Should Dodd-Frank Be Renamed the 'Rube Goldberg' Statute?

Why now, just when business activity is starting to pick up, and just when the interest rate on your loan is starting to creep up, is your bank inquiring if you are a financial entity that is highly leveraged? Can you just say “of course not” and get on with your business? As with so many things in today's world, the answer is not that simple. In this case, however, you (or more likely your advisers) have to plow through numerous federal statutes and regulations issued by agencies you have been thankful not to have to worry about in the past in order to be able to answer the question correctly. How did this happen?

Dodd-Frank

Most everyone knows that the Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law in July 2010 in response to the financial crisis. The publicly announced objectives and goals were to “fix” the financial system so that a similar crisis would not happen again. Most people agree that something needed to be done. But, most businesses assumed that the law only applies to the presumed “bad guys,” the banks and broker dealers that caused the crisis by their actions in the first place. Well, the Dodd-Frank Act is over 1,000 pages, and in turn amends dozens of other laws, and requires hundreds of pages of regulations and guidance to be issued by numerous federal agencies. The provisions of the Act and the regulations that have been adopted, and are still to be adopted, are likely to affect all businesses and all consumers in one way or another.

The CFTC

One of the major things that Dodd-Frank did was to amend the law in the United States to regulate futures contracts, which include interest-rate swaps. These kinds of financial instruments were largely unregulated prior to Dodd-Frank, and some experts believe that much of the crisis was attributable to this lack of regulation. Whether or not that allegation is true may be impossible to prove or disprove. Regardless, swap contracts of virtually all kinds are now regulated in the U.S. The regulator is one you might not expect: The Commodities and Futures Trading Commission (“CFTC”). Commodities contracts, such as those you might have heard about for corn, pork bellies, or gold, were always regulated to some extent by the CFTC. Financial instruments such as rate swaps or currency swaps were not. After Dodd-Frank, financial instruments were regulated, and the CFTC was designated as the regulator.

As required by Dodd-Frank, the CFTC has issued many new regulations, defining which business entities are “swap dealers,” “major swap participants,” and many other arcane definitions relating to those. (To demonstrate the extent of the complexity, the main definitional regulation of the CFTC has subsections that go all the way from “a” to “ssss,” although, to be fair, “nnn” to “www” and several other sections are reserved.) If you're still reading this, you may be wondering, “what has all this have to do with my leasing company?”

As you might expect, the main import of the Dodd-Frank provisions (at least as they relate to swaps) and the regulations of the CFTC primarily impose reporting and other requirements on the “dealers” in swap instruments, that is, the bank or broker-dealer from whom you've been buying interest rate swaps in the past. Now, however, those swap dealers have different reporting and other requirements if their customer (i.e., your company) comes under certain other definitions, such as that of a “major swap participant.” Thus, the definitions issued by the CFTC under the Commodities Exchange Act, as that act was amended by Dodd-Frank, now become directly applicable to your leasing company, even though your company is not a bank or dealer, and you do not consider yourself to be a “financial entity.”

Now It Gets Complicated

Here is where we finally get to the Rube Goldberg analogy. Any kind of a business (or individual) that enters into swap contracts (interest rates, currency, gold, whatever) can be a major swap participant (“MSP”) if it has a “substantial position” in swaps. Not surprisingly, the CFTC has designated different levels of value as being a “substantial position,” depending on the type of swap instrument. For interest rate swaps, the value is $3 billion or more in “daily aggregate uncollateralized outward exposure” (which, of course, is itself a defined term in the CFTC's regulations). You might look at that and say regardless of how the exposure is defined, you are way below $3 billion, so your company couldn't possibly be an MSP. But, your company is a leasing company, not a manufacturing company. Leasing companies are not singled out by name under Dodd-Frank or the CFTC regs, but they are potentially lumped together under “financial entities.” This is where the complicated reference-upon-reference starts (and you thought we had already gotten to that part!).

