Implementation of Title VII of the Dodd-Frank financial reform, entitled the “Wall Street Transparency and Accountability Act of 2010” (the “Act”), requires numerous rulemakings by the Commodity Futures Trading Commission (“CFTC”) and Securities Exchange Commission (“SEC” and, together with the CFTC, the “Commissions”).  The Act is generally intended to bring the $615 trillion over-the-counter (“OTC”) derivatives market under greater regulation by increasing pricing transparency and taking steps to reduce systemic risk.  Among other things, the Act encourages and, in some cases, requires many derivatives to be traded on registered exchanges and cleared through registered central counterparties and imposes margin and capital requirements on such contracts.  Generally, the CFTC and SEC have until July 16, 2011 (or 360 days from July 21, 2010, the date the Act was signed into law) to promulgate the rulemakings necessary to implement the Act.

One of the first significant steps taken by the Commissions was to publish an “Advance Joint Notice of Proposed Rulemaking; request for comments” (the “Interagency Request”) on August 20^th.  The Interagency Request asked for public comment on certain “key definitions” of the Act which the Commissions, in consultation with the Federal Reserve, are required to further define.  The ultimate scope of these key definitions will, to a large extent, define the scope of the Act itself.  One significant example of this is the definition of “major swap participant,” which will determine which end users and other non-dealers will be subject to the rigorous registration, reporting, minimum capital and margin, recordkeeping and other requirements of the Act.  The comment period lasted for thirty days.

On October 1st, the CFTC also published for public comment a “Proposal to Mitigate Potential Conflicts of Interest in the Operation of Derivatives Clearing Organizations, Designated Contract Markets, and Swap Execution Facilities” (the “Proposed Conflicts Rules”).  The CFTC identified several potential conflicts of interest in the operation of the derivatives clearing organizations (“DCOs”) with which most swaps will have to be cleared and designated contract markets (“DCMs”) and swap execution facilities (“SEFs”) on which most swaps will have to be traded.  These potential conflicts of interest include, for DCOs, the determination of (i) whether a particular swap is capable of being cleared, (ii) the minimum criteria that an entity must meet to become a clearing member and (iii) whether a particular entity satisfies that criteria and, for DCMs and SEFs, balancing the advancement of commercial interests and fulfilling self-regulatory responsibilities.  The Proposed Conflicts Rules attempt to mitigate these potential conflicts of interest through the imposition of structural governance requirements and limits on the ownership of voting equity (and exercise of voting power) in the relevant entities.

In particular, the Proposed Conflicts Rules would impose specific composition requirements on the boards of directors of each DCO, DCM and SEF and would require that such entities have a nominating committee and one or more disciplinary panels.  Further, each DCO would be required to have a risk management committee and each DCM and SEF would be required to have a regulatory oversight committee and a membership or participation committee.  Moreover, the Proposed Conflicts Rules would impose (i) a twenty percent (20%) cap on voting power by individual members of DCOs, DCMs and SEFs and (ii) a forty percent (40%) cap on the collective ownership of DCOs by the following “enumerated entities”: bank holding companies with over $50,000,000,000 in total consolidated assets, or any affiliate; nonbank financial companies, or any affiliate, supervised by the Federal Reserve; and swap dealers and major swap participants (each as defined in the Act and further defined by the Commissions).^[1]  The Proposed Conflicts Rules do not, however, place any restriction on the ownership of non-voting equity in DCOs, DCMs and SEFs.

Support for the proposed limits was not unanimous among the CFTC Commissioners.  In particular, Commissioner Jill E. Sommers dissented, stating her “grave concerns that the proposed limitations on voting equity, especially those proposed for enumerated entities in the aggregate with respect to DCOs, may stifle competition by preventing new DCMs, DCOs and SEFs that trade or clear swaps from being formed.”

We will continue to monitor and report on significant developments in the implementation of the Act.

