Copyright © 2011 by K&L Gates LLP. All rights reserved. Emerging Derivatives Reforms Under the Dodd-Frank Act February 23, 2011 Christopher J. DeLise Anthony

Copyright © 2011 by K&L Gates LLP. All rights reserved.

Emerging Derivatives Reforms Under the Dodd-Frank Act

February 23, 2011

Christopher J. DeLiseAnthony R.G. Nolan

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Agenda

Impact of Dodd-Frank on structure of regulation and trading

Jurisdiction of SEC and CFTC over OTC derivatives markets

Regulated Swap Entities

Transactions with “Special Entities”

Clearing, Trade Execution and Documentation

Margin and Collateral Segregation

Bankruptcy issues

Strategic and Compliance Issues

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Introduction

The “Dodd-Frank Wall Street Reform and Consumer Protection Act” (“Dodd-Frank”), through Title VII, the “Wall Street Transparency and Accountability Act of 2010” (“Title VII”), completely overhauls the trading of over-the-counter (“OTC”) derivatives in the United States.

OTC derivatives change from being essentially unregulated to being regulated by the SEC, the CFTC or both (or banking regulators).

New requirements for trading, clearing, margining, reporting, and trade data collection of OTC derivatives, as well as the registration of parties to these transactions, which will make the parties subject to capital and business conduct standards.

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Introduction

Commercial end-users are exempt from all but the reporting requirements and possibly requirements to post margin.

Title VII will generally become effective on July 16, 2011, 360 days following the enactment of the new law.

Title VII has generated a blizzard of proposed regulations and interim final rules promulgated by the SEC and the CFTC.

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Process

Dodd-Frank legislative process Completed June 21, 2010 Legislative approach: broad goals, defer to regulators Speed bumps; unrealistic deadlines

Dodd-Frank rulemaking process Multiple agency coordination; Swaps primarily led by SEC and CFTC Dynamics:

Aggressive positions of CFTC Staffing and budgetary constraints

Congressional oversight in light of the 2010 elections Focus in House Banking Committee and Ag Committee End-users; cost to industry; effect on jobs

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1. 17 CFR Part 23 Orderly Liquidation Termination Provision in Swap Trading Relationship Documentation for Swap Dealers and Major Swap ParticipantsClosing Date: 4/11/2011

2. 17 CFR Part 23 Swap Trading Relationship Documentation Requirements for Swap Dealers and Major Swap ParticipantsClosing Date: 4/11/2011

3. 17 CFR Parts 3, 32, 33, and 35 Commodity Options and Agricultural Swaps -- Closing Date: 4/4/20114. 17 CFR Parts 1, 150 and 151 Position Limits for Derivatives Closing Date: 3/28/20115. 17 CFR Part 39 Risk Management Requirements for Derivatives Clearing Organizations Closing Date: 3/21/20116. 17 CFR Part 37 Core Principles and Other Requirements for Swap Execution Facilities Closing Date: 3/8/20117. 17 CFR Parts 1, 37, 38, 39, and 40 Governance Requirements for Derivatives Clearing Organizations, Designated Contract Markets, and Swap Execution

Facilities; Additional Requirements Regarding the Mitigation of Conflicts of Interest Closing Date: 3/7/2011 8. 17 CFR Part 165 Implementing the Whistleblower Provisions of Section 23 of the Commodity Exchange Act Closing Date: 2/4/20119. 17 CFR Part 23 Confirmation, Portfolio Reconciliation, and Portfolio Compression Requirements for Swap Dealers and Major Swap Participants

Closing Date: 2/28/201110. 117 CFR Part 49 Swap Data Repositories Closing Date: 2/22/201111. 17 CFR Part 39 End-User Exception to Mandatory Clearing of Swaps Closing Date: 2/22/201112. 17 CFR Parts 23 and 155 Business Conduct Standards for Swap Dealers and Major Swap Participants With Counterparties Closing Date: 2/22/201113. 17 CFR Part 1 Securities and Exchange Commission 17 CFR Part 240 Further Definition of "Swap Dealer," "Security-Based Swap Dealer," "Major Swap

