10-012

COMMENT

CL-00005

From:

Sent:

To:

Cc:

Subject:

Attach:

RICHARD MILLER <richard.a.miller@prudential.com>

Friday, September 17, 2010 3:15 PM

secretary <secretary@CFTC.gov>

Gary Neubeck <gary.neubeck@prudential.com>; Ann Kappler

<ann.kappler@prudential.com>; John Bronson <j ohn.bronson@prudential.com>;

marchanille.folley@prudential.com

Comment Letter with respect to the ANPRM re Definitions

Comment Letter to CFTC re ANPRM.PDF

Dear Mr. Stawick: Please find enclosed our Comment Letter respecting the

ANPRM respecting Dodd-Frank definitions.

Richard A. Miller, Esq.

The Prudential Insurance Company of America

2 Gateway Center (5th Floor)

Newark, NJ 07102

Tel: 973-802-5901

Richard.miller@prudential.corn

(See attached file: Comment Letter to CFTC re ANPRM.PDF)
Vice P~esident and Corporate Counsel

Financial Management Law

Two Gateway Center, 5th Floor, Newark NJ 07102

Tel 973 802-5901 973 367-5135

richard,a.miller@prodentiallcom

September 17, 2010

Mr. David Stawick

Secretary

Commodity Futures Trading Commission

Tbxee Lafayette Centre

1155 21 st Street, NW

Washington, DC 20581

Re: Definitions Contained in Title V[I of Dodd~Frank WM~ Street Reform and

Consumer Protection Act, 75 Fed. Reg. 511429 (Auto

Dear Mr. Stawick:

I am pleased to share the comments of Prudential Financial tnc. (

with the Commodity Futures Trading Commission (the "CFTC")on the particular issue

of the interpretation of the definition of"swap’~ .with respect to internal transactions under

Title VII of the Dodd-Frar~ Wall Street Reform and Consumer Protection Act (P.L. No.

111-203) ("Dodd-Frank’,). Our comment letter specifically addresses the treatmer~t of

internal transactions between wholly-owned financial subsidiaries of a parent company,

under Dodd-Frank. We are concerned that Dodd-Frank could require the clearing and

execution of interna! swap transactions between wholly-owned financial subsidiaries of a

parent company. We recommend that these interna! trar~sactions not be treated as "swap

transactions" for the purposes of applying the execution and clearing requirements under

regulations to be promulgated by the CFTC, as required by Dodd-Frankol

Dodd’Frank requires the CFTC to: (i) define the universe of swaps that

wii1 be regulated as s ps ; (ii) impose clearing and execution requirements on certair~ ~ wa ~

parties that enter into %wap~’ transactions; (iii) impose recordkeeping and reporting

requirements for parties that enter into "swap" transactions; (iv) set capital and margin

requirements on certain parties that enter into "swap" transactions; (v) impose business

conduct standards for certain parties that enter into "swap" transactions; and (vii)create

position limits, including aggregate position limits across futures and swap markets, for

market participants that enter ir~to "swap" transactions.
Mr. David Stawick -2-

Many business enterprises, including PFI, elect to operate in a manner that

assigns specific functions to related and commonly-controlled affiliates. With regard to

swap transactions, it has long been our practice, as an enterprise-type company with

separate legal entities that are commonly owned by PFI to use one affiliate, Prudential

Global Funding LLC ("PGF’), to directly face the market as a ’"conduit" to hedge the net

commercial and financial risk of the various operating affiliates within PFL Under thi s

practice, only PGF (i.eo, the conduit) is required to trade with external market

participants, while the internal affiliates within PFI trade directty with the PGF. The use

of PGF as the single conduit for the various affiliates within PFI diminishes the demands

on PFI’s financial liquidity~ operational assets and management resources, as affiliates

within PFI avoid having to establish independent relationships and unique infrastructure

to face the market. Moreover, use of PGF as a conduit within PFI permits the netting of

our affiliates’ trades (e.g., one affiliate is hedging floating rates while another is hedging

fixed rates). This effectively reduces the overall risk of PFI and our affiliates, and allows

us to manage fewer outstanding positions with external market participants.