^[1] The Proposed Conflicts Rules also provide for an alternative ownership limit for DCOs, i.e., that no aggregate limits apply if no single member or enumerated entity has more than five percent (5%) voting control.  The CFTC acknowledged that these ownership limits may not be appropriate for all DCOs and proposes a procedure for exemptions.

On September 15^th, the European Commission issued its “Proposal for a Regulation of the European Parliament and of the Council on OTC derivatives, central counterparties and trade repositories” (the “EC Proposal”).

The EC Proposal states that it is part of a larger international effort to increase the stability of the financial system, in general, and the OTC derivatives market, in particular.  It further states that an internationally coordinated approach is required to avoid the risk of “regulatory arbitrage.”  In that regard, the EC Proposal notes that it has a broadly identical scope of application to the Dodd-Frank legislation in the United States relating to derivatives.  READ MORE →

On July 21^st, the President signed the “Dodd-Frank Wall Street Reform and Consumer Protection Act” (the “Financial Reform”), which was passed by the U.S. Senate on July 15^th and the U.S. House of Representatives on June 30^th 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 2008 financial crisis, including the collapse of Lehman Brothers and the meltdown of AIG, both of 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.

The primary goals of derivatives reform were clearly delineated from the beginning of the regulatory overhaul effort: increasing pricing transparency and reducing systemic risk.  The Act pursues these goals 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.  For a summary of the Act, please click here.

On April 29^th, after certain procedural delays, debate began in the U.S. Senate on a massive financial reform bill, entitled the Restoring American Financial Stability Act of 2010 (the “Proposed Act”), which includes substantial provisions on derivatives regulation.  Numerous legislative proposals for derivatives regulation have been considered since the collapse of Lehman Brothers and the meltdown of AIG, both of which cast a media, political and legislative spotlight on the over-the-counter (“OTC”) derivatives market.  However, the Proposed Act, which was approved by the Senate Committee on Banking, Housing and Urban Affairs, is the primary proposal currently under consideration, although once passed it would have to be reconciled with the financial reform bill passed by the U.S. House of Representatives in December 2009.  The Proposed Act is expected to remain under discussion for several weeks.  Similar to previous draft and proposed legislation, it would make sweeping changes to the regulation of derivatives markets.

From the beginning of the current financial crisis, Administration “framework” documents and proposed legislation have consistently focused on increasing pricing transparency and reducing bilateral credit risk through the use of exchanges and central counterparties.  In its current form, the Proposed Act would, as expected, require that standardized OTC derivatives transactions be entered into on regulated exchanges for more liquid products (including placing an emphasis on electronic trading) and that increased amounts of derivatives transactions be cleared through central counterparties that assume the risk of transactions.  Also, higher capital and margin requirements would exist for customized transactions that are not able to be centrally cleared.

However, a critical point of contention continues to be whether certain derivatives contracts and counterparties will be exempt from regulation, either in the final passed act itself or in subsequent permissive exemptions granted by the relevant regulatory authority.^[1]  Manufacturing, airline, technology, energy and other true “end-users” of OTC derivatives have argued forcefully that they should be exempt from much of the proposed regulation, including the margin and other costs that will likely be associated with compliance with central clearing requirements.  These companies have repeatedly pointed out that, unlike hedge funds, they enter into such contracts exclusively as bona fide hedges of business risk (e.g., interest rate, commodity price and currency risk), and not for purposes of speculation; as such, their use of derivatives is highly unlikely to result in systemic risk.

Extensive proposed amendments are being considered and discussed for inclusion in the Proposed Act (over sixty (60) had been filed as of May 4^th).  Among these are proposals from the Senate Committee on Agriculture, which recently unveiled and passed its own proposed derivatives regulations.  The newest and most controversial of these proposals would effectively require commercial banks that are protected by federal deposit insurance or that have access to the Federal Reserve discount window (generally, financial institutions that are allowed to raise money at lower costs) to spin off their derivatives trading desks that provide derivatives products to customers in the regular course of banking relationships.^[2]  The cost to financial institutions associated with such a spin-off has been estimated to be at least $20 billion and as high as $250 billion, with opponents of the proposal arguing that it would push such trading to foreign banks or to unregulated entities.^[3]   As of the date of this publication, support for the spin-off provision was waning, as it failed to receive an endorsement from the Administration and had been criticized by the Chairman of the Federal Deposit Insurance Corporation.

