On November 26th, the Division of Clearing and Risk (the “Division”) of the Commodity Futures Trading Commission (“CFTC”) published No-Action Letter 14-144 (also referred to as “CFTC Letter 14-144”), in order to update the conditions that must be satisfied by corporate end-users to avail themselves of “treasury affiliate relief” from the central clearing and trade execution mandate, as originally provided for by No-Action Letter 13-22 (the”2013 No-Action Letter”). In general, No-Action Letter 14-144 relaxes conditions and requirements of the 2013 No-Action Letter that market participants highlighted as making use of the relief under that letter impractical for many treasury affiliates.
This posting provides background on the treasury affiliate exception and an overview of the current conditions that must now be satisfied by a treasury affiliate in order to claim relief from central clearing. The relief afforded by this letter is likely to be of interest to both end-user and swap provider counterparties, as there are conditions of the relief that apply to both “sides” of the trade.
Legal Background: The Application of the End-User Exception To Treasury Affiliates
Sections 2(h)(1) and (8) of the Commodity Exchange Act (“CEA”) and part 50 of the CFTC’s rules requires certain swaps to be centrally cleared and, if available, traded over a swap execution facility, unless an applicable exemption applies. This mandate is often referred to as the “central clearing mandate” and, at the present time, it only applies to certain interest rate and credit default index swaps..
Section 2(h)(7)(C) of the CEA and CFTC rule 50.50 contain an exception from the mandate, as long as three three conditions are met:
1) The party claiming the exception must not be a “financial entity,” as that term defined in clause (C) of section 2(h)(7) of the CEA;
2) The swap must be used to to hedge or mitigate commercial risk of the claimant; and
3) The reporting obligations outlined in paragraph (b) of CFTC Rule 50.50 must be satisfied. (These reporting obligations are substantially similar to the conditions of CFTC Letter 14-144 summarized below under the heading “Reporting Conditions”.)
In 2013, the Division issued No-Action Letter 13-22, which provided relief for swaps entered into by certain affiliates (called “treasury affiliates”) acting on behalf of non-financial affiliates within a corporate group for the purpose of hedging or mitigating commercial risk. This relief was necessary since treasury affiliates provide services (such as daily cash management, debt administration, and risk hedging and mitigation) that cause the treasury affiliate to fall within the definition of a “financial entity” under section 2(h)(7)(C)(i)(VIII) of the CEA and, as a result, disqualify that affiliate from claiming the end-user exception. As related background, section 2(h)(7)(C)(i)(VIII) of the CEA defines the term “predominantly engaged in financial activities” by reference to section 4(k) of the Bank Holding Company Act of 1956. And, in CFTC Letter 14-144 the Division indicated market participants can look to the Federal Reserve’s 2013 rule for purposes of Title I of the Dodd-Frank Act in order to assess whether they are predominantly engaged in activities that are financial in nature for purposes of the end-user exception.
The 2013 No-Action Letter permitted treasury affiliates to continue to enter into non-cleared swaps on behalf of its non-financial affiliates, subject to specific conditions and requirements outlined in that letter. However, certain of the conditions and requirements in the 2013 relief presented treasury affiliates with challenges in undertaking hedging activities on behalf of their non-financial affiliates within the corporate group. Accordingly, the Division issued CFTC Letter 14-144 in order to amend some of the conditions and requirements in the 2013 No-Action Letter in order and to allow additional treasury affiliates to rely on the relief from the central clearing mandate.
The remainder of this posting will outline the end-user exception available to treasury affiliates under No-Action Letter 14-144 and provide a summary of the changes to the 2013 No-Action Letter made by No-Action Letter 14-144. The relief afforded by this letter is likely to be of interest to both end-user and swap provider counterparties, as there are conditions of the relief that apply to “both sides of the trade”.
The Treasury Affiliate Exception Under CFTC Letter No. 14-144
The exception available to treasury affiliates under CFTC Letter No. 14-144 (the “Treasury Affiliate Exception”) has two categories of conditions, “General Conditions” and “Reporting Conditions” that must be satisfied. These conditions are discussed below under each respective heading.
As an initial matter, however, it is important to note that the Treasury Affiliate Exception is only available to “Eligible Treasury Affiliates” and their “Related Affiliates,” as those are terms defined by No-Action Letter 14-144.
To be an Eligible Treasury Affiliate a person must meet the following seven qualifications:
1) The person must (A) be directly wholly-owned by another person that is not a financial entity that is defined in section 2(h)(7)(C)(i) (a “non-financial entity”); and (B) Not be indirectly majority-owned by a financial entity. CFTC Letter 14-144 defines wholly-owned to mean ownership whereby one person (“W”) holds 100% of the equity securities of another person (“X”), or has the right to receive upon dissolution, or the contribution of, 100% of the capital of a partnership of X, and X’s financial results are included in the financial statements of W under applicable accounting principles. The letter defines “majority-owned” to mean that one person (“Y”), directly or indirectly, holds a majority of the equity securities of another person (“Z”), or has the right to receive upon dissolution, or the contribution of, a majority of the capital of a partnership of Z, and Z’s financial results are included in the financial statements of Y under applicable accounting principles.
