The Dodd-Frank Act created a new and complex regulatoryregime for derivatives trading. Since the law's passage, regulatorshave adopted a myriad of new trading, reporting, recordkeeping,clearing, trade execution, margin, and anti-fraud rules. With thesenew rules come a plethora of opportunities for companies that tradederivatives to be held liable for violations. That's why everycommercial entity that uses the derivatives markets for riskmanagement purposes should implement a derivatives complianceprogram.

A compliance program will help create and preserve a culture ofintegrity within the organization. It will also demonstrate toregulatory and law enforcement authorities—and investors—that if aderivatives trading issue does occur, the event is anomalous anddoes not constitute wrongdoing by the company. Keep in mind that anorganization can be found liable for misconduct on the part ofindividual employees or other agents of the organization. Properinternal controls, including a well-designed derivatives complianceprogram, can help an organization avoid such liabilities.

A derivatives compliance policy should address regulatorycompliance issues in the following areas:

Deceptive and fraudulent practices. In2011, the Commodity Futures Trading Commission (CFTC) adopted a newanti-fraud rule, pursuant to the agency's new anti-fraud authorityestablished under the Dodd-Frank Act. CFTC Rule 180.1 applies toactivities undertaken “in connection with” exchange-traded futures,swaps, and transactions in commodities in interstate commerce (forexample, physicals and forwards). For any of these products, therule prohibits the “intentional or reckless” use of manipulativedevices or schemes to defraud; false or misleading statements andmaterial omissions; practices that operate, or would operate, as afraud or deceit; and misleading or inaccurate reports concerningconditions that tend to affect the price of any commodity. Conductcan rise to the level of “reckless” when an act or omissiondeviates so far from the customary standards of ordinary care thatit becomes very difficult to believe the defendant was not aware ofwhat he or she was doing.

About 15 years ago, the CFTC began bringing enforcement casesagainst publicly traded energy companies whose rogue employees gavefalse information to industry publications about the prices andvolumes of their daily over-the-counter gas and electric trades.False reporting of the prices of commodities traded in interstatecommerce was a violation of the Commodity Exchange Act (CEA) evenbefore the CFTC adopted Rule 180.1. Every one of these companiessettled the allegations with the CFTC and paid millions of dollarsin civil fines. And these companies were not financial entities;none was required to be registered with the CFTC. During the pastfive years, the CFTC has been investigating collusion andbenchmark-rate fixing in the LIBOR and foreign currency markets by traders for banks and otherfinancial institutions. Some of these investigations have led tosettled CFTC enforcement actions, and several others are underinvestigation by criminalauthorities.

An organization is generally liable for the acts oromissions of its employees. The CFTC has advised that suchcollective liability creates incentives for the organization todevelop and maintain effective internal policies and controls toprevent wrongful conduct. Clearly written compliance policies andprocedures surrounding derivatives activities bolster a company'sdefense against an allegation of “recklessness” if a CFTCenforcement action seeks to hold the organization liable for theacts or omissions of a rogue employee. And if the organization isultimately found liable, a compliance program can also helpmitigate penalties such as monetary fines or trading bans.

Section 4c(a)(1) of the CEA prohibits “wash” or “fictitious”sales, “accommodation trades,” and any other transaction that “isused to cause any price to be reported, registered, or recordedthat is not a true and bona fide price.” The Dodd-Frank Actexpanded these prohibited practices beyond the commodities markets,to include any instrument traded on a futures exchange or a swapexecution facility (SEF), as well as any trade cleared through aCFTC-regulated clearing organization. Many of the same energycompanies that ended up settling with the CFTC around 2000 becauseemployees were publicly reporting false information, employedtraders who engaged in what they termed “round-trip” transactions.They would buy and sell gas and electricity, then engage insubsequent opposite transactions with their counterparties for thepurpose of appearing to engage in a high volume of trading. TheCFTC alleged that these were fictitious “wash” trades in violationof the CEA and again collected millions in civil fines throughuncontested settlements.

Another new provision that the Dodd-Frank Actadded to the CFTC's enforcement arsenal prohibits futures-trade“spoofing,” which is defined as “bidding or offering with theintent to cancel the bid or offer before execution.” In October2014, a high-speed futures trader was indicted for allegedlyviolating this prohibition by designing programs to place large“quote orders,” which were not intended to be executed, in order tocreate the illusion of market interest. The trader also allegedlyused trading programs that automatically canceled all quote ordersimmediately if any quote order was partially filled, to save othertraders from reacting to “false price and volume information” andfrom buying quote orders that appeared to reflect a substantialchange in the market. Section 4c(a)(5)(B) of the CEA prohibits anytrading practice or conduct that demonstrates intentional orreckless disregard for the orderly execution of transactions duringthe closing period on a futures exchange or a SEF.