Under the statutes as amended by Dodd-Frank, and under the regulations issued by the CFTC, a “financial entity” is one that is predominantly engaged in activities that are in the business of banking or financial in nature, as defined in Section 4(k) of the Bank Holding Company Act (BHCA). You might consider your business to be financial in nature in a generic sense, but you probably never thought of yourself as in the banking business, or ever having to worry about anything the BHCA says.

The curious part of this reference to the BHCA, at least for leasing companies, is that leasing companies are not mentioned in Section 4(k) of the BHCA. That should be the end of the story, right? If you're not a financial entity, then you're not an MSP.

This, in fact, will be the end of this line of questioning for many of you, but not all of you. You see, one has to go to the other provisions of the BHCA, and the regulations of the Federal Reserve, to understand which leasing companies are picked up under 4(k) and which are not. This depends on the type of leasing business you do, whether you provide operating leases in addition to non-operating leases, and what is the anticipated percentage of residual value of the leased property at the end of the term. Thus, whether or not your leasing company is a financial entity for purposed of swaps and the CFTC depends (in part) upon the regulations and interpretations of the Federal Reserve that apply directly to bank holding companies, not you.

Therefore, Dodd-Frank, in its efforts to regulate the swaps business, which very likely is a commendable and desirable goal, has indirectly required businesses such as leasing companies to see where they fit under the BHCA and the regulations of the Federal Reserve that apply to bank holding companies, even though you may have never given thought to the BHCA in the past.

Now What?

What happens next? First, you ascertain whether your type of leasing activity is covered by Section 4(k) of the BHCA or not. If it is, you are a financial entity under the CFTC rules. If your business is not covered by 4(k), you are not a financial entity. If you are a financial entity, you then need to look at other definitions issued by the CFTC to see if you are “highly leveraged” (a likely result for most leasing companies), which then might make you an MSP, a Major Swap Participant. Of course, there are exclusions and exemptions in the definitions as well, for someone who would otherwise be an MSP but has an “uncollateralized exposure” under certain amounts. So, your company could be: 1) a financial entity, and an MSP; 2) a financial entity, but exempt from being deemed an MSP; or 3) defined as not a financial entity in the first place.

If you fall into the definition of MSP, that doesn't mean that you can't engage in swaps, or that no bank or dealer will deal with you. It just means that you, and your bank or broker, will have to follow additional procedures and report additional information to the CFTC. (One of the primary functions of the new regulatory scheme is for the CFTC to maintain a database of swap transactions, so that it can theoretically see when a particular participant is overextended, or when an industry might be overextended.) If you do not fall into the definition of an MSP, the requirements imposed on you will be less, but basically every business (or individual) that engages in swaps going forward will be affected by the new regulatory scheme.

Presumably, your bank has already asked you to complete a questionnaire to determine whether or not your company is an “eligible contract participant” among other things. (If you do not complete the questionnaire requested by your bank or broker, you will not be able to purchase any swaps.) This designation is mandatory, if you can't satisfy the definition of eligible contract participant, you won't be able to obtain a swap contract (or at least, the banks and dealers that are registered swap dealers are not supposed to engage in a swap transaction with a person who does not qualify as an eligible contract participant). Most leasing companies will satisfy the definition of eligible contract participant by having total assets over $5 million. (Curiously, if your business happens to be defined as an MSP, an MSP is automatically defined as an eligible contract participant.) Some very small leasing companies will be able to satisfy the definition by using an eligible guarantor, or by using the equity of their owners. There are numerous ways to meet the standards of being an eligible contract participant.

Eligible contract participants can engage in interest-rate swaps, whether or not they are defined as financial entities, and whether or not they are defined as MSPs. An entity that is defined as an MSP will have more reporting requirements going forward, as will the banks and dealers that engage in swaps with that MSP. The reporting requirements are still being phased in by the CFTC, which is making new rules and new interpretations, issuing exemptions for certain transactions or industries, or other adjustments and refinements, almost daily. Your company has probably already obtained a “legal entity identifier,” or “LEI,” or you will be asked for one by your bank or broker soon.