2) The person’s ultimate parent must not be a financial entity. CFTC Letter 14-144 provides that a person’s ultimate parent is the top most, direct or indirect, majority owner of the person, in the corporate hierarchy of which the person is a member;
3) The person’s status as a financial entity must be due solely to the fact that it acts as a treasury affiliate to one or more Related Affiliates (i.e., solely as a result of acting as principal to swaps with, or on behalf, of such affiliates or providing other services that are financial in nature to such affiliates);
4) The person must not be: A) a swap dealer, a major swap participant, a security-based swap dealer or a major security-based swap participant; or B) affiliated with any of these regulated swap entities;
5) The person must not be a private fund, a commodity pool, an ERISA plan, a bank holding company, an insured depository institution, a farm credit system, a credit union, a nonbank financial company that has been designated as systemically important by the Financial Stability Oversight Council (the “FSOC”) under 12 CFR Part 1310, or an insurance company.
6) The person must not provide any services to an affiliate that is a nonbank financial company that has been designated as systemically important by the FSOC.
Related Affiliate of an Eligible Treasury Affiliate, a person must meet one of the following two qualifications:
1) The person must be another Eligible Treasury Affiliate; or
2) The person must be a non-financial entity that is either: A) The ultimate parent of the Eligible Treasury Affiliate; or B) Directly or indirectly wholly- or majority-owned by the ultimate parent of the Eligible Treasury Affiliate.
General Conditions of Swap Activity
Under CFTC Letter 14-144, four general conditions that relate to swap activity must be satisfied.
1) Exempted Swap Must Hedge or Mitigate Commercial Risk
The Eligible Treasury Affiliate can only enter into the exempted swap in order to hedge or mitigate the commercial risk of one or more Related Affiliates. A swap “hedges or mitigates commercial risk” if it meets the requirement of CFTC Rule 50.50(c), which generally require that the swap be used to reduce or manage legitimate commercial risk or qualify as a hedging transaction under applicable accounting principles.
2) Eligible Treasury Affiliate Can Only Use Swaps to Hedge or Mitigate Commercial Risk
The Eligible Treasury Affiliate can only enter into swaps – either with unaffiliated counterparties or its Related Affiliates – for the purpose of hedging or mitigating its commercial risk or the commercial risk of one or more Related Affiliates.
3) No Exposure to Financial Affiliates That Do Not Qualify As Eligible Treasury Affiliates
Neither the Eligible Treasury Affiliate nor any of its Related Affiliates that enters into swaps with the Eligible Treasury Affiliate can:
A) Enter into swaps with or on behalf of any “financial affiliate” (i.e., another affiliate that is a financial entity) that does not qualify as an Eligible Treasury Affiliate; or
B) Otherwise assume, net, combine, or consolidate the risk of swaps entered into by any financial affiliate that does not qualify as an Eligible Treasury Affiliate.
4) Centralized Risk Management Program
Each swap entered into by the Eligible Treasury Affiliate is subject to a centralized risk management program that is reasonably designed to:
A) Monitor and manage the risks associated with the swap; and
B) Identify the Related Affiliate or Affiliates on behalf of which each exempted swap has been entered into by the Eligible Treasury Affiliate.
If an Eligible Treasury Affiliate elects to not clear a swap in reliance on the relief afforded by No-Action Letter 14-144, then several conditions that relate to the reporting of that swap to a swap data repository (“SDR”) or the CFTC, as applicable, must be satisfied. In particular, the party responsible for reporting the swap to the SDR (the “Reporting Counterparty”) must provide the following information:
1) Notice of Election and Satisfaction of General Conditions by Electing Counterparty
The Reporting Counterparty must provide notice of the election of the relief by the Eligible Treasury Affiliate (the “Electing Counterparty”) and that the Electing Counterparty has satisfied the four general conditions of swap activity set forth in No-Action Letter 14-144.
2) How the Electing Counterparty Meets Its Obligations Under Non-Cleared Swaps
The Reporting Counterparty must identify which of the following resources the Electing Counterparty generally uses to meet its financial obligations under non-cleared swaps:
(A) A written credit support agreement;
(B) Pledged or segregated assets;
(C) A written guarantee from another party;
(D) The Electing Counterparty’s financial resources; or
(E) Means other than those described in (A)-(D).
3) Board Approval and SEC Central Index Key, If Electing Company is Public Company / Issuer
If the Electing Counterparty is an entity that is an issuer of securities registered under section 12 of, or is required to file reports under section 15(d) of, the Securities Exchange Act of 1934 (a “Public Company / Issuer”), then the Reporting Counterparty must provide:
(A) The relevant SEC Central Index Key number of the Public Company / Issuer; and
(B) Acknowledgment that an appropriate committee of the board of directors (or equivalent body) of the Electing Counterparty has reviewed and approved the decision to enter into swaps that are exempt from the central clearing and trade execution mandates.
This condition would also apply if the ultimate parent of the Electing Counterparty is a Public Company / Issuer.
4) Information To Be Provided For All Electing Counterparties
The information specified in these Reporting Conditions must be provided with respect to all Electing Counterparties to the exempt swap.
