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Dodd-Lincoln Derivatives Regulation Bill Passes Senate - Issues Shifted to Conference
May 25, 2010
The U.S. Senate on May 20, 2010 voted 59-39 to pass legislation sponsored by Senators Chris Dodd (D-CT) and Blanche Lincoln (D-AR) comprehensively regulating derivatives. Many aspects of the bill will impact energy market participants, as discussed below. The bill will now go to conference where it must be reconciled with the House version of financial regulation legislation, passed in December 2009. Even though some in the Senate had suggested the bill would be fine-tuned before being passed, no material changes to the derivatives regulation portions were made. Thus, any changes will need to be made in conference.
Among the many provisions contained in the Senate bill, some of particular note to the energy industry are the definitions of swaps, swap dealers, and major swap participants, the commercial end-user exemption from the requirement of mandatory clearing of swaps, and federally regulated banks having to spin off their derivative trading units. Specifically:
- The bill prohibits any swaps entity from receiving almost any federal financial assistance (including advances from a Federal Reserve credit facility, FDIC insurance, and federal government guarantees of loans, debts, or purchases). If implemented, this would have the effect of requiring banks to spin their units that trade swaps off into separate subsidiaries. This requirement is not included in the House bill. It was added in the Senate Agriculture Committee and, while it was opposed by many in the administration, the Federal Reserve Chairman, the head of the FDIC, and former Federal Reserve Chair Paul Volcker, it was not removed or modified (even though Chairman Dodd had proposed an amendment that would have weakened it substantially). This will be a significant issue for conference.
- The bill generally requires that swaps be cleared through registered derivatives clearing organizations. Excepted from this requirements are swaps entered into by “commercial end users,” which the bill defines to include any person (other than a financial entity) that, as its primary business activity, owns, uses, produces, purchases, manufactures, distributes, merchandises, or markets goods, services, or commodities, including electricity, natural gas, crude oil, coal, and other energy-related commodities.
- The bill defines both the terms “swap” and “swap dealer” in broad strokes. A “swap” is defined to include a broad range of contracts, agreements, or transactions, including options that are based on other rates, currencies commodities, securities, debt instruments, indices, quantitative measures, or other financial or economic interests; transactions that provide for purchase, sale, payment or delivery that is dependent on the occurrence or non-occurrence of a contingency associated with financial consequences; transactions that provide for payments based on interest or other rates; or transactions that are commonly known in the trade as swaps or swap agreements. Of particular note, the bill excludes from the definition of “swap” any “sale of a nonfinancial commodity or security for deferred shipment or delivery, so long as the transaction is intended to be physically settled.” This introduces an element of subjectivity into the definition, as issues may arise as to whether their “intent” was to physically settle a particular transaction. There is particular concern that this language may be interpreted expansively to define energy book-out transactions as swaps if there is some frequency to the book-outs.
- “Swap dealer” is defined to include any person who holds itself out to be a dealer in swaps or makes a market in swaps, or who is commonly known in the trade as a dealer or market maker, or who regularly engages in the purchase and sale of swaps in the ordinary course of business. The bill specifically excludes persons that buy or sell swaps for their own accounts, not in the ordinary course of their business. Many energy companies have expressed concern about the vagueness of this definition as they could be alleged to purchase and sell swaps in the ordinary course of business without actually “dealing” in swaps. Dealers have been generally defined as market makers who stand ready to take either side of a transaction. This definition appears to be broader.
- The bill defines a “major swap participant” to be any person (not a swap dealer) that (i) maintains a “substantial” position in swaps (excluding “positions held for hedging or mitigating commercial risk” and positions maintained by employee benefit plans), OR (ii) whose outstanding swaps “create substantial counterparty exposure” that could have “serious adverse effects on the financial stability of the United States banking system or financial markets,” OR (iii) who is also a “highly leveraged” financial entity that maintains a substantial swap position. Thus, the definition of a major swap participant includes not only those parties whose swap positions may have a material impact on the U.S. financial markets or banking system, but also includes entities whose positions may be considered “substantial,” a threshold the bill leaves for the CFTC to define.
- The bill attempts to compromise the ongoing dispute between the CFTC and FERC over their respective jurisdictions with respect to energy transactions. The language could be read as a stalemate with it preserving FERC’s authority to find rates just and reasonable under the Federal Power Act and Natural Gas Act, but also preserving the CFTC’s “exclusive” authority with respect to the trading, execution, or clearing of any regulated agreement or transaction. In addition, the bill provides that the CFTC may exempt FERC regulated transactions from its jurisdiction. In some ways, the bill provides support to each of FERC’s and the CFTC’s jurisdiction, but it does not provide the “bright line” that some had hoped for. This will need to be addressed in conference, as the House bill gives the CFTC final say over which transactions and contracts are exempt from its oversight.