The LEI is nothing more than an identification number, like the IRS EIN, but in a new version that will be used by all entities internationally. Your bank or dealer already has an LEI, and is probably already using it on the forms it is sending you. In addition, all swaps transactions are required to have new documentation, which your bank or dealer may have already asked you to sign. Some banks are using a master form produced by the International Swap Dealers Association (ISDA), while many are using a customized version.

Conclusion

Swaps can be an important part of your business plan, depending on your specific situation and funding program. Whether or not to engage in swaps is primarily a financial decision based on factors specific to your business. Once you have decided to use swaps as a financial tool, you will be asked to complete a questionnaire and submit documents to support your status as an eligible contract participant, or possibly whether or not you are an MSP. When you get to that point, the questions and answers are difficult and depend on multiple regulations. While you may think you can simply check off the boxes on a form your bank sends you, it would be advisable to have an expert help you parse the convoluted definitions.'

Beth Stern Fleming is a shareholder at the law firm of Stevens & Lee, P.C., Chair of the Equipment Leasing Group and a member of this newsletter's Board of Editors. She practices in the areas of commercial transactions and financing, creditor's rights and restructuring.' She may be reached at [email protected] or 215-751-2886. Timothy
Demers is of counsel to the firm. He has practiced for over 30 years in the areas of bank regulatory and securities law.'

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You've been comfortably existing as a privately held commercial leasing company for years. You routinely cover your interest-rate exposure on your funding debt by entering into interest-rate swaps in modest amounts. You've been doing this for some time, no big deal. This year your bank or broker sends you a ton of documents and asks you to sign umpteen pages of gobbledy-gook, telling you that you might be a “highly leveraged financial entity,” which might make you a “major swap participant,” which requires your bank to follow certain procedures, and may require you to do certain things. To which you say, “what just happened?”

Why Now?

Perhaps purposely, or just fortuitously, your company has avoided any regulation by the federal banking agencies, as well as your state banking agencies, by being unaffiliated with a banking entity and by concentrating on commercial leases, engaging in no consumer business. You have enjoyed this autonomous and unregulated existence, content to concentrate on the difficult enough issues of making a profit in a tough and competitive environment. The interest-rate swaps you have had over the years cost significant money that could have been used elsewhere, but those swaps have also saved you interest rate expense, or at least provided you peace of mind that is priceless.

Why now, just when business activity is starting to pick up, and just when the interest rate on your loan is starting to creep up, is your bank inquiring if you are a financial entity that is highly leveraged? Can you just say “of course not” and get on with your business? As with so many things in today's world, the answer is not that simple. In this case, however, you (or more likely your advisers) have to plow through numerous federal statutes and regulations issued by agencies you have been thankful not to have to worry about in the past in order to be able to answer the question correctly. How did this happen?

Dodd-Frank

Most everyone knows that the Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law in July 2010 in response to the financial crisis. The publicly announced objectives and goals were to “fix” the financial system so that a similar crisis would not happen again. Most people agree that something needed to be done. But, most businesses assumed that the law only applies to the presumed “bad guys,” the banks and broker dealers that caused the crisis by their actions in the first place. Well, the Dodd-Frank Act is over 1,000 pages, and in turn amends dozens of other laws, and requires hundreds of pages of regulations and guidance to be issued by numerous federal agencies. The provisions of the Act and the regulations that have been adopted, and are still to be adopted, are likely to affect all businesses and all consumers in one way or another.

