a financial entity, (ii) is using the swap to hedge or mitigate "commercial risk" (as such term will be defined by the CFTC) and (iii) notifies the CFTC how it generally meets its financial obligations associated with uncleared swaps. Notwithstanding this exemption, such a party that satisfies these requirements and enters into a swap with a swap dealer or major swap participant may elect to require clearing of the swap and, in any such case, will have the sole right to select the DCO at which the swap will be cleared. Governmental entities may be able to take advantage of this exemption, especially if the CFTC clarifies that governmental entities entering into traditional swaps are hedging or mitigating commerical risk.

The derivatives market for governmental entities has seen its share of turmoil during the market crisis of the past few years.  Therefore, it was not surprising that the Act would take steps to provide for the protection of such parties, particularly because public monies are at stake.

[1] For a more comprehensive summary of the Act, click here.

[2] A "swap dealer" is defined, with certain exceptions, as any person who (i) holds itself out as a dealer in swaps; (ii) makes a market in swaps; (iii) regularly enters into swaps with counterparties as an ordinary course of business for its own account; or (iv) engages in any activity causing the person to be commonly known in the trade as a dealer or market maker in swaps.  To qualify as a swap dealer, a person must enter into swaps for such person's own account, either individually or in a fiduciary capacity, as part of a regular business.  A person may be designated as a swap dealer for one or more types or classes of swaps but not others.  This term is to be further defined by the regulators.

[3] A "major swap participant" is defined as any person who is not a swap dealer and (i) maintains a "substantial position" in swaps for any of the major swap categories (excluding positions held for hedging or mitigating commercial risk and positions maintained by any employee benefit plan (or any contract held by such a plan) for the primary purpose of hedging or mitigating any risk directly associated with the operation of the plan), (ii) whose outstanding swaps create "substantial counterparty exposure" that could have serious adverse effects on the financial stability of the U.S. banking system or financial markets or (iii) is a financial entity that is highly leveraged relative to the amount of capital it holds and that is not subject to capital requirements established by an appropriate federal banking agency and maintains a substantial position in outstanding swaps in any major swap category.  In drafting this definition, the Act instructs the Commodity Futures Trading Commission (CFTC) to consider a person's relative position in uncleared, as opposed to cleared, swaps and provides that the CFTC may take into account the value and quality of collateral held against counterparty exposures.  A person may be designated as a major swap participant for one or more categories of swaps without being classified as a major swap participant for all classes of swaps.  The ultimate scope of the definition of major swap participant will be largely determined by the CFTC definition of "substantial position", which is to be set at the threshold that the CFTC determines to be prudent for the effective monitoring, management, and oversight of entities that are systemically important or can significantly impact the financial system of the U.S.  This term is to be further defined by the regulators.

[4] Perhaps the most notable case in the U.S. involves Jefferson County, Alabama.  Several years ago, Jefferson County refinanced its fixed rate debt to variable rate debt and entered into interest rate swaps, which it later alleged exceeded the notional amount of bonds being hedged and may have been awarded in a less-than-competitive manner.  Its interest rate swap positions helped push the county to the brink of bankruptcy.  In another Alabama case filed in October 2008, the Alabama Public School and College Authority sought to void a swaption (or an option to enter an interest rate swap) that it sold to a bank in 2002.  Disputes have also arisen in connection with derivatives entered into by local governmental entities in Europe.  For example, in April 2009, Italian financial police seized approximately €476 million of assets of four large banks in connection with a probe relating to a derivative transaction entered into by the city of Milan.  The seizure was ordered by a judge in connection with an investigation of whether the banks fraudulently made over €100 million in "illicit profits" under that transaction.

[5] For example, the Pennsylvania Senate Finance Committee considered a bill in May to ban school districts and local governmental entities from entering into interest rate swaps related to bond issuances in the wake of one school district's swap-related losses of more than $10 million (purportedly due to "excessive" fees and a termination payment).  Also, prompted by a rash of losses incurred (and negative values accrued) by many Italian municipalities during the credit crisis and against the backdrop of the investigation into the city of Milan's derivatives, the Italian Senate Finance Committee in March unanimously approved a proposal to restrict the use of derivatives by municipalities to towns having at least 100,000 residents (other than capitals of provinces), ban upfront payments and compel municipalities to obtain an opinion from the Economy Ministry before execution of any transaction.

[6] Virtually every derivative instrument commonly traded by governmental entities fits within this definition, which includes, inter alia, interest rate swaps, caps and floors, credit default swaps, total return swaps, weather swaps, energy swaps, equity swaps, equity index swaps, agricultural swaps, commodity swaps and any "agreement, contract, or transaction that is, or in the future becomes, commonly known to the trade as a swap."  Primary regulatory authority over swaps is granted to the CFTC.

[7] Note that, as their definitions suggest, it is highly unlikely that governmental entities would be subject to regulation under the Act as either swap dealers or major swap participants.

[8]  For purposes of simplicity, this Alert does not summarize or address issues relating to special entities that are employee benefit plans and governmental plans under ERISA.

[9] Note, however, that the CEA continues to permit governmental entities to enter into derivatives with financial institutions, brokers, dealers and other specified parties without regard to any discretionary investment threshold.  Also note that the discretionary investment threshold does not explicitly exclude bond proceed investments, as certain earlier drafts of derivatives regulation had proposed.