The CFTC Further Clarifies End-User Exception to theMandatory Clearing Requirement for Swaps
July 18, 2012
Section 2(h) of the Commodity Exchange Act (the “CEA”), as amended by the Dodd-Frank WallStreet Reform and Consumer Protection Act, grants the CFTC authority to require that certain
categories of swaps be subject to a mandatory clearing requirement. To the extent the CFTC
makes such a determination with respect to a category of swaps, the rule provides that it shallbe unlawful for any person to engage in such swaps unless that person submits such swaps forclearing to a derivatives clearing organization (“DCO”).1 However, the CEA also provides anexception from this mandatory clearing requirement if one of the counterparties to a swap: “(i)is not a financial entity; (ii) is using the swaps to hedge or mitigate commercial risk; AND (iii)
notifies the CFTC, in a manner set forth by the CFTC, how it generally meets its financial
obligations associated with entering into non-cleared swaps”.2 Such exception is commonlyreferred to as the “end-user exception” to mandatory clearing. 3
In its final rule entitled “End-User Exception to the Clearing Requirement for Swaps” (the“Final Rule”), released on July 11, 2012, the Commodity Futures Trading Commission (“CFTC”)
clarifies which entities are exempt from the clearing requirement by (i) further defining which
entities will be considered “financial entities” and exempting certain entities from suchdefinition; (ii) setting forth criteria for determining whether the swap is being used to hedge or
mitigate commercial risk; and (iii) specifying what information an entity needs to provide theCFTC, as well as the methods by which it can provide such information.

FIRST PRONG: “FINANCIAL ENTITY”
Under the CEA, a “financial entity” is defined as a (i) swap dealer, (ii) security-based swap
dealer, (iii) major swap participant, (iv) major security-based swap participant, (v) commodity
pool, (vi) private fund,4 (vii) employee benefit plan,5 or (viii) person predominantly engaged in
activities that are in the business of banking, or in activities that are financial in nature.6

12
3

456

7 U.S.C. 2(h)(1)(A).
7 U.S.C. 2(h)(7)(A).
It should be noted that the end-user exception applies on a swap-by-swap basis, and not on a counterparty-bycounterparty basis. Therefore an electing counterparty must perform the analysis for each swap it enters into to
determine its eligibility for the end-user exception with respect to such swap.
As defined in section 202(a) of the Investment Advisers Act of 1940 (15 U.S.C. 80-b-2(a)).
As defined in paragraphs (3) and (32) of section 3 of the Employee Retirement Income Security Act of 1974 (29U.S.C. 1002).
7 U.S.C. 2(h)(7)(C)(i). The term “financial in nature” is defined in section 4(k) of the Bank Holding Company Actof 1956.

Memorandum – July 18, 2012

The CEA also provides for certain entities that would otherwise meet the definition of “financialentity” to be excluded from the definition for purposes of the end-user exception. An affiliate ofa non-financial entity, that would otherwise be considered a financial entity, may nonethelessavail itself of the end-user exception if the affiliate is acting on behalf, and as an agent, of suchnon-financial affiliate and the swaps are being used to hedge the commercial risk of such person
or another non-financial entity affiliate of such person.7 Additionally, the “90 percent rule”,
excludes certain captive finance companies from the definition of “financial entity”. The 90
percent rule excludes from the definition of “financial entity” those entities whose primarybusiness is providing financing, and which use derivatives for the purpose of hedging
underlying commercial risks related to interest rate and foreign currency exposure, i) 90 percent
or more of which arise from financing that facilitates the purchase or lease of products, and ii)
90 percent or more of such products are manufactured by the parent company or anothersubsidiary of the parent company.8
In addition to carving out certain entities from the “financial entity” definition under the CEA,Section 2(h)(7)(C)(ii) of the CEA allows the CFTC to consider whether to exempt certain types offinancial entities from the definition of “financial entity” for purposes of the end-user exception
if such entity’s total assets do not exceed a $10 billion threshold. In the Final Rule, the CFTC
specifically exempts some smaller banking institutions from the definition of financial entity.
Section 39.6(d) of the Final Rule excludes certain financial institutions9 that have total assets on
the last day of the fiscal year of less than $10 billion. Such entities are excluded from thedefinition of “financial entity” for purposes of the end-user exception even if they otherwise
would have met that definition because they are predominately engaged in activities that are in
the business of banking, or in activities that are financial in nature.
The release for the Final Rule also includes interpretive guidance from the CFTC regarding
certain foreign entities that could be considered financial institutions, such as foreigngovernments, foreign central banks, and international financial institutions. In paragraph 4 ofSection I of the release, the CFTC indicated that foreign governments, foreign central banks andinternational financial institutions, given considerations of comity, are not subject to the clearing
requirement of 2(h)(1) of the CEA.