If a commercial entity hedges in the futures markets, itstraders should be educated about the new anti-spoofing rules. Ifthe company retains a third-party manager to trade on behalf of thecorporation, a prudent corporate treasurer will conduct adequatedue diligence and ask the manager to furnish a copy of itscompliance procedures, which should include policies concerningspoofing and other disruptive trading practices. In the event thata trader or third-party manager for a corporation goes rogue andemploys any of the prohibited practices, the corporation can use athoughtful compliance program to demonstrate that it did notrecklessly disregard its compliance obligations. Commercialentities should adopt written compliance procedures to preventtheir trading managers from engaging in fraudulent conduct andother prohibited derivatives practices, and to audit their outsideadvisers and brokers as to how their procedures are designed tocomply with the CFTC's rules.

Commercial end-user clearingexception. The CFTC has the authority to require thatvarious categories of swaps be cleared through a centralclearinghouse, which also means that the swap may be required to beexecuted on a regulated futures exchange or SEF. To date, the CFTChas issued clearing mandates for certain interest rate swaps andindex credit default swaps, with non-deliverable foreign exchange forwards expected to be thenext subject of a clearing mandate. Central clearinghouses imposemargin requirements on the parties to each cleared swap trade.

A company that is not classified as a financial entity, and thatuses swaps only to mitigate commercial risk, can qualify for anexception from the clearing mandate—and, therefore, from the marginrequirements imposed by the clearinghouse. Swaps will be deemed tomitigate commercial risk if they are economically appropriate tothe reduction of the organization's risk, if they qualify as bonafide hedges for purposes of CFTC position limits, or if theyqualify for hedging treatment under an applicable accountingstandard. According to the CFTC, positions which are executedprimarily for the purpose of taking an outright view on a marketdirection, or to obtain an appreciation in the value of the swapposition itself, are generally considered to be positions enteredinto for the purpose of speculation, investing, or trading, whichwould not qualify as commercial risk mitigation. To rely on theexception, a company must file with a swap data repository,providing information about how it generally meets its financialobligations in connection with non-cleared swaps. There are similarclearing exemptions for corporate treasury affiliates andinteraffiliate swaps that satisfy certain conditions.

A public company that issues registered securities, or that isrequired to file reports under the Securities Exchange Act of 1934,can apply for the commercial end-user exception only after itsboard of directors, or an equivalent governing body or committee ofthe board, reviews and approves the decision to use the end-userclearing exception.

Abusing the commercial end-user exception is a felony subject topossible imprisonment and a substantial monetary penalty. Anycompany electing the end-user clearing exception needs to adoptappropriate policies governing the use of non-cleared swaps, and itshould review those policies on an annual basis or more frequently.If a swap is inadvertently entered into for purposes other thanrisk management, the company needs to be able to demonstrate thatthe trade violated company policy and that the portfolio managerhad been properly instructed about the policy. This could beestablished by written compliance policies, maintaining records ofregular compliance training for its relevant employees, andmaintaining robust internal-monitoring systems.

Position limits. In November 2013, theCFTC proposed rules setting speculative position limits for certainderivatives. The rules set a limit on the dollar value that anindividual or company can hold in any of 28 core physical energy,metals, and agricultural commodity futures contracts that aretraded on futures exchanges. They also limited an individual's orcompany's holdings in “economically equivalent” futures, options,and swaps, including commercial trade options that are notregulated as swaps and are widely used in the energy, metals, andagricultural industries. The proposed position limits rules arecurrently pending final adoption by the CFTC.

The proposed rules would also require a company toaggregate all its positions in accounts in which the company,directly or indirectly, holds an ownership or equity interest of 10percent or greater, as well as positions in accounts over which thecompany controls trading. The proposed rules would establish adisaggregation exemption for a company with an ownership or equityinterest in an owned entity of at least 10 percent but not greaterthan 50 percent, and for a company with an ownership or equityinterest exceeding 50 percent in another non-consolidated entity,provided that prescribed trading coordination firewalls areestablished between the entities.

Corporate treasurers whose companies use the derivatives marketsfor investment purposes should use their compliance program tomonitor trading positions so that they can be sure to avoid runningafoul of the soon-to-be-finalized position limits and aggregationrules.

