Section 716: The do-nothing approach

Dodd-Frank’s swaps push-out rule takes effect for non-US banks in July 2013, but many are said to be doing nothing to prepare – a gamble that the requirement will be repealed before it can force them to restructure their business. Peter Madigan reports

The ostrich has long been defamed by the rumour that it sticks its head in the sand when confronted with danger. A nonsensical myth – if only from an evolutionary standpoint – it is nevertheless the tactic that derivatives dealers are said to be adopting in the run-up to the implementation of section 716 of the Dodd-Frank Act.

The rule – known colloquially as the swaps push-out or the Lincoln amendment, after former Arkansas senator Blanche Lincoln, who introduced the measure – forces banks operating in the US to push out specific swap trading activities from any part of the firm that receives federal assistance. That assistance is defined as the use of any Federal Reserve credit facility or discount window, or receiving Federal Deposit Insurance Corporation (FDIC) insurance or guarantees.

The rule is seen by banks as counterproductive – forcing selected trading desks into a separate entity breaks up netting sets and increases total margin and capital requirements. It also denies to non-US banks a hedging and market-making exemption that US institutions receive – something Lincoln herself said was an error.

With next to no guidance from regulators on the timing and scope of the rule, and a bill to repeal section 716 currently stalled in the US Congress, banks are finding it difficult to come up with a strategy to prepare for its implementation.

As a result, dealers in the US have decided to ignore it and hope it goes away. “We are pretty much doing nothing regarding the Lincoln amendment right now, and as far as I know, that is what most other banks are doing too,” says a New York-based general counsel at a non-US bank. “We are not seeing US banks setting up separate legal entities. We would know if they were, because they would be asking us to sign new agreements and to consent to transfer our trades to that new legal entity. That is not happening.”

Lincoln inserted her proposal into an early version of the financial reform bill passed during her chairmanship of the Senate Committee on Agriculture, Nutrition and Forestry on April 21, 2010. There was no corresponding provision in the draft bill from the Senate banking committee or in the final House bill, and the push-out rule was given little chance of making it into the final, consolidated bill. It confounded those predictions – in part, possibly because Lincoln was facing a tough re-election battle, and the senator hoped that being tough on banks might help her chances. It then also came through the now-infamous June 25, 2010, 20-hour congressional conference committee that merged the House and Senate bills into what is now known as the Dodd-Frank Act.

While Dodd-Frank does not require supervisors to add detailed rules to the measure, it does specify five factors supervisors shall consider in prescribing rules regarding the provision – the implication, say lawyers, is that Congress expected the agencies to flesh the requirement out. But since Dodd-Frank was signed into law in July 2010, the three US prudential regulators charged with overseeing the carve-out – the Federal Reserve Board, the FDIC and the Office of the Comptroller of the Currency (OCC) – have said almost nothing about how dealers should comply.

On May 10, the first – and so far only – instruction regarding section 716 was issued by the three supervisors after 22 months of silence. It was a one-page notice in the Federal Register that simply stated section 716 will take effect on July 16, 2013.

That cleared up some confusion about whether the effective date could in fact have been July 16, 2012 – the Dodd-Frank text was seen as ambiguous by some – but it did not clarify a potential 24-month transition period for US banks insured by the FDIC, known officially as insured depository institutions (IDIs), to divest themselves of spun-off swap products. Under the transition period, the effective date of section 716 for insured US banks could be as far off as July 16, 2015. Foreign banks that have branches in the US, whether FDIC-insured or not, do not have the same grace period, and must push out all swap trading activity by the mid-2013 compliance date.

The notice also did nothing to clarify the legal form the pushed-out swap entity should take, nor did it offer any guidance to foreign banks on how regulators would respond if they simply moved all swap trading activities out of the US.

Unsurprisingly, foreign banks in particular are looking for answers. On December 5, 2011, law firm Davis Polk & Wardwell, acting for Japan’s three largest banks – Mizuho Corporate Bank, Sumitomo Mitsui Banking Corporation and Bank of Tokyo-Mitsubishi UFJ – submitted a comment letter to the Federal Reserve, the FDIC, the OCC, the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) asking for confirmation “that US branches of foreign-based banks receive treatment under section 716 equal to that afforded insured depository institutions”. No response was received from any of the regulators, according to lawyers at Davis Polk.

The Federal Reserve and the FDIC declined to comment for this article. A spokesman for the OCC said the issue “is still something the regulators involved are discussing”.

Scott Cammarn, a financial regulation attorney at Cadwalader Wickersham & Taft in Charlotte, North Carolina, says there is nothing on the Federal Reserve’s calendar of upcoming rules relating to the Lincoln amendment.

