United States: CFTC No-Action Letter May Have Implications For The Treatment Of Swap Obligations In Secured Bank Financings

1. Introduction

Lenders in secured bank financings frequently require or allow borrowers and their subsidiaries to hedge against interest rate, commodity and/or currency fluctuations by entering into swap agreements or other derivative products ("swaps") with financial institution counterparties. To facilitate borrowers and their subsidiaries entering into such swaps, secured loan agreements often allow financial institution counterparties providing the swaps to share in the collateral provided by the borrower and its subsidiaries to lenders under the loan documentation, and also to benefit from guarantees given for the bank financing.

Section 723(a)(2) of Dodd-Frank1 amended Section 2(e) of the Commodity Exchange Act (the "CEA")2 to provide that "it shall be unlawful for any person other than an "eligible contract participant" to enter into a swap unless the swap is entered into on, or subject to the rules of, a board of trade designated as a contract market under section 5 of the CEA.3 The CFTC has previously determined to treat a guaranty of a swap as the equivalent of entering into such swap. In a no-action letter dated October 12, 2012 (the "No-Action Letter"), the Office of the General Counsel of the U.S. Commodity Futures Trading Commission (the "CFTC") clarified whether, under the amended CEA, guarantors of swaps must meet the same requirements as direct swap participants.4

In this Client Alert, we explain how the No-Action Letter interprets the status of guarantors and pledgors under swap arrangements, discuss the potential consequences of that interpretation for secured bank financings and the credit support features there under and suggest certain steps that may be taken to address the pronouncements contained in the No-Action Letter.

2. The No-Action Letter requires swap guarantors and pledgors to be eligible contract participants

Under the CEA, either a swap participant must meet the definition of an "eligible contract participant" (hereinafter, an "ECP") or the swap must be conducted on, and pursuant to the rules of, a designated contract market (a "DCM"), such as the Chicago Board of Trade.5 A swap conducted on a DCM would also be subject to a host of other protective rules and regulations.

The No-Action Letter explains that "the intent behind the ECP requirement in Section 2(e) of the CEA is to limit the availability of non-DCMlisted swaps to market participants of sufficient financial sophistication and with sufficient assets or net worth to assess, appreciate and bear the implications and risks of swap transactions not subject to the regulatory protections applicable to swaps listed on DCMs." The No-Action Letter interprets Dodd-Frank to have amended the CEA to subject guarantors or parties pledging assets to secure swaps to the same requirements as direct swap participants. As a result, each such guarantor and pledgor must be an ECP, or it may not provide credit support for such swaps.

Requirements for ECP Status

The definition of an ECP provides several alternatives for meeting its test, but the alternative most likely to be relevant for entities in secured lending transactions is as follows:

"(v) a corporation, partnership, proprietorship, organization, trust, or other entity —

(I) that has total assets exceeding $10,000,000;

(II) the obligations of which under an agreement, contract, or transaction are guaranteed or otherwise supported by a letter of credit or keepwell, support, or other agreement by an entity described in subclause (I), ...; or

(III) that:

(aa) has a net worth exceeding $1,000,000; and

(bb) enters into an agreement, contract, or transaction in connection with the conduct of the entity's business or to manage the risk associated with an asset or liability owned or incurred or reasonably likely to be owned or incurred by the entity in the conduct of the entity's business;" 6

Although most large corporate borrowers involved in secured bank financings easily meet the threshold of total assets in excess of $10,000,000, their obligations are often guaranteed by, or secured by assets of, many or all subsidiaries or affiliates of the borrower, regardless of their total assets or net worth. Many guarantors or pledgors may meet the criteria in clause (I) or (III) above, but others may not.

In the case of entities that do not otherwise qualify as an ECP, a solution for a typical bank financing could be for a parent entity that otherwise qualifies as an ECP to provide a "keepwell" or other similar credit support for such entities, pursuant to clause (v)(II) of the definition of an ECP above. An example of a keepwell provision is set forth below. Such a solution would be the simplest approach, in many cases, of addressing the pronouncements of the No-Action Letter while maintaining the typical credit support structure for swaps.