5) Certain Information Can Be Provided Annually by Electing Counterparty
The information required by the second and third reporting condition above (i.e., respectively, how the Electing Counterparty meets its obligations and board approvals and CIK of Public Company / Issuer) may be provided by the Electing Counterparty annually in anticipation of electing the relief under No-Action Letter 14-144 for one or more swaps. Such reporting will cover the subsequent 365 day period, provided that the Electing Counterparty will need to amend its report as necessary to reflect any material changes to the information previously reported by it.
6) Reporting Counterparty Must Have Reasonable Basis to Believe General Conditions Met
The reporting counterparty must have a reasonable basis to believe that the Electing Counterparty has satisfied the four general conditions of swap activity set forth in No-Action Letter 14-144.
The Differences Between the 2013 No-Action Letter and CFTC Letter 14-144
CFTC Letter No. 14-144 relaxed or altogether eliminated several requirements and conditions of the 2013 No-Action Letter. The remainder of this posting summarizes the differences between the 2013 No-Action Letter and CFTC Letter 14-144.
1) The 2013 No-Action Letter required that the ultimate parent of an Eligible Treasury Affiliate identify all wholly- and majority- owned affiliates within the corporate group and ensure that a majority of those affiliates qualify for the end-user exception. This requirement was removed in its entirety, in recognition of the facts that: (a) the ratio of the absolute number of financial entities to non-financial entities does not necessarily provide meaningful information about the corporate family as a whole; and (b) requiring market participants to keep track of that ratio adds on-going surveillance responsibilities and expenses for the corporate family.
2) The 2013 No-Action Letter required that an Eligible Treasury Affiliate could itself not be, or not even be affiliated with, a systemically important nonbank financial company. CFTC Letter 14-144 continues to require that an Eligible Treasury Affiliate not itself be a systemically important nonbank financial company; however, an Eligible Treasury Affiliate is permitted to be affiliated with systemically important nonbank financial company, as long as it does not: (a) enter into transactions with, or on behalf of, such a designated company; or (b) provide any services (financial or otherwise) to such a designated company.
3) The 2013 No-Action Letter required an Eligible Treasury Affiliate to only act on behalf of designated Related Affiliates and the manner in which such affiliates were designated had the effect of excluding affiliated entities that performed a cash pooling function for a corporate family. CFTC Letter 14-144 amended the Related Affiliate definition to allow entities that provide financial services on behalf of a financial entity to qualify as an Eligible Treasury Affiliate.
4) The 2013 No-Action Letter required the Eligible Treasury Affiliate to enter into an exempt swap for the sole purpose of hedging or mitigating commercial risk of Related Affiliates that was transferred to the Eligible Treasury Affiliate by operation of one or more swaps with such Related Affiliates. CFTC Letter 14-144 relaxed this requirement in recognition of the fact that a Related Affiliate may transfer the commercial risk that is being hedged by the Eligible Treasury Affiliate by means other than a swap (for example, through the use of book-entry transfers, a technique that is used in connection with the transfer of foreign-exchange risk). CFTC Letter 14-144 does not mandate the transfer of risk vis-a-vis a swap, but does require the Eligible Treasury Affiliate to identify the Related Affiliate(s) on behalf of which the exempt swap was being entered into.
5) Under the 2013 No-Action Letter, the treasury affiliate exception would only be available if the Eligible Treasury Affiliate entered into swaps on behalf of its Related Affiliates to to hedge or mitigate the risk of one or more Related Affiliates – the treasury exception was not available if the Eligible Treasury Affiliated entered into swaps, even for commercial risk hedging or mitigation purposes, for its own behalf. CFTC Letter 14-144 provides that an Eligible Treasury Affiliate will not lose its status as such, solely because it enters into a hedging transaction on its own behalf. The Division clarified that this change to the relief does not allow an Eligible Treasury Affiliate to enter into any speculative transactions.
6) The 2013 No-Action Letter prohibited an Eligible Treasury Affiliate, and any Related Affiliate that enters into swaps with the Eligible Treasury Affiliate, from entering into swaps with or on behalf of any financial affiliate (i.e., another affiliate that is a financial entity) or otherwise assuming, netting, combining, or consolidating the risk of swaps entered into by any financial affiliate. CFTC Letter 14-144 modified this prohibition to clarify that it does not apply if the particular financial affiliate qualifies as an Eligible Treasury Affiliate.
7) The 2013 No-Action Letter required that an exempt swap be guaranteed by the non-financial parent of the Eligible Treasury Affiliate or the Related Affiliates on behalf of which the hedge was being entered into. CFTC Letter 14-144 eliminated this condition in order to accommodate the additional support arrangements that may exist with regard to the Eligible Treasury Affiliate’s payment obligations (such as, keepwell agreements, letters of credit, or revolving credit facilities).
Key Legal Resources
CFTC Letter No. 14-144 is available here.
CFTC Letter No. 13-22 is available here.
CEA Section 2(h) is available here.
CFTC Rule 50.50 is available here.
Good day. Good to give thanks for everything – even (especially) a more useful treasury affiliate exception! Happy Thanksgiving. DR2.