Guarantees of Interest Rate Swap Obligations by Non-ECP Guarantors Are Probably Illegal and Unenforceable

by Holland & Knight LLP
Contact

Options for Lenders to Consider Until the CFTC Offers Further Guidance

The Commodity Futures Trading Commission (the CFTC) has made a determination that could affect the legality and enforceability of certain guarantees of interest rate swap obligations, although it may not seem logical at first.

Section 723(a)(2) of the Dodd-Frank Wall Street Reform and Consumer Protection Act ("DF") amended Section 2(e) of the Commodities Exchange Act and the rules thereunder (the "CEA") to provide that "it shall be unlawful for any person, other than an eligible contract participant,to enter into a swap" unless the swap meets certain trading and clearing requirements. The CFTC has determined that each guarantee agreement covering a borrower's obligation under an interest rate swap1 must be treated as a separate "swap." Each guarantee and each guarantor must meet the regulatory requirements for swaps and swap counterparties under the CEA. The logic as stated by the CFTC is that "[g]uarantors of swaps assume and bear the risk of the swaps that they guarantee."2 Thus, for purposes of the CEA, a guarantee of a swap will be treated as a separate “swap,” to the extent that a counterparty (e.g., a bank) to a borrower's swap position would have recourse to the guarantor in connection with the swap.

It is common in lending transactions: (i) for subsidiaries and/or affiliates to guarantee the obligations of a parent or affiliate borrower, and (ii) for the guarantee agreements to be written broadly to cover all of the parent’s or affiliate's obligations under the credit documents and also any derivative transactions executed with a lender or its affiliates.3 Such subsidiaries or affiliates may execute mortgages or security interests securing the obligations of the parent or affiliate, whether or not a separate formal guarantee is executed. Even in the absence of formal "guarantee" language, it may be the case that those security arrangements could be treated as limited guarantees and as such could constitute separate "swaps" for purposes of the CFTC rule.4 For purposes of this review, we will treat security agreements as if they were guarantee agreements.

If a guarantee is or becomes a swap under DF and the guarantor is not able to qualify as an "eligible contract participant," as described below (ECP): (i) both the bank and the guarantor may have violated DF, and (ii) the guarantee may, in whole or in part, become unenforceable. If multiple guarantors sign a single guarantee covering both loan obligations and swap obligations, further questions could arise as to whether violation of DF by one guarantee could taint the other guarantees contained in the same agreement.

To be treated as an ECP, the borrower and each guarantor must satisfy one of the prongs of the definition of an ECP. The following is the prong most frequently used by corporations, partnerships or other organizations:5

(18) Eligible contract participant
The term “eligible contract participant” means—
(A) acting for its own account—
....
(v) a corporation, partnership, proprietorship, organization, trust, or other entity—
(I) that has total assets exceeding $10,000,0006;
(II) the obligations of which under an agreement, contract, or transaction are guaranteed or otherwise supported by a letter of credit or keepwell, support, or other agreement by an entity described in subclause (I), in clause (i), (ii), (iii), (iv), or (vii), or in subparagraph (C); or
(III) that—
(aa) has a net worth exceeding $1,000,000; and
(bb) enters into an agreement, contract, or transaction in connection with the conduct of the entity’s business or to manage the risk associated with an asset or liability owned or incurred or reasonably likely to be owned or incurred by the entity in the conduct of the entity’s business.7

A party’s ECP status is not determined when the loan is extended to the borrower, but rather when the "swap" is entered into. With respect to the guarantee, this could occur concurrently with the consummation of the loan if the swap transaction and the guarantee are signed and effective on the same day. If the swap or the guarantee is entered into after the loan is in place, the ECP status of the guarantor must be determined at the time the guarantee is entered into or the date the underlying swap is effectuated, whichever is later. The ECP status also may be required when the swap, guarantee or collateral support are amended or modified in such a material respect that the CFTC would consider the agreement to be a new swap, guarantee or collateral support. Thus, there are various times during the life of a loan when the guarantor may have to meet the ECP requirements; it is not a test that must be met only when the loan is entered into or the guarantee is signed. ECP status must also be tested when material amendments of swaps, guarantees of swaps and collateral arrangements supporting swaps are made.

As noted above, ECP status can be established if the obligations of each entity that is not an ECP are "guaranteed or otherwise supported by a letter of credit or keepwell, support, or other agreement by an entity" that satisfies certain criteria of the definition of ECP.8 Thus, if a loan transaction has a guarantor which is not itself an ECP, the guarantor may achieve ECP status if any ECP provides the non-ECP guarantor with a guarantee, keepwell agreement or other support. The market has not come to a consensus about the nature of a keepwell or other support that will be sufficient for such purpose, and whether it must provide recourse to the counterparty or just the non-ECP guarantor.