3. Consequences of not meeting CFTC requirements for non-ECP entities

At a high level, the consequences of non-compliance with the requirements set forth in the No-Action Letter are as follows:

  • illegality and unenforceability of the guaranty or pledge by the non-ECP guarantor or pledgor, as applicable, of the swap obligations; and
  • potential CFTC enforcement action against the offending swap dealer.7

These consequences are in place to penalize the swap counterparties rather than unsophisticated swap participants or swap guarantors. The No-Action Letter does not offer guidance regarding the consequences of non-compliance for certain situations, particularly in the context of secured bank financings. For example, how will the thousands of credit arrangements currently outstanding without regard to the guidance in the No-Action Letter be affected by the No-Action Letter? Will such arrangements need to be amended or otherwise be subject to technical defaults8 under the applicable documents? Also, the No-Action Letter is silent as to whether non-swap related guarantees or asset pledges made by non-ECP entities (i.e., those supporting loans rather than swaps but included in the loan documents) could be affected by the illegality and unenforceability of a swap guarantee or pledge. 9

4. Steps to consider

The No-Action Letter gives rise to the need to address its pronouncements in the context of many secured bank financings. Many large financings can no longer be structured to grant the swap provider credit support equal to that of the loan obligations without additional steps.

The following should be considered:

  • Conduct due diligence to determine whether there are any guarantors, pledgors or grantors in a secured bank financing that would not qualify as ECPs
  • Require each guarantor, pledgor or grantor in a secured bank financing to make a representation that it is an ECP (which representation would be made at any time a swap is entered into).10
  • Contractually exclude non-ECPs as guarantors and pledgors with respect to swaps.
  • Include "keepwell" support from credit parties that qualify as ECPs in the credit documents (as contemplated by sub-section (II) of Section 1a(18)(v) of the CEA) that would require other parties to the bank financing transaction that qualify as ECPs to provide support to non-ECP compliant entities with respect to their credit support for swaps. The following is an example of a keepwell provision that might be used for this purpose:

"Each ECP guarantor hereby jointly and severally absolutely, unconditionally and irrevocably undertakes to provide such funds or other support as may be needed from time to time by each other credit party hereunder to honor all of its obligations under this guaranty agreement in respect of swap obligations (provided, however, that each ECP guarantor that at the time the swap is entered into, has total assets in excess of $10.0 million shall only be liable for the maximum amount of such liability that can be hereby incurred without rendering its obligations under this section, or otherwise under this guaranty agreement, as it relates to such credit party, voidable under applicable law relating to fraudulent conveyance or fraudulent transfer, and not for any greater amount). The obligations of each ECP guarantor under this section shall remain in full force and effect until the guaranteed obligations shall have been indefeasibly paid in full and the commitments shall have terminated. Each ECP guarantor intends that this section constitute, and this section shall be deemed to constitute, a "keepwell, support, or other agreement" for the benefit of each other credit party for all purposes of Section 1a(18)(A)(v)(II) of the Commodity Exchange Act."

Note that, with respect to outstanding credit arrangements that do not comply with the guidance offered in the No-Action Letter, simply entering into a separate keepwell arrangement between an ECP credit party for the benefit of all non-ECP credit parties may serve to achieve compliance with the No-Action Letter.

  • Include a severability provision in guaranty and security agreements specifying that if entities are not ECPs, such status would not affect their non-swap guaranty obligations, the validity of the security documents themselves, or the obligations of other ECP guarantors under the security documents.

5. Conclusion

In time, it is possible that the CFTC will give further attention to how the No-Action Letter's pronouncements affect secured bank financings and may give lenders and other bank finance parties additional guidance. In the meantime, it would be prudent to consider and discuss with legal counsel how to address non-ECP swap obligations and how these may intersect with guarantees and asset pledges documented in secured bank financings, both those currently "on the shelf" and those being entered into going forward.


1. Dodd-Frank Wall Street Reform and Consumer Protection Act, Public Law 111-203, 124 Stat. 1376 (2010) ("Dodd-Frank").

2. 7 U.S.C. § 1 et seq. (2012).

3. Further Definition of "Swap Dealer." "Security-Based Swap" and "Security-Based Swap Agreement"; Mixed Swaps, Security-Based Swap Agreement Recordkeeping; Final Rule, 77 Fed. Reg. 48225 (August 13, 2012).

4. Swap Guarantee Arrangements; Jointly and Severally Liable Counterparties; Amounts Invested on a Discretionary Basis; and "Anticipatory ECPs", CFTC No-Action Letter No. 12-17, (October 12, 2012).

5. The swaps typically contemplated in secured bank financings are "over the counter" arrangements provided by a lender or a lender's affiliate to the borrower and are not provided through a DCM.

6. 7 U.S.C. § 1a(18)(v).

7. 7 U.S.C. §§ 6b-1, 9(1).

8. For example, certain loan documents provide that it would be a default if any of the obligations (which frequently are defined to include obligations relating to swaps) of the loan parties are determined to be invalid.

9. Although the No-Action Letter does make clear that these rules do not limit the ability of a non-ECP to guarantee a loan. (See No-Action Letter, fn. 17).

10. The test of whether an entity is an ECP is made at the time a swap agreement is entered into and is not an ongoing maintenance test.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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