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