Participant," "Major Security-Based Swap Participant" and "Eligible Contract Participant" Closing Date: 2/22/201114. 17 CFR Parts 1, 21, and 39 Information Management Requirements for Derivatives Clearing Organizations Closing Date: 2/14/201115. 17 CFR Parts 1 and 39 General Regulations and Derivatives Clearing Organizations Closing Date: 2/11/201116. 17 CFR Part 43 Real-Time Public Reporting of Swap Transaction Data Correction Closing Date: 2/7/201117. 17 CFR Part 23 Reporting, Recordkeeping, and Daily Trading Records Requirements for Swap Dealers and Major Swap Participants Closing Date: 2/7/201118. 17 CFR Part 45 Swap Data Recordkeeping and Reporting Requirements Closing Date: 2/7/201119. 17 CFR Part 43 Real-Time Public Reporting of Swap Transaction Data Closing Date: 2/7/201120. 17 CFR Part 165 Implementing the Whistleblower Provisions of Section 23 of the Commodity Exchange Act Closing Date: 2/4/201121. 17 CFR Parts 23 and 190 Protection of Collateral of Counterparties to Uncleared Swaps; Treatment of Securities in a Portfolio Margining Account in a Commodity

Broker Bankruptcy Closing Date: 2/1/201122. 17 CFR Part 44 Reporting Certain Post-Enactment Swap Transactions Closing Date: 1/18/201123. 17 CFR Part 190 Protection of Cleared Swaps Customers Before and After Commodity Broker Bankruptcies Closing Date: 1/18/201124. Public Input for the Study Regarding the Oversight of Existing and Prospective Carbon Markets Closing Date: 12/17/201025. Regulations Establishing and Governing the Duties of Swap Dealers and Major Swap Participants Closing Date: 1/24/201026. 17 CFR Part 23 Implementation of Conflicts of Interest Policies and Procedures by Swap Dealers and Major Swap Participants Closing Date: 1/24/201027. 17 CFR Parts 3, 23 and 170 Registration of Swap Dealers and Major Swap Participants Closing Date: 1/24/201028. 17 CFR Part 3 Designation of a Chief Compliance Officer; Required Compliance Policies; and Annual Report of a Futures Commission Merchant, Swap Dealer, or

Major Swap Participant Closing Date: 1/18/2010

CFTC Proposed Rules on Swaps in 2011

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Current Swap Market Structure

A. Private bilateral terms set exclusively by the parties (including

definition of default)

B. Any margin/collateral requirements and terms of custody set by the parties in the contract

C. Two ways to execute:1. Direct communications 2. Unregulated trading platforms

where buyers and sellers can discover and accept each other’s bids and offers and form agreements

Counterparty Counterparty

CFTC Regulated Clearing Organization becomes counterparty

to each side of transactions

(Clearing available for some Swaps upon election of both parties)

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New Swap Market Structure

A. Example of OTC Swap between End User and Regulated Swap Counterparty

1. CFTC Registration as SD or MSP2. Capital Requirements3. Verification that counterparty is

eligible contract participant4. Disclosure of material risks/material

incentives/conflicts of interest/daily market.

5. Recordkeeping6. Audit Trail7. Risk management systems8. Internal information gathering

systems9. Establishment of Chief Compliance

Officer10.CFTC Registration as Futures

Commission Merchant if it holds End User’s margin/collateral for Swap

CommercialEnd User

(must be eligible contract participant)

Swap Dealer/ Major Swap Participant(“SD”) (“MSP)

