Beginning May 1, 2013, many new business conduct regulations adopted by the Commodity Futures Trading Commission (“CFTC”) pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) will begin to take effect. Although the requirements of the new regulations apply on their face just to swap dealers and major swap participants, any end users (including bond issuers and borrowers) that are parties to a swap agreement will need to amend their master agreements to provide information and make representations to dealers in order to enter into new swaps with such dealers after May 1. In addition to the business conduct regulations, there are various new reporting and record-keeping requirements that must be satisfied regarding the end user’s existing and new swaps. There are also special rules that apply to municipal bond issuers that qualify as “special entities” under the regulations. This advisory addresses some of the more common questions regarding this new regulatory regime.
Dodd-Frank regulates swap markets, giving regulatory jurisdiction over some kinds of swaps to the CFTC and jurisdiction over others to the SEC. The kinds of swaps most commonly used in connection with municipal bond issuances, including interest rate swaps, are regulated by the CFTC under the Commodity Exchange Act. Swaps, including credit default swaps, based on the return of broad-based indices (including broad-based municipal securities indices) are also under the CFTC regime. Commodity derivatives, such as fuel swaps, are under the CFTC regime unless they fall into an exception for forward delivery agreements.
The kinds of swaps that will be under the SEC regime when the SEC’s final rules are issued and go into effect are called “security-based swaps” and include swaps based on the yield of individual debt securities, and swaps based on the value or return of narrow-based securities indices and baskets (including narrow-based municipal securities indices and baskets). Financial guarantees, such as bond insurance or bond wraps, will not be treated as swaps or security-based swaps so long as the right to accelerate payments is exclusively the insurer’s and other conditions are met.
End users that are parties to existing swaps are subject to certain requirements, even if they do not intend to enter into any new swaps for the foreseeable future. (For the purposes of the regulations amending the material terms of an existing swap may constitute entering into a new swap). As described in a previous alert, all parties to existing swaps are required to obtain an identification number known as a CICI. If the end user is a party to any “post-enactment swaps” (swaps that were executed after April 25, 2011, the date the Dodd-Frank Act went into effect), the regulations require the end user to obtain, or confirm its counterparty has obtained for it, a legal entity identifier using the CICI process by April 10, 2013, which the deadline has been extended, for enforcement purposes, to October 31, 2013 by CFTC no action letter. End users that are only parties to “historical swaps” (i.e. any swap that is not a post-enactment swap) are not required to obtain a CICI until October 7, 2013.
All existing swaps are also subject to reporting requirements. Only one party to the swap is required to file the reports and in most cases the reporting burden will fall on the swap dealer, not on a municipal bond issuer or borrower. Since the majority of swaps done in the public finance context are between a municipal bond issuer or borrower and a swap dealer, most bond issuers or borrowers will not need to worry about the reporting requirement. However, beginning April 10, 2013, all swap parties must keep adequate records to allow their counterparties to comply with reporting requirements. The text of 17 CFR 46 contains tables of minimum primary economic terms data that all counterparties must maintain during the life of the swap and for five years thereafter. Such data includes the names and characteristics of the parties, the assets involved in the swap, the contract type, certain relevant dates and the price, rate, or notional amount of the swap, as applicable. There is no requirement that the records be kept in electronic form, only that they be kept in such a way that they may be easily accessed for reporting purposes. End users will not be required to create or re-create records that were not in their possession as of October 14, 2010, but they must retain the records that are currently in their possession (including records of swaps that have already expired) for a period of five years after the termination date of the applicable swap.
Even if an end user has made it clear that it does not intend to enter into new swaps, swap dealers may be reluctant to continue speaking with an end user that has not taken the steps required to enter into new swaps, as described below. Dealers will be required to record all conversations that could “lead to the execution of a swap” and to verify certain information about the end user before offering to enter into a swap. Additionally, dealers who are offering advice to “special entities” will be held to heightened standards of fair dealing, as further described below. Because it is difficult to pinpoint where in a conversation the intent to enter into a swap begins, many dealers may exercise caution and refuse to speak to end users that are not eligible to execute new swaps, in order to avoid inadvertently violating these regulations.
Beginning May 1, 2013, all swap counterparties will be required to amend their master agreements in order to incorporate certain provisions required by the Dodd-Frank regulations. Although there is no penalty for missing this deadline, dealers will not enter into swaps with counterparties until the counterparties have provided certain information and addressed the new requirements in their master agreements. As discussed in further detail below, the master agreement amendments sought by dealers to comply with Dodd-Frank typically include the affirmation or waiver of certain new legal rights and obligations, such as the end user’s right to restrict the dissemination of material confidential information, and, in the case of “special entities,” such as municipal bond issuers, information and representations relating to new, heightened fair dealing duties on swap dealers.
In 2012, the International Swap Dealers Association (“ISDA”) released a document known as the ISDA DF Supplement that was intended to incorporate all of the recent regulations into a common amendment that would provide uniformity and allow both end users and swap dealers to comply with the regulations without needing to draft individual contracts.
The ISDA DF Supplement has two required components: Schedule 1, which contains defined terms, and Schedule 2, which incorporates most of the business conduct regulations issued by the CFTC. There are also four additional schedules (Schedules 3–6) that may be selected by an end user that is categorized as a certain type of entity under the regulations. Schedule 4 is the one that pertains to municipal special entities. However, it is not necessary to include Schedule 4 (or any of the other additional schedules), and an end user may refuse to add any without jeopardizing the validity of the remainder of the ISDA DF Supplement.
