INTRODUCTION

On June 24, 2014, the House of Representatives voted 265 to 144 to pass H.R. 4413, entitled the “Customer Protection and End-User Relief Act” (the “Reauthorization Act”). The Reauthorization Act reauthorizes the operations of the Commodity Futures Trading Commission (the “CFTC”) through the 2018 fiscal year. In addition to reauthorizing the CFTC, the Reauthorization Act would, if enacted, amend the Commodity Exchange Act (the “CEA”), among other things, to:

• require statutorily the CFTC and Securities and Exchange Commission (“SEC”) to issue joint rules regarding the application of U.S. swaps rules to transactions made between U.S. and foreign entities;
• modify the requirements for the CFTC’s cost-benefit analyses for rules promulgated under the CEA;
• enhance certain protections afforded to customers of futures commission merchants (“FCMs”);
• require the CFTC to conduct a study on high-frequency trading no later than one year after the enactment of the bill;
• amend the procedures for taking actions without a full vote of the CFTC commissioners; and
• provide relief to end-users from certain requirements implemented under the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”).

The Reauthorization Act will now be considered by the Senate and will need to be passed by the Senate and signed by the President prior to enactment. The Senate is not expected to pass the Reauthorization Act in the form passed by the House and will likely offer a Senate version with substantial differences from the House’s Reauthorization Act. The bills must then be reconciled by Congress before they are presented to the President. Furthermore, the Reauthorization Act, as passed by the House, does not provide the CFTC with additional funding and imposes new requirements on its operation, to which the CFTC will likely object. If the House and the Senate fail to reach an agreement on an act to reauthorize the CFTC, Congress will likely be forced to reauthorize the CFTC temporarily for an additional year based on its current statutory authorization.

Enhanced Protection for Customers of FCMs

The Reauthorization Act would provide clarification of certain protections afforded to customers of FCMs that are clearing derivative contracts through derivatives clearing organizations. Pursuant to Section 4d of the CEA, an FCM is required to hold sufficient funds in each of its customer accounts (by product type (e.g., futures, swaps, etc.) to satisfy its customers’ margin requirements for the customers’ cleared positions.[1] In a recent final rule, the CFTC explained that it interprets the CEA to prohibit an FCM from using margin furnished by one customer to satisfy the margin requirements of another customer of the FCM in any manner.[2] In light of this interpretation, the CFTC adopted rules that require that, at the end of each day, an FCM must maintain a residual interest (i.e., its own assets that it deposits in the account as customer funds) in each of its customer segregated accounts in an amount sufficient to cover any shortfall in a specific customer’s initial margin with respect to that customer’s margin requirement for that day.[3] Certain changes to the CEA in the Reauthorization Act effectively would require that, if the CFTC adopts rules that require an FCM to hold a residual interest in its customer segregated account in an amount sufficient to exceed a specific customer’s margin deficits, the rule can only require the residual interest requirement to be calculated at the end of the business day as of the close of business on the previous day. The Reauthorization Act would also include a provision that overrules a prior bankruptcy court decision[4] and would require statutorily that “customer property” in an FCM bankruptcy would include most unencumbered cash, securities, or other property of a commodity broker’s estate but only to the extent that the property that is otherwise deemed to be “customer property” is insufficient to satisfy the net equity claims of the FCM’s public customer account. This amendment would effectively give customers of a bankrupt FCM a higher priority in the general assets of the FCM’s estate if the assets in the customer account are not sufficient to satisfy customer claims.

High-Frequency Trading

In response to the recent allegations with respect to, and focus on, high-frequency trading, the Reauthorization Act would also require that the CFTC perform a study of high-frequency trading in markets subject to the CFTC’s jurisdiction.

Cost Benefit Analysis

Currently, the CFTC is required to consider the costs and benefits of any regulation prior to promulgating such regulation. In particular, the CFTC is required to consider:

• the protection of market participants and the public;
• the efficiency, competitiveness and financial integrity of the futures market;
• price discovery; and
• sound risk management practices.

The Reauthorization Act would require that the CFTC, in engaging in this cost-benefit analysis, also consider:

• the impact on market liquidity in the futures and swaps markets;
• available alternatives to direct regulation;
• the degree and nature of the risks posed by various activities within the scope of its jurisdiction;
• the costs of complying with the proposed regulation or order by all regulated entities, including a methodology for quantifying the costs (recognizing that some costs are difficult to quantify); and
• whether the proposed regulation or order is inconsistent, incompatible, or duplicative of other Federal regulations or orders.

The imposition of these additional factors that the CFTC must consider with respect to each rulemaking could make it more difficult for the CFTC to adopt regulations in certain instances and would likely facilitate legal challenges to CFTC rulemaking.

