July 22, 2010
Derivatives Reform Signed into Law as Part of Dodd-Frank Legislation
On Wednesday, July 21, 2010, President Obama signed into law the final conference report of H.R. 4173, the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Senate passed this bill by a vote of 60 to 39 on July 15, and the House passed the same legislation on June 30 by a vote of 237 to 192. CLICK HERE to read the final legislative text.
Among other things, the comprehensive reform law includes provisions intended to provide new consumer protections; establish an orderly resolution process for failed financial firms; and provide new oversight over private investment funds. And, of particular interest to a number of NAREIT members, the new law would reform the over-the-counter (OTC) derivatives market. CLICK HERE to view the official "Joint Explanatory Statement" of the full contents of the new law.
NAREIT and its members supported efforts to provide greater transparency to the entire OTC derivatives market and to contain the systemic risk posed by significant market participants, dealers, and speculators. However, NAREIT had significant concerns that some initial proposals to require clearing, exchange trading or margining for the derivatives used by real estate companies or other "end-users" to hedge against fluctuations in interest or exchange rates would dramatically increase the cost, and limit credit and liquidity at a time when both are already in short supply.
While the derivatives reform provisions in the new law represent a considerable improvement over earlier proposals, and efforts were made to limit its direct impact on many end-users, uncertainty regarding the implications of the law will likely remain as regulators undertake the rulemaking process. It is clear that the Dodd-Frank Act will significantly impact the derivatives market by providing transparency and containing risk, but it also could increase costs for end-users.
REITs and publicly-traded real estate companies, like other so-called "end-users" of derivatives, often rely upon low-cost, customized contracts – such as interest rate swaps and foreign exchange forwards – to hedge business risk and to manage the cost of their investment, development and operational activities.
For example, interest payments on debt are often the single largest expense for real estate companies. Since some creditors prefer to extend variable rate interest loans, an interest rate swap can be used to lock in a consistent payment on this debt, allowing borrowers to add predictability to their income and balance sheets. In some cases, such a swap is even required by the lender, particularly on secured floating rate loans. Many real estate companies have been able to access these derivatives on an unsecured basis, and if they have been required to pledge collateral on these trades, they have generally been able to use physical property assets to secure both the loan and swap.
From the beginning of the debate on derivatives reform, legislative proposals (including those made by the Obama Administration) have focused on requirements that derivatives be exchange traded, centrally cleared, or otherwise subjected to mark-to-market margin payments between counterparties. Initially, many policymakers wanted to see these requirements imposed on all derivatives transactions. While these requirements may be generally appropriate to contain the risk posed by the 85-90% of derivatives trades that occur between a small number of systemically significant institutions, dealers, and speculators, NAREIT and its members contended that these requirements should not be imposed on end-users.
Whether margin requirements are imposed on them as a result of exchange trading, central clearing, or as a direct requirement on parties to non-cleared derivatives, end-users would be required to tie up significant amounts of cash in margin accounts. Considering that the derivatives transactions involving any one of the thousands of diverse end-user companies make up just 10-15% of all derivatives contracts, these requirements would not only pull liquidity out of the economy, it would do very little to contain systemic risk.
Beginning in July 2009, and with guidance from members of its Derivatives Reform Task Force, NAREIT has worked to inform key lawmakers and regulators about the impact of derivatives reform proposals on REITs and publicly traded real estate companies. This included direct advocacy on concerns that were specific to real estate, but it also included coordinated advocacy through the Coalition for Derivatives End-Users, an organization of trade associations such as the Chamber of Commerce, the Business Roundtable, the National Association of Manufacturers, The Real Estate Roundtable, and others. CLICK HERE for more information on these efforts.
While NAREIT and the Coalition for Derivatives End-Users were successful in focusing much of the debate on derivatives reform around the impact of various proposals on end-users, and key policymakers in both parties made significant efforts to address end-user concerns, the results for end-users are mixed and depend on how regulators define key terms during the rulemaking process.
In an improvement over the original Senate-passed bill – which defined "commercial end-users" as those entities engaged in certain activities but did not explicitly include real estate activities – the construct of the new law exempts end-users if they are neither systemically significant, nor financial in nature, without requiring them to also meet a narrow definition of "commercial end-user."
