Dodd-Frank Compliance Overview


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WG Consulting held an early morning breakfast seminar at the Houston Junior League to discuss the Dodd-Frank Compliance landscape as it currently stands as is expected to shape out--and how that effects energy businesses of all sizes today.

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Dodd-Frank Compliance Overview

  1. 1. Thought Leadership Breakfast Seminar Dodd-Frank Compliance Overview
  2. 2. Table of Contents Objectives of the Act & Why Commodities? Definition of a Swap – REALLY? Nature of the Rules – A Prescription for Every Ailment Implications on the Market, Systems, Processes and Programs Page 2
  3. 3. Objectives of the Act & Why Commodities? President Obama signed the Dodd Frank Wall Street Reform and Consumer Protection Act into federal law on July 21, 2010 Objectives of Title VII: regulate the Over-the-Counter (“OTC”) swaps market • Transparency: • Registration • Mandatory Exchange Trading • Real Time Reporting • Excessive Speculation • Position Limits for Swaps • Systemic Risk Management • Mandatory Clearing • Capital and Margining Requirements • Participant Protections • Anti-Manipulation Prohibitions • Business Conduct Standards Why Commodities? • The Banking Crisis 2008/2009 (Bear Stearns, Lehman, AIG) • Derivatives • Price of Oil As of September 2013 Page 3
  4. 4. Rulemaking Process and Implementation Dodd Frank Act amended sections of the Commodity Exchange Act (“CEA”) • CEA • Law that governs the U.S. commodity futures … and now … swaps markets • Commodity Futures Trading Commission (“CFTC”) writes the regulations that implement the CEA and enforces the CEA and CFTC regulations • CFTC Regulations CFTC identified 38 areas where rule writing was necessary in accordance with Title VII of the Dodd-Frank Act • Proposed Rules: • CFTC drafts Proposed Rules and distributes them for public comment • Final Rule: • Each Final Rule consists of a: • Preamble, which describes the public comments received and the reasons for the CFTC’s final determination of the requirements • Cost – benefit analysis • An Effective Date and Compliance Date • Once the Final Rule is published in the Federal Register, the “countdown to compliance” begins As of September 2013 Page 4
  5. 5. Key Definitions Swap Dealer (SD) • Holds itself out as a dealer in swaps; Makes a market in swaps; Regularly enters into swaps with counterparties as an ordinary course of business for its own account; Engages in activities causing itself to be commonly known in the trade as a dealer or market maker in swaps • De-minimis threshold for dealing: $8 billion aggregate gross notional swaps over the preceding 12 months, decreasing to $3 billion in about 2.5 years; $25 million gross notional over the preceding 12 months for swaps with “Special Entities”; $800 million with Utility Special Entities Major Swap Participant (MSP) • Swaps positions are “substantial” and could have serious adverse effects on the financial stability of the United States banking system Non-Swap Dealer / Major Swap Participant (Non-SD/MSP) • Any entity that does not meet the definition of a SD or MSP. Non-SD/MSPs are not required to be registered with the CFTC, but they do have obligations under the CFTC Final Rules. Non-SD/MSPs are often referred to as End Users As of September 2013 Page 5
  6. 6. Key Definitions Swap Execution Facility (SEF) • An entity that serves as a facility, trading system, or platform in which multiple participants have the ability to execute or trade swaps Swap Data Repository (SDR) • An entity that collects and maintains swap data information and records of executed swap transactions and reports this swap transactional data to the public in real time. There are currently 3 provisionally approved SDRs: ICE Trade Vault; CME Repository Service; DTCC Data Repository U.S. Person • The CFTC definition of “U.S. person” includes: • A natural person who is a U.S. resident. • A corporation, partnership, LLC, trust, association, joint-stock company, fund or other similar enterprise that 1) is incorporated in the U.S. or 2) has its principal place of business in the U.S. • Foreign branches of U.S. banks. • Non-U.S. affiliates or subsidiaries: if majority-owned by a U.S. person and U.S. person bears the risk of unlimited liability for the obligations of the affiliate or subsidiary. • Any entity not covered by this definition is considered a “non-U.S. person” for the purposes of this CFTC Final Order. As of September 2013 Page 6
  7. 7. Definition of a Swap – Really? Swap Generally: • Commodity swaps and commodity options , whether or not physically settled, are regulated under the CFTC Final Rules, subject to certain Exclusions and Exemptions • Exclusions exist for any sale of a nonfinancial commodity for deferred shipment or delivery, so long as the transaction is intended to be physically delivered (the Forward Contract Exclusion) • Commodity Options are subject to the Trade Option Exception: Trade Options are still deemed a swap, but are exempt from some of the DF swap regulations • In order to determine whether a transaction is a swap, excluded from the definition of a swap, or exempt from some of the rules regulating swaps, the CFTC will examine the facts and circumstances of each transaction As of September 2013 Page 7