Commission Action with No Vote

In the wake of the Dodd-Frank Act-related rulemakings, the CFTC staff issued a substantial number of letters providing interpretations of various rules, as well as no-action relief (including delaying the compliance date of certain rules). In response to those issuances, the Reauthorization Act would institute a procedure governing these staff actions that are issued without a vote of the Commissioners, pursuant to which the staff would be required to notify the Commissioners prior to issuing any response to a formal, written request or petition from any member of the public for an exemptive, no-action, or interpretive letter.

Judicial Review of Commission Rules

The Reauthorization Act would provide a means for market participants to challenge rules promulgated by the CFTC under the CEA. In particular, the Reauthorization Act would provide that a person adversely affected by a rule adopted by the CFTC may request that a U.S. Court of Appeals review the rule and consider a written petition requesting that the new rule be set aside.

End User Relief

In enacting the Dodd-Frank Act, Congress generally indicated that it did not intend to impose significant regulatory requirements on commercial end users of derivative products or to limit their ability to engage in, or increase their cost of, hedging transactions.[5] The Reauthorization Act provides relief to these end users with respect to certain regulations implemented by the CFTC under the Dodd-Frank Act with regard to, among other things:

• margin requirements for uncleared swaps;
• swaps with non-financial entity affiliates;
• certain swaps with special entities that are utilities;
• the definition of “financial entity”;
• reporting of certain illiquid swaps;
• end user recordkeeping requirements;
• forward contracts with volumetric optionality; and
• the definition of bona fide hedging.

With respect to uncleared margin requirements,[6] the Reauthorization Act would statutorily provide that the uncleared margin requirements do not apply to swaps with respect to which one counterparty would qualify for the non-financial end-user exception to clearing under Section 2(h)(7)(A) or would otherwise be exempt from the clearing requirement, regardless of whether the swap is subject to the clearing requirement. This relief would apply to both CFTC-regulated swaps as well as SEC-regulated security-based swaps. As proposed, the CFTC’s uncleared margin rules would not impose margin requirements on non-financial end users while the banking regulators’ uncleared margin rules may impose margin requirements on non-financial end users (albeit with very high threshold levels).[7] The Reauthorization Act would statutorily prohibit imposing margin requirements on certain swaps of non-financial end users.

The Reauthorization Act would provide relief with respect to the definition of “financial entity”. Under the CEA, a financial entity is defined currently as:

• a swap dealer;
• a security-based swap dealer;
• a major swap participant;
• a major security-based swap participant;
• a commodity pool;
• a “private fund”;
• an “employee benefit plan”; or
• a person predominantly engaged in activities that are in the business of banking, or in activities that are financial in nature.

The Reauthorization Act would provide that an entity, which might otherwise be captured within the definition of financial entity by the last prong, with an affiliate that qualifies for the non-financial end-user exception to the clearing requirement under Section 2(h)(7)(A), could rely on that exception, provided that the entity is entering into the swap to hedge or mitigate the commercial risk of the non-financial affiliate, subject to certain credit support conditions.[8]

The Reauthorization Act would also provide relief from the definition of “financial entity” for commercial market participants (who may be financial entities because they are predominantly engaged in physical delivery contracts) and persons who use derivatives to mitigate commercial risk.[9] The Reauthorization Act would also statutorily define “commercial market participant” as “any producer, processor, merchant, or commercial user of an exempt or agricultural commodity, or the products or byproducts of such a commodity.”[10]

The Reauthorization Act would provide relief to counterparties of certain “special entities” (i.e., governmental entities) that own or operate natural gas or electric utility facilities from the de minimis threshold requirements of the CFTC Rules. The CFTC Rules provide that a person shall not be deemed to be a “swap dealer” if that person does not engage in swap dealing transactions with an aggregate gross notional amount in excess of certain thresholds over the past 12 months.[11] The relief in the Reauthorization Act would provide that “utility-operations-related swaps” (as defined in the Reauthorization Act) that are part of swap dealing activities would be included in the general de minimis threshold (currently $8 billion in notional amount per 12-month period) rather than the special entity de minimis threshold (currently $25 million in notional amount per 12-month period).[12]

The Reauthorization Act would also provide relief from the reporting requirements for certain swaps in illiquid markets.[13] This relief is in response to concerns recently raised in the industry that, by publicly reporting these swaps pursuant to the CFTC’s swap data reporting rules, a market participant is providing others with insight into its positions and strategies. The Reauthorization Act would provide that the CFTC must adopt rules with respect to the reporting of hedging swaps in illiquid markets entered into by non-financial entities where such swaps data would only be publicly available at least 30 days after execution.

