Protecting the Enforceability of Swap Guaranties in Light of Dodd-Frank: What’s a Lender to Do?
Recent rules and guidance issued by the Commodity Futures Trading Commission (CFTC) related to implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) have significant implications for the enforceability of guaranties and, potentially, security agreements in lending and related swap transactions. As a result of these new rules and guidance, if a lending transaction includes swaps, the lender needs to ensure that its loan and security documents are in compliance with applicable Dodd-Frank requirements or it runs the risk that any related swap guaranties, pledges of collateral and other security agreements could be deemed illegal and unenforceable. Certain basic compliance guidelines and other protective measures to consider are discussed below.
In connection with secured lending transactions, it is common for the borrower to enter into separate hedging transactions in the form of swaps to minimize the effect of interest rate, commodity and/or currency fluctuations. These swaps are generally entered into over-the-counter with the lender or its affiliate and not on a designated contract market (i.e., a CFTC regulated board of trade or exchange) (DCM). The borrower’s obligations under the lending transaction and the swap are usually cross-collateralized and also guaranteed by the borrower’s subsidiaries and affiliates.
Swap Guarantors Generally Must Be ECPs
Under the Commodity Exchange Act (CEA), as amended by Dodd-Frank, it is unlawful for any person other than an eligible contract participant (ECP), as defined in Section 1a(18) of the CEA, to enter into a swap unless the swap is entered into on, or subject to the rules of, a DCM or certain other limited exemptions apply. In No-Action and Interpretation Letter 12-17, the CFTC Office of General Counsel confirmed its view that the definition of the term “swap” in the CEA also includes any guarantee of a swap and therefore that swap guarantors must generally meet the same requirements as direct swap participants. In other words, even if the direct swap counterparty is itself an ECP, each guarantor of the obligations of such counterparty under the swap must also be an ECP. Although the letter did not address the application of these amendments to security agreements, market practice has been to interpret the new rules to apply not only to guaranties but also to security agreements and other pledges of collateral in support of swap obligations.
As a result of the Dodd-Frank amendments to the CEA, if the obligations secured by guaranties and asset pledges in loan documentation include swap obligations, each guarantor or pledgor is generally required to be an ECP at the time the swap is entered into. The ECP status determination also may be required when a swap, guaranty or security agreement is amended or modified in such a material respect that the CFTC would consider the agreement to be a new swap, guaranty or collateral support.
If the guarantor or pledgor is not an ECP at the relevant time, then the guaranty or security agreement could be deemed unenforceable and illegal. However, it is not clear whether only the swap guarantee (or security) would be invalidated or whether the entire guarantee (or security) for the underlying loan obligations could also be rendered invalid and unenforceable. Additionally, if the guarantee or pledge is not in compliance with the CEA requirements, the parties could be subject to an enforcement action by the CFTC.
It is important to note that the new rules can apply to existing loan documents if a related swap is entered into on or after March 31, 2013. As a result, many existing loan documents could be subject to technical default if the definition of “obligations” is broad enough to include swap obligations, since invalidity of the underlying obligations (i.e., the swap obligation, if a borrower or a guarantor is not an ECP at the time the swap is entered into) generally constitutes a default. This obviously raises a number of concerns for lenders who are also counterparties under loan-related swap transactions.
Who Qualifies as an ECP?
While the definition of ECP under Section 1a(18) of the CEA provides a number of alternatives to meet the ECP eligibility requirement, the most common alternative for borrowers (and swap guarantors) in secured lending transactions is an entity (i) that has total assets exceeding $10,000,000; (ii) the obligations of which are guaranteed or otherwise supported by a letter of credit or keepwell, support, or other agreement by an entity that has total assets exceeding $10,000,000; or (iii) that has a net worth exceeding $1,000,000 and is hedging its commercial risk. In situations where a swap is hedging commercial risk, it is not clear whether a subsidiary guarantor or pledgor could qualify as an ECP under clause (iii) because the commercial risk would not be its own risk but rather that of its parent (i.e. the borrower/swap counterparty). As a result, transaction parties are generally attempting to qualify guarantors and pledgors as ECPs under clause (i) or (ii). In a keepwell agreement under clause (ii) above, the qualified ECP entity would unconditionally agree to provide funds or other support as may be needed by the non-ECP entity to honor all of the non-ECP entity’s obligations. For entities that are not ECPs in their own right, a keepwell agreement would generally be the easiest approach to meet the ECP requirement while maintaining the typical credit support structure for swaps.
How to Protect the Enforceability of Swap Guaranties.
In light of the Dodd-Frank amendments to the CEA, the CFTC’s new rules under the CEA and the CFTC’s related interpretation letter, lenders should consider taking some or all of the following actions to ensure that the credit support for all swap and lending transactions that are subject to the new rules will continue to be enforceable:
- Conduct due diligence to determine whether there are any guarantors or pledgors that would not qualify as ECPs;
- Require each guarantor or pledgor to make a representation in the loan documents and swap documents that it is an ECP at the time each guaranty or security agreement is entered into, as well as at the time each swap is entered into;
- Include provisions in the loan documents to exclude (a) non-ECPs as guarantors and pledgors with respect to swaps, and (b) “swap obligations” from the “guaranteed obligations” for a particular guarantor if and to the extent the guarantor is not an ECP at the relevant time;
- Include “keepwell” support from credit parties that qualify as ECPs in the loan documents where necessary for entities that would not otherwise qualify as an ECP;
- Include a severability provision in the guaranty and security agreement specifying that if the relevant guarantors or pledgors are not ECPs, such status would not affect their non-swap guaranty obligations, the validity of the guaranty and security agreement, or the obligations of other ECP guarantors and pledgors under the guaranty and security agreement; and
- For loan documents with waterfall distribution provisions, include language prohibiting swap providers from receiving payments under guaranties by non-ECP guarantors.
The above items are only a few examples of possible actions that should be considered to ensure compliance with the CEA as amended by Dodd-Frank. Until further guidance is received from the CFTC, we recommend that lenders conduct a thorough review of their documentation and due diligence policies to ensure that the requirements regarding ECPs and related swap issues are properly addressed for new and existing lending and swap transactions.