It has been argued that all guarantors can meet the ECP requirements if the parent/borrower guarantees the obligations of each non-ECP guarantor under a keepwell agreement using the logic of 7 USC 1a(18)(v)(II) quoted above. While this logic is supported by the CEA, it may be viewed as circular given that this amounts to a borrower’s guarantee of the obligations of its guarantors (whether or not that "borrower guarantee" runs solely to the subsidiary guarantor, or to the counterparty as well).9 Until further clarification, this issue should be reviewed on a case-by-case basis.

If, however, the non-ECP is owned entirely by ECPs (e.g., if a non-ECP guarantor is a wholly owned subsidiary of an ECP parent), the net worth of any owner of such guarantor (e.g., the parent) may be included in the guarantor's net worth for purposes of Section 1a(18)(A)(v)(III).10 Under this rule, the owners (parent) do not have to provide a guarantee or keepwell agreement.

Alternative Approaches

Until further guidance is received from the CFTC, lenders should consider one or more of the following options:

  1. Where possible, obtain representations that all parties to swaps (and guarantees and collateral arrangements with respect to swaps) are eligible contract participants. The representations should include statements of which prong of the definition of eligible contract participant the party satisfies and that the party is not a commodity pool.11
  2. If the ECP status of each party cannot be verified, the safest approach is to totally exclude swap obligations from the scope of the obligations covered by the guarantees and security documents.12 Alternatively, lenders could require separate guarantees of swap obligations for each guarantor (rather than a single guarantee covering both loan obligations and swap obligations) and require each of the guarantors to execute a separate guarantee, not joined in by the other guarantors.13
  3. Another approach would be to draft guarantees to exclude swap obligations for a particular guarantor if and to the extent the guarantor is not an ECP at the times required by DF. Include severability language in the guarantees. Although logically this approach should be enforceable, there has been some question as to the enforceability of "savings clauses" in other contexts. As a result, this approach is not without some risk.
  4. Require any non-ECPs to become ECPs. One way to accomplish this is to require that all obligations of non-ECP guarantors be separately credit enhanced by a guarantee or keepwell agreement from an ECP other than the borrower.14 Market practice is currently to include a keepwell agreement within a joint guarantee agreement, whereby ECP guarantors confer ECP status on otherwise non-ECP guarantors.

Lenders should be aware that borrower's counsel may take an exception to its legal opinion with respect to the legality or enforceability of guarantees of swaps given by non-ECPs, even if the documents are drafted as above. As the situation develops, a consensus may develop as to acceptable risk in the documentation of the guarantees, and also a consensus may develop as to the acceptability and scope of opinion exceptions for the guarantees.


Notes

1   Although the rule described in this alert is broader than interest rate swaps, we have limited this bulletin in the interest of avoiding additional complexities. Additionally, we focus here only on the ECP status of guarantors and do not address other requirements that must be followed by guarantors if their guarantees are treated as "swaps," such as obtaining a Legal Entity Identifier or a Interim Compliant Identifier. See www.ciciutility.org.

2   CFTC No-Action Letter No. 12-17 (October 12, 2012) (the "No-Action Letter").

3   As we discuss elsewhere in this alert, if there are multiple guarantors, it is customary to have all guarantors sign a single guarantee.

4   However, footnote 12 of the No-Action Letter states that the interpretation is limited to guarantees and does not address other credit support arrangements. CFTC noted "Thus, for example, a non-ECP may provide collateral to support a third party’s swap obligations," but stated that the CFTC or the SEC, or both, may address those issues in the future. It is concerning that the CFTC position could be changed in the future, as there is not much distinction in function between a party giving a monetary guarantee and a party pledging its collateral as credit enhancements of another person's debt.

5  Only the rules applying to corporate type entities are covered here. There are other rules that apply to individuals, financial institutions, insurance companies, commodity pools (which has been broadly defined by the CFTC), employee benefit plans and governmental or other "Special Entities," among others, and the rules in Section 1a(18)(A)(v) may not apply to those entities.

6   The “total asset” requirement can include both loan proceeds and anticipated loan proceeds available to the borrower under bona fide commitments to fund that meet certain CFTC rules outlined in the No-Action Letter. The resulting liability of the borrower is not taken into account in determining the total asset test.

7   CEA 7 USC 1a(18).

8   CEA 7 USC 1a(18)(A)(v)(II), as quoted above.

9  One could argue that, absent a waiver of subrogation, a guarantor would always have recourse against the borrower if, following a borrower default, the guarantor had to pay the counterparty amounts that the borrower owed but did not pay. In a sense, the subrogation right would be tantamount to a "keepwell" agreement, whether or not express and arguably would allow the guarantor to achieve the ECP status of the borrower under 1a(18)(v)(II). The CFTC has not yet accepted that logic.

10 17 CFR Part 1, §1.3(m)(7)(i) [May 23, 2012]. Note that this test applies only to the "net worth" qualification. It does not apply to the "total asset" test.

11       The lender may want to conduct at least some diligence, such as obtaining audited or internal financial statements, to determine the accuracy of the representation. If the ECP status is achieved by a keepwell agreement, the agreement should be reviewed and consideration should be given to current and evolving regulatory rules as to what types of agreements are qualified. Note that this representation and due diligence must be repeated in connection with material amendments to the swap, the guarantees, and the credit support documents.