Non-cleared Swap

• End User must notify CFTC how it will meet financial obligations

• For public companies, board approval required to enter into non-cleared Swaps

Cleared Swap

1. Clearing at election of Commercial End User

2. Swap Dealer/MSP Submits Swap to CFTC Regulated Clearing Organization for clearing

ReportingCleared Swap

Clearing organization reports Swap to Swap

Data Repository

ReportingNon-cleared Swap

Swap Dealer/MSP reports Swap to Swap

Data Depository or CFTC

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New Swap Market Structure

B. Example of Exchange-Traded Swap

SwapCounterparty

ReportingExchange Reports

Swap to Swap Data Repository or CFTC

CFTC-Registered

Futures Commission

Merchant imposes margin

requirements and holds customer

margin collateral

CFTC Regulated Exchange

Provides for execution of

trade and sets minimum

margin requirements

SwapCounterparty

CFTC-RegisteredFutures

Commission Merchant

imposes margin requirements and holds customer margin collateral

ClearingCFTC-Regulated

ClearingOrganization clears

the trade

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Prior to Dodd-Frank over-the counter swaps were largely exempt from substantive regulation:

Swaps or other agreements that were individually negotiated between eligible contract participants were outside of CFTC jurisdiction

SB Swaps were exempt from most requirements of the Securities Act and Securities Exchange Act

Dodd-Frank brings all swaps under SEC or CFTC regulation: CFTC has jurisdiction over “Swaps” SEC has jurisdiction over “SB Swaps” SEC and CFTC have joint jurisdiction over “mixed Swaps”

To be determined: FX – Treasury determination Stable value contracts – SEC determination

SEC and CFTC Jurisdictions

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“Swap” includes any agreement, contract or transaction that: Is an option based upon the value of one or more commodities, currencies,

interest or other rates, securities, debt instruments, indices, quantitative measures, “or other financial or economic interests or property of any kind.”

Provides for the purchase, sale, payment or delivery that is dependent on the occurrence or non-occurrence, or the extent of an occurrence, of an event or contingency with a potential financial, economic or commercial consequence.

Provides for an exchange of payments based upon the value of one or more currencies, commodities, rates, securities, debt instruments, indices, quantitative measures “or other financial or economic interests or property of any kind” and that transfers financial risk, but not ownership of an asset or liability.

Is “commonly known” as a Swap.

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Swaps do not include: Futures and options on futures. Sales of a nonfinancial commodity or security for deferred shipment or

delivery, so long as the transaction is intended to be physically settled. Securities, including any option on a security, certificate of deposit, group or

index of securities, and foreign currency options entered into on a national securities exchange.

Agreements providing for the purchase or sale of one or more securities on a contingent basis, any note, bond or evidence of indebtedness that is a security, and any SB Swap other than a “mixed Swap.”

Agreements with a Federal Reserve bank, the Federal Government or a Federal agency that are expressly backed by the full faith and credit of the United States.

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“SB Swap”: any “Swap” based on: A narrow-based securities index (i.e. with nine or fewer component

securities), including any interest therein or on the value thereof; A single security or loan, including any interest therein or on the value thereof;

or The occurrence, non-occurrence, or extent of an occurrence, of an event

relating to a single issuer of a security or the issuers of securities in a narrow-based security index, provided that such event directly affects the financial statements, financial condition, or financial obligations of the issuer.

SB Swap is a “security” under the Securities Act and the Securities Exchange Act (but not the Investment Company Act or Investment Advisers Act).

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“Mixed Swap”: an agreement, contract or transaction based on:

The value of one or more of the components of an SB Swap and

The value of one or more of the following: Any non-securities component of a Swap (e.g., interest or other rates,

currencies, commodities, instruments of indebtedness); or the occurrence, non-occurrence, or the extent of the occurrence of an event

or contingency associated with a potential financial, economic, or commercial consequence that is not otherwise within the definition of SB Swap.

The definition generally would include agreements where one counterparty receives a return based on a single security or loan or a narrow-based securities index and the other counterparty receives a return based on the value of a non-securities-based measure (e.g., a commodity index).

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Definition of Swap Dealer, SB Swap Dealer

Dodd-Frank defines a Swap Dealer as: “any person who (1) holds itself out as a dealer in Swaps; (2) makes a market in Swaps; (3) regularly enters into Swaps with counterparties as an ordinary course of business for its own account; or (4) engages in any activity causing the person to be commonly known in the trade as a dealer or market maker in Swaps.”

