Month: August 2011

Dodd-Frank Act Implementation Update

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Title VII of the Dodd-Frank financial reform, titled the “Wall Street Transparency and Accountability Act of 2010” (the “Dodd-Frank Act”), was enacted on July 21, 2010.[1] Under the Dodd-Frank Act, which is generally intended to bring the $600 trillion over-the-counter derivatives market under greater regulation, the Commodity Futures Trading Commission (“CFTC”) has primary responsibility for the regulation of “swaps” and the Securities and Exchange Commission (“SEC” and, together with the CFTC, the “Commissions”) has primary responsibility for the regulation of “security-based swaps.” A summary of certain noteworthy developments since our last update follows.

Effective Date for Swap Regulation

In an effort to provide additional market clarity as it finalizes its numerous rulemakings in connection with the Dodd-Frank Act,[2] on June 17th, the CFTC issued a notice of proposed order (the “Proposed Order”)[3] in which it proposed, pursuant to its exemptive authority under Section 4(c) of the Commodity Exchange Act, as amended (the “CEA”), to temporarily exempt persons or entities from provisions of the CEA that were added or amended by the Dodd-Frank Act that reference one or more terms that must be “further defined,” including, most significantly, the terms “swap,” “swap dealer,” “major swap participant” and “eligible contract participant,” to the extent that such provisions (or portions thereof) specifically relate to such terms. The Proposed Order further proposed granting relief from certain provisions of the CEA that will or may apply to certain contracts in exempt or excluded commodities (e.g., financial, energy and metals commodities) as a result of the repeal of various CEA exemptions or exclusions.

Following a brief comment period, the CFTC issued its final order (the “Final Order”)[4] granting the temporary relief, which was largely based on the provisions set forth in its Proposed Order. Specifically, the CFTC broadly grouped the provisions of the Dodd-Frank Act into four categories: (i) provisions that require a rulemaking (which include most of the core reforms of the Dodd-Frank Act, such as capital and margin requirements applicable to swap dealers and major swap participants, as well as key defined terms); (ii) self-effectuating provisions (i.e., provisions that do not require a rulemaking) that reference terms that require further definition under the first category; (iii) self-effectuating provisions that do not reference terms that require further definition and that repeal provisions of current law; and (iv) self-effectuating provisions for which the CFTC did not grant relief. The provisions falling into the first category did not require relief, as they take effect not less than 60 days after the corresponding final rules are published. The provisions falling into the second category were granted relief, but only to the extent they specifically relate to the referenced terms. The provisions falling into the third category[5] were granted relief to allow existing trading practices to continue without being “unduly disrupted” until the effectiveness of the required final rulemakings (for example, the CFTC confirmed that market participants could continue to temporarily rely on exemptions for options on energy commodities or metals and swaps on agricultural commodities). Finally, the provisions falling into the fourth category (many of which require the CFTC to undertake studies or are otherwise administrative and not directly relevant to market participants) were not granted relief because they would not result in undue disruption, and so, took effect on July 16th.[6] Where granted, the specified relief expires upon the earlier of the effective date of the applicable final rule (or the repeal, withdrawal or replacement of the applicable exemption or exclusion) and December 31, 2011. The Final Order does not limit, in any way, the CFTC’s anti-fraud or anti-manipulation authority under the CEA.

On the same day the Final Order was issued, the CFTC also produced a “no action” letter in connection with the Dodd-Frank Act’s implementation. This letter provides comfort that enforcement actions temporarily will not be commenced against: (i) persons for failure to comply with certain collateral segregation requirements for uncleared swaps imposed on swap dealers and major swap participants; (ii) derivatives clearing organizations clearing swaps for failing to register with the CFTC; and (iii) persons in connection with the designation and duties of a chief compliance officer for swap dealers and major swap participants. The relief under the no-action letter expires upon the earlier of the effective date of the applicable final rule and December 31, 2011.

