February 18, 2013 at 10:34 pm Leave a comment

Secured bank financings often include swaps, which allow borrowers to protect themselves against interest rate and/or currency fluctuations.  Typically, the financial institution counterparty to the swap will share in the collateral securing, and benefit from any guarantees supporting, the underlying financing.

The Dodd-Frank Act amended the Commodity Exchange Act to prohibit any person other than “eligible contract participant” from entering into a swap unless the swap is on, or subject to the rules of, a board of trade designated as a contract market under the Commodity Exchange Act. 

Treatment of Guarantors – CFTC No-Action Letter

The U.S. Commodity Futures Trading Commission (“CFTC”), in a no-action letter dated October 12, 2012, has taken the position that Dodd-Frank amended the Commodity Exchange Act to subject guarantors and parties pledging assets to secure swaps to the same requirements as direct swap participants.  Accordingly, unless the swap is conducted pursuant to a designated contract market, each party providing credit support for a swap must be an eligible contract participant in its own right.

Definition of Eligible Contract Participant 

There are several ways to meet the definition of an eligible contract participant pursuant to the Commodity Exchange Act.  However, most borrowers qualify under the total assets or net worth test.  An entity qualifies as an eligible contract participant if it has total assets exceeding $10,000,000.  Alternatively, an entity qualifies if it has a net worth exceeding $1,000,000 and has entered into a agreement or transaction in connection with the conduct of its business or to manage the risk associated with an asset or liability owned or incurred or reasonably likely to be owned or incurred in the conduct of the entity’s business. 

While most borrowers will qualify as eligible contract participants under one of the above tests, subsidiary and affiliate guarantors and pledgors may not.   In such event, there is another way to meet the test.  Specifically, under the Commodity Exchange Act, an entity is an eligible contract participant if its obligations under an agreement or transaction are guaranteed or otherwise supported by a letter of credit or keepwell, support, or other agreement by an otherwise qualifying entity.   

What This Means to Lenders

The consequences for failure to comply with the above requirements may include illegality and unenforceability of a guaranty or pledge by the non-qualifying guarantor or pledgor of the swap obligations and potential CFTC enforcement action against the offending swap dealer. 

Given the foregoing, with respect to new financings with a swap component, loan documents should include representations regarding the status of each borrower, guarantor and pledgor as an eligible contract participant.  Either non-qualifying entities should be excluded as guarantors and pledgors with respect to swap obligations or keepwell language, requiring credit parties who are eligible contract participants to provide support for non-qualifying credit parties, should be included.  Finally, severability language should be included in the applicable loan documents to ensure that the failure to meet eligible contract participant status does not affect non-swap related obligations or otherwise invalidate loan documents.    

In the case of outstanding credit facilities, it is unclear whether such facilities need to be immediately amended to avoid defaults as the CFTC has not provided any guidance in this area.  At a minimum, it may be prudent to include a keepwell undertaking from an eligible contract participant credit party for the benefit of non-qualifying credit parties as part of any renewal or other amendment to the facility.

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