7897 U.S.C. 2(h)(7)(D)(i). It should be noted that the exception for affiliates is not available if such entity is i) a swapdealer; ii) a security-based swap dealer; iii) a major swap participant; iv) a major security-based swap
participant; (v) an issuer that would be an investment company, as defined in section 3 of the Investment
Company Act of 1940 (15 U.S.C. 80a-3), but for paragraph (1) or (7) of subsection (c) of that Act (15 U.S.C. 80a3(c)); (vi) a commodity pool; or (vii) a bank holding company with other $50 billion in consolidated assets (CEA2(h)(7)(D)(ii)).
7 U.S.C. 2(h)(7)(C)(iii).
In order to qualify for the exemption, the banking institution must be (1) organized as a bank or savings
association as defined by the Federal Deposit Insurance Act and have their deposits insured by the Federal
Deposit Insurance Corporation; (2) a farm credit system chartered under the Farm Credit Act of 1971; or (3) aninsured Federal credit union or State-charted credit union under the Federal Credit Union Act.

Page 2

Memorandum – July 18, 2012

SECOND PRONG: HEDGE OR MITIGATE COMMERCIAL RISKThe second prong of the end-user exception is that such person must be using the swap tohedge or mitigate commercial risk. In the Final Rule, the CFTC lays out certain criteria for
determining whether a swap hedges or mitigates commercial risk. These criteria are virtually
the same as the criteria used in the definition of “major swap participant”. First, the swap mustnot be used for a purpose that is in the nature of speculation, investing, or trading. Second, it is
not used to hedge or mitigate risk of another swap or security-based swap unless such
underlying position itself is used to hedge or mitigate commercial risk (pursuant to the samecriteria). Finally, such swap must meet any of the following three requirements: i) it is
economically appropriate to the reduction of risks in the conduct and management of acommercial enterprise, where such risks arise from a specifically enumerated list provided by
the CFTC10; ii) it qualifies as bona fide hedging for purposes of an exemption from position
limits under the CEA; or iii) it qualifies for hedging treatment under either the FinancialAccounting Standards Board Accounting Standards11 or the Governmental AccountingStandards Board.12

THIRD PRONG: REPORTING
The third prong of the end-user exception requires that one of the parties act as the “reportingcounterparty” and notify the CFTC of certain information regarding the non-cleared swap.13
The Final Rule states that the reporting counterparty shall be determined in accordance withSection 45.8 of the CEA, which lays out swap data recordkeeping and reporting rules. Since theelecting party for purposes of the end-user exception must not be a “financial entity” bydefinition, then pursuant to Section 45.8, as long as the other party to the swap is a swap dealer,major swap participant, or a financial entity, such other party will be the reporting party. If,
however, both parties are non-financial entities, then the parties themselves must choose whowill be the reporting party.
The Final Rule specifies that the reporting counterparty must report three types of information
to a registered swap data repository or, if no registered swap data repository is available toreceive the information, directly to the CFTC: (i) notice of the election of the exception; (ii)identity of the electing counterparty; and (iii) an enumerated list of information regarding the10111213(A) The potential change in value of assets that a person owns, produces, manufactures, processes, ormerchandises in the ordinary course of business; (B) the potential change in value of liabilities that a person has
incurred in the ordinary course of business; (C) the potential change in value of services that a person provides
or purchases in the ordinary course of business; (D) the potential change in value of the assets, services, inputs,products, or commodities that a person owns, produces, manufactures, processes, merchandises, lease, or sells in
the ordinary course of business; (E) any potential change in value related to any of the foregoing arising frominterest, currency, or foreign exchange rate movements associated with such assets, liabilities, services, inputs,products, or commodities; or (F) any fluctuation in interest, currency or foreign exchange rate exposures arisingfrom a person’s current or anticipated assets or liabilities.
Financial Accounting Standards Board Accounting Standards Codification Topic 815, Derivatives and Hedging(formerly known as Statement No. 133).
Governmental Accounting Standards Board Statement 53, Accounting and Financial Reporting for Derivative
Instruments.
7 U.S.C. 2(h)(7)(A)(iii).

