Tuesday, November 13, 2012

Case Study: Roadmap to Dodd-Frank Compliance

Procrastination is opportunity's assassin. ~Victor Kiam, American entrepreneur

Last week, on the day of President Obama's re-election, CommodityPoint, a division of energy and utilities consultancy UtiliPoint International Inc., published a report on the current state of progress in implementing Dodd-Frank compliant processes and technology.[1] The study's survey responses indicated "widespread doubt... as to when the regulations will eventually come into force," and/or "significant amount of confusion as to the requirements and burdens".

CommodityPoint's warnings to the industry could not be more clear:
In reviewing the data, there appears to be a general lack of urgency on the part of many market participants...
[A] lack of movement by a significant number of market participants (especially in the ‘end-user’ segment) is creating a large backlog of work across the industry... this circumstance should be considered a significant risk as companies consider their compliance planning and efforts.

As with all regulations, companies exposed to Dodd-Frank rules will be considered guilty until they prove themselves innocent... continuously and consistently.
Clearly the time for "wait-and-see" is over. Firms need to apply a structured and proactive approach going forward despite the difficulty in anticipating how regulations will eventually evolve. Key is preparation. Firms that jumped started their initiatives based on rule proposals are going to be better prepared than those left scrambling after final rules are published.

To be blunt, notwithstanding that the industry is taking the battle to the courts, time is starting to run out...

According to Davis Polk's October 2012 Progress Report, 45 out of the 90 Dodd-Frank required Title VII rules have been finalized. However, this halfway mark doesn't tell the whole story. The CFTC has finalized 80% or 34 out of 43 rules with only 9 proposed rules having missed their deadline. The SEC, on the other hand, is behind the eight ball with 9 rules finalized and 11 proposed out of the 20 required for which deadlines have passed.[2]

One advantage that results from basing work on final rules is increased certitude. Firms are now better positioned to determine where gaps exist in their processes, prioritize activities required to comply with regulations, and convert requirements into implementation tasks. Key is having a methodology which considers the broad contours of areas impacted, along with the recognition that each new rule brings about new challenges. A robust methodology, in turn, generates the roadmap.

Establishing project scope

This case study applies IQ3 Group's strategy assessment framework as a method for scoping regulatory projects and forging
a pathway to compliance. The underlying approach involves topic decomposition until all relevant areas of investigation are defined in sufficient detail. The result of this analysis is then mapped to deliverables that need to be developed.

Figure 1

The CFTC has identified 8 categories and 38 areas where rules are necessary under Dodd-Frank Title VII and Title VIII.[3] A closer look, however, reveals 61 Federal Register (FR) publications of which 17 are still in the proposal stage with the balance representing final rules. The table below lists the 61 final and proposed rules within the categories established by the CFTC. Within each category, the rulemaking area is sorted by the effective date. Proposed rules are sorted by date of publication.

Figure 2

While the above table is helpful in providing a high level overview of Title VII and Title VIII CFTC rules, it still does not provide detailed descriptions of the rules, or a calendar of compliance dates which may be different than the effective date of the rule.

The following compliance matrix and calendar is a more complete overview and is also available in a spreadsheet format.

Dodd-Frank Act - Final and Proposed Rules Compliance Matrix and Calendar

Hypothesis and data collection

In order to focus the collection of data and begin to analyze and develop solutions, there must be a basis from which to drive an understanding of the issues. What are the potential operational gaps, problems or opportunities inherent in the rulemaking areas? What procedures and processes do we need to institute or re-engineer? What technology systems do we need to implement? What data will we need to support new processes and technology systems? Is compliance with these new regulations the responsibility of a particular department, or a firm-wide organizational commitment?

Formulating hypotheses---educated hunches to be tested---provides a focus for data collection and gives form to findings which ultimately leads to conclusions, and the development of recommendations. Subject matter expertise is often required to formulate relevant hypotheses. From hypotheses, specific questions can be developed that will help drive data collection.