Swap Dealer does not include a person that enters into Swaps for such person’s own account, either individually or in a fiduciary capacity, but not as part of a regular business.

A person may be designated as a Swap Dealer for a single type or single class or category of Swap, but not for other types, classes, or categories of Swaps.

The definition of SB Swap Dealer is similar to Swap Dealer, with references to SB Swaps appearing in place of Swaps and references to the SEC appearing in place of the CFTC.

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Definitions of Swap Dealer, SB Swap Dealer

The SEC and the CFTC have proposed a rule that would focus on market activities to determine whether a person is a dealer.

Proposed “core tests” of dealer status: Do you accommodate demand for transactions from others? Do you enter into transactions to facilitate others? Do you propose terms rather than request terms from counterparty? Do you arrange customized terms on request?

Note differences in approach between CFTC and SEC

Factors that may indicate a person holding self out as a dealer include:

contacting potential counterparties to solicit interest in transactions; developing or marketing new types of instruments; membership in ISDA in a category reserved for dealers.

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Definitions of Swap Dealer, SB Swap Dealer

De Minimis Exception. A person would not be a dealer under the proposed rules if over the prior

12 months (i) it entered into Swaps or SB Swaps with an aggregate effective gross notional amount not greater than $100 million and with no more than 15 counterparties (other than SB Swap dealers but including affiliates); and (ii) it executed 20 or less Swaps or SB Swaps as a dealer.

Self Determination. The SEC and CFTC expect market participants to make their own

determinations as to whether their activities make them a Swap dealer or SB Swap dealer”

Nonetheless, they will have authority to take enforcement actions in response to a Swap or SB Swap dealer’s failure to register.

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Definitions of Major Swap Participant and Major SB Swap Participant

Title VII defines a Major Swap Participant as a non-Swap Dealer that: Maintains a “substantial position” in Swaps for any major category (excluding positions

to hedge or mitigate (i) commercial risk or (ii) risks directly associated with operation of an employee benefits plan);

Has substantial counterparty exposure that could have serious adverse effects on financial stability of U.S. financial system; or

Is a financial entity, is highly leveraged relative to its capital, is not subject to the federal bank regulatory capital requirements, and has a substantial position in outstanding Swaps in any major category.

The definition of Major SB Swap Participant is similar to Major Swap Participant, with references to SB Swaps appearing in place of Swaps and references to the SEC appearing in place of the CFTC.

A person may be designated as a Major Swap Participant for one or more categories of Swaps or SB Swaps, without being classified as a Major Swap Participant for all classes of Swaps.

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Two proposed tests for measuring “substantial position”: Daily Average of Current Uncollateralized Net Outward Exposure

$1 billion in major categories of SB Swaps and commodity Swaps (including credit and equity Swaps, as applicable);

$3 billion in rate swaps category.

Daily Average Current Uncollateralized Net Outward Exposure Plus Potential Future Net Uncollateralized Outward Exposure.

$2 billion in major categories of SB Swaps and commodity Swaps (including credit and equity Swaps, as applicable);

$6 billion in the rate swaps category.

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Two proposed tests for measuring “substantial counterparty exposure:”

CFTC standard: Swap positions equal or exceed either: $5 billion in daily average aggregate uncollateralized outward exposure; or $8 billion in daily average aggregate uncollateralized outward exposure

plus daily average aggregate potential outward exposure.

SEC standard: SB Swap positions would equal or exceed: $2 billion in daily average aggregate uncollateralized outward exposure; or $4 billion in daily average aggregate uncollateralized outward exposure

plus daily average aggregate potential outward exposure.

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Exclusions Financing Affiliates of Product Manufacturers: The definition excludes

financing affiliates of product manufacturers, provided that their primary business is to provide financing and they use derivatives to hedge commercial risks related to interest rate and currency exposures, where at least 90 percent of the exposures arise from financing that facilitates the purchase or lease of products, if 90 percent or more of the products are manufactured by the entity’s parent company or another subsidiary of the parent company.

