The Dodd-Frank Act created a new and complex regulatory regime for derivatives trading. Since the law’s passage, regulators have adopted a myriad of new trading, reporting, recordkeeping, clearing, trade execution, margin, and anti-fraud rules. With these new rules come a plethora of opportunities for companies that trade derivatives to be held liable for violations. That’s why every commercial entity that uses the derivatives markets for risk management purposes should implement a derivatives compliance program.
A compliance program will help create and preserve a culture of integrity within the organization. It will also demonstrate to regulatory and law enforcement authorities—and investors—that if a derivatives trading issue does occur, the event is anomalous and does not constitute wrongdoing by the company. Keep in mind that an organization can be found liable for misconduct on the part of individual employees or other agents of the organization. Proper internal controls, including a well-designed derivatives compliance program, can help an organization avoid such liabilities.
A derivatives compliance policy should address regulatory compliance issues in the following areas:
Deceptive and fraudulent practices. In 2011, the Commodity Futures Trading Commission (CFTC) adopted a new anti-fraud rule, pursuant to the agency’s new anti-fraud authority established under the Dodd-Frank Act. CFTC Rule 180.1 applies to activities undertaken “in connection with” exchange-traded futures, swaps, and transactions in commodities in interstate commerce (for example, physicals and forwards). For any of these products, the rule prohibits the “intentional or reckless” use of manipulative devices or schemes to defraud; false or misleading statements and material omissions; practices that operate, or would operate, as a fraud or deceit; and misleading or inaccurate reports concerning conditions that tend to affect the price of any commodity. Conduct can rise to the level of “reckless” when an act or omission deviates so far from the customary standards of ordinary care that it becomes very difficult to believe the defendant was not aware of what he or she was doing.
About 15 years ago, the CFTC began bringing enforcement cases against publicly traded energy companies whose rogue employees gave false information to industry publications about the prices and volumes of their daily over-the-counter gas and electric trades. False reporting of the prices of commodities traded in interstate commerce was a violation of the Commodity Exchange Act (CEA) even before the CFTC adopted Rule 180.1. Every one of these companies settled the allegations with the CFTC and paid millions of dollars in civil fines. And these companies were not financial entities; none was required to be registered with the CFTC. During the past five years, the CFTC has been investigating collusion and benchmark-rate fixing in the LIBOR and foreign currency markets by traders for banks and other financial institutions. Some of these investigations have led to settled CFTC enforcement actions, and several others are under investigation by criminal authorities.
An organization is generally liable for the acts or omissions of its employees. The CFTC has advised that such collective liability creates incentives for the organization to develop and maintain effective internal policies and controls to prevent wrongful conduct. Clearly written compliance policies and procedures surrounding derivatives activities bolster a company’s defense against an allegation of “recklessness” if a CFTC enforcement action seeks to hold the organization liable for the acts or omissions of a rogue employee. And if the organization is ultimately found liable, a compliance program can also help mitigate 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 “is used to cause any price to be reported, registered, or recorded that is not a true and bona fide price.” The Dodd-Frank Act expanded these prohibited practices beyond the commodities markets, to include any instrument traded on a futures exchange or a swap execution facility (SEF), as well as any trade cleared through a CFTC-regulated clearing organization. Many of the same energy companies that ended up settling with the CFTC around 2000 because employees were publicly reporting false information, employed traders who engaged in what they termed “round-trip” transactions. They would buy and sell gas and electricity, then engage in subsequent opposite transactions with their counterparties for the purpose of appearing to engage in a high volume of trading. The CFTC alleged that these were fictitious “wash” trades in violation of the CEA and again collected millions in civil fines through uncontested settlements.
Another new provision that the Dodd-Frank Act added to the CFTC’s enforcement arsenal prohibits futures-trade “spoofing,” which is defined as “bidding or offering with the intent to cancel the bid or offer before execution.” In October 2014, a high-speed futures trader was indicted for allegedly violating this prohibition by designing programs to place large “quote orders,” which were not intended to be executed, in order to create the illusion of market interest. The trader also allegedly used trading programs that automatically canceled all quote orders immediately if any quote order was partially filled, to save other traders from reacting to “false price and volume information” and from buying quote orders that appeared to reflect a substantial change in the market. Section 4c(a)(5)(B) of the CEA prohibits any trading practice or conduct that demonstrates intentional or reckless disregard for the orderly execution of transactions during the closing period on a futures exchange or a SEF.