Under Dodd-Frank, al! swap transactions must now be cleared through a

derivatives clearing organization ("DCO") and executed on an exchange or swap

execution facility ("SEF"), unless the swap is not required to be cleared or one of the

counterparties to the swap (I) is not a financial entity~, (2) is using swaps to hedge or

mitigate commercial risk, and (3) notifies the CFTC as to how it generally meets its

financial obligations associated with entering into uncieared swaps. For the purposes of

the clearing exemption under Section 723 of Dodd-Frank, a financial entity is defined to

include, among other entities, "a person predominantIy engaged ir~ activities that are in

the business of banking, or in activities that are financial in nature, as defined in section

4(k) of the Bank Holding Company Act of 1956." Pursuant to regulations promulgated

by the Board of Governors of the Federal Reserve System under section 4(k), such

financial activities include engaging as a principal in certain swap activities, including

interest rate swaps and foreign exchange transactions.2 Therefore, conduits that are

solety (and therefore ~’predominantly") engaged in just facilitating their affiliates’ swaps,

including PGF, will become by virtue of the operation of sub-paragraph (VIII) ~’financial

entities" for purposes of the determination of which counterparties are eligible for the

clearing exemption, pursuant to Section 723 of Dodd-Franko

When a conduit financial entity faces an affiliate that is itself a financial

entity (e.g., in the case of PFI, an insurance company), the clearing exemption becomes

inapplicable and the internal transaction would now have to clear tbxough aDCO and be

centrally executed. Obviously, this unintended consequence of Dodd-Frank~ if left un2 12 C.F.R. §§ 225.28(8)(ii)(C)
Mr. David Stawick -3-

remediated, wi!l defeat the legitimate purpose of having a conduit structure, because it

will make no sense to margin and clear the same trade twice: once between the conduit

and its affiliate and again between the conduit and its street-side counterparty. As a result,

conduits, including PGF, will be rendered incapable of providing their enterprise-wide

risk management and control. Consequently, absent a conduit structure, PFIs’ operating

financial affiliates will be forced t~ go directly to the market to hedge their risks,

requiring reallocations of capital and/or expertise in order to directly enter into swap

transactions with third parties.

]importantly, our concern in this regard was shared by one of the principal

architects of Dodd-Frar~k, Senate Agriculture Committee Chairman Blanche Lincoln,

who also believes that such an outcome is not an intended consequence of Dodd-Frank.

She noted in a floor colloquy during consideration of Dodd-Frank, ~it would appropriate

for regulators to exempt from mandatory clearing and trading inter affiliate swap

transactions which are between wholly owned affiliates of a financial entity." 3 Senator

Susan Collins also noted, in a colloquy with the Senate Bar, king Committee Chairman

that it was not CongressionaI intent to "capture as swap dealers end users that primarily

enter into swaps to manage their business risks, including risks among affiliates.’’4

Senate Banking Committee Chairman Chris Dodd agreed with Senator Collins that swap

transactions with an affiliate should not be considered in determining an entity’s status as

a swap dealer, further clarifying that internal transactions between end users and affiiiates

should not determine whether an entity wouId be deemed a swap deaier as a resutt of

such transactions,s

The staff of the CFTC has previousIy acknowledged and accommodated

transactions between affiliates that are f~,anctionally outside the intended scope of its

regulatory domain. Thus, for example, in response to a request for an interpretation of

CFTC regulations, the CFTC staff noted that commonly-owned and controlled entities

were considered to be a single entity or the "same person" for pu~oses of compliance

with CFTC regulations, including Regulation 1.3(z) and Regulation 150.2 ("CFTC

Interpretive Letter").6 Under the CFTC Interpretive Letter, the CFTC Staff agreed that

where a physical commodity transaction and the related hedging futures trading were

3 156 Cong. Rec. $5921, July 15, 2010.

4

156 Cortg, Rec. $5907, July 15, 2010.

5

6 CFTC Letter interpretation, Re: Request for Confirmation of

Interpretations Regarding ~’Bona Fide Hedging" and "Exchanges of Futures for Product"

(available May 9, 1994),
Mr. David Stawick -4-

conducted by separate but commonly-owned corporations or other legal entities, "the

mere existence of the above structures should not disqualify" such transactions from bona

fide hedging transactions. In other words, the physical transaction and the hedging

transaction would be viewed as one and the separation between the commonly-owned

legal entities is disregarded. This conclusion is consistent with the CFTC requirement

that there must be a bona fide trade, which would not occur here because there is no

change in ultimate beneficial ownership. We believe that the CFTC should continue to

limit the regulatory requirements it imposes on interna! transactions between affiliates of

a parent company, as we do not believe that the statute would require such an

interpretation. In order to do so, the CFTC should clarify that internal swap transactions

between whoIly-owned subsidiaries of a parent company are not subject to the clearing

and execution requirements under any rulemakings promulgated by the CFTC, as

required under Dodd-Frank.