In other words, if an entity is determined to be a "major swap participant" (MSP) or a "swap dealer" (dealer), they will be subjected to the most aggressive new requirements. Similarly, if an entity is determined to be a "financial entity" or one of a list of certain "prohibited financial affiliates" (prohibited affiliate), it will likely be subjected to at least some of the more costly requirements. But, if the entity is determined not to be an MSP, dealer, financial entity or prohibited affiliate – and if they are using swaps to hedge or mitigate "commercial risk" – they will be exempted from being directly subjected to the most onerous provisions, provided that they notify the CFTC how they meet their financial obligations related to these swaps.
Based on this structure, to determine how it will be impacted by the new law, an entity must first determine if could be considered an MSP, a swap dealer, a financial entity or a prohibited affiliate. NAREIT believes most equity REITs and publicly traded property companies will be able to avoid these classifications, while many mortgage REITs may be considered "financial entities." If this is the case, there is also the risk of being considered an MSP depending on the definition of key terms during the regulatory process. Additionally, there will likely be unique implications for equity REITs or other real estate companies that are affiliated with entities that are classified as "financial." For these reasons, NAREIT encourages you to work with your internal and external counsels to determine the specific impact of this new law on your company's risk management activities.
Under the new law, Major Swap Participants (MSPs) and Swap Dealers will be subjected to the most aggressive and onerous requirements. For their swaps that are not otherwise exempted, this will include: mandatory clearing for swaps that are accepted for clearing, mandatory exchange trading for swaps that are accepted for exchange trading, and mandatory bilateral margin payments on non-cleared swaps with other MSPs or dealers. On non-cleared swaps with exempt entities, MSPs or dealers may be required to post margin if the swap becomes a liability for them.
MSPs are those entities that have a "substantial position" in swaps that are not used for hedging or mitigating "commercial risk", and whose outstanding positions create "substantial counterparty exposure" that could negatively impact the broader banking and financial system. "Highly leveraged" "financial entities" with "substantial positions" in swaps will also be deemed MSPs. As explained in the next section, the terms "commercial risk," "substantial position," "substantial counterparty exposure," and "highly leveraged" will be defined in the rulemaking process. CLICK HERE to read the legislative definition of the term "Major Swap Participant."
Swap dealers are generally those entities that make a market in swaps or hold themselves out as a dealer in swaps. CLICK HERE to read the legislative definition of the term "Swap Dealer."
The derivatives reform title of the Dodd-Frank Wall Street Reform and Consumer Protection Act gives regulators the ability to define key terms. The final definition of these terms could have a dramatic impact on the way the new law impacts NAREIT members and other end-users of derivatives.
"Commercial Risk" - The law, both in its definition of which entities are major swap participants and in its provision that provides an exemption from clearing requirements, provides preferential treatment for swaps used to manage "commercial risk." NAREIT has consistently advocated that this term should include "balance sheet risk." If "balance sheet risk" is not included as a form of "commercial risk," a real estate company or any other entity that seeks to hedge substantial interest rate risk on their debt may risk being considered an MSP or otherwise be required to clear their swaps.
"Substantial position" and "Substantial net counterparty exposure" – When determining which entities are considered MSPs, regulators will have to set guidelines around what is considered a "substantial position" in swaps and what positions create "substantial net counterparty exposure." NAREIT will continue to advocate that these terms should be defined in such a way that it encompasses only systemically significant entities.
"Financial entity that is highly leveraged" – Another term that will have implications for entities that may be considered MSPs is, "a financial entity that is highly leveraged." The law does not explicitly establish guidelines for what is considered "highly leveraged." NAREIT will closely monitor the process that defines this term.
"Swaps" – There remains uncertainty as to whether or not foreign exchange derivatives will be regulated as swaps. Beginning with the earliest derivatives reform proposals drafted by the Obama Administration, the entire foreign exchange swaps and forwards market was exempted from new requirements and regulation. The House-passed bill and initial drafts in the Senate included the same exclusion for foreign exchange derivatives.
However, due to changes endorsed by the Senate Agriculture Committee, the law will subject all foreign exchange derivatives to new requirements – unless the Secretary of the Treasury, "makes a written determination that either foreign exchange swaps or foreign exchange forwards or both should be not be regulated as swaps." CLICK HERE to read the legislative language related to the "Treatment of Foreign Exchange Swaps and Forwards."