If a commercial entity hedges in the futures markets, its traders should be educated about the new anti-spoofing rules. If the company retains a third-party manager to trade on behalf of the corporation, a prudent corporate treasurer will conduct adequate due diligence and ask the manager to furnish a copy of its compliance procedures, which should include policies concerning spoofing and other disruptive trading practices. In the event that a trader or third-party manager for a corporation goes rogue and employs any of the prohibited practices, the corporation can use a thoughtful compliance program to demonstrate that it did not recklessly disregard its compliance obligations. Commercial entities should adopt written compliance procedures to prevent their trading managers from engaging in fraudulent conduct and other prohibited derivatives practices, and to audit their outside advisers and brokers as to how their procedures are designed to comply with the CFTC’s rules.
Commercial end-user clearing exception. The CFTC has the authority to require that various categories of swaps be cleared through a central clearinghouse, which also means that the swap may be required to be executed on a regulated futures exchange or SEF. To date, the CFTC has issued clearing mandates for certain interest rate swaps and index credit default swaps, with non-deliverable foreign exchange forwards expected to be the next subject of a clearing mandate. Central clearinghouses impose margin requirements on the parties to each cleared swap trade.
A company that is not classified as a financial entity, and that uses swaps only to mitigate commercial risk, can qualify for an exception from the clearing mandate—and, therefore, from the margin requirements imposed by the clearinghouse. Swaps will be deemed to mitigate commercial risk if they are economically appropriate to the reduction of the organization’s risk, if they qualify as bona fide hedges for purposes of CFTC position limits, or if they qualify for hedging treatment under an applicable accounting standard. According to the CFTC, positions which are executed primarily for the purpose of taking an outright view on a market direction, or to obtain an appreciation in the value of the swap position itself, are generally considered to be positions entered into for the purpose of speculation, investing, or trading, which would not qualify as commercial risk mitigation. To rely on the exception, a company must file with a swap data repository, providing information about how it generally meets its financial obligations in connection with non-cleared swaps. There are similar clearing exemptions for corporate treasury affiliates and interaffiliate swaps that satisfy certain conditions.
A public company that issues registered securities, or that is required to file reports under the Securities Exchange Act of 1934, can apply for the commercial end-user exception only after its board of directors, or an equivalent governing body or committee of the board, reviews and approves the decision to use the end-user clearing exception.
Abusing the commercial end-user exception is a felony subject to possible imprisonment and a substantial monetary penalty. Any company electing the end-user clearing exception needs to adopt appropriate policies governing the use of non-cleared swaps, and it should review those policies on an annual basis or more frequently. If a swap is inadvertently entered into for purposes other than risk management, the company needs to be able to demonstrate that the trade violated company policy and that the portfolio manager had been properly instructed about the policy. This could be established by written compliance policies, maintaining records of regular compliance training for its relevant employees, and maintaining robust internal-monitoring systems.
Position limits. In November 2013, the CFTC proposed rules setting speculative position limits for certain derivatives. The rules set a limit on the dollar value that an individual or company can hold in any of 28 core physical energy, metals, and agricultural commodity futures contracts that are traded on futures exchanges. They also limited an individual’s or company’s holdings in “economically equivalent” futures, options, and swaps, including commercial trade options that are not regulated as swaps and are widely used in the energy, metals, and agricultural industries. The proposed position limits rules are currently pending final adoption by the CFTC.
The proposed rules would also require a company to aggregate all its positions in accounts in which the company, directly or indirectly, holds an ownership or equity interest of 10 percent or greater, as well as positions in accounts over which the company controls trading. The proposed rules would establish a disaggregation exemption for a company with an ownership or equity interest in an owned entity of at least 10 percent but not greater than 50 percent, and for a company with an ownership or equity interest exceeding 50 percent in another non-consolidated entity, provided that prescribed trading coordination firewalls are established between the entities.
Corporate treasurers whose companies use the derivatives markets for investment purposes should use their compliance program to monitor trading positions so that they can be sure to avoid running afoul of the soon-to-be-finalized position limits and aggregation rules.