Figure 3

Industry comments to proposed rules and corresponding CFTC responses within the FR publications is an excellent source of insight. The following discussion on affiliates that qualify for the end-user exception[4] is a good example:
Section 2(h)(7)(D)(i) of the CEA provides that an affiliate of a person that qualifies for the end-user exception… may qualify for the exception only if the affiliate… uses the swap to hedge or mitigate the commercial risk of the person or other affiliate of the person that is not a financial entity.
As the CFTC reiterates, an affiliate may elect the end-user exception, even if it is a financial entity, if the affiliate complies with the requirement that the swap is used to hedge or mitigate commercial risk; provided, however, that the affiliate is not a swap dealer or major swap participant. Nevertheless, Shell Energy North America (US) raises the issue that:
...potential electing counterparties that centralize their risk management through a hedging affiliate that is designated as a swap dealer or major swap participant may be unable to benefit from the end-user exception. As a result, many potential electing counterparties may need to restructure their businesses and risk management techniques, thereby losing the many benefits of centralized hedging.
Kraft, Philip Morris and Siemens Corp clarify that this concern relates to how treasury subsidiaries function:
...the Commission should exclude wholly-owned treasury subsidiaries of non-financial companies from the ‘‘financial entity’’ definition, to the extent that they solely engage in swap transactions to hedge or mitigate the commercial risks of an entire corporate group. These commenters noted in particular that the treasury subsidiaries may be, or are likely to be, "financial entities" ... because they are predominantly engaged in activities of a financial nature as defined in Section 4(k) of the Bank Holding Company Act.
In response, the CFTC states that it lacks discretion because Congress specifically defined financial entities (which cannot use the end-user exception) to include swap dealers and major swap participants. Further, Congress specifically outlines who may qualify as an affiliate eligible for the end-user exception. The specificity with which Congress defines these concepts constrains the CFTC’s discretion in this area. The CFTC, however, notes "it is important to distinguish where the treasury function operates in the corporate structure" and then establishes means by which concerns can be alleviated:
Treasury affiliates that are separate legal entities and whose sole or primary function is to undertake activities that are financial in nature as defined under Section 4(k) of the Bank Holding Company Act are financial entities as defined in Section 2(h)(7)(C)(VIII) of the CEA because they are ‘‘predominantly engaged’’ in such activities. If, on the other hand, the treasury function through which hedging or mitigating the commercial risks of an entire corporate group is undertaken by the parent or another corporate entity, and that parent or other entity is entering into swaps in its own name, then the application of the end-user exception to those swaps would be analyzed from the perspective of the parent or other corporate entity directly.
In other words, a parent company or other corporate entity predominantly engaged in manufacturing, agriculture, retailing, energy may elect the end-user exception for inter-affiliate swaps. The CFTC explains how:
If the parent or other corporate entity then aggregates the commercial risks of those swaps with other risks of the commercial enterprise and hedges the aggregated commercial risk using a swap with a swap dealer, that entity may, in its own right, elect the end-user exception for that hedging swap. The parent or other corporate entity in the example is not a ‘‘financial entity’’ as defined in Section 2(h)(7)(C)(VIII) of the CEA, because that entity is ‘‘predominantly engaged’’ in other, nonfinancial activities undertaken to fulfill its core commercial enterprise purpose. However, if the parent or other corporate entity, including, for example, a separately incorporated treasury affiliate, is a ‘‘financial entity,’’ then that entity cannot elect the end-user exception unless one of the specific affiliate provisions of the statute, Section 2(h)(7)(C)(iii) or Section 2(h)(7)(D), apply.
Generally speaking, the CFTC notes that Congress did not treat inter-affiliate swaps differently from other swaps in Section 2(h)(7) of the CEA. Accordingly, if one of the affiliates is not a financial entity and is using the swap to hedge or mitigate commercial risk, even if the other affiliate is a financial entity, the non-financial entity affiliate may elect the end-user exception and neither affiliate needs to clear the swap. Based on this analysis, such entities face a strategic choice...