“The other banking agencies have not announced any rule-making plans either. While we have spoken to lawyers at the agencies requesting guidance, they have been unable to provide it. The agencies are very guarded concerning selective releases of rule-making information, especially after the leaked release of the draft Volcker rule language last year,” says Cammarn.

This wall of silence is frustrating foreign banks in particular, due to the uneven treatment the rules mete out. The text states that IDIs can keep hedges and market-making positions in interest rate swaps, cleared credit default swaps (CDSs) and foreign exchange swaps within an insured part of the bank, along with swaps referencing gold and silver. Non-IDIs – for example, US branches of foreign banks – don’t qualify for this exemption, forcing them to push out all swap activities in all asset classes regardless of whether they are held for hedging or market-making purposes.

That is the result of a drafting error, which former senator Lincoln herself highlighted in a conversation with senator Chris Dodd on the Senate floor on July 15, 2010. “Due to the fact that the section 716 safe harbour only applies to insured depository institutions, it means that US branches of foreign banks will be forced to push out all their swap activities. This oversight on our part is unfortunate and clearly unintended,” said Lincoln in what is known as a colloquy – a scripted conversation designed to put important information about Congressional intent on public record.

Dodd agreed that uninsured US branches of foreign banks needed to be treated the same as insured depository institutions in Section 716. But Dodd and Lincoln left the Senate – the former voluntarily, the latter forcibly – after the mid-term elections of 2010, and the error has yet to be corrected.

Politicians have been trying to provide a fix. On May 1, 2011, congresswoman Nan Hayworth introduced House resolution 1838 – a one-page bill that consists of a single sentence: “Section 716 of the Dodd-Frank Wall Street Reform and Consumer Protection Act is repealed.”

By the time the bill passed the full House Committee on Financial Services in May 2012, it had grown to 12 pages and was proposing less sweeping changes. But the resolution remains stuck within the House Committee on Agriculture, with consideration of the resolution having been extended four times, most recently until November 16. Even if the bill is taken up during the congressional session that follows the US presidential election on November 6, it is regarded as having no chance of passing the Senate before the swearing in of the 113th Congress in late January next year.

Some hope remains that the bill could pass both houses of Congress in 2013, but dealers currently seem to be betting on full repeal of the rule, rather than partial amendment – and regulatory silence on the topic is encouraging that view.

“It took the regulators a pretty long time to even clarify that 716 won’t take effect until July 2013. If a bank had interpreted 716 to apply as of July 2012, then the agencies waited until pretty late in the day before they gave that bank confidence the section would not apply this year. Right now, banks are more concerned about whether they have to register as swap dealers before the end of the year but the application of the push-out rule is still an issue,” says David Felsenthal, a derivatives partner at law firm Clifford Chance in New York.

The general counsel at the non-US bank is more blunt, drawing a direct link between the reluctance of the regulators to interpret section 716 and the willingness of US banks to use that as a licence to do nothing.

“The regulators do not think this is a smart rule, and as such they are ignoring it, for now at least. We’ve been asking whether there will be guidance forthcoming and we can’t get an answer,” the general counsel says. “The attitude is the same among the US banks that don’t have the option of moving swap trading activities offshore. Nothing is happening.”

The general counsel says most dealers simply expect section 716 will be repealed, and are therefore not wasting precious resources on preparing for it. “Talking to my legal colleagues in the industry, I know that one of the very large US derivatives dealers is not making any efforts at all to move its swap business to a new entity in order to comply with 716. Its legal team told me the bank has taken the position that section 716 has to be changed or repealed because it’s unworkable. There is some expectation in the market that it will be repealed – so it makes no sense to take steps to implement it at this time, especially without any guidance from the regulators on how to do so,” says the general counsel.

This view is confirmed by US private-practice derivatives lawyers. Don Lamson, counsel in the financial institutions advisory and financial regulatory group of law firm Shearman & Sterling in Washington, DC, says he has heard little about any banks that are preparing for the introduction of the rule.

Willa Cohen Bruckner, a partner in the financial services and products group at law firm Alston & Bird in New York, also says she has yet to receive any calls on the topic from dealer clients. “I am not hearing of any dealers doing anything about 716. I’m not getting questions about it, there is no buzz in the industry about it and I think there are so many other deadlines that come first – and that are certain to go ahead, such as swap dealer registration – that it may be that swap dealers are only focused on what they have to deal with now,” says Bruckner.

But a repeal is not assured, so private-practice and in-house bank lawyers have had to at least consider some contingencies. One big question is whether to leave exempted swaps in the bank and push out only those required – or whether to push all over-the-counter trading activity into a new entity.