Recordkeeping. The CFTC has adopteddetailed reporting and recordkeeping rules applicable to trading inswaps, whether or not those swaps are subject to mandatoryclearing. Fortunately for commercial swaps end users, the reportingburden falls mostly on the large dealers that dominate the sellside of the market. However, recordkeeping requirements under theCFTC rules are bilateral and fall on both parties to a transaction.The CFTC's new recordkeeping requirements for swaps are burdensomeand confusing, even to the lawyers. But recordkeeping goes to theheart of the CFTC's goal to make the swaps market transparent.Recordkeeping violations are easy for the CFTC to prove. Everyyear, the CFTC brings enforcement cases against its registrants forrecordkeeping violations, but the new swaps rules apply with equalvigor to non-registrant participants in the swaps markets. Theprudent treasurer will adopt robust swaps recordkeeping, withwritten policies governing the company's swaps recordkeepingobligations.

Anti-evasion procedures. The CFTC'sgeneral anti-evasion provision provides that any agreement,contract, or transaction which is willfully structured to evade theCFTC's swaps rules is deemed to be a swap. For example, atransaction that is willfully structured as a foreign exchangeforward or foreign exchange swap and qualifies for an exemptionfrom substantive regulation by the CFTC, but with the sole intentto evade any CFTC requirement, may be deemed by the CFTC to be aregulated swap.

CFTC Rule 50.10 makes it unlawful for any person to “knowinglyor recklessly” evade or “participate in or facilitate” an evasionof the CFTC's clearing mandates. It also outlaws the “abuse” of thecommercial end-user exception from a clearing mandate or “abuse” ofany exception or exclusion from a clearing mandate that the CFTCmay provide by rule, regulation, or order. In adopting this rule,the CFTC advised that although circumventing the costs of clearingmay be a legitimate business purpose, it cannot be the principalconsideration in order to satisfy the legitimate business purposetest.

The CFTC believes a principles-based approach to itsanti-evasion rules is appropriate. As a result, the agency willconsider an entity's “legitimate business purposes” to avoid—ratherthan to evade—clearing on a case-by-case basis. The CFTC hasrefused to adopt an alternative approach that would provide abright-line test of non-evasive conduct, which it believes wouldprovide potential wrongdoers with a roadmap for structuring evasivetransactions.

Commercial organizations need to be able to demonstrate to theCFTC that they have not attempted to evade any of the newderivatives rules, including clearing, position limits, andreporting. In the event that an employee causes a violation tooccur, the CFTC will consider the company's written compliancepolicies in determining the extent to which the company, asupervisor, or the employee may be held liable or be subject toenforcement action.

Crime and Punishment

In the event that a company runs afoul of one or more ofthese regulations, the CFTC will apply the Federal SentencingGuidelines for Organizational Defendants, established by the U.S.Sentencing Commission to punish large corporations that are foundto have engaged in criminal activity. While organizations cannot beimprisoned, they can be fined, required to disgorge ill-gottenprofits, made to pay restitution, or enjoined from engaging incertain activities. The guidelines state that organizations aresubject to criminal penalties for federal offenses associated withfraud, criminal business activities, and other felonies, with afocus on the behavior of the organization's management.

The Sentencing Guidelines are intended to deter wrongfulbehavior by encouraging organizations to develop their ownreasonable compliance program to reduce the possibility of criminalactivity. They outline seven key criteria for establishing aneffective compliance program; those seven key criteria have becomeknown as the “seven pillars” of an effective compliance program.They are (1) standards and procedures; (2) oversight; (3)education and training; (4) auditing and monitoring; (5) reporting;(6) enforcement and discipline; and (7) response and prevention. Aneffective derivatives compliance program should follow theSentencing Guidelines' seven pillars and tailor policies to theorganization's risk management practices around the use ofderivatives.

The Dodd-Frank Act substantially altered the regulatory andcompliance environment for commercial end users of swaps. Corporatetreasurers and their counsel must carefully evaluate their writtenpolicies and procedures and adopt appropriate written proceduresthat comply with relevant derivatives laws and regulations.

—————————————–

Nathan Howell is a partner in the Chicagooffice of international law firm Sidley Austin LLP. He advises abroad range of financial services clients on regulatory andtransactional matters, with a particular focus on issues arisingunder the Dodd-Frank Act. Howell represents major investmentadvisory firms, futures commission merchants, derivatives clearingorganizations, clearing agencies, commodity pool operators,commodity trading advisors, exchanges, and other financialcompanies in a variety of matters relating to derivatives.

Michael Sackheim is a partner in the New Yorkoffice of international law firm Sidley Austin LLP. He focuses onfutures and derivatives regulatory, transactional, and enforcementmatters. Sackheim concentrates on advising end users on compliancewith the new derivatives financial reform laws andregulations.

Kunal Malhotra is an associate in theInvestment Funds, Advisers, and Derivatives practice group in theChicago office of international law firm Sidley Austin LLP. Heassisted in preparing this article.