Recordkeeping. The CFTC has adopted detailed reporting and recordkeeping rules applicable to trading in swaps, whether or not those swaps are subject to mandatory clearing. Fortunately for commercial swaps end users, the reporting burden falls mostly on the large dealers that dominate the sell side of the market. However, recordkeeping requirements under the CFTC rules are bilateral and fall on both parties to a transaction. The CFTC’s new recordkeeping requirements for swaps are burdensome and confusing, even to the lawyers. But recordkeeping goes to the heart of the CFTC’s goal to make the swaps market transparent. Recordkeeping violations are easy for the CFTC to prove. Every year, the CFTC brings enforcement cases against its registrants for recordkeeping violations, but the new swaps rules apply with equal vigor to non-registrant participants in the swaps markets. The prudent treasurer will adopt robust swaps recordkeeping, with written policies governing the company’s swaps recordkeeping obligations.
Anti-evasion procedures. The CFTC’s general anti-evasion provision provides that any agreement, contract, or transaction which is willfully structured to evade the CFTC’s swaps rules is deemed to be a swap. For example, a transaction that is willfully structured as a foreign exchange forward or foreign exchange swap and qualifies for an exemption from substantive regulation by the CFTC, but with the sole intent to evade any CFTC requirement, may be deemed by the CFTC to be a regulated swap.
CFTC Rule 50.10 makes it unlawful for any person to “knowingly or recklessly” evade or “participate in or facilitate” an evasion of the CFTC’s clearing mandates. It also outlaws the “abuse” of the commercial end-user exception from a clearing mandate or “abuse” of any exception or exclusion from a clearing mandate that the CFTC may provide by rule, regulation, or order. In adopting this rule, the CFTC advised that although circumventing the costs of clearing may be a legitimate business purpose, it cannot be the principal consideration in order to satisfy the legitimate business purpose test.
The CFTC believes a principles-based approach to its anti-evasion rules is appropriate. As a result, the agency will consider an entity’s “legitimate business purposes” to avoid—rather than to evade—clearing on a case-by-case basis. The CFTC has refused to adopt an alternative approach that would provide a bright-line test of non-evasive conduct, which it believes would provide potential wrongdoers with a roadmap for structuring evasive transactions.
Commercial organizations need to be able to demonstrate to the CFTC that they have not attempted to evade any of the new derivatives rules, including clearing, position limits, and reporting. In the event that an employee causes a violation to occur, the CFTC will consider the company’s written compliance policies in determining the extent to which the company, a supervisor, or the employee may be held liable or be subject to enforcement action.
Crime and Punishment
In the event that a company runs afoul of one or more of these regulations, the CFTC will apply the Federal Sentencing Guidelines for Organizational Defendants, established by the U.S. Sentencing Commission to punish large corporations that are found to have engaged in criminal activity. While organizations cannot be imprisoned, they can be fined, required to disgorge ill-gotten profits, made to pay restitution, or enjoined from engaging in certain activities. The guidelines state that organizations are subject to criminal penalties for federal offenses associated with fraud, criminal business activities, and other felonies, with a focus on the behavior of the organization’s management.
The Sentencing Guidelines are intended to deter wrongful behavior by encouraging organizations to develop their own reasonable compliance program to reduce the possibility of criminal activity. They outline seven key criteria for establishing an effective compliance program; those seven key criteria have become known 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. An effective derivatives compliance program should follow the Sentencing Guidelines’ seven pillars and tailor policies to the organization’s risk management practices around the use of derivatives.
The Dodd-Frank Act substantially altered the regulatory and compliance environment for commercial end users of swaps. Corporate treasurers and their counsel must carefully evaluate their written policies and procedures and adopt appropriate written procedures that comply with relevant derivatives laws and regulations.
Nathan Howell is a partner in the Chicago office of international law firm Sidley Austin LLP. He advises a broad range of financial services clients on regulatory and transactional matters, with a particular focus on issues arising under the Dodd-Frank Act. Howell represents major investment advisory firms, futures commission merchants, derivatives clearing organizations, clearing agencies, commodity pool operators, commodity trading advisors, exchanges, and other financial companies in a variety of matters relating to derivatives.
Michael Sackheim is a partner in the New York office of international law firm Sidley Austin LLP. He focuses on futures and derivatives regulatory, transactional, and enforcement matters. Sackheim concentrates on advising end users on compliance with the new derivatives financial reform laws and regulations.
Kunal Malhotra is an associate in the Investment Funds, Advisers, and Derivatives practice group in the Chicago office of international law firm Sidley Austin LLP. He assisted in preparing this article.