H.R. 2682 seeks to harmonize a recent joint-rulemaking by certain bank and financial regulators, which would have subjected certain OTC end-user transactions with banks or other financial institutions to margin requirements, with a conflicting proposed rulemaking from the CFTC expressly not imposing similar requirements on registered swap entities, including banks and other financial institutions. The proposed legislation resolves the conflict by applying the exemption across the board to all OTC end-user transactions with registered swap entities, bank or non-bank.

Under the proposed legislation, a derivative transaction involving an end-user may be exempt from margin requirements if it satisfies the requirements under Dodd-Frank for the end-user clearing exemption. The clearing exemption is available to any end-user that (i) is not a “financial entity” and (ii) is using swaps to “hedge or mitigate commercial risks.”

The term “financial entity” is defined under the Dodd-Frank Act to include certain registered swap entities, banks, commodity pools, and private funds. The precise contours of who is a financial entity depends upon the yet-to-be finalized rules containing the definitions for the terms “swap dealer,” “major swap participant,” “security-based swap dealer” and “major security-based swap participant.”

The determination as to when a swap is being used to hedge or mitigate commercial risk is also addressed in other proposed rules. Generally, a swap is deemed to be used to hedge or mitigate commercial risk when the swap is not in the nature of speculation, investing or trading, and either (i) qualifies as bona fide hedging for purposes of the Commodity Exchange Act’s position limits exemption, (ii) qualifies for hedging treatment for certain accounting purposes or (iii) is an economically appropriate swap used to hedge risks arising from potential changes in the value of assets, liabilities, services, inputs, products, commodities or interest/currency/exchange rates. 

In sum, H.R. 2682 would clarify that all non-cleared OTC end-user transactions used to hedge or mitigate commercial risk are exempt from margin requirements.

While H.R. 2682 is limited to the application of the margin requirements to commercial end-users, it signals a renewed congressional direction to clarify, and arguably limit, the impact of the Dodd-Frank Act on OTC end-user transactions. This direction may be instructive to the various regulators in resolving other open issues of concern to end-users.

For any questions regarding H.R. 2682, the end-user clearing exemption, or other issues related to OTC derivatives and the Dodd-Frank Act, please contact Brian Harms or John Leonti.

For more information, review the full text of H.R. 2682 or the Proposed Rule regarding the end-user clearing exemption.

While the basic framework of many swaps regulations is established under Title VII of  Dodd-Frank, many of the details are left up to a rulemaking process that is behind schedule.

The temporary relief applies to those provisions of the Commodity Exchange Act (CEA) that were either added or amended by Dodd-Frank and reference a swap entity, swap instrument or other term to be “further defined” under Dodd-Frank, such as “swap,” “swap dealer,” “major swap participant” or “eligible contract participant.” Although notices of proposed rulemakings have been issued regarding these terms, the final rulemakings were not in place as of July 16, 2011.

Additionally, temporary relief has been granted to those provisions of the CEA that are scheduled to apply to certain transactions in exempt or excluded commodities on July 16. Prior to Dodd-Frank’s repeal of certain provisions, transactions in various commodities were exempt or excluded under the CEA.

Generally, these commodities include financial, energy and metals commodities. The exemption is based on the CFTC’s existing “Part 35” exemption for swap agreements, but will be available for certain transactions that may not otherwise qualify under those rules (e.g., cleared swaps).

It should be noted that the order does not provide a blanket temporary relief. For example, it does not limit the application of the CEA anti-fraud or anti-manipulation rules for swaps, nor does it apply to any provision of Dodd-Frank or CEA that became effective prior to July 16 (e.g., certain swap record-keeping requirements).

The temporary relief became effective as of July 16 and continues until the earlier of the effective day of final rules or December 31, 2011.

Issued concurrently with the order for temporary relief, the CFTC Division of Clearing and Intermediary Oversight and Market Oversight issued a joint staff, no-action letter regarding certain Dodd-Frank amendments to the CEA. The no-action letter covers certain Dodd-Frank provisions that may not have been covered by the final order for temporary relief due to the CFTC’s limited exemptive authority.