Non-US banks do not have a choice. When interest rate trades are booked in a US branch, Section 716 will force those positions into a spun-off subsidiary, regardless of the rule’s hedging and market-making exemption, or whether the underlying exposure that a swap is hedging originates in the US or not. It’s not clear what proportion of trades are booked in the US, however.

US dealers can keep rate hedges within the bank, but non-US dealers claim that is not much of a benefit. Allowing cleared CDS, rates and foreign exchange hedges to stay within the bank is of little value to IDIs when risk limits are set at the aggregate level for counterparties as a whole, they argue.

If cleared CDS and rates exposure to one large counterparty remains within the insured part of the bank while all non-cleared CDS and equity trades with the same counterparty are forced into a subsidiary, it will actually increase the risk posed by that counterparty because the positions cannot be netted against one another, increasing the total amount of margin a dealer must post against that entity – and the capital it has to hold.

“Moving those hedges would create a mismatch in our accounting, and our regulator is insistent we keep our hedges and our loans together. Splitting them up makes no sense because it increases the risk on our book,” says the general counsel at the non-US dealer.

“Even though the IDIs can keep certain swaps on their book, no institution is going to because they will lose their ability to net cleared CDS or rates positions against uncleared CDSs or a structured equity derivative with the same counterparty. All those trades need to remain in the same legal entity in order to receive the benefit of payment netting – as well as close-out netting in the event of bankruptcy. Even the US banks aren’t going to make use of that exclusion because it is against their own interests and their regulators will not want them to do it,” the counsel says.

Shearman & Sterling’s Lamson says the most logical course for all bank dealers, regardless of whether they are IDIs or not, would be to push all swaps out into the same non-bank subsidiary – despite the cost of separately capitalising it – because it will be simpler to calculate those costs and meet regulatory reporting requirements. However, he notes, there are funding advantages to keeping swaps in the bank.

“The bank funds its obligations at a discount to the rate at which its subsidiaries fund their obligations, so putting everything into a separately funded subsidiary will be more expensive. Ultimately, management will have to ask itself what makes the most sense from a funding perspective,” says Lamson.

The capital treatment for each spun-off swap desk also remains a mystery. It depends what kind of entity is used to house the business. The CFTC is drawing up capital and margin rules for non-bank swap entity subsidiaries that will apply to both cleared and uncleared trades, but the rules are not yet final.

Non-US banks do have one escape route. They could stop trading OTC derivatives out of US branches and conduct all that business outside the US. Nothing in section 716 prevents foreign banks from doing so, but it would mean trading one Dodd-Frank rule for another.

“It’s my understanding that many foreign banks are thinking about consolidating all their swap dealing activity out of their foreign headquarters or major foreign branches. If they do that, then this would alleviate the need to deal with the push-out provision under the Lincoln amendment but they would still need to consider how the extraterritorial guidance will apply to them, so they move from one problematic regulation to another,” says David Kaufman, a derivatives partner at law firm Morrison & Foerster in New York.

“Those cross-border rules are complicated, but at least they will have to go through the comment process and they will be worked on and thought out. The Lincoln amendment is flawed and there doesn’t appear to be an easy regulatory path to fixing it,” he adds.

Could IDIs do the same thing? Section 716 says nothing about how and whether it applies to the swap activities of IDI branches overseas – and the CFTC’s 111-page proposed interpretive extraterritorial guidance does not mention the swaps push-out – which has left lawyers scratching their heads. A tentative conclusion is that a branch of an IDI overseas would be subject to the same restrictions on swap activities as the US-based IDI itself.

“The cross-border guidance talks about how the OTC derivatives elements of Dodd-Frank apply overseas, but it does not mention Section 716 or the swap push-out requirement. What it does say is, in the CFTC’s view, a bank that is a swap dealer is viewed as having all its branches regarded as swap dealers, regardless of where they are located. We read the guidance as saying that a non-US branch of a US bank that has registered as a swap dealer is itself a swap dealer,” says Don Thompson, managing director and associate general counsel at JP Morgan in New York.

“That would make that branch a swap entity for the purposes of section 716, which means it has to push certain equity derivatives, credit derivatives and commodity derivatives out of that foreign branch, even though the CFTC has not explicitly said that. We are devoting a lot of time and effort to planning against this outcome based on that interpretation – I can’t see how you can come to any other interpretation,” Thompson adds.

Other lawyers agree, noting that if the Lincoln amendment is meant to drive swap activities out of federally assisted banking entities, permitting US bank branches overseas to trade derivatives would contradict that goal.