The CFTC

One of the major things that Dodd-Frank did was to amend the law in the United States to regulate futures contracts, which include interest-rate swaps. These kinds of financial instruments were largely unregulated prior to Dodd-Frank, and some experts believe that much of the crisis was attributable to this lack of regulation. Whether or not that allegation is true may be impossible to prove or disprove. Regardless, swap contracts of virtually all kinds are now regulated in the U.S. The regulator is one you might not expect: The Commodities and Futures Trading Commission (“CFTC”). Commodities contracts, such as those you might have heard about for corn, pork bellies, or gold, were always regulated to some extent by the CFTC. Financial instruments such as rate swaps or currency swaps were not. After Dodd-Frank, financial instruments were regulated, and the CFTC was designated as the regulator.

As required by Dodd-Frank, the CFTC has issued many new regulations, defining which business entities are “swap dealers,” “major swap participants,” and many other arcane definitions relating to those. (To demonstrate the extent of the complexity, the main definitional regulation of the CFTC has subsections that go all the way from “a” to “ssss,” although, to be fair, “nnn” to “www” and several other sections are reserved.) If you're still reading this, you may be wondering, “what has all this have to do with my leasing company?”

As you might expect, the main import of the Dodd-Frank provisions (at least as they relate to swaps) and the regulations of the CFTC primarily impose reporting and other requirements on the “dealers” in swap instruments, that is, the bank or broker-dealer from whom you've been buying interest rate swaps in the past. Now, however, those swap dealers have different reporting and other requirements if their customer (i.e., your company) comes under certain other definitions, such as that of a “major swap participant.” Thus, the definitions issued by the CFTC under the Commodities Exchange Act, as that act was amended by Dodd-Frank, now become directly applicable to your leasing company, even though your company is not a bank or dealer, and you do not consider yourself to be a “financial entity.”

Now It Gets Complicated

Here is where we finally get to the Rube Goldberg analogy. Any kind of a business (or individual) that enters into swap contracts (interest rates, currency, gold, whatever) can be a major swap participant (“MSP”) if it has a “substantial position” in swaps. Not surprisingly, the CFTC has designated different levels of value as being a “substantial position,” depending on the type of swap instrument. For interest rate swaps, the value is $3 billion or more in “daily aggregate uncollateralized outward exposure” (which, of course, is itself a defined term in the CFTC's regulations). You might look at that and say regardless of how the exposure is defined, you are way below $3 billion, so your company couldn't possibly be an MSP. But, your company is a leasing company, not a manufacturing company. Leasing companies are not singled out by name under Dodd-Frank or the CFTC regs, but they are potentially lumped together under “financial entities.” This is where the complicated reference-upon-reference starts (and you thought we had already gotten to that part!).

Under the statutes as amended by Dodd-Frank, and under the regulations issued by the CFTC, a “financial entity” is one that is predominantly engaged in activities that are in the business of banking or financial in nature, as defined in Section 4(k) of the Bank Holding Company Act (BHCA). You might consider your business to be financial in nature in a generic sense, but you probably never thought of yourself as in the banking business, or ever having to worry about anything the BHCA says.

The curious part of this reference to the BHCA, at least for leasing companies, is that leasing companies are not mentioned in Section 4(k) of the BHCA. That should be the end of the story, right? If you're not a financial entity, then you're not an MSP.

This, in fact, will be the end of this line of questioning for many of you, but not all of you. You see, one has to go to the other provisions of the BHCA, and the regulations of the Federal Reserve, to understand which leasing companies are picked up under 4(k) and which are not. This depends on the type of leasing business you do, whether you provide operating leases in addition to non-operating leases, and what is the anticipated percentage of residual value of the leased property at the end of the term. Thus, whether or not your leasing company is a financial entity for purposed of swaps and the CFTC depends (in part) upon the regulations and interpretations of the Federal Reserve that apply directly to bank holding companies, not you.

Therefore, Dodd-Frank, in its efforts to regulate the swaps business, which very likely is a commendable and desirable goal, has indirectly required businesses such as leasing companies to see where they fit under the BHCA and the regulations of the Federal Reserve that apply to bank holding companies, even though you may have never given thought to the BHCA in the past.

Now What?