  8. 8. Definition of a Swap – Really? Specifically: • All financially-settled contracts (except futures and options on futures, insurance; customer business arrangements such as a purchase, sale, lease or transfer of real property) • Physically-settled contracts that do not meet the Forward Contract Exclusion • Forward Contract Exclusion requires: • The contract pertains to a non-financial commodities (i.e. commodities that can be physically delivered, such as metals); • For deferred shipment or delivery; and • Parties intend to physically deliver Forward contracts that do not actually go to physical delivery (i.e. book outs, offsets) may still qualify for the Forward Contract Exclusion provided that the contracts are transacted between “commercial” entities entering into the transaction for commercial purposes with the capability and intent of taking/making physical delivery. Designed to exempt transactions from the definition of a swap where the intent is to transfer ownership of the commodity and not just its price risk. As of September 2013 Page 8
  9. 9. Definition of a Swap – Really? • Commodity Options, whether physically or financially-settled • Trade Options Exception: • Offeror is an ECP or commercial/merchandiser entering into transaction solely for purposes related to its business; • Offeror has a reasonable basis to believe offeree is a commercial/merchandiser entering into the transaction solely for purposes related to its business; • Option must be intended to be physically-settled, so that if exercised, a sale of a physical commodity would result for immediate or deferred delivery • Commodity Options Embedded in Forward Contracts: excluded if the embedded option: • May be used to adjust the forward price, but does not undermine the overall nature of the contracts as a forward contract; • Does not target the delivery term, so the predominant feature of the contract is actual delivery, and • Cannot be severed and marketed separately from the overall forward contract in which it is embedded • Forward Contracts with Embedded Volumetric Optionality: excluded if passes a seven part test: #7: the exercise or non-exercise of the embedded volumetric optionality is based primarily on physical factors, or regulatory requirements, that are outside the control of the parties … If exercised for discretionary reasons (i.e. price), an option and therefore a swap. • Usage Contracts: excluded if satisfies 5 conditions, including a two-part fee covering fixed and variable costs, as well as the right to use the facility is legally established upon contract execution. As of September 2013 Page 9
  10. 10. Nature of CFTC Regulations Implementing DF • • • • • • • • • • Highly Prescriptive Definitional Uncertainty Compliance Delays – No Action Relief Still Pending Subject to Legal Challenges Good Practices (in some cases) Documentation – Policies & Procedures Monitoring to ensure compliance Expensive to Implement CFTC sympathetic to “end users” • Commissioner Chilton’s April 3, 2013 “End User Bill of Rights” • #1: Right to reasonable Dodd-Frank implementation: “I will not approve an action against end-users seeking to comply with CFTC Dodd-Frank rules in good faith, provided they act in ways consistent with a good faith intention to comply, until after October 31, 2013.” • #2 Right to legal certainty: “…The Commission should strive to provide the market relief or clarity well in advance of a compliance date – last minute relief and clarification should be avoided…I will not support an action against an end user, exchange or anyone else on an issue deserving clarity that is the subject of an outstanding request for interpretive guidance.” As of September 2013 Page 10
  11. 11. General Requirements: SDR Reporting Basic Reporting Requirements • Elements of each swap transaction, whether cleared or uncleared, are required to be: • Made available to the public in real time (ASATP) • Reported to a SDR (historical and current swaps) Purposes • Improve price discovery and transparency and promote fairness and efficiency in the swaps market • Ensure swap data is current and readily available to Regulators to carry out their market monitoring and enforcement duties What is to be reported: • Swap Creation Data: • Primary Economic Terms (“PET”) • Confirmation Data • Swap Continuation Data: • Life Cycle Event Data • Valuation Data • Corrections of Errors and Omissions Who is to Report (for “off-facility”, non-cleared swaps) • SD -> MSP -> Non-SD/MSP Financial Entity ->Non-SD/MSP Non-Financial Entity • Non-SD/MSP U.S. Person executed with a Non-U.S. Person: Non-SD/MSP U.S. Person • Non-U.S. Persons: executed on a SEF/DCM/U.S. market or cleared on a DCO: agree As of September 2013 Page 11