The Reauthorization Act would also provide relief for end users from certain newly adopted recordkeeping requirements implemented by CFTC Rule 1.35. CFTC Rule 1.35 requires a member of a designated contract market or a swap execution facility that is not registered in any capacity with the CFTC to “keep full, complete, and systematic records, which include all pertinent data and memoranda, of all transactions relating to its business of dealing in commodity interests and related cash or forward transactions.”[14] The Reauthorization Act would require a person that is a member of a designated contract market or swap execution facility and that is otherwise not required to be registered with the CFTC only to keep records of “each transaction in a contract for future delivery, option on a future, swap, swaption, trade option, or related cash or forward transaction. The written record shall be sufficient if it includes the final agreement between the parties and the material economic terms of the transaction and is identifiable and searchable by transaction.”[15] This would be a significant reduction in the recordkeeping burden.

The Reauthorization Act would modify the definition of “swap” under the CEA to address concerns raised by market participants in response to the CFTC’s guidance on forward contracts with volumetric optionality.[16] The Reauthorization Act would provide that any contract:

• that is on a non-financial commodity;
• that is intended to be physically settled;
• where the exercise of any embedded option in such contract would result in a physical delivery obligation;
• where any embedded optionality cannot be severed or marketed separately from the overall transaction for the purpose of financial settlement; and
• with respect to which both parties are commercial market participants,

would be a forward contract that is excluded from the definition of swap. This exclusion would apply to both embedded options and stand-alone options.[17]

The Reauthorization Act would provide additional clarity to the definition of bona fide hedging and provide the CFTC with the authority to define further which activities may constitute bona fide hedging.

Cross Border Rules

Although both the CFTC and the SEC have adopted guidance or rules concerning the cross-border applicability of certain of each agency’s swaps-related rules,[18] the Reauthorization Act would require the CFTC and SEC jointly to adopt rules that govern the application of the requirements applicable to U.S. swaps to transactions involving U.S. persons or non-U.S. persons. The joint rules must address:

• the nature of the connections to the United States that require a non-U.S. person to register as a swap dealer, major swap participant, security-based swap dealer, or major security-based swap participant under each Commission’s respective Acts and the regulations issued under such Acts;
• which of the United States swaps requirements shall apply to the swap and security-based swap activities of non-U.S. persons, U.S. persons, and their branches, agencies, subsidiaries, and affiliates outside of the United States and the extent to which such requirements shall apply; and
• the circumstances under which a non-U.S. person in compliance with the regulatory requirements of a foreign jurisdiction shall be exempt from United States swaps requirements.

The Reauthorization Act would prohibit either agency from issuing any guidance, memorandum of understanding, or any similar type of agreement in lieu of a joint rulemaking. The Reauthorization Act would also define the term “U.S. person” to mean:

• any natural person resident in the U.S.;
• any partnership, corporation, trust, or other legal person organized or incorporated under the laws of the United States or having its principal place of business in the U.S.;
• any account (whether discretionary or non-discretionary) of a U.S. person; and
• any other person as the CFTC and SEC may further jointly define to more effectively carry out the purposes of this Act.

This definition would specifically exclude the International Monetary Fund, the International Bank for Reconstruction and Development, the Inter-American Development Bank, the Asian Development Bank, the African Development Bank, the United Nations, their agencies and pension plans, and any other similar international organizations and their agencies and pension plans from the definition of U.S. Person.

Reaction to Reauthorization Act

On June 19, 2014, the Executive Office of the President issued a statement regarding the Reauthorization Act. The administration stated that it “strongly opposes the passage of H.R. 4413 [(i.e., the Reauthorization Act)] because it undermines the efficient functioning of the [CFTC] by imposing a number of organizational and procedural changes and offers no solution to address the persistent inadequacy of the agency’s funding.”[19] In light of the fact that “[t]he enactment of the Dodd-Frank Act resulted in significant expansion of the CFTC’s responsibilities,” the Administration expressed concerns that the Reauthorization Act would “hinder the CFTC’s progress in successfully implementing these critical responsibilities and would unnecessarily disrupt the effective management and operation of the agency, without providing the more robust and reliable funding that the agency needs.”[20]

On June 24, 2014, Sen. Debbie Stabenow, Chairwoman of the U.S. Senate Committee on Agriculture, Nutrition and Forestry, released a statement on the passage of the Reauthorization Act stating that she was “pleased to see the House bill includes measures related to customer protections as well as important considerations for end users.” However, she expressed disappointment that “the bill provides no additional funding mechanism and adds new layers of administrative burdens, hindering the agency’s ability to do its job and effectively regulate these markets.”[21]

Endnotes

[1] 7 U.S.C. § 6d.