Employee Benefit Plans

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Duties of Regulated Swap Entities

Regulated Swap Entities have the following statutory duties, which have been further elaborated by proposed rules of the SEC and CFTC:

Registration with one or both Commissions Capital and margin requirements Verifying status of counterparty Disclosure to counterparties Fair dealing Recordkeeping, reporting and documentation of transactions Risk management systems Conflict-of-Interest protections Chief Compliance Officer requirement

SEC and CFTC have also proposed anti-manipulation rules that apply particularly to Regulated Swap Entities

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Transactions With “Special Entities”

Regulated Swap Entities are subject to heightened business conduct standards when acting as an advisor or counterparty to a “Special Entity.”

“Special Entity:”i. a Federal agency,ii. a state, state agency, city, county, municipality, or other political

subdivision of a state,iii. an employee benefit plan or a governmental plan as defined in

Section 3 of ERISA, oriv. any endowment, including an endowment that is an organization

described in Section 501(c)(3) of the Internal Revenue Code.

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Regulated Swap Entities acting as advisers to Special Entities may not engage in any act that “operates as a fraud or deceit” on any Special Entity or prospective customer that is a Special Entity.

Swap Dealers and SB Swap Dealers must Act in the best interests of the Special Entity, Make reasonable efforts to obtain information (including information

relating to financial status, tax status, investment and financing objectives) as is necessary to make a reasonable determination that any Swap or SB Swap recommended by the Swap Dealer or SB Swap Dealer is in the best interests of the Special Entity.

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A Regulated Swap Entity that acts as a counterparty (but not as an advisor) to a Special Entity must have a reasonable basis to believe that the Special Entity has an “independent representative” that:

has sufficient knowledge to evaluate the transaction and risks; is not subject to a statutory disqualification; is independent of the Regulated Swap Entity; undertakes a duty to act in the best interests of its counterparty; makes appropriate disclosures; provides written representations to the Special Entity regarding fair pricing

and the appropriateness of the transaction; and in the case of an employee benefit plan subject to ERISA, is a fiduciary as

defined in Section 3 of ERISA.

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A Swap Dealer or SB Swap Dealer must disclose in writing to the Special Entity the capacity in which it is acting prior to initiation of the transaction.

The CFTC and the SEC have proposed a rule with other requirements for those dealing with Special Entities. The proposed regulation includes restrictions on political contributions by Regulated Entities to Special Entities that are governmental entities.

The special duties owed to a Special Entity do not apply to transactions initiated by a Special Entity on an exchange or Swap execution facility if the Regulated Swap Entity does not know the identity of the counterparty to the transaction.

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Dodd-Frank requires that a Special Entity be advised by an independent representative for Swaps and SB Swaps.

Dodd-Frank expressly requires that an independent representative must be “independent of” the Regulated Swap Entity but not of the Special Entity itself.

Special Entity provisions generally are structured to provide greater protection to Special Entities only from activities of Regulated Swap Entities, not protection from themselves.

Many types of Special Entities are widely known to have highly sophisticated internal investment expertise that would satisfy the qualifications of an independent representative. Nothing indicates Congress intended to require Special Entities to contract with third parties for that expertise.

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Implications: Added layer of pay-to-play regulation on Regulated Swap Entities Compliance cost for certain Special Entities Risk that Regulated Swap Entities may have increased leverage over

clients and counterparties that are Special Entities client

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Clearing

If a Swap is required to be cleared, it is unlawful for any person to engage in the Swap unless it is submitted for clearing to a derivatives clearing organization or, if a SB Swap, to a registered or exempt clearing agency.

There are very limited exemptions and exclusions from clearing. Exemptions for transactions entered into prior to July 21, 2010 or thereafter but before

clearing requirement becomes applicable to them. Commercial end-user exemption for

A commercial entity (i.e., not a financial entity); Entering into a transaction to hedge its own commercial risk; That notifies the SEC or CFTC how it meets its financial obligations associated with

entering into uncleared Swaps; and That obtains (if a public company) the approval of its board of directors or governing

body or committee thereof.

