Finance Alert, April 2013 Dodd-Frank and Interest Rate Swap ...

Finance AlertA Publication of the Stradley Ronon Finance Practice Groupwww.stradley.com APRIL 2013Stradley Ronon Stevens & Young, LLP2005 Market StreetSuite 2600Philadelphia, PA 19103-7018215.564.8000 Telephone215.564.8120 Facsimilewww.stradley.com1250 Connecticut Avenue, N.W.Suite 500Washington, DC 20036202.822.9611 Telephone202.822.0140 FacsimileWith other offices in:Harrisburg, Pa.Malvern, Pa.Wilmington, Del.Cherry Hill, N.J.New York, N.Y.www.meritas.orgOur firm is a member of Meritas –a worldwide business alliance of morethan 210 law offices in 70 countries,offering high-quality legal servicesthrough a closely integrated group ofindependent, full-service law firms.Information contained in this publicationshould not be construed as legal advice oropinion or as a substitute for the advice ofcounsel. The enclosed materials may havebeen abridged from other sources. They areprovided for educational and informationalpurposes for the use of clients and otherswho may be interested in the subject matter.Copyright © 2013Stradley Ronon Stevens & Young, LLPAll rights reserved.Dodd-Frank and Interest Rate SwapTransactions – Impact of “Eligible ContractParticipant” Requirements on Interest RateSwaps and Commercial LoansBy Kevin P. Kundra, Richard M. Zucker, Michael Migliaccio and Daniel C. KnoxThe enactment of the Dodd-Frank Wall Street Reform and Consumer ProtectionAct (Dodd-Frank) has created a myriad of novel legal issues that borrowers andlenders must consider. This Client Alert identifies some of the new interest rate swapissues that stem from Dodd-Frank and proposes certain actions lenders should considertaking to address these issues.Eligible Contract Participant RulesAs a result of Dodd-Frank, only entities or individuals that meet the definition of EligibleContract Participant (ECP) under the Commodity Exchange Act (CEA) will be permitted toenter into over-the-counter swap transactions (such as the typical interest rate swaparrangement governed by an ISDA agreement). Dodd-Frank amended the CEA toincorporate what has become knownas the “Limitation on ParticipationRule.” This rule provides that “itshall be unlawful for any person,other than an Eligible ContractParticipant, to enter into a swapunless the swap is entered into on,or subject to the rules of, a board oftrade designated as a contractmarket.” Due to the fact that sucha contract market alternative hasbeen slow to develop, for theforeseeable future the ability ofborrowers to enter into interest rateswaps will primarily be contingentupon a borrower’s ability to qualifyas an ECP.As a result of Dodd-Frank, onlyentities or individuals that meetthe definition of Eligible ContractParticipant (ECP) under theCommodity Exchange Act (CEA)will be permitted to enter intoover-the-counter swaptransactions (such as the typicalinterest rate swap arrangementgoverned by an ISDA agreement).The Commodity Futures Trading Commission (CFTC) has also clarified itsinterpretation of the “Limitation on Participation Rule” to require that each guarantor ofa non-contract market swap transaction be an ECP, as well as the parties to the swaptransaction themselves. As a result of this determination, guaranties of non-contractmarket swap obligations entered into by non-ECP guarantors are unenforceable, even ifthe borrower qualifies as an ECP. Moreover, failing to distinguish, and exclude, swapobligations from other guaranteed obligations by a non-ECP guarantor could render theentire guaranty unenforceable.Dealing With the ECP RequirementsAs a result of the effects of Dodd-Frank on interest rate swap transactions, it isrecommended that lenders should pursue, among other actions:

1. Due diligence with respect to the assets and net worth ofpotential borrowers and guarantors to determine whethersuch parties would qualify as ECPs.2. Modification of loan documents to account for non-ECPloan parties.Qualifying a Borrower as an ECPWhile there are several categories of ECPs, for purposes ofmost loan transactions, the most likely to be applicable are:1. The “Hedging Entity” category, which requires that theentity: (i) have a net worth exceeding $1 million; and (ii)enter into swaps in connection with the conduct of suchentity’s business or to manage the risk associated with anasset or liability (such as a floating rate loan) owned orincurred or reasonably likely to be owned or incurred bysuch entity in the conduct of its business.2. The “Large Entity” category, which requires that the entity:(i) have total assets exceeding $10 million; or (ii) have itsobligations guaranteed, or otherwise supported by a letterof credit, keepwell, or support or other agreement, byanother entity that has total assets exceeding $10 million.For borrowers that would meet the $10 million total assetstest only after the subject loan was funded, the CFTC hasreleased a no-action letter that provides that an entity willbe deemed to meet the requirements if the loan fundingwould result in the entity having sufficient total assets,provided that:• the swap is necessary to manage a floating interestrate risk;• there is a bona fide loan commitment for such loan; and• the loan closing is subject to commercially reasonableconditions that are not designed to permit the lender toavoid funding the loan while leaving the interest rateswap transaction in place.An entity that fails to meet the ECP requirements in its ownright may look to its owner(s) in order to qualify. If an entity byitself does not have sufficient net worth or total assets to qualifyas an ECP, it may still qualify if each of the followingconditions is met: (i) it must be entering into a swap that is nota security-based swap or mixed swap; (ii) it must be enteringinto the swap to hedge or mitigate commercial risk; (iii) theentity and its owners in aggregate must have at least $1 millionin net worth; and (iv) all of the owners of the entity must beECPs. When relying on the owners of an entity to qualify theentity as an ECP, however, it is important to note that therequirements for an individual to qualify as an ECP includecertain thresholds with respect to amounts invested by theindividual on a discretionary basis..Qualifying a Guarantor as an ECPTo the extent that a guarantor meets the requirements of a“Hedging Entity” or “Large Entity” described above, theguarantor will qualify as an ECP. Additionally, a guarantor mayhave ECP status conferred on it if: (i) another guarantor entityFor more information about the new interestrate swap issues, please contact:Kevin P. Kundra Richard M. Zuckerkkundra@stradley.com rzucker@stradley.com215.564.8183 215.564.8547Michael Migliaccio Daniel C. Knoxmmigliaccio@stradley.com dknox@stradley.com215.564.8182 856.414.6350(or the borrower) is a qualified ECP and (ii) such entity entersinto a keepwell agreement with the non-ECP guarantor. In suchan agreement, the qualified ECP entity would unconditionallyagree to provide funds or other support as may be needed by thenon-ECP guarantors to honor all of such entities’ obligations.Loan Documentation ModificationsFrom a loan documentation standpoint, a number of itemsshould be considered:1. Specific borrower and guarantor representations should beincluded in the loan documentation regarding ECP status.2. Lenders should exclude swap obligations from the list ofobligations guaranteed by a non-ECP guarantor. Suchexclusion should be limited to the extent that all or aportion of the guaranty of such non-ECP guarantor is, orbecomes, unlawful under the CEA. Any such languageshould explicitly state that such exclusion shall apply onlyto the portion of the borrower’s obligation that isattributable to swaps for which such guaranty is a violationof the CEA.3. To the extent that loan documentation includes a“waterfall” provision that distributes payments by non-ECP2 | Finance Alert, April 2013 © 2013 Stradley Ronon Stevens & Young, LLP

parties or proceeds of assets from non-ECP parties,distribution to swap providers of such payments orproceeds should be excluded from the waterfall. Loandocumentation should make it clear that, to the extent swapproviders share in waterfall distributions, such swapproviders may not share in the proceeds of collateralpledged by, or payments made by, a non-ECP loan party.4. In multiple borrower/guarantor transactions, to the extentthat any one borrower or guarantor is a qualified ECP,keepwell language from the qualified ECP party should beincluded in the documentation. Such language shouldinclude, among other things, the agreement by the qualifiedECP party to unconditionally and irrevocably provide fundsor other support to any entity that is a non-ECP party sothat such non-ECP party can honor all of its obligationsunder the loan documents. Such language shouldspecifically reference the “keepwell, support, or otheragreement” clause in Section 1a(18)(A)(v)(II) of the CEA.In situations when only the borrower is a qualified ECP, inorder to avoid violating the provisions of Dodd-Frank, itmay be necessary to have the borrower agree to support theobligations of the non-ECP guarantors – a truly bizarreconsequence of the legislation.The above items are only examples of possible actions that maybe required to ensure interest rate swap compliance with therequirements of Dodd-Frank. We recommend that lendersconduct a thorough review of their documentation and duediligence policies to ensure that ECP and related interest rateswap issues are properly addressed. nFinance Practice GroupRichard M. Zucker, Chair ....................................215.564.8547 ..........................................rzucker@stradley.comElizabeth K. Bradley ............................................610.640.5815 ........................................ebradley@stradley.comValentino F. DiGiorgio III ....................................610.640.5804......................................vdigiorgio@stradley.comLinda A. Galante ..................................................215.564.8075..........................................lgalante@stradley.comAmber A. Hough ..................................................215.564.8537 ..........................................ahough@stradley.comDaniel C. Knox.....................................................856.414.6350 ............................................dknox@stradley.comChristine M. McDevitt .........................................215.564.8136 ......................................cmcdevitt@stradley.comJulie M. Murphy...................................................215.564.8541 .....................................jmmurphy@stradley.comLaura E. Souchik..................................................215.564.8517.........................................lsouchik@stradley.comAndrew K. Stutzman............................................215.564.8008......................................astutzman@stradley.comSteven J. White.....................................................215.564.8161............................................swhite@stradley.com3 | Finance Alert, April 2013 © 2013 Stradley Ronon Stevens & Young, LLP