[2] 17 C.F.R. § 1.22(a) (“No futures commission merchant shall use, or permit the use of, the futures customer funds of one futures customer to purchase, margin, or settle the trades, contracts, or commodity options of, or to secure or extend the credit of, any person other than such futures customer.”). See also Enhancing Protections Afforded Customers and Customer Funds Held by Futures Commission Merchants and Derivatives Clearing Organizations, 78 Fed. Reg. 68506 (Nov. 14, 2013).

[3] 17 C.F.R. § 1.22. These newly adopted CFTC rules would apply to futures, swaps and foreign futures contracts.

[4] See In re Griffin Trading Company, No. 98-41742 (Bankr. N.D. Ill).

[5] See, e.g., Letter to Rep. Barney Frank and Rep. Colin Peters from Sen. Christopher Dodd and Sen. Blanche Lincoln, dated June 30, 2010.

[6] The uncleared margin requirements are those requirements imposed under Section 4s(e) of the CEA that would require that registered swap dealers collect margin from counterparties with respect to swaps that are not submitted for clearing.

[7] See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 76 Fed. Reg. 23732 (Apr. 28, 2011); see also Margin and Capital Requirements for Covered Swap Entities, 76 Fed. Reg. 27564 (May 11, 2011). For a further discussion of these proposed rules, please see our Memorandum to Clients, entitled “Proposed Margin Requirements for Uncleared Swaps under Dodd-Frank: Federal Reserve Board, OCC, FDIC, Farm Credit Administration, Federal Housing Finance Agency and CFTC Propose Rules for Minimum Margin and Capital Requirements for Certain Dealers and Major Participants in Swaps and Security-Based Swaps”, dated Apr. 18, 2011.

[8] This provision in the Reauthorization Act is largely analogous to the relief in CFTC Letter 13-22 (Jun. 4, 2013).

[9] It is unclear how an individual that is primarily engaged in physical delivery contracts and that actually takes delivery of physical commodities would be a “financial entity”, as such term is defined under the CEA.

[10] Section 351(b) of the Reauthorization Act.

[11] 17 C.F.R. § 1.3(ggg)(4).

[12] This provision in the Reauthorization Act would largely codify the relief provided in CFTC Letter 14-34 (Mar. 21, 2014).

[13] The Reauthorization Act would define an “illiquid market” as “any market in which the volume and frequency of trading in swaps is at such a level as to allow identification of individual market participants.”

[14] 17 C.F.R. § 1.35(a). This rule would require that such record include “all orders (filled, unfilled, or canceled), trading cards, signature cards, street books, journals, ledgers, canceled checks, copies of confirmations, copies of statements of purchase and sale, and all other records, which have been prepared in the course of its business of dealing in commodity interests and related cash or forward transactions”, as well as all “written communications provided or received concerning quotes, solicitations, bids, offers, instructions, trading, and prices that lead to the execution of a transaction in a commodity interest and related cash or forward transactions” and also must be in “a form and manner identifiable and searchable by transaction.” Id.

[15] Section 353 of the Reauthorization Act.

[16] The CFTC adopted a seven-part test to address whether a forward contract with volumetric optionality would qualify for the forward contract exclusion. See Further Definition of “Swap,” “Security-Based Swap,” and “Security-Based Swap Agreement”; Mixed Swaps; Security-Based Swap Agreement Recordkeeping, 77 Fed. Reg. 48207, at 48238 (Aug. 13, 2012). For a further discussion of this rule, please see our Memorandum to Clients, entitled “Final Product Definitions Under Title VII of Dodd-Frank: CFTC and SEC Adopt Rules and Guidance to Further Define ‘Swap’, ‘Security-Based Swap’, ‘Mixed Swaps’ and Other Swap-Related Terms”, dated Aug. 27, 2012.

[17] Effectively, this would exclude from the definition certain contracts that qualify for treatment as “trade options” under the CFTC’s current commodity option rules. See 17 C.F.R. Part 30.

[18] See Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. 45292 (Jul. 26, 2013). For a further discussion of this guidance, please see our Memorandum to Clients, entitled “CFTC Cross-Border Application of Dodd-Frank Title VII: CFTC Approves Final Guidance and Exemptive Order on Cross-Border Application of the Swaps Provisions of Dodd-Frank”, dated Jul. 22, 2013. See also Application of “Security-Based Swap Dealer” and “Major Security-Based Swap Participant” Definitions to Cross-Border Security-Based Swap Activities, Exchange Act Release No. 34-72472 (Jun. 25, 2014), available here.

[19] Executive Office of the President, STATEMENT OF ADMINISTRATION POLICY H.R. 4413 – Customer Protection and End User Relief Act (Jun. 19, 2014).

[20] Id.

[21] Chairwoman Stabenow Statement on House Passage of CFTC Reauthorization Bill, available here.

The full and original memo was published by Sullivan & Cromwell LLP on July 1, 2014, and is available here.