Background
A recent decision by the Commodity Futures Trading Commission, Khorram Properties v. McDonald Investments, CFTC Docket No. 04-R045 Oct. 13, 2005, addresses the question of whether the line of business exemption created by the CFTC's 1989 Policy Statement Concerning Swap Transactions continues to be viable. It also considers whether the exemption continues to be necessary--or helpful--for transactions in which the parties qualify as eligible contract participants or eligible swap participants.
The 1989 policy statement exempted certain derivative transactions from regulation, provided they meet specified criteria. The line of business exemption is one of these criteria. It provides that if a transaction is entered into in conjunction with a line of business, then it will not be treated as a futures contract subject to CFTC regulation.
The Commodity Futures Modernization Act of 2000 expanded the universe of derivatives that can qualify for exclusion and exemption from the Commodity Exchange Act and CTFC jurisdiction. In 1993, the Commission had adopted Part 35 of the CFTC Rules, exempting swap transactions between parties qualifying as eligible swap participants from regulation. The CFMA added the term eligible contract participant, based on the eligible swap participant definition. The CFMA also added Section 2(g) to the CEA, which excludes from CEA regulation swap transactions that are entered into between eligible contract participants and that meet certain additional criteria.
Neither the CFMA nor Part 35 of the CFTC Rules, however, exempts a transaction in which one of the parties does not qualify as either an eligible contract participant or an eligible swap participant. Most post-CFMA International Swaps and Derivatives Association Master Agreement Schedules include a provision in the Schedule whereby each party represents that it is an eligible contract participant within the meaning of Section 1a(12) of the CEA, and pre-CFMA Schedules generally include the Part 35 "eligible swap participant" representation.
In the Khorram case, the CFTC unequivocally endorsed the continued viability of the line of business exemption, stating that the Policy Statement remains a "non-exclusive, complementary" source of regulatory relief.
The Khorram Decision
Khorram Properties had borrowed USD5.671 million from KeyBank National Association to construct an apartment complex. It also entered into a fixed/floating interest-rate swap with KeyBank in order to lock in a fixed rate in connection with its anticipated refinancing of the apartment complex. After the swap terminated and Khorram Properties paid KeyBank the amount it owed under the terms of the transaction, Khorram Properties brought a reparations proceeding against KeyBank to recover the amount paid, alleging that the swap was an illegal, off-exchange futures contract.
Khorram claimed it was neither an eligible swap participant nor an eligible contract participant and that these were the only types of entities that could enter into over-the-counter swap transactions. Khorram argued that the Policy Statement, which includes the line of business exemption, had been superseded by both Part 35 of the CFTC Rules and Section 2(g) of the CEA. After the administrative law judge denied the respondent's motion to dismiss the complaint, the CFTC accepted the case for review.
Calling the issue one of "first impression in our reparations forum," the CFTC rejected Khorram's claim that the Policy Statement had been superseded. The Commission found that "[t]he treatment of swaps under the Commission's Part 35 rules is not at cross-purposes to the treatment of qualifying swaps under the Policy Statement," and that "[t]hey are non-exclusive, complementary sources of regulatory relief." Moreover, the Commission found not only had the Policy Statement not been superseded, it had been reaffirmed on two separate occasions: First in 1993, in connection with the Part 35 Rule Approval, and again in the CFTC's 1998 Concept Release concerning Over-the-Counter Derivatives.
Finally, the Commission noted even though Section 2(g) would not have applied to Khorram's swap with KeyBank, which was entered into prior to the CFMA's enactment, it was not relevant to the inquiry:
"Because the Policy Statement governs this transaction, whether Khorram qualifies as an eligible swap participant under Part 35 or an eligible contract participant under Section 2(g) is not relevant to our inquiry."
Applying that conclusion, the Commission found the transaction in dispute was exempt from CTFC regulation and dismissed the complaint.
In a lengthy footnote, the CFTC reiterated its concern, previously expressed to Congress, as to "the risk that the CFTC or a court might determine that a particular class of swap agreement is an illegal, off-exchange futures contract." The Policy Statement represented the CFTC's attempt to address this concern by stating that swaps should not be regulated like futures contracts. "As a result," according to the Khorram decision, "the de facto reality is that swaps have never been regulated as futures under the CEA. Every day banks write an enormous volume of swaps contracts that are sustained by this consensus." [Khorram Properties, LLC v. McDonald Investments, Inc., fn8].
The Policy Statement And The Line Of Business Exception
Under the Policy Statement, a swap will not be regulated as a futures contract if it:
* has individually negotiated terms based on individualized credit determinations;
* does not provide for termination through exchange-style offset;
* is not supported by the credit of a clearing organization or a margin system designed to eliminate individualized credit risk;
* is undertaken in connection with the parties' lines of business; and
* is not marketed to the general public.
The Commission found that Khorram's swap with KeyBank met all of the above criteria. The Commission rejected Khorram's argument that the swap was not individually negotiated because it was documented using an ISDA form of agreement, noting that the Policy Statement specifically permits the use of a master agreement. The CFTC also rejected the argument that the notional amount and interest rate were determined by the market and not the parties, based on a finding that the economic terms of the swap were tied to the terms of KeyBank's loan to Khorram. The respondent proved to the Commission's satisfaction that swaps such as that entered into with Khorram were marketed only to KeyBank's commercial loan customers and, indeed, because the terms of KeyBank's swap with Khorram were specific to KeyBank's loan to Khorram, the swap would not have been marketed to anyone except Khorram.
Khorram argued that the swap was not undertaken in connection with its line of business because it was not an institutional swaps market participant and had no experience in derivatives. The Commission, quoting a footnote from the Policy Statement, rejected this narrow interpretation of the line of business requirement: "Swap transactions entered into with respect to exchange rate, interest rate, or other price exposure arising from a participant's line of business or the financing of its business would be consistent with this standard."
Underscoring its view that the Policy Statement and Part 35 were alternative bases of exemptive relief, the Commission stated:
"Unlike Part 35 and Section 2(g), which define the classes of persons eligible to enter into swaps under their authority, and establish financial qualifications for swap participants, the Policy Statement focuses on the nature and purpose of the transaction."
The CFTC concluded that Khorram had entered into the swap with KeyBank in order to lock in an interest rate for its loan refinancing. Because Khorram was in the business of purchasing and constructing the apartment complex, its interest-rate swap with KeyBank was entered into in connection with its line of business, and it was irrelevant that Khorram had no prior experience with derivatives. The swap met all the requirements of the Policy Statement and was therefore not subject to regulation by the CFTC.
Lesson From Khorram
The lesson for those who draft and negotiate ISDA Master Agreement Schedules is that the line of business representation should be included when one of the parties may not qualify as an eligible contract participant or an eligible swap participant. This is especially relevant for lending institutions that enter into interest-rate swaps or caps in order to hedge floating-rate business loans and for energy companies that offer energy-price hedges, in both of which cases the customer may be a relatively small company. If the derivatives transaction does not provide for termination through exchange-style offset, is not supported by a clearing organization or margin system that obviates the need for individualized credit determinations, contains individually negotiated terms, is not marketed to the general public and has been entered into in connection with the parties' lines of business, then the transaction should not be deemed a futures contract regulated by the CFTC under the CEAregardless of whether the parties would otherwise qualify as eligible contract participants or eligible swap participants.
This week's Learning Curve was written by Mark Rae, partner, and Sherri Venokur, special counsel at Stroock & Stroock & Lavanin New York.