Page 3

Memorandum – July 18, 2012

electing counterparty, which is laid out in the bulleted list below under the heading “RequiredInformation”. With respect to (iii), the CFTC recognized that providing all of the required
information for each individual swap could be overly burdensome. As such, the Final Rulegives parties the option of reporting such information annually in anticipation of electing theend-user exception for one or more swaps. While a party that takes advantage of this option
would still need to notify the CFTC each time it enters into a non-cleared swap, electing to file
the required information annually would obviate the need to submit any information, otherthan notice of the election and the identity of the electing party, to the CFTC.
REQUIRED INFORMATION
The following information regarding the electing counterparty must be provided either (i) by
the reporting counterparty on a swap-by-swap basis, or (ii) by the electing counterparty in anannual report, as discussed above:

whether the electing counterparty is a “financial entity”;
o If “yes”, whether such financial entity is:electing the affiliate exception or the 90% rule exception, ora small banking institution that meets the exception requirements set
forth in Section 39.6(d) of the Final Rule14;

whether the swaps for which the electing counterparty is electing the exception are used
to hedge or mitigate commercial risk (as provided in 39.6(c))15;



how the electing counterparty generally meets its financial obligations associated withentering into non-cleared swaps by indentifying one or more of the following:o a written credit support agreement,o pledged or segregated assets,o a written third-party guarantee,
o the electing counterparty’s available financial resources, oro some other means; and

whether the electing counterparty is an issuer of securities registered under section 12,
or is required to file reports under section 15(d) of , the Securities Exchange Act of 1934o If “yes”, the reporting party must:provide the electing counterparty’s SEC Central Index Key number, and

indicate whether an appropriate committee of that counterparty’s boardof directors (or equivalent body) has reviewed and approved the decision
to enter into uncleared swaps.
***

1415

See “Financial Entity” Section above.
See “Hedge or Mitigate Commercial Risk” Section above.

Page 4

Memorandum – July 18, 2012

For more information about any of the foregoing, please contact the following members of theFirm’s Derivatives Group: Joyce Xu (jxu@stblaw.com), Solomon Bashi (sbashi@stblaw.com), orJordan Taylor (jtaylor@stblaw.com).
This memorandum is for general information purposes and should not be regarded as legal advice. Pleasecontact your relationship partner if we can be of assistance regarding these important developments. The
names and office locations of all of our partners, as well as our recent memoranda, can be obtained fromour website, www.simpsonthacher.com.
The contents of this publication are for informational purposes only. Neither this publication nor the lawyers
who authored it are rendering legal or other professional advice or opinions on specific facts or matters,
nor does the distribution of this publication to any person constitute the establishment of an attorney-client relationship. Simpson
Thacher & Bartlett LLP assumes no liability in connection with the use of this publication.

Page 5

Memorandum – July 18, 2012

UNITED STATESNew York
425 Lexington Avenue
New York, NY 10017+1-212-455-2000

Houston2 Houston Center
909 Fannin Street
Houston, TX 77010+1-713-821-5650

Los Angeles
1999 Avenue of the Stars
Los Angeles, CA 90067+1-310-407-7500

Palo Alto
2550 Hanover Street
Palo Alto, CA 94304+1-650-251-5000

ASIABeijing3919 China World Tower
1 Jian Guo Men Wai Avenue
Beijing 100004
China+86-10-5965-2999

Hong Kong
ICBC Tower
3 Garden Road, Central
Hong Kong+852-2514-7600

Tokyo
Ark Mori Building
12-32, Akasaka 1-Chome
Minato-Ku, Tokyo 107-6037
Japan+81-3-5562-6200

SOUTH AMERICA

Washington, D.C.

São Paulo1155 F Street, N.W.
Washington, D.C. 20004+1-202-636-5500

Av. Presidente Juscelino Kubitschek, 1455
São Paulo, SP 04543-011
Brazil+55-11-3546-1000

EUROPELondon
CityPoint
One Ropemaker Street
London EC2Y 9HUEngland+44-(0)20-7275-6500

www.simpsonthacher.com