We believe that the CFTC has the authority to provide such clarity to all

market participants. Section 723 of Dodd-Frank requires the CFTC to create an approval

process for swaps that are required to be cleared through a DCO. Section 723 also

mandates that all swaps that are required to be cleared must be executed on a designated

contract market and/or a SEF. Under these rulemakings, the CFTC should clarify that

internal swap transactior~s between wholly-owned affiliates and subsidiaries are not

required to be cleared by DCOs and that such transactions are not subject to the execution

requirement. Through this process, the CFTC can avoid imposing unnecessary regulatory

burdens on market participants, while ensuring that a!! swap transactions between an

internal conduit and external counterparties will be subject to the regulatory requirements

of Dodd-Frank, as necessary.

We appreciate the opportunity to provide our comments to the CFTC on

this issue and would welcome the opportunity to discuss any questions the CFTC may

have with respect to our comments. Any questions about this letter may be directed to

me at (973) 802-5901.

Sincerely, ..,,

Richard A. Miller

Vice President and Corporate Co~sel

Enclosure: CFTC Interpretive Letter
!994 CFTC Ltr. LEXIS 42, *

Page 1

Philip McBride Johnson, Esq.

Skadden, Arps, Slate, Meagher & Flom

1440 New York Avenue, N.W,

Washington, D.C. 20005-2111

Re: Request for Confirmation of Interpretations Regarding "Bona Fide Hedging" and "Exchanges of Futures for

Product"

Dear Mr. Johnson:

This is in response to your letter dated March 23, 1994, in which you requested confirmation from the Division of

Trading and Markets ("Division") regarding certain views expressed therein. Based upon the representations made in

the letter, we understand the facts to be as follows.

You have received inquiries from clients regarding what constitutes "bona fide hedging" and what qualifies as a

permissible "exchange of futures for physicals or product" (,’EFPs") where the physica! commodity transactions and the

related futures trading are under common control although they may be conducted by- separate but commonly owned

[’2] corporations or other legal entities. These inquiries have related to situations where separation of physicals trans,

actions ~om other functions such as futures activity is viewed as desirable, such as where an entity seeks to isolate en,

vironmenta! risks in a particular affiliate.

With respect to bona fide hedging, you note that the examples in Commission Regulation 1.3(z) each posit that the

physical and futures activity are engaged in by "the same person." In this context an issue may arise whether a hedge is

bona fide should an ultimate parent organization choose as a matter of routine practice to own and market physical

commodities directly or through an affiliate which k owns and controls and to trade futures to hedge the physicals activity through another affiliate it owns and controls. For this purpose, you have defined ownership as fo!lows:

100% ownership [which] may be diluted minimally due to employee stock ownership p]ans or other rea,

sons, but.., in all cases nearly complete ownership and effective control of the affiliates exist.

You also state that we should assume there is

no doubt that the physical and futures t.ansactions associated with the hedges [ 3] and the EFPs are

genuine and legitimate and that the only issue is that which is presented in... [your] letter.

Similarly, you state that contract market EFP rules may require that the physical and futures legs be entered into by

one party on each side of the EFP, Here, there can be an issue whether an EFP is bona tide where the physical and

futures activity on one side of the EFP are each engaged in, as a matter of routine practice, by different commonly

owned and controlled affiliates of the same parent organization.

You state your view that the mere existence of the above structures should not disqua~if~ the hedging or EFP activity described and request staff confirmation of that view. Based upon the representations set forth in your March 23,

1994 letter, the Division and the Division of Economic Analysis confirm their view that the corporate structure and routine allocation of functions described therein and summarized above are not inconsistent with Commission Regulation

1.3(z), which defines bona fide hedging, and Commodity Exchange Act Section 4c(a), which permits contract markets

to provide for EFPs to be entered into in accordance with their Commission approved rules. [’4]

The Commission staffhistorically has considered commonly owned and controlled entities to be a single entity or

the "same person" for purposes of compliance with Commission regulation 1.3(z). n1 As to EFPs, the Commission staff

previously has focused, in general, on the legitimacy of the cash leg of an EFP and the nature of the relationship between the conga parties. The staff has not required that, under the circumstances you have described, the same legal

entity handle both the physical and futures legs on one side of an EFP. Accordingly, the Division and the Division of

Economic Analysis also would not object to a contract market interpretation consistent with the views expressed herein.
1994 CFTC Ltr. LEXIS 42, *

Page 2

nl Commission Regulation 150.2, which addresses speCulative position limits, has been applied by Commission staff in a similar manner.