12 Although this broad brush approach is clearly safe, it does not provide counterparties with security that might otherwise be allowable if the ECP tests under the CEA are met at all relevant times.

13 This approach could greatly increase the documentation burden.

14 As noted above, the keepwell agreement arguably could come from the borrower under the technical rules of the CEA, but we are uncertain whether the CFTC will accept that position.

Written by:

Holland & Knight LLP
Contact
more
less

Holland & Knight LLP on:

Readers' Choice 2017
Reporters on Deadline

"My best business intelligence, in one easy email…"

Your first step to building a free, personalized, morning email brief covering pertinent authors and topics on JD Supra:
Sign up using*

Already signed up? Log in here

*By using the service, you signify your acceptance of JD Supra's Privacy Policy.
Privacy Policy (Updated: October 8, 2015):
hide

JD Supra provides users with access to its legal industry publishing services (the "Service") through its website (the "Website") as well as through other sources. Our policies with regard to data collection and use of personal information of users of the Service, regardless of the manner in which users access the Service, and visitors to the Website are set forth in this statement ("Policy"). By using the Service, you signify your acceptance of this Policy.

Information Collection and Use by JD Supra

JD Supra collects users' names, companies, titles, e-mail address and industry. JD Supra also tracks the pages that users visit, logs IP addresses and aggregates non-personally identifiable user data and browser type. This data is gathered using cookies and other technologies.

The information and data collected is used to authenticate users and to send notifications relating to the Service, including email alerts to which users have subscribed; to manage the Service and Website, to improve the Service and to customize the user's experience. This information is also provided to the authors of the content to give them insight into their readership and help them to improve their content, so that it is most useful for our users.

JD Supra does not sell, rent or otherwise provide your details to third parties, other than to the authors of the content on JD Supra.

If you prefer not to enable cookies, you may change your browser settings to disable cookies; however, please note that rejecting cookies while visiting the Website may result in certain parts of the Website not operating correctly or as efficiently as if cookies were allowed.

Email Choice/Opt-out

Users who opt in to receive emails may choose to no longer receive e-mail updates and newsletters by selecting the "opt-out of future email" option in the email they receive from JD Supra or in their JD Supra account management screen.

Security

JD Supra takes reasonable precautions to insure that user information is kept private. We restrict access to user information to those individuals who reasonably need access to perform their job functions, such as our third party email service, customer service personnel and technical staff. However, please note that no method of transmitting or storing data is completely secure and we cannot guarantee the security of user information. Unauthorized entry or use, hardware or software failure, and other factors may compromise the security of user information at any time.

If you have reason to believe that your interaction with us is no longer secure, you must immediately notify us of the problem by contacting us at info@jdsupra.com. In the unlikely event that we believe that the security of your user information in our possession or control may have been compromised, we may seek to notify you of that development and, if so, will endeavor to do so as promptly as practicable under the circumstances.

Sharing and Disclosure of Information JD Supra Collects

Except as otherwise described in this privacy statement, JD Supra will not disclose personal information to any third party unless we believe that disclosure is necessary to: (1) comply with applicable laws; (2) respond to governmental inquiries or requests; (3) comply with valid legal process; (4) protect the rights, privacy, safety or property of JD Supra, users of the Service, Website visitors or the public; (5) permit us to pursue available remedies or limit the damages that we may sustain; and (6) enforce our Terms & Conditions of Use.

In the event there is a change in the corporate structure of JD Supra such as, but not limited to, merger, consolidation, sale, liquidation or transfer of substantial assets, JD Supra may, in its sole discretion, transfer, sell or assign information collected on and through the Service to one or more affiliated or unaffiliated third parties.

Links to Other Websites

This Website and the Service may contain links to other websites. The operator of such other websites may collect information about you, including through cookies or other technologies. If you are using the Service through the Website and link to another site, you will leave the Website and this Policy will not apply to your use of and activity on those other sites. We encourage you to read the legal notices posted on those sites, including their privacy policies. We shall have no responsibility or liability for your visitation to, and the data collection and use practices of, such other sites. This Policy applies solely to the information collected in connection with your use of this Website and does not apply to any practices conducted offline or in connection with any other websites.

Changes in Our Privacy Policy

We reserve the right to change this Policy at any time. Please refer to the date at the top of this page to determine when this Policy was last revised. Any changes to our privacy policy will become effective upon posting of the revised policy on the Website. By continuing to use the Service or Website following such changes, you will be deemed to have agreed to such changes. If you do not agree with the terms of this Policy, as it may be amended from time to time, in whole or part, please do not continue using the Service or the Website.

Contacting JD Supra

If you have any questions about this privacy statement, the practices of this site, your dealings with this Web site, or if you would like to change any of the information you have provided to us, please contact us at: info@jdsupra.com.

- hide
*With LinkedIn, you don't need to create a separate login to manage your free JD Supra account, and we can make suggestions based on your needs and interests. We will not post anything on LinkedIn in your name. Or, sign up using your email address.