Findings and conclusions

Assuming that a corporate entity engaged in commercial activities is structured to include a treasury subsidiary engaged in swaps which hedges the commercial risks of the corporate group, such subsidiary can: (i) continue to operate as a "financial entity" and if applicable register as a swap dealer or major swap participant; or (ii) seek to elect the end-user exception by restructuring where in the corporate structure swaps are transacted. But we are getting ahead of ourselves...

After collecting data from questions based on our hypotheses, the next step is synthesizing such data to derive findings and galvanize conclusions about what was learned. Findings and conclusions are defined as follows:
  • Finding—is a summary statement derived from raw data that directs our thinking toward solutions or opportunities regarding a problem.
  • Conclusion—is a diagnostic statement, based on the data and findings that explains problems or opportunities and is significant enough to warrant action

Figure 4

In performing an in-depth examination of the final end-user exception rule to the clearing requirement for swaps we can arrive at findings and conclusions appropriate to the context of a market participant that may fall within such category. To accomplish this task, IQ3 Group assembled a variety of decision flow charts including the "end-user exception" (see Figure 5 below).[5]

Below we step through the analysis of §39.6 "Exceptions to the clearing requirement":
Under §39.6(a)(1), a counterparty to a swap may elect the exception to the clearing requirement on condition that either: [1] under §39.6(a)(1)(i) it is not a "financial entity" as defined by CEA §2(h)(7)(C)(i)*; or [2] under §39.6(a)(1)(ii) it is using the swap to hedge or mitigate commercial risk as provided by CEA §2(h)(7)(A)(ii) or §39.6(b)(1)(ii)(B); or [3] provide, or cause to be provided information to a registered swap data repository (SDR) or, if no SDR is available to the Commission. A counterparty that satisfies this criteria and elects the exception is an "electing counterparty".

*Under §39.6(d), for purposes of CEA §2(h)(7)(A), a financial entity because of CEA §2(h)(7)(C)(i)(VIII) shall be exempt if: (i) it is organized as a certain type of bank [e.g., organized as a bank as defined in §3(a) of the Federal Deposit Insurance Act. See §39.6(d)(i)]; or (ii) has total assets of $10 billion or less on the last day of the entity's most recent fiscal year.

When electing the exception under CEA §2(h)(7)(A), one of the counterparties (the "reporting counterparty") shall provide, or cause to be provided information to a registered swap data repository (SDR) or, if no SDR is available to the Commission. Under §39.6(b)(3) each reporting counterparty needs to have a reasonable basis to believe the electing counterparty meets requirements for an exception to the clearing requirement.[6]

Under §39.6(b) the reporting counterparty will provide information in the following form and manner: (i) notice of the election of the exception; (ii) identity of the electing counterparty; and (iii) the following information [continues below next para], unless...

...such information has previously been provided by the electing counterparty in a current annual filing pursuant to §39.6(b)(2), which states that an entity under this section may report the information annually in anticipation of electing the exception for one or more swaps. Further, any such reporting shall be effective for 365 days following the date of such reporting, provided the entity shall amend such information as necessary to reflect any material changes to the information reported.

Under §39.6(b)(iii) the following information shall be provided by the reporting counterparty:

(A) Whether the electing counterparty is a "financial entity," and if yes, whether it is: (1) electing in accordance with §2(h)(7)(C)(iii) or §2(h)(7)(D); or (2) exempt from the definition of "financial entity" as described in §39.6(d).

(B) Whether the swap(s) for which the electing counterparty is electing the exception are used by the electing counterparty to hedge or mitigate commercial risk as provided in §39.6(c). [See §39.6(c) discussion below.]

(C) How the electing counterparty generally meets its financial obligations associated with entering into non-cleared swaps by identifying one or more of the following categories, as applicable: (1) a written credit support agreement; (2) pledged or segregated assets; (3) a written third-party guarantee; (4) the electing counterparty's available financial resources; or (5) means other than those described.

