The initial election of the end-user clearing exception represents a unique opportunity for boards to comply with Dodd-Frank and meet their fiduciary duties. Matthew E. Hoffman and Christina Norland Audigier, both of Chatham Financial explain how boards can establish a proper foundation of robust policies, processes, and procedures that will position their companies to hedge efficiently while evolving with the rapidly changing post-regulatory regime.
Under Dodd-Frank, companies will be required to clear and fully collateralize certain interest-rate derivatives beginning September 9, 2013, unless they qualify for and elect the end-user clearing exception. For most companies, particularly those that trade on an uncollateralized basis, it is not desirable, or in some cases even feasible to devote liquidity to posting margin on OTC derivatives. This suggests that the question for these companies is how — not whether — to elect the exception. In some cases, Dodd-Frank requires action by a company’s board of directors, who are bound by fiduciary duties and the obligation to act on an informed basis in making decisions on behalf of the company. Accordingly, while clearing may be a nonstarter for many, if not most of these companies, their boards must do more than simply “rubber stamp” the decision to utilize the end-user clearing exception in order to meet all of their obligations. And as regulatory incentives develop, this decision will become less obvious, making it important for boards to establish a framework for evaluating this decision as the OTC market evolves.
Mandatory Clearing under Dodd-Frank and the End-User Clearing Exception
Mandatory clearing is intended to minimize the impact of a default by either party to a swap and, by extension, reduce the impact of that default upon the entire financial system. Parties to a cleared trade are required to fully collateralize the transaction and post collateral in the form of initial margin (akin to an independent amount under an ISDACredit Support Annex, or CSA). In late 2012, the CFTC issued its first (and so far, only) clearing determination, subjecting certain interest rate swaps to mandatory clearing. Non-financial end users must clear these swaps beginning September 9, 2013 — that is, unless they elect the end-user clearing exception.
Regulators authorized use of the exception in response to advocacy by the Coalition for Derivatives End Users, consisting of hundreds of non-speculative business hedgers across America. The Coalition argued that end-user hedging benefitted the economy and did not contribute to systemic risk, and policymakers agreed and ultimately granted relief, though only for a subset of end users. At a high level, any non-financial end user may elect the clearing exception if it uses swaps to hedge, rather than for purposes of speculation, and reports certain information to a swap data repository (SDR), including how it generally meets its swap obligations. But SEC filers (i.e. publicly held companies or those that have issued public debt), as well as entities that are controlled by them, are subject to the following additional requirements by the CFTC:
• an appropriate committee of the company’s board or governing body must review and approve its decision to enter into uncleared swaps pursuant to the end-user exception
• the board committee must set appropriate policies regarding the use of uncleared swaps
• the board committee must review such policies at least annually, or more often upon a “triggering event”
This nonspecific regulatory guidance gives rise to a number of questions.
What is the appropriate board committee for reviewing the election of the end-user exception?
An “appropriate committee” is one that has specific authorization, whether by charter amendment or board resolution, to review and approve the company’s decision to enter into all swaps, including swaps subject to the end-user exception.
How should the board committee review the decision to utilize the end-user clearing exception?
SEC filers’ boards of directors are obligated to act on an informed basis in making decisions on behalf of the company. Consequently, it is prudent for board committees to do more than simply “rubber stamp” this decision, even if turns entirely on their unwillingness or inability to post margin. The board committee’s review should be broad in scope and consider matters such as:
• confirmation that the company satisfies the regulatory prerequisites to elect the exception
• an understanding of the company’s use of derivatives and current and planned hedging strategies
• identification of the types of derivatives for which the clearing exception is or may become relevant
• amendments to the company’s hedging policies
• an analysis of the relative merits of cleared versus uncleared swaps, including key differences and cost-benefit analyses, and the factors that could alter the analysis of the relative merits of each over time
What are appropriate policies?
In the post-regulatory world, appropriate policies for entering into swaps subject to the end-user clearing exception should address any number of factors, including:
• the types of transactions for which the company will elect the exception
• the factors management will consider when evaluating whether to clear a transaction
• how the company will monitor and ensure that the prerequisites for electing the exception continue to be met, including how the company will report required information to a SDR
• what events should trigger board committee review of the policies governing the use of the exception
How does the board committee approve the decision to utilize the exception?
The board committee must pass a resolution that specifically approves the decision to enter into swaps that are exempt from the clearing and related trading requirements.
How often must the board committee revisit these policies, reviews, and approvals?
Regulations specify that these policies, reviews, and approvals must be reviewed and updated, as necessary, at least annually, or more frequently upon a “triggering event”, such as a new hedging strategy that was not contemplated in the original board approval. Another triggering event might be new trades becoming subject to mandatory clearing: we currently anticipate that certain energy derivatives may become subject to mandatory clearing in 2013 and certain currency derivatives in 2014. More generally, boards should remember that adopting appropriate policies for using swaps subject to the end-user clearing exception is only one piece of larger revisions that should be made to hedging policies in light of Dodd-Frank.
What happens after the board approves use of the exception?
Once the board approves use of the end-user clearing exception, the question becomes what factors to consider in evaluating whether to elect the exception on a per trade basis.In the current regulatory environment, if a company tradeson an uncollateralized basis, the cost of posting collateral often is the predominant — and therefore dispositive — factor. But the evolution of regulatory incentives could make this decision less obvious for all corporates.The introduction of margin requirements on uncleared transactions could alter the cost of collateral comparison between uncleared and cleared transactions, while products such as futures and swap-futures may become attractive alternatives in certain cases. Implementation of Basel III likely will require banks to increase their capital reserves, which could result in costs being passed on to end users, while the introduction of trading platforms likely will increase price transparency and reduce certain transaction costs. Even in the current regulatory environment, companies that collateralize their trades may want to consider whether clearing offers a better alternative, particularly in terms of pricing, counterparty credit risk, and the cost of collateral.
The initial election of the end-user clearing exception represents a unique opportunity for boards to comply with Dodd-Frank and meet their fiduciary duties, while establishing a proper foundation of robust policies, processes, and procedures that will position their companies to hedge efficiently while evolving with the rapidly changing post-regulatory regime.