  12. 12. General Requirements: Swap Data Recordkeeping Non-SD/MSPs: • Records: Keep full, complete, and systematic records, including all pertinent data and memoranda, relating to each swap to which the Non-SD/MSP is a counterparty • Retention Period: Life of the swap, plus 5 years • Form: Retain records in either electronic or paper form • Readily Retrievable: retrievable within 5 business days SDs/MSPs: • Records: Keep full, complete, and systematic records, including all pertinent data and memoranda, of all activities related to its swaps business relating to to which the Non-SD/MSP is a counterparty • Retention Period: Life of the swap, plus 5 years • Form: Retain records in either electronic or paper form • Readily Retrievable: readily accessible via real time electronic access throughout life of swap plus 2 years and retrievable within 3 business days for the remainder As of September 2013 Page 12
  13. 13. General Requirements: Internal Business Conduct Standards (IBC) IBC constitutes specified duties and internal controls that SDs and MSPs are required to implement to effectively monitor and manage the risks they incur through their Swaps Activities (a SD/MSP’s activities related to swaps and any product used to hedge such swaps), including: • • • • • • • • • • Reporting, Recordkeeping, and Daily Trade Records Risk Management Program Monitoring of Position Limits Diligent Supervision Business Continuity and Disaster Recovery General Information: Availability for Disclosures and Inspection Anti-trust Considerations Conflicts of Interest Policies and Procedures – Research Conflicts of Interest Policies and Procedures – BTU and Clearing Unit Designation of a Chief Compliance Officer As of September 2013 Page 13
  14. 14. General Requirements: External Business Conduct Standards (EBC) EBC defines the pre-trade, time of execution and post trade duties a SD/MSP has to its counterparties as part of its commodity Swaps Activities. The purpose of these duties is to ensure the counterparties are treated fairly and are adequately informed and protected. Duties and actions include: • Advisory activities incidental to SD/MSP business • Written Compliance Policies and Procedures and Monitoring to ensure compliance • Dealing with Counterparties – Generally • Pre-Trade Duties; Time of Execution and Post Trade Actions; Record Retention • Prohibition on Fraud, Manipulation and Other Abusive Practices • Communications – Fair Dealing • Recommendations to Counterparties – Institutional Suitability • Rules or Dealing with Special Entities • Acting as an Advisor to a Special Entity • Acting as a Counterparty to a Special Entity • Political Contributions As of September 2013 Page 14
  15. 15. General Requirements: Position Limits Federal Position Limits On Sept. 28, 2012, the CFTC Final Position Limit rule, in which commodity swaps were subject to speculative position limits in order to limit “excessive speculation” in commodity contracts, was vacated by a U.S. District Court. The CFTC has decided to appeal the decision, and may be working towards revising its earlier Final Rule to address the necessity of the Rule and the costbenefit of it. Exchange Position Limits: CME NYMEX/COMEX and ICE Futures US rules require owners of futures contracts to comply with the speculative limits these DCMs apply to the commodity futures contracts that they offer in their markets. As of September 2013 Page 15
  16. 16. General Requirements: Mandatory Clearing • Section 723(a)(3) of the Dodd-Frank Act amends the Commodity Exchange Act (CEA) by adding Section 2(h)(1), which makes it unlawful for any person to engage in a swap that is required to be cleared unless that person submits the swap for clearing to a DCO. • Section 723(a)(3) also added Section 2(h)(2) to the CEA. This section requires the Commission to determine whether a swap is required to be cleared pursuant to either a Commission initiated review or pursuant to a submission from a derivatives clearing organization (DCO) for the review of a swap, or group, category, type, or class of swap. • Section 723(a)(8) of the Dodd-Frank Act amends the CEA by adding Section 2(h)(8), which requires that the execution of all clearable swaps occur on Designated Contract Markets (DCMs) or Swap Execution Facilities (SEFs), except where no DCM or SEF makes the swap available for trading. • Non-SD/MSPs and other non-financial entities may elect the End-user Exception to the clearing requirement if the swaps are eligible for the End-User Exception to Clearing. • As of the date of this presentation, the Commission has not set an implementation schedule for the mandatory clearing of commodity swaps. As of September 2013 Page 16
  17. 17. General Requirements: End User Exception To Clearing Clearing requirements shall not apply to a swap if one of the counterparties to the swap applies for the End-User Exception to Clearing and meets the following characteristics: • Is not a Financial Entity • Is using swaps to hedge or mitigate commercial risk • Notifies the Commission, in a manner set forth by the Commission, how it generally meets its financial obligations associated with entering into non-cleared swaps • If the counterparty is an SEC filer, the counterparty must have the board of the SEC filer or a committee thereof approve its decision to enter into uncleared swaps pursuant to the End User Exception. A party’s ability to elect the End User Exception for a particular swap is a function of the purpose of the particular swap in question and is not limited to physical position hedging. The use by non-financial entities of the end-user exception for financial risk-hedging must be an incidental part (i.e. not central to) of the Electing Counterparty’s business. The determination of whether the risk being hedged or mitigated is “commercial” will be based on the underlying activity to which the risk relates, not on the type of entity claiming the End User Exception. As of September 2013 Page 17