What happens next? First, you ascertain whether your type of leasing activity is covered by Section 4(k) of the BHCA or not. If it is, you are a financial entity under the CFTC rules. If your business is not covered by 4(k), you are not a financial entity. If you are a financial entity, you then need to look at other definitions issued by the CFTC to see if you are “highly leveraged” (a likely result for most leasing companies), which then might make you an MSP, a Major Swap Participant. Of course, there are exclusions and exemptions in the definitions as well, for someone who would otherwise be an MSP but has an “uncollateralized exposure” under certain amounts. So, your company could be: 1) a financial entity, and an MSP; 2) a financial entity, but exempt from being deemed an MSP; or 3) defined as not a financial entity in the first place.

If you fall into the definition of MSP, that doesn't mean that you can't engage in swaps, or that no bank or dealer will deal with you. It just means that you, and your bank or broker, will have to follow additional procedures and report additional information to the CFTC. (One of the primary functions of the new regulatory scheme is for the CFTC to maintain a database of swap transactions, so that it can theoretically see when a particular participant is overextended, or when an industry might be overextended.) If you do not fall into the definition of an MSP, the requirements imposed on you will be less, but basically every business (or individual) that engages in swaps going forward will be affected by the new regulatory scheme.

Presumably, your bank has already asked you to complete a questionnaire to determine whether or not your company is an “eligible contract participant” among other things. (If you do not complete the questionnaire requested by your bank or broker, you will not be able to purchase any swaps.) This designation is mandatory, if you can't satisfy the definition of eligible contract participant, you won't be able to obtain a swap contract (or at least, the banks and dealers that are registered swap dealers are not supposed to engage in a swap transaction with a person who does not qualify as an eligible contract participant). Most leasing companies will satisfy the definition of eligible contract participant by having total assets over $5 million. (Curiously, if your business happens to be defined as an MSP, an MSP is automatically defined as an eligible contract participant.) Some very small leasing companies will be able to satisfy the definition by using an eligible guarantor, or by using the equity of their owners. There are numerous ways to meet the standards of being an eligible contract participant.

Eligible contract participants can engage in interest-rate swaps, whether or not they are defined as financial entities, and whether or not they are defined as MSPs. An entity that is defined as an MSP will have more reporting requirements going forward, as will the banks and dealers that engage in swaps with that MSP. The reporting requirements are still being phased in by the CFTC, which is making new rules and new interpretations, issuing exemptions for certain transactions or industries, or other adjustments and refinements, almost daily. Your company has probably already obtained a “legal entity identifier,” or “LEI,” or you will be asked for one by your bank or broker soon.

The LEI is nothing more than an identification number, like the IRS EIN, but in a new version that will be used by all entities internationally. Your bank or dealer already has an LEI, and is probably already using it on the forms it is sending you. In addition, all swaps transactions are required to have new documentation, which your bank or dealer may have already asked you to sign. Some banks are using a master form produced by the International Swap Dealers Association (ISDA), while many are using a customized version.

Conclusion

Swaps can be an important part of your business plan, depending on your specific situation and funding program. Whether or not to engage in swaps is primarily a financial decision based on factors specific to your business. Once you have decided to use swaps as a financial tool, you will be asked to complete a questionnaire and submit documents to support your status as an eligible contract participant, or possibly whether or not you are an MSP. When you get to that point, the questions and answers are difficult and depend on multiple regulations. While you may think you can simply check off the boxes on a form your bank sends you, it would be advisable to have an expert help you parse the convoluted definitions.'

Beth Stern Fleming is a shareholder at the law firm of Stevens & Lee, P.C., Chair of the Equipment Leasing Group and a member of this newsletter's Board of Editors. She practices in the areas of commercial transactions and financing, creditor's rights and restructuring.' She may be reached at [email protected] or 215-751-2886. Timothy
Demers is of counsel to the firm. He has practiced for over 30 years in the areas of bank regulatory and securities law.'

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