The CFTC has proposed regulations setting forth the manner in which end-users provide notice to the CFTC

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Clearing – Trade Execution

A commercial end-user that is counterparty to a Swap or SB Swap that is required to be cleared “has the sole right to select” the DCO or clearing agency on which the Swap will be cleared.

If the Swap is not required to be cleared, such a counterparty “may elect to require clearing” (assuming there is a DCO or clearing agency

that clears it); and “has the sole right to select” the DCO or clearing agency on which the Swap

will be cleared (again assuming the availability of a choice).

Swaps that are required to be cleared must also be executed either: on a board of trade that is designated as a contract market or on a regulated Swap (or SB Swap) execution facility.

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Requirement not applicable if no board of trade or Swap execution facility makes the Swap available for trading or if Swap is subject to the commercial hedging exception.

“Swap (and SB Swap) execution facilities” do not currently exist. These are newly minted terms for trading platforms that the statute specifies

must be distinct from the existing “designated contract markets.” Their characteristics are thinly drawn under Title VII.

A Swap execution facility is “a trading system or platform in which multiple participants have the ability to execute or trade Swaps by accepting bids and offers made by multiple participants in the facility or system through any means of interstate commerce that (A) facilitates the execution of Swaps between persons, and (B) is not a designated contract market.”

Similar definition for SB Swaps.

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Only eligible contract participants (“ECPs”) may enter into Swaps that are NOT entered into on or subject to the rules of a designated contract market or, in the case of SB Swaps, that are not effected on a national securities exchange.

The CEA definition of “Eligible Contract Participant” has been slightly narrowed by Dodd Frank.

Commodity pools are eligible for purposes of FX transactions only if all participants in the pool are themselves ECPs;

Individuals must have “amounts invested on a discretionary basis” (rather than “total assets”) in excess of $10 million or, if hedging, $5 million.

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Clearing Process and Documentation

Title VII does not address the mechanics of clearing. Likelihood is that they will be similar to those of existing markets. But OTC derivatives transaction volume is hugely greater than the current

volume of exchange traded futures. The systems needed to handle that volume may need to be somewhat

different than those currently in place.

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Most non-dealer customers will not be able to clear and settle trades directly with the clearing entity.

Trades normally will need to be intermediated by a dealer that is a clearing member of the relevant clearing entity.

Also, since not all dealers are likely to be members of all relevant clearing entities, a “give-up” arrangement between a non-member and member dealer may also be necessary.

This means that centrally cleared trades involve additional levels, in terms of parties, mechanics and documentation.

In other words, central clearing seems likely to make Swap documentation more complex – not to simplify it.

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Submission of derivatives trades to a clearing entity likely will take one of two basic forms.

An “OTC style” arrangement involving back-to-back or “mirror image” transactions, respectively between the customer and a clearing member and another between the clearing member and the clearing entity; or

A “futures style” arrangement in which the clearing member acts as the agent for and the guarantor of its customer to novate a customer-dealer transaction into one between the customer and the clearing entity through give-up agreements.

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Mandatory Transaction Reporting for Cleared Swaps and SB Swaps

All cleared Swaps and SB Swaps must be reported to a Swap data repository or SB Swap data repository, or to the CFTC or SEC, respectively.

Cleared Swaps and SB Swaps entered into prior to date of enactment of Title VII must be reported within 180 days after effective date, i.e., by January 12, 2012.

Cleared Swaps and SB Swaps entered into on or after date of enactment of Title VII must be reported within 90 days after such effective date (October 14, 2011) or such other time as prescribed by the CFTC or the SEC.

SEC and CFTC have adopted interim final rules for reporting and recordkeeping; the absence of clearing infrastructure has been a practical impediment to a robust reporting regime.

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Collateral and Margin Requirements

Collateral Segregation for Cleared Swaps Only an FCM or (in the case of an SB Swap) a broker, dealer or SB Swap

dealer may accept margin or collateral for a cleared Swap. Collateral so received must be “treated as belonging to the Swaps customer”

and be segregated from the dealer’s proprietary assets. Unlawful for any person to “hold, dispose of or use” any such collateral assets

“as belonging to” any person other than the customer. Meaning of “as belonging to” unclear in this context.