  18. 18. General Requirements: Margin The CFTC has proposed regulations requiring that all SD/MSPs collect appropriate margin from their Swap Counterparties. Though the rule is not yet finalized, the proposed regulations offer margin calculation methodologies and uncollateralized exposure limitations. SD/MSPs will not be required to collect margin from non-SD/MSP counterparties unless uncollateralized exposure exceeds certain thresholds set by the SD/MSP. It is very likely that collateral documentation is going to be required for all swaps even if no collateral is expected to be transferred. Non-SD/MSPs that are not currently required to post collateral will be required to put credit support arrangements in place with their swap counterparties. It is recommended that Non-SD/MSPs negotiate this documentation with their SD/MSP counterparties carefully to ensure that appropriate thresholds for posting collateral are properly documented. As of September 2013 Page 18
  19. 19. General Requirements: Prohibition on Fraud and Price Manipulation In order to help promote integrity of the commodity markets and to protect market participants, the CFTC’s Anti-Manipulation Final Rule broadly prohibits fraud and non-fraud based manipulation in connection with any swap, contract of sale of any commodity in interstate commerce, or contract for future delivery on or subject to the rules of any registered entity (i.e. Designated Contract Market or Swap Execution Facility). Fraud–based manipulation makes it unlawful to intentionally or with reckless disregard make false or misleading statements or be manipulative, fraudulent or deceptive, regardless of whether the conduct in question was intended to create or did create an artificial price. Proof of knowledge, therefore, is not required. The CFTC defines fraudulent conduct as conduct that impairs, obstructs or defeats a wellfunctioning market. “Reckless” is defined by the CFTC as an act or omission that “departs so far from the standards of ordinary care that it is very difficult to believe the actor was not aware of what he or she was doing.” In contrast, non-fraud based manipulation requires specific intent, and the CFTC will be guided by the traditional four part test for determining manipulation: 1. The accused had the ability to influence market prices; 2. The accused specifically intended to create or effect a price or price trend that does not reflect legitimate forces of supply and demand; 3. Artificial prices existed; and 4. The accused caused the artificial prices. Penalties for manipulation or attempted manipulation include a civil penalty of up to the greater of $1,000,000 or triple damages. Criminal prosecution is also a potential result of a violation of the manipulation prohibition. As of September 2013 Page 19
  20. 20. Implications on the Market, Systems, Processes and Programs • Wider bid – offers • Fewer market makers in certain markets • Expanded hedging counterparties beyond traditional banks • Movement to block trades • Revised Counterparty documentation • Clearing and collateral arrangements • Cost of clearing vs. exempt from clearing and cost to report • System automation • Changes to operational and business processes to support swap protocols • Automated monitoring to ensure compliance • Documented Policies and Procedures • Chief Compliance Officer rules As of September 2013 Page 20
  21. 21. Regulatory Compliance Practice Within Regulatory Compliance, WG SMEs apply our: • Understanding of the: • Mechanics of the underlying commercial trading and marketing activities • Letter and intent of those external laws, rules and regulations that govern these activities (“Applicable Rules”) • Knowledge of the information systems and processes that are required to support a Regulatory Risk Management Compliance Program (“Program”) • Experience in developing and implementing this systematic approach to Compliance to help our clients establish and maintain a Program that effectively mitigates the risk of violations, while evidencing the organization’s commitment to a culture of compliance. As of September 2013 Page 21
