Few financial instruments have received more consistently bad press in recent years than swaps.

Famed for their illiquidity, lack of transparency and overall incomprehensibility, swaps received a huge amount of Congressional attention in the run-up to the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010. Since then, the Commodity Futures Trading Commission (the primary swaps regulator) has been hard at work, issuing scores of regulations, no-action letters and interpretations. That process is still ongoing.

A number of these new CFTC rules have the potential to trip up the unwary. A prominent example is a CFTC interpretation regarding the meaning of the term “eligible contract participant” (ECP).

Dodd-Frank requires that all parties to a swap be ECPs, unless the swap is entered into on a regulated futures market. The motivation behind the law is straightforward enough. Futures markets are designed to protect the interest of retail customers. Swaps markets, on the other hand, aren’t. So Dodd-Frank generally limits swaps to ECPs – persons and entities that are considered to have the necessary financial sophistication and sufficient assets or net worth to access and bear the risks of swaps.

The task of complying with the ECP requirement became more complicated in October of last year, when the CFTC issued an interpretation to the effect that not only must each party to a swap be an ECP, but also that each guarantor of a swap must be an ECP, too. The problem is that many existing and new swap guarantor entities won’t automatically qualify as ECPs.

The CFTC interpretation is important news for lenders that enter into swaps with their borrower customers. As a matter of course, these lenders often require guarantees from the borrower’s subsidiaries or affiliates as credit support. This interpretation could also be relevant to smaller banks (including community banks) that enter into swaps as end-users or “buy-side” swap counterparties, and which may have offered up their non-bank affiliates as swap guarantors.

There are a variety of alternative tests under which a person or entity could qualify as an ECP. Financial institutions and a variety of other regulated financial and investment entities will generally qualify. For other entities, the rule is that the entity must have total assets exceeding $10 million, or have its swap obligations guaranteed by an entity that has total assets of more than $10 million or by certain categories of qualifying ECPs. An entity may also qualify as an ECP if it has a net worth of more than $1 million and enters into a swap in connection with the operation of its own business or to manage the risk associated with an asset or liability connected to its business. The takeaway is that smaller entities may not automatically qualify as ECPs.

Ignoring the CFTC interpretation (which became effective March 31) isn’t advisable. Swap guaranties by non-ECP guarantors can’t be enforced, and lenders that have registered as swap dealers may be subject to regulatory sanctions.

Additional Steps Needed

There are varieties of approaches lenders can take to help ensure compliance with the CFTC interpretation.

One approach is simply to limit subsidiary or affiliate guarantees to those entities that pass the ECP tests. However, that approach may not provide a practical fix where a non-ECP entity has already delivered its swap guaranty.

Another approach, and one that should work for both existing and new guarantees, is to qualify an entity that would otherwise not be an ECP by using a guarantee, support or “keepwell” agreement. Under this approach, the parent borrower or other entity that qualifies as an ECP agrees to guarantee the non-ECP entity’s swap obligations or provide funding or other support to ensure that the non-ECP entity meets its swap obligations. The nice part of this approach is that it can qualify existing swap guarantors as ECPs, and so bring legacy credit arrangements into compliance with CFTC requirements.

The bottom line is that additional steps may be needed to ensure compliance with the new requirements. The good news is that there is a straightforward path to compliance, and that it is not expensive to implement.

Banks of all sizes are advised to consult with their legal advisors to ensure that guarantors in swap transactions meet the ECP criteria.n

Harry E. Ekblom Jr. is a partner in the Corporate Department at Sullivan & Worcester LLP, with offices in Boston, New York and Washington DC. His practice is concentrated in bank and institutional financings and derivatives transactions.