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Notwithstanding the general segregation requirement: Collateral assets can be withdrawn to meet clearing entity margin

requirements, transfer or settle trades, payment of brokerage commissions and the like.

Collateral assets can be commingled: in omnibus accounts at a bank, trust company or DCO/clearing agency with

collateral assets that the FCM/broker-dealer is holding for its other Swap customers; and

Subject to Commission rules, in commingled customer accounts at the FCM/broker-dealer along with any other assets that the relevant Commission requires to be separately accounted for and treated as belonging to the customer.

Segregated cash collateral can be invested in Treasuries, municipal obligations and other liquid investments.

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The CFTC has issued an advanced notice of proposed rulemaking (“ANPR”) soliciting comment on four models for treatment of collateral posted by customers of futures commission merchants clearing Swaps. These are:

Full physical segregation of collateral, Legal segregation with commingling, Provisions for use of collateral in case of default with pro rata sharing of

downward valuations adjustments and Transfer or return of positions and collateral.

The baseline starting point for cleared futures consists of omnibus collateral accounts in which participants are subject to "fellow customer" risks. In general the clearing houses favor hewing close to this omnibus position while end users tend to favor segregation and bilateral contracts and margin in the context of a clearing house environment.

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Collateral Segregation for Non-Cleared Swaps Not mandatory, but customers do have a right to require such segregation by

contract. Any Swap dealer or major Swap participant must notify its Swap

counterparties of the right to require segregation of margin or other security posted by it

If segregation is requested, the Swap (or SB Swap) dealer or major Swap (or SB Swap) participant must segregate the collateral in a segregated account that is:

Separate from its own proprietary assets; and Carried by an independent, third party custodian “for and on behalf of” the

customer.

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The segregation-upon-request requirement applies only to initial, not variation margin.

It does not preclude: Any commercial arrangement regarding the investment in such investments as

the relevant Commission may permit by rule or regulation; or Any commercial arrangement regarding the allocation of gains or losses from

such investments.

If a customer does not require segregation, the dealer or major participant must certify quarterly that its back office procedures relating to collateral comply with the agreement of the parties.

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Bankruptcy Issues Relating to Derivatives

Dodd Frank bankruptcy provisions relating to derivatives: Title II creates a new “orderly liquidation authority” for non-bank financial

companies. Generally retains the exceptions to the automatic stay for qualified financial

contracts that previously existed in the Bankruptcy Code and the Federal Deposit Insurance Act.

The Financial Stability Oversight Council must conduct a study of secured creditor haircuts. This may affect pricing and margin for repurchase agreements and other derivatives.

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Orderly Liquation Authority is a new hybrid FDIC receivership / bankruptcy process for “covered financial companies.” These generally include:

“Bank holding companies” and nonbank financial companies subject to supervision by the Federal Reserve.

Companies predominantly engaged in activities that the Federal Reserve determines are financial in nature,

Subsidiaries of the foregoing of financial companies, other than subsidiaries that are insured depository institutions or insurance companies and

SEC-registered brokers and dealers that are members of the SIPC.

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Title II contains several provisions that afford special protections to parties to “qualified financial contracts” with covered financial companies (“QFCs”).

QFCs include repurchase agreements, securities contracts, forward contracts, commodity contracts and Swap agreements and, in each instance, specifically defined classes of counterparties.

The definition is similar to the corresponding term in the Federal Deposit Insurance Act applicable to bank receiverships

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Certain counterparties to qualified financial contracts (“protected parties”) may exercise contractual rights to terminate, close-out and liquidate their positions upon the insolvency of counterparties that are covered financial companies. However, the right is subject to some limitations:

Stay of termination right A counterparty may not terminate, liquidate or net out its position solely by

reason of the appointment of the FDIC as receiver or the financial condition of the financial company in receivership until 5:00 p.m. Eastern Time on the business day following the date of appointment of the FDIC.