  22. 22. Financial Advisory Services Financial Advisory CFO Services Financial & Operational Reporting Transaction Advisory Business Process & Controls Process Improvement Internal Controls • SEC & IFRS Reporting • M&A Services (buy/sell side) • Sarbanes-Oxley Compliance • Private Equity Services • External Audit Preparation • Business Transformation • Project Management • Turnaround Management • Regulatory Reporting • Capital Transaction Services (equity & debt raises) • Technical Research • Transaction Due Diligence • Procure-to-Pay Process • Controls Needs Assessment & Program Development • Lender & Private Equity Services • Financial Reporting Process • Budgeting & Forecasting • Interim or Outsourced Corporate Development • Supply Chain / Inventory Management • Management Reporting & Dashboards • Valuation & Dispute Resolution • Demand Planning & Forecasting • Oil & Gas Reporting • Restructuring Services • Control Design & Integration • Interim CFO • IPO Services • Merger Integration • Interim Controller / CAO • Treasury Management • Strategic Planning & Analysis • Federal & State Tax • Quote-to-Cash Process • Controls Risk Assessment • IT Controls • Interim Personnel • Controls Testing • Fraud Investigations & Forensics • FCPA • Change Management As of September 2013 Page 22
  23. 23. Risk, Systems & Compliance Services Regulatory Compliance & Dodd Frank Solutions Trading and Risk Management • • • • ETRM System Selection & Implementation • Strategy & Operations for Front, Middle & Back Office • Supply, Trading & Risk Management • • Interim CRO • • • As of September 2013 Enterprise Performance Management (EPM) Business Intelligence (BI) All aspects of DF CFTC Final Rules Implementation • Data Discovery • Visualization Design Policies, Procedures, Manual Drafting • Dashboard Design and Implementation • Analytical Application Design & Development Training Compliance Program Reviews and Testing Trade Monitoring Service Regulatory Reporting and Recordkeeping Compliance Function Outsourcing/ Interim CCO • • Project Management • Application functionality enhancement and end user training • Self-Discovery & Analytics Training • Workflow Control • Areas of Expertise: TIBCO Spotfire, Oracle BIEE, SAP BusinessObjects • Reporting Strategy, Process Review and Optimization Enterprise Architecture Strategy and Roadmap • Interim and Outsourced Managed Services • Application Upgrades and Assessments Enterprise Resource Planning (ERP) • System Selection • Implementation • Upgrades • Functional Enhancements • • • • Application Integration Areas of Expertise: J.D. Edwards, Oracle eBusiness Suite, PeopleSoft, SAP, OGSYS Managed Services Treasury Services • • Improvement and Automation of Treasury and Finance Processes Asset Based Lending Facilities (ABL) Set-up, Automation and Maintenance Treasury and Cash Management Functions • System Support • Process Design • Report Management • Quality Assurance • System Assessment • Middle Tier Administration • Database Support • System Forensics/Root Cause Analysis • Middle and Back Office processing Financial Analysis Page 23
  24. 24. Regulatory Compliance Risk Mgmt. Services Dodd Frank & CFTC Final Rules Trade Monitoring Service All aspects of CFTC Final Rules implementing Dodd Frank, including: • Reporting requirements under Parts 43, 45, and 46 and LTR Part 20 • Business Conduct Standards (Internal and External) • Confirmations, Portfolio Reconciliation, Portfolio Compression, and Swap Documentation Standards • Whistleblower Provisions • End User Exception to Clearing • Commodity Options • Chief Compliance Officer duties • Prohibition on Manipulation • SD Registration and de-minimis calculations • WG SMEs review our client’s trading activity against a variety of Scenarios to identify potential areas of exposure for further investigation Services include: • Explaining the requirements and validating the specifications • Training applicable personnel on the Rules and the resulting Policies, Procedures and Manuals • Providing IT and business process support, including coding, mapping and source system modifications • Performing gap analyses, measuring current practices against the requirements, and recommending solutions for closing those gaps • Drafting Policies, Procedures and Manuals tailored to the client’s commercial profile and internal controls • Proposing monitoring activities to ensure compliance and prevent evasion of the CEA and CFTC regulations. • Reviews and testing As of September 2013 • WG SMEs have designed the Scenarios and coded the logic within its monitoring tools, and use these tools to analyze the client’s trades and trading patterns • These Scenarios incorporate the factors that underlie many of the violations described in enforcement actions and experienced by WG SMEs during our industry practice • The basis of the approach is identifying trading anomalies based on patterns of behavior, activities and market movements , and applying the knowledge and experience of WG SMEs to highlight targeted high risk activities for mitigation • It is a robust, secure and cost effective approach that supports our client’s efforts to take reasonable steps to prevent and detect non-compliant activity, thus effectively mitigating the risk of violations while satisfying Regulatory expectations Page 24
  25. 25. Let’s Stay in Touch Tim McKone David Stephan Dan Masch David McIlrath Managing Director, Risk, Systems & Compliance C: 713.359.6483 Director, Regulatory Compliance C: 713.962.5586 Managing Director, Trading and Risk Management C: 713.517.1807 Director, Regulatory Compliance C: 832.863.6659 James Yu Managing Director, Trading & Risk Management C: 832.603.1572 WG Consulting, LLC @thewgcpromise WG Consulting WG Consulting 1415 Louisiana, Suite 3450 Houston, TX 77002 Page 25