The business borrower entering into a secured financing transaction at a floating interest rate typically attempts to manage the interest rate risk by entering into a “swap” with a “counterparty” resulting in fixing the interest rate the borrower is required to pay. Lenders almost always require that commercial loans to a privately owned business be guaranteed by its owners. As a swap involves some potential liability to the lender, the lender normally includes such liability in the definition of the “Obligations” being incurred and required to be paid by the borrower, secured by any collateral and guaranteed by the borrower’s owner.
This standard loan/guaranty structure is being impacted by regulations recently issued by the U.S. Commodity Futures Trading Commission (CFTC) as required by the Dodd-Frank Act. Under the regulations, all swaps, including those entered into by borrowers solely to manage the floating interest rate on loans received, must be entered into by an “eligible contract participant” (ECP) unless entered into on a regulated exchange. Under the Dodd Frank Amendments to the Commodity Exchange Act, to be an ECP, an entity or an individual must either have total assets of more than $10,000,000 or total assets of more than $5,000,000 and have entered into the swap “¼ to manage the risk associated with an asset owned or liability incurred or reasonably likely to be owned or incurred ¼.” (Section 1a(1)(A)(xi) of the Commodity Exchange Act).
Importantly for the commercial lender, under the regulations, the guaranty of a swap is also defined as a swap, and the guaranty of a lender’s obligations related to a swap is unenforceable and unlawful if the guarantor is not an ECP. In addition, it is possible that the unenforceable guaranty of swap obligations may also result in a blanket guaranty of all borrower obligations – swap-related and non-swap-related – being unenforceable in its entirety.
In response to requests to the CFTC for clarification of and relief from the regulations, the CFTC issued Staff Interpretations and No-Action Relief (CFTC Letter No. 12-17 issued October 12, 2012) (the “Letter”). In the Letter, the Office of General Counsel (OGC) of the CFTC stated that it would not recommend that the CFTC take an enforcement action against a guarantor guaranteeing the swap obligations of a third party (typically, the borrower-entity owned by the guarantor) or against the swap counterparty if a series of conditions are met.
For our typical example (individual owner guaranteeing the swap obligations of his or her company) the relevant conditions are:
- The guarantor must be an “indirect proprietorship” (i.e. one who operates “a small business through a legal entity for creditor protection, tax efficiency or other legitimate business reasons”);
- The guarantor must have a net worth of more than $1,000,000;
- The “Guaranteed Swap “Counterparty”’ (the company owned by the guarantor in our example) must enter into the swap “solely to manage the floating interest rate risk associated with a loan received, or reasonably likely to be received”;
- The guarantor must be “an owner of the Guaranteed Swap Counterparty and play[s] an active role in operating the business of such Guaranteed Swap Counterparty (other than performing solely clerical, secretarial or administrative functions)” and may not be simply a passive investor;
- The guarantor must compute his/her net worth in accordance with generally accepted accounting principles (GAAP) consistently applied (but real property may be determined using fair market value); and
- The guaranty beneficiary (the lender) must verify that the guarantor and the Guaranteed Swap Counterparty satisfy the above conditions.
In the case of multiple guarantors of a swap obligation, each guarantor must individually meet the above conditions.
WHAT TO DO?
In all cases, lender should: (a) obtain representations from their guarantors that they meet the required conditions listed in the Letter; (b) carefully examine the guarantor’s personal financial statement and consider whether some form of independent accountant’s confirmation be obtained that the financial statement meets GAAP requirements for personal financial statements; and (c) review the lender’s standard loan documentation to be sure that swap obligations and non-swap obligations are carefully segregated.
Various approaches to the issue of guaranty drafting have been suggested to address this issue, such as:
- excluding a lender’s potential swap liability from the definition of obligations guaranteed by a borrower’s owner;
- or requiring the guarantor-owner to sign two separate guaranties – one covering all loan obligations except obligations to the lender related to the swap and a separate guaranty of the lender’s potential swap obligations (assuming the guarantor passes the net worth, active participation and other conditions outlined in the Letter).
Even though the Letter outlines the conditions under which the OGC has recommended that the CFTC take no enforcement action, the Letter recites that it is only the position of the OGC and does not bind the CFTC or any other Federal agency (e.g., SEC, FDIC, Federal Reserve Board) and is subject to being modified, suspended or terminated in the OGC’s discretion.
One safe course to assure that the possible unenforceability of the guaranty of the lender’s swap obligation does not taint the guaranty of all other borrower obligations is for the lender to exclude lender’s liability arising out of any swap from obligations otherwise guaranteed by the owner-guarantor. Anything less creates risks: that in fact the guarantor does not meet the ECP requirement; that the guarantor’s personal financials do not meet GAAP standards; that the unenforceability of a single guaranty covering all obligations, including swap obligations, might invalidate the guaranty of even non-swap obligations; or that the OGC or the CFTC may determine in the future to alter the conditions set forth in the Letter or rescind the letter in its entirety. In addition, arrangements under which subsidiaries or affiliates of a borrower are added as co-borrowers or which otherwise require credit support for a swap raise the same issues as swap guarantors in substance as raised by the typical owner-guarantor scenario discussed above.
This Alert discusses only one scenario affected by the CFTC regulations related to swaps. The advice of legal counsel is essential in any situation involving credit support for a swap to assist the commercial lender to walk with some level of comfort through the regulatory minefield and uncertainty spawned by Dodd-Frank provisions affecting the guarantee of swap obligations.