International Reform Implementation and Harmonization

Section 722(d) of the Dodd-Frank Act provides that certain of its requirements may apply to non-U.S. activities that have a “direct and significant connection with activities in, or effect on, commerce” of the United States. U.S. and non-U.S. banks have both been concerned with the ambiguity and potential applicability of this provision on banks with global operations. In particular, it is not entirely clear how the Dodd-Frank Act will apply to non-U.S. banks with large U.S. operations. In recent statements, the Commissions appear to be acutely aware of this ambiguity, with the SEC stating that it intends to prepare clarifying guidance.

On a related note, derivatives market participants and, especially, U.S. banks, have continued to voice concerns regarding the pace of implementation of U.S. derivatives reform in comparison with similar reform efforts in Europe and Asia. Specifically, they are concerned that U.S. banks could be disadvantaged if they become subject to the contemplated regulation (and its related burdens and costs) long before their non-U.S. competitors.[7] Market participants may engage in regulatory arbitrage, resulting in the outflow of capital and liquidity to more accommodating jurisdictions. Throughout the reform effort, U.S. legislators and regulators have repeatedly acknowledged the importance of international harmonization (both with respect to substance and timing). So far, however, there is no indication that there will be any delay in the implementation of the Dodd-Frank Act to allow other jurisdictions to catch up in their reform efforts.

CFTC Issues Final Rule one Swap Data Repositories

Section 728 of the Dodd-Frank Act established swap data repositories (“SDRs”), new entities to which swap data would be required to be reported. The primary purpose of SDRs is to promote transparency and standardization, as well as to help reduce systemic risk by making swap data and information directly and electronically available to regulators. The CFTC was charged with establishing the registration requirements and core duties and responsibilities for SDRs. On December 23, 2010, the CFTC published for comment proposed rules to this end. On August 4th, the CFTC adopted final rules (the “Final SDR Rules”) implementing this portion of the Dodd-Frank Act.

Among other things, the Final SDR Rules (which have not yet been published in the Federal Register) will require that prospective SDRs file electronically for registration using new Form SDR. The CFTC is required to review an application within 180 days (although it may extend the review period in certain circumstances) and will register an SDR that it finds is appropriately organized and, inter alia, has the capacity to operate in a fair, equitable and consistent manner. Upon request, the CFTC may grant an applicant provisional registration if it is in substantial compliance for registration. An SDR located outside the United States also must certify (and provide a supporting opinion of counsel) that it is legally able to provide the CFTC with prompt access to its books and records and that it may submit to on-site inspection and examination by the CFTC.

Under the Final SDR Rules, SDRs will be responsible for, inter alia: (i) establishing, maintaining and enforcing policies and procedures for the reporting of swap data; (ii) accepting and promptly recording all relevant swap data; (iii) establishing policies ensuring the accuracy of swap data and other information required to be reported; (iv) monitoring, screening and analyzing swap data in such manner as the CFTC requires; (v) maintaining books and records in accordance with specified requirements; and (vi) making available all data obtained to specified foreign and domestic regulators.

The Final SDR Rules also will require that SDRs maintain sufficient financial resources and establish provisions ensuring non-discriminatory access and fees for their services. Moreover, SDRs will be required to establish governance arrangements and manage and minimize conflicts of interest (including establishing processes for resolving such conflicts).

[1] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. 111-203, 124 Stat. 1376 (2010). The text of the full Dodd-Frank reform is available at https://www.cftc.gov/LawRegulation/DoddFrankAct/index.htm.

[2] Note that the CFTC reopened or extended the comment period for numerous substantive proposed rulemakings (including those that relate to the definitions of critical terms) until June 3rd. As a result, it was not possible for many final rulemakings to be issued by the ambitions goal set forth in the Dodd-Frank Act, 360 days after enactment, or July 16, 2011.

[3] Effective Date for Swaps Regulation, 76 Fed. Reg. 35372 (June 17, 2011). Derivatives market participants generally welcomed the Proposed Order, although certain industry groups submitted comments suggesting that the CFTC more broadly grant relief from all material terms of the Dodd-Frank Act until all final rules necessary for implementation are issued.

[4] Effective Date for Swaps Regulation, 76 Fed. Reg. 42508 (July 19, 2011).

[5] The provisions in this category generally relate to statutory exclusions or exemptions enacted under the Commodity Futures Modernization Act of 2000 that were repealed by the Dodd-Frank Act.