In connection with the ISDA DF Supplement, end users are also required to complete a questionnaire, known as the ISDA DF Protocol Questionnaire, which seeks more information about the entity entering into the swap, and its status under the regulations. The whole process of answering the questionnaire and executing the supplement is known as the August 2012 ISDA Protocol. (ISDA issued an additional protocol in March 2013 and is expected to issue future protocols as the CFTC and SEC finalize additional rules under Dodd-Frank.) In addition to determining whether the end user is a "special entity," the questionnaire in the August 2012 DF Protocol asks if the party is an "eligible contract participant" or a "swap dealer" under the law and if it has a third-party evaluator acting on its behalf when it enters into swaps. Although the questionnaire is relatively short, the responses to several of the questions involve legal conclusions, and such questions should not be answered without some review by counsel.
In order to adhere to the August 2012 ISDA Protocol and enter into an ISDA DF Supplement, the end user must complete the ISDA DF Protocol Questionnaire on the ISDA website, select the schedules it wishes to use, and submit it to ISDA for approval. This submission generates a document that serves as an amendment to an existing ISDA Master Agreement. Because ISDA has the authority to reject any nonconforming agreement, end users do not generally have the ability to modify individual terms. Instead, every end user must generally either accept or reject the agreement (including any required and selected schedules) in whole.
End users that wish to continue entering into swaps are not obligated to use the ISDA DF Supplement. The purpose of the ISDA DF Supplement is to encourage compliance with the Dodd-Frank regulations, but this can also be achieved if the parties execute a bilateral amendment to their existing master agreement or agreements. Some swap dealers have drafted their own questionnaires and master agreement supplements to be used with their existing counterparties in lieu of the ISDA Protocol.
Although the ISDA Protocol provides administrative convenience, it also contains certain provisions that protect swap dealers in ways that go beyond what is required by the Dodd-Frank regulations. The regulations provide end users with certain new legal rights and impose heightened fair dealing duties on swap dealers and major swap participants. However, the regulations permit end users to waive certain of these rights in writing, and the ISDA DF Supplement contains some of the permissible waivers. For example, the ISDA DF Supplement contains provisions in which the end user consents to dissemination of material confidential information for the counterparty’s marketing purposes. End users that execute the ISDA DF Supplement will therefore concede new rights they have gained under Dodd-Frank and the regulations, although the practical extent and materiality of those concessions remain to be seen.
Ultimately, an end user’s decision to use the ISDA Protocol may be a matter of administrative convenience. Although the ISDA Protocol contains some dealer-friendly provisions, it is recognized as an acceptable template and nearly every swap dealer will be willing to enter into the ISDA DF Supplement with an end user. The ISDA Protocol will be particularly attractive to end users that have several ISDA master agreements in effect since they can all be updated simultaneously with a single execution of the ISDA Protocol. Unique bilateral agreements may provide an opportunity for end users to tailor an agreement in a way that impacts end users’ interests more favorably than the ISDA DF Supplement. A bilateral agreement may require legal review and negotiation, and the bilateral agreements may need to be separately negotiated and worded in each case.
Under the regulations, a swap dealer has a heightened due diligence responsibility when its counterparty is a “special entity.” Most municipal bond issuers qualify as “special entities,” as the definition includes any state, state agency, city, county, municipality, other political subdivision of a state, or any instrumentality, department, or corporation of or established by a state or political subdivision of a state. In contrast, obligors on conduit bonds will not constitute special entities unless they are a 501(c)(3) organization that is an endowment. Typical 501(c)(3) borrowers, such as schools and hospitals, do not qualify as special entities.
Under the regulations a swap dealer transacting with a special entity is presumed to be an adviser to that special entity and has a duty to make a reasonable determination that any swap or trading strategy involving a swap recommended by the swap dealer is in the special entity’s best interests. However, the swap dealer can be relieved of this duty if it obtains a written representation from the special entity that it will not rely on recommendations provided by the swap dealer, and will rely instead on advice from a designated qualified independent representative (“Designated QIR”). A Designated QIR can be any individual or entity that has sufficient knowledge to evaluate the transaction and risks of a given swap, is independent of the swap dealer or major swap participant, undertakes a duty to act in the best interests of the special entity it represents, makes appropriate and timely disclosures to the special entity, evaluates the fair pricing and the appropriateness of the swap consistent with the entity’s swap policy, and agrees to refrain from making certain political contributions.
Schedule 4 to the ISDA DF Supplement contains language waiving the swap dealer’s duty to recommend only swaps or swap trading strategies that it determines are in the special entity’s best interests. Bond issuers and other special entities should bear in mind that even if they use the ISDA DF Supplement, they need not make the representations listed in Schedule 4. If such an end user declines to execute Schedule 4 (or cannot make the representations that Schedule 4 requires because, for example, it hasn’t hired an independent analyst) the swap dealer will effectively assume a fiduciary duty towards that end user in the case of recommended swaps or swap trading strategies and must undertake the necessary diligence to comply with such duty. However, swap dealers may not wish to assume these additional duties and may cease acting as swap dealers to their existing special entity clients unless and until they receive the Schedule 4 waiver or, in the case of amendments not involving the ISDA DF Supplement, a comparable waiver. Alternatively, dealers may seek increased spreads on swaps with special entities that have not agreed to waive the new Dodd-Frank fiduciary duty to compensate for their greater degree of regulatory risk.
For further information on the new Dodd-Frank regulations for swap markets, please contact the authors of this advisory or an attorney in our Public Finance Practice.