The period covered by this report is July 1, 2010, through January 20, 2011.*
I. OVERALL OBJECTIVES OF DODD-FRANK TITLE VII
In the words of the current chair of the CFTC, Commissioner Gary Gensler, the key objective of Title VII of Dodd-Frank is to'bring the unregulated over-the-counter derivatives markets under comprehensive regulation. Those derivatives, also known as 'swaps,' were not the only cause of the 2008 financial crisis, but they played a significant role.'2 Dodd-Frank does not apply particularly or solely to energy companies; however, companies participating in every sector of the energy business - oil, natural gas, coal, uranium, electricity - rely on swaps to hedge or manage their commodity price risks as well as exposures to interest rates and, in some cases, foreign currencies. All of these hedging transactions will be impacted in some way by Dodd-Frank.
Until Dodd-Frank becomes effective, there are broad exemptions for energy commodity derivatives from CFTC regulation.3 Dodd-Frank amends the Commodity Exchange Act4 to repeal those exemptions and regulate all over-the-counter swaps transactions for the first time. Dodd-Frank was signed into law on July 21, 2010.5 Most of its provisions will not take effect until July 16, 2011, or 60 days after publication of final rules from the CFTC and other affected agencies.6 The transactions and the markets on which they are transacted are complex; therefore, these statutory provisions and regulations are equally complex. This report is intended to aid the industry in considering the likely impacts of Dodd-Frank on the way that they conduct hedging transactions in the future.
II. KEY FEATURES OF DODD-FRANK TITLE VII AFFECTING ENERGY COMPANIES
'Markets work best when they are transparent, open and competitive.'7 To achieve that goal for swaps markets, Dodd-Frank requires that all swaps must be transacted on an exchange (for pre-trade transparency) and reported as directed by the CFTC, with data made publicly available (for post-trade transparency).8 To reduce risks perceived to have contributed to the 2008 financial crisis, swaps must also be backed by collateral and cleared by a clearinghouse.9'End-users,' such as airlines and utilities, when they use swaps to hedge against commercial risk, will be exempt from the exchange-trading and clearing requirements (for public companies, the board must approve entering into exempt swaps), as well as the capital and margin rules.10
Even though regulations promulgated by the CFTC under Dodd-Frank might exempt most or all of an energy company's swaps under the so-called'end user exemption' from the exchange-trading and clearing requirements,11 market conditions might require the company to transact on exchanges or with clearinghouses, all of which have margin requirements, and position limits on swaps may be imposed by the CFTC to assure market integrity. In all cases, there are reporting requirements that could become the burden of an energy company, even though it qualifies for the end user exemption.12
A. End User Exemption from Clearing and Exchange-Trading Requirements
Dodd-Frank amends section 2(h)(1)(A) of the CEA13 to make it unlawful for anyone to enter into a swap that is required to be cleared unless the swap is submitted to a designated clearing organization for clearing.14 In new section 2(h)(7) of the CEA, however, Dodd-Frank provides an exemption giving'end users' the option not to clear swaps.15 Under Dodd-Frank, the end-user exemption applies when one counterparty to the swap:'(i) is not a financial entity; (ii) [uses the relevant] swaps to hedge or mitigate commercial risk; and (iii) notifies the [CFTC] . . . how it . . . meets its financial obligations associated with . . . [un]cleared swaps.'16 Swaps qualifying for this exemption also do not have to be traded on an exchange.17
New section 2(h)(7)(C)(i) of the CEA defines the term'financial entity'18 to include: (i) swap dealers and security-based swap dealers, (ii) major swap participants and major security-based swap participants, (iii) commodity pools, (iv) private funds as defined in the Investment Advisers Act of 1940,19 (v) employee benefit plans as defined in the Employee Retirement Income Security Act of 1974,20 and (vi) persons predominantly engaged in banking or financial activities, as defined in the Bank Holding Company Act of 1956. …