[6] The Final Order includes an Appendix specifying the appropriate category for listed sections of the Dodd-Frank Act.

[7] Indeed, the risk also exists that competing jurisdictions not only delay reform efforts but ultimately implement requirements that fall short of those implemented by U.S. regulators. At a hearing on July 21st, Federal Reserve Chairman Ben Bernanke expressed concern at the potential for different margin requirements across jurisdictions, stating that unless an equal playing field was established, “we will have to think again about how to meet Dodd-Frank’s requirements for improved prudential safety, which is what margins are intended to achieve, without disadvantaging our banks.”

IRS Issues Temporary Regulations on Transfers of Derivative Contracts

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On July 15th, the Department of the Treasury, Internal Revenue Service (“IRS”), issued temporary and proposed regulations (the “Temporary Regulations”)[1] addressing when a transfer of certain derivative contracts does not result in an “exchange” to the remaining party for purposes of Section 1.1001-1(a) of the Income Tax Regulations (the “Tax Regulations”) of the Internal Revenue Code (the “Code”). The significance of the Temporary Regulations is that they clarify that, subject to certain specified conditions, a transfer of a derivative contract by a counterparty does not, in and of itself, result in an event for which gain or loss must be calculated by a remaining party, irrespective of whether the terms of the derivative contract itself require the consent of the remaining party for the transfer. READ MORE →

UK Supreme Court Upholds “Flip” Clauses

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Structured finance transaction documents have typically included subordination provisions in their post-default waterfalls, effectively changing a swap counterparty’s right to get paid from above that of the noteholders to below that of the noteholders. In January 2010, in a case relating to the “Dante” credit-linked note program, a New York bankruptcy court voided certain document provisions providing for the subordination of Lehman Brothers Special Financing Inc.’s rights as swap counterparty to an early termination payment when the swap counterparty or one of its close affiliates went into bankruptcy. In effect, the bankruptcy court held that such clauses altering the priority of payment constitute unenforceable ipso facto clauses under the U.S. Bankruptcy Code (the “Bankruptcy Code”). After an appeal was filed, the parties settled the matter later that year, leaving market participants with substantial uncertainty in connection with similar clauses.[1]

The same issues have arisen in the United Kingdom, but with a different outcome. In Belmont Park Investments Pty Limited & ors v. BNY Corporate Trustee Services Limited and Lehman Special Financing Inc., the U.K. Supreme Court decided on July 27th that a “flip” clause in the relevant documentation did not violate the common-law principle of “anti-deprivation,” which (similar to the Bankruptcy Code’s ipso facto rule) invalidates contractual provisions having the effect of transferring the property of a debtor upon its insolvency, hence depriving the bankruptcy estate of that asset. In its decision, the court first reviewed the anti-deprivation principle’s development to describe its nature and limits. In doing so, the court noted that the absence of good faith, or an intention to obtain an advantage over creditors in the bankruptcy, was an essential element in the application of the principle. Indeed, the court pointed out that, historically, where the principle has been held not to apply, good faith and commercial sense of the transaction have been important factors. Applying this understanding to the transaction at issue, the court concluded that there was no evidence that the “flip” clauses were deliberately intended to evade insolvency law (as evidenced by the numerous other non-bankruptcy defaults that also would trigger a change in priority). The court further noted that Lehman itself had designed, arranged and marketed the Dante program, and that the flip clauses (more specifically, noteholder priority to collateral upon a Lehman bankruptcy) was a very material factor in the notes obtaining a triple-A rating, hence enabling Lehman to sell them to non-banks. In addition, the collateral was purchased with funds supplied by the noteholders, not Lehman. In bolstering its conclusion, the court also emphasized that “party autonomy” (i.e., the ability of sophisticated counterparties to agree to commercial terms at arms’ length) was at the heart of English commercial law, particularly where complex financial instruments are involved.

The inconsistency of the New York and U.K. decisions leaves market participants with a stark difference of opinion across jurisdictions and may raise the possibility of forum-shopping in connection with future structured finance transactions.