A protected party also is precluded from exercising any such contractual rights after it has received notice that its qualified financial contract has been transferred to another financial institution — including a bridge financial company. The FDIC is required to notify a protected party of any such transfer by 5:00 p.m. Eastern Time on the business day following the date of appointment of the FDIC.

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A protected party may not enforce a “walkaway clause” against a covered financial company.

A walkaway clause is a provision that permits a non-defaulting counterparty to make only limited payments or no payments at all to the other on termination even if the defaulter is a net creditor (i.e., the non-defaulting party is out of the money.

E.g., (“First Method” in 1992 ISDA) E.g., section 2(a)(iii) of 1992 and 2002 ISDA

Walkaway clauses are not enforceable in a qualified financial contract of a covered financial company in default.

This limitation is similar to existing provisions in the Bankruptcy Code and the Federal Deposit Insurance Act.

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Study on Secured Creditor Haircuts The Financial Stability Oversight Council is required to conduct a study

evaluating the importance of maximizing United States taxpayer protections and promoting market discipline with respect to the treatment of fully secured creditors in the utilization of the orderly liquidation authority authorized by Dodd-Frank Title II.

Not later than July 21, 2011 the Council must issue a report to Congress containing all findings and conclusions made by the Council in carrying out the study required under subsection (a). Importance to repo, may affect margin in non-cleared OTC derivatives.

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Strategic Issues and Compliance Challenges

Implications of revision of Commodities Exchange Act to remove the exception for Swaps from the definition of “commodity”

Swaps based on commodities (including broad-based securities indices are excluded from the definition of security, but subject to CFTC jurisdiction.

A fund that primarily invests in Swaps based on a broad based securities index, now may be treated as a fund that does not invest in “securities,” and is specifically subject to CFTC jurisdiction.

As a result of the new legislation, registered funds and funds seeking to register with the SEC may have to rethink their use of Swaps if they wish to be regulated as investment companies rather than as commodity pools.

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Compliance challenges Multiple new regulatory frameworks of the CFTC and SEC may create

dual registration requirements Clearing rules may create bifurcated or trifurcated work flow with separate

documentation and compliance requirements and non-netted margin. Multiple clearing agencies Cleared and non-cleared bilateral trades.

Statutory ambiguities Definitions of Swaps and SB Swaps will need to be resolved to delineate

jurisdictional boundaries between the CFTC and SEC. Statutory ambiguities among the definitions and overlapping regulation of

futures, options, Swaps and forwards add to legal complexity and may affect trading decisions.

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Requirements for Regulated Swap Entities. Registration requirements Business conduct standards Special business conduct requirements for advisors or counterparties to

“Special Entities” Clearing, exchange trading, margining and reporting requirements for Swaps

and SB Swaps.

Impacts on end-users Scope of commercial end-user exemption from clearing Increased costs Commercial end-user direct margin??

Impact of convergence of OTC and exchange traded markets

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Regulatory implications for funds Registered Investment companies using Swaps may need to reconsider

regulatory status and investment strategies. Private investment companies using Swaps might be deemed to be dealers

or major participants and be required to register with the CFTC, the SEC or both. Relevant considerations include:

The “regularity” with which the fund or its adviser enters into Swaps “in the ordinary course of business”

The degree of leverage employed Managers also must carefully consider how the instruments they employ in

their investment programs might be characterized and regulated

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Regulatory process and studies may provide an opportunity to impact the process.

SEC / CFTC rulemaking for (i) definitions of Swap, major Swap participant etc. and (ii) regulation of mixed Swaps

Treasury determination of whether FX trades are “swaps” Study on collateral haircuts Other studies on topics such as margin requirements, treatment of stable

value contracts etc.

Congressional oversight and budget process is becoming more prominent, may be key to the future of Dodd Frank

Oversight hearings Budget approval

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Thank you!

Christopher J. DeLise+1.312.807.4347

Anthony R. G. Nolan+1.212.536.4843

Documents

Copyright © 2011 by K&L Gates LLP. All rights reserved. Emerging Derivatives Reforms Under the Dodd-Frank Act February 23, 2011 Christopher J. DeLise Anthony