Tuesday, June 21, 2011

Senate and House Oversight Chairs Urge Regulators Not to Undermine Derivatives End-User Exemption and Limit Title VII’s Extraterritorial Scope

The Chairs of the Senate and House Agriculture Committees are concerned that recent proposed regulations may undermine the exemptions Congress provided from mandatory clearing, exchange trading, and margin for end users using derivatives to hedge commercial risks. In a letter to the SEC, CFTC and banking regulators, House Agriculture Committee Chair Frank Lucas (R-OK) and Senate Ag Chair Debbie Stabenow (D-MI) said that undermining these exemptions would substantially increase the cost of hedging for end users and needlessly tie up capital that would otherwise be used to create jobs. The Chairs are also concerned about the extraterritorial scope of rule proposals that could put US firms and markets at a competitive disadvantage. The Chairs urged the regulators implementing Dodd-Frank to be mindful of recognized international law principles and provide additional guidance and clarity on the extraterritorial scope of the proposed regulations.

The letter states that there is a continuing lack of clarity regarding the territorial scope of Dodd-Frank. Section 722(d) directed the regulators not to apply new requirements to activities outside the US unless those activities have a direct and significant connection with activities in, or effect on, US commerce. The Chairs said that this provision is consistent with the historical practice of US regulators to recognize and defer to foreign regulators when registered entities engage in activities outside the US and are subject to comparable foreign regulation.

Despite Section 722(d) and historical practice, noted the oversight Chairs, the CFTC has proposed the possibility of treating foreign subsidiaries of US persons as a US person for purposes of swap dealer registration. If the Commission does that, the proposal would apply margin requirements to all of a US financial institution’s transactions, even those between a foreign subsidiary of a US financial institution and non-US customers that are conducted wholly outside the US. In the view of the Chairs, this proposal could put US firms at a significant competitive disadvantage to their foreign competitors when dealing with non-US counterparties outside the US. In addition, the extraterritorial application of Dodd-Frank to non-US activities, particularly if it engenders reciprocal foreign regulatory treatment, could deter cross-border participation in markets, fragmenting them and making them less liquid and efficient.

Regarding margin for end-users, the letter said that, despite clear congressional intent to the contrary, the prudential regulators proposals could require swap dealers and major swap participants to collect margin from non-financial end-users. Further, despite a statutory objective to allow the use of non-cash collateral, the proposals are overly restrictive when it comes to requiring and valuing highly liquid assets such as cash, treasuries and GSE securities, and does not provide sufficient clarity that the use of other forms of non-cash collateral is permitted.

In addition, there is uncertainty over which entities will be deemed financial end users. Captive finance affiliates of manufacturing companies that exist to facilitate the sale of parent company’s goods should not be deemed high risk financial end users, said Sen. Stabenow and Rep. Lucas. Such a designation would subject these affiliates to significant and substantial cash burdens that would reduce their ability to provide financing to businesses and consumers. The definition of financial entity in Title VII expressly excludes captive finance affiliates of manufacturers and grants them a full exemption from clearing requirements.

The Ag Committee Chairs asked the regulators to clarify that transactions involving non-financial end users meeting the statutory requirement are exempt from margin, consistent with congressional intent. It should also be clarified that captive finance affiliates of manufacturing companies are non-financial end users. The regulators were also urged to ensure that any new capital requirements are carefully linked to the risk associated with the uncleared transactions and not used as a means to deter OTC derivatives trading.

Congress specifically clarified that captive finance affiliates should be exempt from the clearing requirement when their primary business is providing financing and they use derivatives to hedge underlying commercial risks related to interest rate and foreign currency exposures, 90 percent or more of which arise from financing facilitating the purchase or lease of products, 90 percent or more of which are manufactured by the parent company or another subsidiary of the parent company.

The CFTC’s proposed rule on the end user exception to mandatory clearing did not clarify the calculation of this exemption, said the Chairs, creating uncertainty regarding the eligibility of many captive finance affiliates. In order to facilitate the sale of the parent company’s manufactured goods, captive finance affiliates often finance the sale or lease of products that are connected to the underlying product, such as financing an implement for farming equipment or financing a marine vessel to facilitate the sale of the vessel’s engine. Essentially, financing offered by the captive affiliate facilitates the sale of the parent’s manufactured goods.

If the CFTC were to require 90 percent or more of a particular package of equipment be manufactured by the parent company, reasoned the Chairs, the test itself would be an enormous burden to calculate and impractical to apply. They thus urged the CFTC to provide further guidance regarding the calculation of this exemption and its application, and do so in a way that is flexible and responsive to the general practices and operational realities of captive finance affiliates. This clarification should be provided for the identical provisions providing an exemption for captive finance affiliates from designation as major swap participants.