On Monday, January 12, 2015, President Obama signed into law, the Terrorism Risk Insurance Program Reauthorization Act of 2015 ("TRIA"). Title III of TRIA contains the Business Risk Mitigation and Price Stabilization Act of 2015 ("BRMPSA"), wherein amendments are made to parts of the Commodity Exchange Act ("CEA") and the Securities Exchange Act of 1934 ("SEA") that were added as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“DF”).
BRMPSA, which is not related to terrorism insurance, was added to the end of TRIA as a short Title III (less than 350 words). It removes certain margining obligations imposed on certain end-users and other germane counterparties.
DF requires the Prudential Regulators (i.e., the Farm Credit Administration, the Federal Deposit Insurance Corporation, the Federal Housing Finance Agency, the Federal Reserve Board, and the Office of the Comptroller of the Currency) and the Commodity Futures Trading Commission ("CFTC") to adopt rules that put initial and variation margin requirements on uncleared swaps traded by certain financial entities.
BRMPSA, with respect to certain non-financial hedging entities1, certain cooperatives2, and certain financial entities who perform a hedging function for affiliates3 (each, for the sake of this discussion, being referred to as a "commercial end-user oriented business"), amends DF by specifying that (1) the requirement of the regulators to adopt margin rules, along with (2) any margin rules adopted based on such requirement, shall have no application to any swap where a counterparty is a commercial end-user oriented business.
Recent uncleared swap margin rules proposed by the Prudential Regulators (see the Notice of Proposed Rulemaking entitled “Margin and Capital Requirements for Covered Swap Entities,” 79 Fed.Reg. 57348, Sep. 24, 2014)(the "Prudential Regulators' Proposal") and by the CFTC (see Proposed Rule and Advance Notice of Proposed Rulemaking entitled “Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants,” 79 Fed.Reg. 59898, Oct. 3, 2014) (the "CFTC's Proposal") largely and already exclude non-financial end-users from the scope of what BRMPSA now states shall not apply to a commercial end-user oriented business. That said, there are some potential nuances of note:
With respect to the Prudential Regulators
The Prudential Regulators' Proposal provides (see excerpts below from §§.3,.4 on pages 57391, 57392) that covered swap entities are not required to collect initial margin or variation margin from end-users, however, the Prudential Regulators' Proposal also (in this author's opinion) grants to a covered swap entity a sweeping amount of discretion to collect margin from an end-user at any time, in any form, and in any amount that it determines addresses the credit risk posed by uncleared swaps with such end-user.
Ҥ_.3 Initial margin.
. . .
(d) Other counterparties. A covered
swap entity is not required to collect
initial margin with respect to any non-
cleared swap or non-cleared security-
based swap with a counterparty that is
neither a financial end user with
material swaps exposure nor a swap
entity but shall collect initial margin at
such times and in such forms and such
amounts (if any), that the covered swap
entity determines appropriately address
the credit risk posed by the counterparty
and the risks of such non-cleared swaps
and non-cleared security-based swaps.
. . .
§_.4 Variation margin
. . .
(c) Other counterparties. A covered
swap entity is not required to collect
variation margin with respect to any
non-cleared swap or non-cleared
security-based swap with a counterparty
that is neither a financial end user nor
a swap entity but shall collect variation
margin at such times and in such forms
and such amounts (if any), that the
covered swap entity determines
appropriately address the credit risk
posed by the counterparty and the risks
of such non-cleared swaps and non-
cleared security-based swaps.”
To the extent that BRMPSA eliminates this grant of discretion, a degree of respect has been restored to the interest that a commercial end-user oriented business has in the sanctity of contract.
To demonstrate the potential harm such discretion would otherwise pose to a commercial end-user oriented business, the following hypothetical example may be considered:
- A covered swap entity ("X") has an ISDA master agreement ("ISDA") with a Credit Support Annex ("CSA") in place with a non-financial end-user ("Y") that provides Y with a collateral Threshold (like a line of credit) of $50 million.
- Under the ISDA, X and Y have a portfolio of interest rate swap transactions that were entered into over a period of months.
- Recently, interest rates have moved in such a way as to create significant unrealized losses for Y (e.g., $35 million) on the portfolio of interest rate swaps that have not yet settled such that X is exposed to the risk that Y may not pay the amount owed to X (currently an unrealized gain of $35 million) upon settlement or termination of the interest rate swaps.
- X has not received any collateral or margin from Y because the value of the exposure is below the Threshold (i.e., Y's agreed line of credit has not been exceeded)
- X determines that the credit risk posed by the interest rate swaps is high because of turbulent market conditions
- Notwithstanding the fact that X and Y have previously agreed to a $50 million Threshold in the CSA, X unilaterally decides to amend the Threshold to $zero and makes a margin call on Y for $35 million
- X states that it is given the right to adjust such Threshold based on a determination made in accordance with applicable regulation (i.e., the Prudential Regulators' Proposal)
In effect, in the foregoing example, the non-financial end-user's counterparty is given a discretionary right to demand adequate assurance. To analyze the power of this discretion, one needs to ask whether or not regulation in such a case can trump contract. But now, with the passing of BRMPSA, the more relevant question becomes whether or not the power of the Prudential Regulators to grant such discretion has been (or has to be) eliminated.
With respect to the CFTC
The CFTC's Proposal does not grant a discretionary right to non-financial end-users' counterparties to demand margin. However, the CFTC has retained discretion for itself to treat any entity (e.g., a non-financial end-user) as a financial end-user for margin purposes (see the excerpt below from the definition of “Financial end user” on page 59927 of the CFTC's Proposal):
“(xiii) Notwithstanding paragraph (2)
of this definition, any other entity that
the Commission determines should be
treated as a financial end user.”
It would appear that with the passing of BRMPSA, this discretion of the CFTC to deem a non-financial end-user to be a financial end-user for margin purposes has been (or has to be) eliminated.
The text of BRMPSA is available at PDF p26 of TRIA at this link, and it is also included below with color coded cross-references to the CEA and the US Code (to help differentiate between references to "paragraphs (2)" and "section 2").
1. See CEA §2(h)(7)(A) and CFTC Regulation at 17 C.F.R. §50.50.
2. See CEA §4(c)(1) and CFTC Regulation at 17 C.F.R. §50.51.
3. See CEA §2(h)(7)(D) and CFTC No-Action Letter 14-144 (Nov. 24, 2014).