NAREIT will monitor actions by the Treasury Department that will determine the ultimate treatment of foreign exchange derivatives.
The new law requires that all derivatives transactions must be reported to a central trade repository. For trades that are cleared or traded on an exchange, swap dealers or major swap participants will be required to report price and volume information on a real-time basis. For swaps that are not cleared, the dealer will be responsible for reporting, however the information will not include the identity, the business transactions or the market positions of the end-user, and reporting for large trades will be delayed to limit any impact on liquidity and to maintain pricing efficiency. CLICK HERE to read the legislative language related to "Reporting and Recordkeeping."
NAREIT and the Coalition for Derivatives End-Users consistently argued that requirements on certain derivatives should depend on the purpose of the derivative (i.e., risk management vs. speculation) rather than on the nature of the entity pursuing the derivative (i.e., commercial vs. financial). Unfortunately, the Administration and other key policymakers were insistent in their desire to include stronger requirements for all "financial entities" – even smaller financial entities that use derivatives primarily to manage risk.
Under the new law, unless they enter into a swap that is otherwise exempted, financial entities will be required to clear swaps that are accepted for clearing and exchange or electronically trade those swaps that are listed on an exchange or a "swap execution facility" (e.g., trading platform). Similarly, a "prohibited financial affiliate" of an entity that is otherwise exempt from clearing, cannot rely on its affiliate's exemption from clearing or exchange trading.
"Financial entities" include: MSPs, dealers, commodity pools, private funds (defined as entities that would be an investment company but for the exemptions provided under 3(c)1 or 3(c)7 of the Investment Company Act of 1940), employee benefit plans, and entities predominantly engaged in the business of banking or defined as "financial in nature" by the Bank Holding Company Act of 1956. CLICK HERE to read the legislative language defining the term "Financial Entities," as it relates to clearing requirements.
"Prohibited financial affiliates" include: MSPs, dealers, commodity pools, private funds, and bank holding companies with over $50 billion in consolidated assets. CLICK HERE to read the legislative "prohibition relating to certain affiliates."
Under the law, barring a specific regulatory exemption, all swaps will be required to be centrally cleared unless: 1) one of the counterparties is not an MSP, dealer, financial entity or prohibited affiliate, and 2) no clearinghouse is able to accept it for clearing. Similarly, barring a specific regulatory exemption, all cleared swaps will be required to be traded on an exchange or executed on a trading platform ("swap execution facility" or "SEF"), unless no exchange or SEF is able to accept it for trading.
In other words, commercial end-user transactions will never be required to be cleared, exchange traded or electronically traded; while other transactions (including those executed by non-MSP/non-dealer financial entities) will generally – but not always – be required to clear, exchange trade or electronically trade. Regardless of why a non-cleared transaction is not subjected to the clearing requirement, it will be subjected to certain capital and margin requirements.
At the beginning of the debate on derivatives reform, many policymakers expressed a desire to impose significantly, and seemingly arbitrarily, higher capital requirements on banks and non-bank swap dealers that were party to non-cleared derivatives. While it may be appropriate for regulators to use risk-based capital guidelines to establish capital requirements for financial institutions to protect against losses on their derivatives transactions, NAREIT and the Coalition for Derivatives End-Users consistently advocated that capital requirements for non-cleared trades should be based on actual risk of loss, rather than as an inducement to clear or exchange trade these contracts.
In an improvement over earlier proposals, the new law appropriately focuses on the actual risk posed by non-cleared swaps when giving regulators the ability to set capital requirements. However, it also allows regulators to examine the other activities of a swap dealer or major swap participant when determining the magnitude of derivatives capital requirements, which would create different requirements for each swap provider. CLICK HERE to read the legislative language related to "Standards for Capital and Margin."
Under the new law, regulators will be required to impose margin requirements on any non-cleared swap entered into by two entities that are classified as MSPs or dealers. Ever since the closing moments of the initial Conference Committee meetings in the early morning hours of June 25, 2010, when an explicit prohibition against any margin requirements on end-user transactions was removed from the final bill, there has been significant debate about the legal authority provided for regulators to impose margin on non-cleared swaps in which one of the counterparties is not an MSP or dealer.