Specifically, the no-action letter addressed concerns related to the segregation requirements for uncleared swaps, registration obligations for derivatives clearing organizations and certain chief compliance officer requirements for swap dealers and major swap participants.

Similar to the temporary relief, the no-action relief continues until the earlier of the effective day of final rules or December 31, 2011.

For any questions regarding the temporary exemptive relief, the no-action letter or other issues related to OTC derivatives and the Dodd-Frank Act, please contact Brian Harms or John Leonti.

For more information, review the CFTC final order or the staff no-action letter.

Some community banks will likely be exempt from the upcoming incentive compensation rules. Section 956 of the Dodd-Frank Act does not apply to financial institutions with less than $1 billion in assets. However, even if the federal banking agencies do not impose additional incentive compensation regulations on community banks, the rulemaking process may provide valuable insights regarding how banking regulators may view and address incentive compensation issues during examinations of all banks.

The incentive compensation reporting system and prohibitions are the next steps in the federal banking agencies’ recent focus on compensation at financial institutions. We anticipate that the impending incentive compensation rules will be consistent with the guidance provided by the federal banking agencies on sound incentive compensation policies, which was jointly issued in June, 2010. For a summary of the June 2010 guidance please see our Advisory found here. We expect the federal banking agencies to jointly release these proposed rules in the next few weeks. Section 956 of the Dodd-Frank Act requires these rules be effective by April 21, 2011.

The Security and Exchange Act of 1934 criminalizes “willful” violations of its provisions and certain SEC rules or regulations.  While in some other contexts the term “willful” signals a requirement that the defendant “knowingly” violated federal law, several U.S. Courts of Appeal, including the Second and Ninth Circuits, have held that the government need only show that the defendant “intended to commit an act prohibited under the statute.”  The Second Circuit reiterated this position as recently as July 1, 2010, when it upheld the trial court’s jury instruction defining the term “willful” under the Act with reference only to the defendant’s “intent to cause a deception, a falsification,” rather than requiring any knowledge of illegality.  United States v. Kaiser, 609 F.3d 556, 567-68 (2nd Cir. 2010) (reversing conviction on other grounds).  The Court reached this interpretation due in large part to the Act’s “unique statutory language,” which criminalizes willful violations, but shields defendants who violate a rule or regulation without knowledge of its existence from imprisonment.  The Second Circuit had previously suggested that this safe harbor provision would be meaningless if the threshold for criminal liability in the first place was knowledge of illegality.  United States v. Dixon, 536 F.2d 1388, 1396 (2nd. Cir. 1976).  In other words, a person can “willfully” violate an SEC rule even if he does not know of the existence of the rule. 

While Courts in other jurisdictions have yet to definitively interpret the “willful” requirement of the Act’s penalty provision, a number of decisions indicate that judges within those circuits may likely lean in the Second Circuit’s direction.  The Fourth Circuit, for example, upheld a securities fraud conviction focused on the defendant’s intent to manipulate and deceive, making no indication that it required a knowing violation of the Act.  See Bryan v. United States, 58 F.3d 933 (4th Cir. 1995).  In United States. v. Johnson, 553 F. Supp. 2d 582 (E.D. Va. 2008), the District Court likewise focused on the defendant’s act of designing a scheme to defraud investors with no reference to his knowledge of securities laws.

With prior cases from Courts like the Fourth Circuit focusing on the defendant’s intent to commit wrongful acts, and the Second Circuit’s interpretation of the Securities and Exchange Act’s penalty provision, companies and individuals would do well to err on the side of caution and treat the Second Circuit’s view of the Act as prevailing law in any circuit that has not explicitly held otherwise.  Despite the “willful” requirement under the Act, if an incident occurs that could give rise to an enforcement action, asserting lack of knowledge of securities laws and regulations is unlikely to make the government go away.  Given the recent tenacity with which the Commission has pursued such actions, and its new ability to effectively provide bounties for a whistleblower’s information on criminal violations, companies’ and individuals’ potential exposure in this context will likely only increase in the future.