Another provision under discussion is a requirement that would impose fiduciary duties on dealers that propose or advise on, or serve as counterparties under, derivatives transactions with state and local governments or pension funds.  (In its original form, the Proposed Act only called for an SEC study on whether broker-dealers who provide investment advice should meet the same fiduciary obligations as investment advisers.)  Similar to other derivatives markets, the municipal derivatives market, which is largely comprised of interest rate swaps, is currently predicated on the parties having entered into “arms-length” transactions.  To this end, it is typical for each counterparty to represent to the other that it understands and accepts the risks of any transaction entered into, it has not relied on investment advice of the other party and it has made its own investment decision, engaging such professional advisors as it deems appropriate.  Such representations are, of course, inconsistent with a fiduciary relationship.

The proposed fiduciary approach is likely, at least in part, a reaction to well-publicized recent situations where governmental entities, both in the United States and in Europe, incurred large losses on derivatives transactions (for related summaries, see the March 2010 and May 2009 Derivatives Month In Review.^[4]  However, the risk inherent in a dealer agreeing to be its counterparty’s fiduciary may be significant and the potential consequences for a dealer may be severe.^[5]  For instance, a governmental entity could assert a breach of fiduciary duty and claim a right to walk away from a transaction that is heavily in-the-money to a dealer; if the governmentall entity were successful on its claim, this would leave the dealer with losses.  The proposed fiduciary standard therefore would significantly increase counterparty risk in—and could effectively shut down—the municipal derivatives market.  Such a change could leave governmental entities entirely unable to hedge interest rate risk related to floating rate debt issuances (perhaps the most common use of municipal derivatives) or, at the very least, acutely drive up of the cost of purchasing such protection.  It may also leave pension funds (including private pension plans subject to ERISA and state and other governmental plans) unable to hedge risk and diversify portfolios through the use of derivatives transactions.

Also under discussion is a proposal to increase the discretionary investments threshold for governmental entities to qualify as “eligible contract participants” under the Commodity Exchange Act of 2000, as amended (the “CEA”), to $50 million from $25 million.  However, as drafted, this increased threshold should have a minimal effect, as the CEA currently permits municipal entities to enter into derivatives with a broker-dealer or institution without regard to any discretionary investment threshold.

We will continue to monitor and report on the progress of the Proposed Act as the Senate debate continues and as amendments are proposed for inclusion.

^[1] Regulatory authority over derivatives would be largely divided between the Commodity Futures Trading Commission, generally covering “swaps,” and the Securities and Exchange Commission (“SEC”), generally covering “security-based swaps.”

^[2] This proposal should not be confused with the so-called “Volcker rule”, which would ban commercial banks from proprietary derivatives trading.

^[3] Notably, over $22 billion in revenue was generated for financial institutions from derivatives trading in 2009 and just five (5) United States-based financial institutions accounted for ninety-five percent (95%) of American financial firms’ derivatives holdings.

^[4] For example, earlier this month, the Pennsylvania Senate Finance Committee considered a bill 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).  Some proponents of the ban likened the use of such transactions as “gambling” with taxpayer monies, while others opposed to the ban warned of the potential exposure of municipal entities to interest rate risk on bonds issued in connection with capital projects.

^[5] The standard that would be applicable to a “fiduciary” has not been defined or described in the relevant proposal.  However, for example, Section 404(a) of the Employee Retirement Income Security Act of 1974, as amended, states, in relevant part, that a fiduciary of a pension plan “shall discharge his duties with respect to a plan solely in the interest of participants and beneficiaries.”