[1] For a detailed summary of this litigation, please see DMIR November 2010, DMIR October 2010 and DMIR January 2010.

Appellate Court Decides CSX Total Return Swap Case

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On July 18th, the U.S. Court of Appeals for the Second Circuit (the “Second Circuit”) issued its long-awaited opinion in CSX Corporation v. The Children’s Investment Fund Management (UK) LLP, et. al.[1] The issue that made the case so closely-monitored by derivatives market participants was whether, and under what certain circumstances, a total return receiver (i.e., the “long” party) under a cash-settled total return equity swap should be deemed to be the “beneficial owner,” for purposes of Section 13(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”),[2] of the underlying shares its counterparty (i.e., the “short” party) purchases to hedge its position.

CSX Corp. (“CSX”) had attempted to enjoin two hedge funds (collectively, the “Funds”) from voting their shares in a proxy contest to elect certain candidates to its board of directors. CSX claimed that the Funds acted together as a “group” and should have been deemed to have beneficially owned, in the aggregate, more than 5% of CSX’s stock, both outright and as long parties to cash-settled total return equity swaps with various banks. As such, the Funds should have disclosed that they had formed a “group” that owned more than 5% of CSX’s shares, as required by the Exchange Act. The U.S. District Court for the Southern District of New York (the “District Court”) concluded that: (i) the Funds failed timely to disclose that they had formed a “group” (based on evidence that the Funds communicated regarding their efforts to exert control over CSX and taking “concerted action”); and (ii) one of the Funds failed timely to disclose that it was the beneficial owner of more than 5% of CSX’s shares (based on evidence that it had violated Rule 13d-3(b) under the Exchange Act by engaging in a “plan or scheme” to evade Section 13(d) disclosure requirements).[3] However, the District Court did not conclude definitively that the Funds, as long parties to the equity swaps, obtained beneficial ownership in the shares acquired by their counterparties as hedges. The District Court also refused to enjoin the Funds from voting their shares because they had disclosed their share ownership for a sufficient period of time prior to the vote.

The Second Circuit only considered the issues concerning a “group” violation of Section 13(d)(3) with respect to the CSX shares owned outright by the Funds, without regard to any beneficial ownership they might have acquired as long parties to the equity swaps. As to that issue, the Second Circuit remanded the case to the District Court to make findings as to whether the Funds specifically formed a “group” for the purpose of “acquiring, holding, voting or disposing” of CSX shares owned outright and, if so, the latest date by which such a group was formed. The Second Circuit found that “[o]nly if such a group’s outright ownership of CSX shares exceeded the 5 percent threshold prior to the filing of a section 13(d) disclosure can a group violation of section 13(d) be found.”

The Second Circuit also affirmed the District Court’s denial of the voting injunction sought by CSX. However, significantly for the derivatives market, the Second Circuit did not address the issues that “would require decision as to the circumstances under which parties to cash-settled total-return equity swap agreements must comply with the disclosure provisions of section 13(d),” noting that the panel was divided on numerous issues relating to the treatment of equity swaps.[4]

[1] 2011 WL 2750913 (2d Cir. July 18, 2011).

[2] Section 13(d) generally requires that a party acquiring, directly or indirectly, the beneficial ownership of more than 5% of certain classes of equity securities, within ten days of such acquisition, send to the issuer of the securities and to each exchange where the securities are traded, and file with the Securities and Exchange Commission (the “SEC”), a statement containing certain specified information and such additional information as the SEC may prescribe as necessary or appropriate in the public interest or for the protection of investors.

[3] See CSX Corp. v. The Children’s Inv. Fund Mgmt., 562 F. Supp. 2d 511 (S.D.N.Y. 2008).

[4] Nevertheless, in a concurring opinion, one member of the panel stated that:
any agreement or understanding between long and short swap parties regarding: (i) the purchase of shares by the short party as a hedge; (ii) the sale of such shares to the long party when the swaps are unwound (as in settled-in-kind equity swaps); or (iii) the voting of such shares purchased by the short party, would cause the shares purchased as a hedge and any shares owned by the long party to be aggregated and counted in determining the 5 percent trigger.