At the time, House Financial Services Committee Chairman Frank indicated that the explicit prohibition was removed because it was "redundant." However, the impact of this change has been interpreted in a number of ways by various organizations, ranging from a belief that the law now requires regulators to impose margin on both parties of ALL non-cleared trades to a belief that it allows regulators to impose margin requirements only on the MSP or dealer side of non-cleared trades.
When, in an unprecedented moment, the Conference Committee re-opened negotiations on June 29, 2010, in order to modify the provisions in the bill that will raise funds to cover the cost of implementation, Senate Agriculture Committee Ranking Member Saxby Chambliss (R-GA) offered an amendment to restore the explicit end-user exemption from margin. While this amendment failed on a tie vote, Chairmen Frank and Dodd provided assurances that they would work with Senator Chambliss to address his concerns.
The result was a letter, which is now part of the formal legislative history of the Dodd-Frank Act, that states that the Congressional intent that margin requirements shall not be directly applied to end-users, but that margin could be applied to the MSP or dealer side of their non-cleared trades with end-users. Additionally, the letter says, "While Congress may not have the expertise to set specific standards, we have laid out our criteria and guidelines for implementing reform. It is imperative that these standards are not punitive to the end-users, that we encourage the management of commercial risk, and that we build a strong but responsive framework for regulating the derivatives market." CLICK HERE to read the letter in the Congressional Record.
While this is a positive development, margin requirements on end-user trades – even if they are not imposed directly on the end-user – very well could increase the cost of these trades and will raise new questions for businesses that consider using derivatives to manage their risk. Furthermore, Congressional intent does not have the same force as law, and it will be critical that the regulators abide by this intent throughout the rulemaking process.
Another issue that NAREIT, the Coalition for Derivatives End-Users and many other advocates have repeatedly raised is whether or not the new law – particularly its clearing and margin requirements – can be retroactively applied to existing contracts.
The law explicitly prohibits the retroactive application of clearing requirements on any swap in effect prior to the enactment of the new law. This applies equally across all entities ranging from MSPs to end-users. CLICK HERE to read the legislative language providing "Clearing Transition Rules."
On the issue of margin, however, the law provides less certainty. The original House-passed bill included an explicit prohibition against the retroactive application of margin requirements. And, until the very late stages of debate in the Senate of its original bill, that chamber was expected to include a similar provision. Unfortunately, some journalists, outside groups and even some lawmakers, started to claim that this provision was an effort of a single Senator to protect a single nationally-known investor and his business holdings. Unfortunately, this mischaracterization permanently changed the debate on this issue and turned a provision once seen as noncontroversial into a politically troublesome issue. Needless to say, the final conference report did not include an explicit prohibition against retroactive margin requirements.
Initially, those entities that would be considered end-users under the final bill took some additional comfort in the provision discussed above that would have explicitly prevented any margin requirements on their non-cleared trades. When that provision was removed in the late stages of the Conference, uncertainty grew about possible retroactive requirements.
Some observers point to the fact that, while the law does not explicitly deny retroactive authority to regulators, it also does not explicity provide them with this authority. Additionally, regulators, including CFTC Chairman Gary Gensler, have said they do not believe they will have the authority to impose retroactive margin. This interpretation has been echoed by several key lawmakers – and the letter that is now part of the legislative history on margin requirements in general also expresses that certainty for existing contracts is, "imperative...for the sake of our economy and financial system." Furthermore, the American Bar Association (ABA) has indicated that they believe any retroactive application of margin would be subject to legal challenge. CLICK HERE to read the ABA letter on this matter.
As with many other key provisions in the new law, the final result of this effort may not be known until the rulemaking process is complete.
While the derivatives reform title in the Dodd-Frank Wall Street Reform and Consumer Protection Act does not achieve the complete balance advocated by NAREIT and the Coalition for Derivatives End-Users, it represents a definite improvement over initial reform proposals. And, depending on the outcome of the rulemaking process, while end-users of derivatives products might well face increased costs, many of them will not be subjected to the most direct and burdensome requirements that are intended to contain systemic risk in the derivatives market.
NAREIT will closely monitor the regulatory process and will encourage the regulators to adopt rules and define terms in such a way that will protect, to the greatest extent possible, its members that use derivatives to manage risk.