Any different, omitted, or changed facts or conditions might require a different conclusion. Finally, you should

note that the views expressed herein are solely those of the Division and Division of Economic Anatysis and are not

binding on the Commission or any other division or office of the Commission.

Sincerely,

Andrea M. Corcoran

Director

[’51

March 23, 1994

Andrea MI Corcoran, Esq.

Director

Division of Trading and Markets

Commodity Futures Trading Commission

2033 K Street, N.W.

Washington, D,C. 2058 ~

Re: Request for Confirmation of Interpretations Regarding "Bona Fide Hedging" and "Exchanges of Futures for

Product"

Dear Ms. Corcoran:

On repeated occasions, we have been asked by clients to advise them on compliance with requirements under the

Commodity Exchange Act (CEAct") and khe regulations of the Commodity Futures Trading Commission ("Commission ) pertaining to w~at constitutes bona fide hedging, and what qualifies as a permissible exchange of futures for

product (or physicals)" also known as "EFPs’ where the physical commodity transactions and the related futures trading

are under common control although they may be conducted by separate but commonly owned corporations or oNer

legal entities, Frequently, these issues arise when a client is considering a reorganization for reasons u~elated to the

CEAct where separation of physicals transactions from other functions such as futures activity is viewed as desirable

(e.g., to isolate environmental risks). To assist those clients, we request confirmation of [’6] our interpretations of

CEAct § 4c (EFPs)and Commission Reg, § 1.3(z) (bona fide hedging) in the context of the organizational structure

described below.

Many business enterprises elect to operate in a manner that assigns different functions ~o related and controlled affiliates. For exampIe, an ultimate parent organization may carry on various business operations through affiliates that

owns n ! and controls or may choose to conduct some activities itself while assigning other functions to such an affiliate.

For present purposes, let us suppose that the parent organization or one subsidiary (either refe~ed to herein as "A")

gages in the ownership and marketing of physical commodities while another commoMy controlled affiliate ("B")

gages in futures market activities to hedge "A*s’’ physica! transactions and to implement the futures aspects of EFPs for

which "A" has carried out the physical transactions, n2 In many instances, the results of those entities’ operations are

combined and included in consolidated financial statements and reports, Mthough not in all cases.

nl I00% ownership maybe diluted minimally due to employee stock ownership plans or other reasons, but

this letter assumes that in all cases nearly complete ownership and effective control of the affiliates exist.
i994 CFTC Ltr. LEXIS 42, *

Page 3

[’7]

n2 h is assumed in this example that there is no doubt that the physical and futures transactions associated

with the hedges and the EFPs are genuine and legitimate, and that the only issue is that which is presented in the

next paragraph of this letter.

Commission Reg. § 1.3(z) enumerates several examples of "bona fide hedging" transactions, in each instance, it is

posited that the physical transactions and the futures activity are by "the same person." As, in the example above, if two

commonly controlled entities were deemed to be different legal persons under Commission Reg. § 1.3(z), questions may

arise regarding }vtaether the activities of "B" in the futures market can qualify as bona fide hedging. Similarly, at those

contract markets whose rules allow EFPs only where the physical and the futures legs are entered into by one party on

each side of the EFP. a similar question might be raised under the described organizationa~ structure. ~n our view, the

mere existence of this structure should not disqualify either the hedging or the EFP activity of those entities as co mmonly-controlled and owned organizations.

Accordingly, we request confirmation that the corporate structure [’8] and allocation of functions as described

herein are consistent with CEAct § 4c and Commission Reg. § 1.3(z). W2qile we do not ask the Commission to interpret the rules of any relevant contract market with respect to these matters, we atso request confirmation that the Commissmn would no~ disapprove an interpretation conslstent with our wew if it were adopted by a contract market, where

EFPs are limited to physical and futures transactions between the "same persons." the "same par~ies," or equivalent language.

Sincerely,

Philip McBride Johnson

XXXXX

CONTACT:

Aton L. Seife~

Andrea M. Corcoran

Division of Tradi~ag and Markets

Commodity Futures Trading Commission

2033 K Street, NW

Washington, DC 20581

(202) 254-8955

(202) 254-80 t 0 Facsimiie