2011 WL 2750913, at *27 (Winter, J., concurring).

Sovereign Bailouts and CDS Restructuring Triggers

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On July 21st, the International Monetary Fund and European Union agreed to a second bailout package for Greece amounting to some €109 billion, subject to the beleaguered country implementing structural reforms and meeting specified fiscal targets. This is in addition to the €110 billion package launched in May 2010. For investors in the private sector, the new plan involves a voluntary restructuring of Greek debt, whereby investors voluntarily elect to exchange existing debt into four instruments. This exchange will result in a 21% net present value loss on private investor debt holdings (assuming a 9% discount rate) and an extension of the average debt maturity from six years to 11 years. The private sector contribution to the plan is estimated to be worth some €37 billion, with a target of 90% of private investors participating.

Rating agencies have indicated that they intend to treat the plan as a “selective” default. However, as discussed in greater detail below, the voluntary nature of the private sector involvement means that credit default swaps (“CDS”) are not able to trigger based on the plan.[1] This, in turn, has called into question the value of credit default swaps, at least with respect to sovereign reference entities.

CDS protection payments are triggered (subject to the satisfaction of certain other conditions) upon the occurrence of a “credit event,” including a “Restructuring.” Under the 2003 ISDA Credit Derivatives Definitions, which govern virtually all CDS transactions, a Restructuring is generally defined to include: (i) a reduction in either the interest rate or amount of interest or principal payable on an obligation; (ii) a postponement or other deferral of the payment of interest or principal on an obligation (including an extension of maturity); (iii) a change in the ranking or priority of payment of an obligation, resulting in its subordination; or (iv) a change in the currency of the obligation to other than a permitted currency.[2] However, any such event must “occur[] in a form that binds allholders” (emphasis added) of an obligation for a Restructuring to take place. The exchange of privately-held debt under the plan will be voluntary, and so, will not be binding on all holders.

The triggering of Greek CDS, if it were to occur, would be highly unlikely to have systemic implications.[3] Nevertheless, it appears that the rescue plan was intentionally structured to not result in a CDS credit event, perhaps to dissuade continued speculation in European sovereign CDS.[4] Certain commentators have argued that the restructuring plan has flipped market expectation on its head and have questioned the continued value of sovereign CDS. However, others insist that CDS products continue to work as contemplated, pointing out that private investors electing not to participate in the voluntary restructuring that continue to hold the original debt remain protected against a “hard” credit event (such as a payment failure or mandatory restructuring) under CDS contracts where they have bought protection. The International Swaps and Derivatives Association, Inc., the primary industry group for the derivatives marketplace, has indicated that it intends to gauge market sentiment in the wake of these developments and may explore changes to the definition of Restructuring.[5]

[1] Despite the controversy surrounding the Greek plan, it is sufficiently clear that this is the case under the existing regime governing CDS transactions. Indeed, as of the date of this publication, not one market participant has even bothered to ask the relevant regional determination committee (i.e., the committee charged with making certain decisions for CDS transactions with respect to reference entities in Europe) to decide whether a Restructuring credit event has occurred with respect to Greece in connection with the plan.

[2] Note that three separate types of this credit event exist: standard Restructuring (known as “Old R”); Modified Restructuring (known as “Mod R”); and Modified Modified Restructuring (known as “Mod Mod R”). Unlike Mod R and Mod Mod R, Old R does not limit the maturity of what a buyer of protection may delivery in connection with a credit event. Old R typically applies to CDS having Western European sovereigns as reference entities.

[3] As of July 1st, according to data from Depository Trust & Clearing Corporation, the aggregate net exposure for sellers of credit protection on Greek sovereign debt CDS was $4.8 billion (or just 1% of the government’s outstanding debt), without taking into account any recovery value or collateral. Moreover, the vast majority of CDS exposure is collateralized, either partially or fully.

[4] European governments have long been concerned about the economic implications of speculation in sovereign CDS markets. For additional information on this topic, please see DMIR March 2010.

[5] See Katy Burne, Swaps Group Weighs Revamp of Triggers on Default Insurance, Wall Street Journal (Aug. 3, 2011).