(D) Whether the electing counterparty is an entity that is an issuer of securities registered under section 12 of, or is required to file reports under section 15(d) of, the Securities Exchange Act of 1934, and if so: (1) the relevant SEC Central Index Key number for that counterparty; and (2) whether an appropriate committee of that counterparty's board of directors has reviewed and approved the decision to enter into swaps that are exempt from the requirements of CEA §§2(h)(1) and 2(h)(8).

The following discussion analyzes a key concept pertinent to §39.6(c) "Hedging or mitigating commercial risk":
A swap is deemed to hedge or mitigate commercial risk if such swap:

(i) is economically appropraite to the reduction of risks in the conduct and management of a commercial enterprise where the risks arise from §39.6(c)(i)(A),(B),(C),(D),(E), or (F);

(ii) qualifies as bona fide hedging for purposes of an exemption from position limits; or

(iii) qualifies for hedging treatment under (A) Financial Accounting Standards Board Accounting Standards Codification Topic 815, Derivatives and Hedging (formerly known as FAS 133) or (B) Governmental Accounting Standards Board Statement 53, Accounting and Financial Reporting for Derivative Instruments.

Additionally, a swap is deemed to hedge or mitigate commercial risk is such swap is:

(i) not used for a purpose that is in the nature of speculation, investing, or trading; and

(ii) not used to hedge or mitigate the risk of another swap or security-based swap position, unless that other position itself is used to hedge or mitigate commercial risk as defined by §39.6(c) or §240.3a67-4.

Figure 5

A key finding identified by IQ3 Group regarding how the CFTC approached writing Title VII rules is the CFTC's departure from a legacy approach that relied on the concept of "exclusion from the definition" and "exemption from the definition". As seen from the above analysis, if an entity transacts in swaps it falls under the definition, but can be "excepted from the definition". The burden of proof to elect such exception, however, is upon the entity, who for that reason must continue to collect and report required data. If called upon by the regulators, such recordkeeping is necessary to support the election of the exception.

Generating recommendations

Based on conclusions regarding problems and opportunities, practical recommendations can be generated, evaluated and finalized. The first step is specifying alternatives including next steps, and describing the intended results and benefits related to each alternative. Such analysis should take into account existing conditions, as well as barriers and resource constraints. Recommendations should cover the topics and outputs originally scoped out, and trace back to address root findings:

Figure 6

Each regulation that is promulgated brings about new challenges. The underlying impetus of Dodd-Frank regulations, however, is clear. By imposing "robust recordkeeping and real-time reporting regimes" regulators have signaled their intent on ushering stricter risk management across the financial system supported by robust data governance and straight through processing.

With that in mind, CommodityPoint's fulmination merits attention:
Give the potential legal and financial exposures of non-compliance... it is incumbent upon all levels of leadership, from risk managers to C-level executives, to create a culture of [Dodd-Frank] compliance within their companies. ...while the regulators' response will not be immediate, it will most likely be aggressive once in motion; and once a company is identified as one that has not been compliant in the past, that company will likely remain under CFTC scrutiny for a very long time.


[1] Reames, P. and Bell, E. (2012). "2012 Dodd-Frank Market Survey and Report" CommodityPoint, sponsored by RiskAdvisory, November 2012

[2] Davis Polk & Wardwell LLP (2012). "Dodd-Frank Progress Report October 2012" Generated using the Davis Polk Regulatory Tracker™

[3] See: http://www.cftc.gov/LawRegulation/DoddFrankAct/Rulemakings/index.htm

[4] Federal Register / Vol. 77, No. 139 / Thursday, July 19, 2012 / Rules and Regulations (77 FR 42559)

[5] Decision flow chart based on Final Rule §39.6 "Exceptions to the clearing requirement" (77 FR 42590)

[6] The term "reasonable basis to believe" imposes a requirement upon the reporting counterparty that information from the electing counterparty supporting §39.6(b)(3) needs to be collected and maintained.

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