Many standard subsidiary guarantees in secured financing transactions may be illegal under rules recently issued by the Commodity Futures Trading Commission (“CFTC”) under the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”). These rules, which became effective on March 31, 2013, expanded the meaning of the term “swap” to include a guarantee of a swap and made it illegal for any person other than an “eligible contract participant” (ECP) to enter into a swap that is not on, or subject to the rules of, a designated contract market (DCM). ECPs include entities with total assets exceeding $10 million, those whose obligations are guaranteed by an ECP, and those with a net worth exceeding $1 million that are hedging commercial risk.
In secured financing transactions, borrowers frequently enter into hedging transactions (swaps), for the purpose of managing floating interest rate risk. These hedging transactions typically are over-the-counter swaps not provided through a DCM. The borrower’s obligations under swap agreements, as well as the credit agreement, are usually guaranteed by the borrower’s subsidiaries. Because a guarantee of a swap is itself a “swap” for purposes of Dodd-Frank beginning March 31, 2013, if a subsidiary guarantor of swap obligations does not qualify as an ECP each time the swap is entered into, the guarantee by the subsidiary would not be enforceable. In many instances, subsidiary guarantors will not pass the total assets test to qualify as ECPs.
A failure to meet CFTC requirements for non-ECP subsidiary guarantors renders swap guarantees illegal and unenforceable. Moreover, because such guarantees and other “Guaranteed Obligations” are often combined in a single guarantee, the entire guarantee may be unenforceable, resulting in a default under the related loan documents. To minimize these risks, borrowers and lenders should ensure that their loan documents include:
1. Representations that all parties to swaps (and swap guarantees) are ECPs.
2. A carve-out of swap obligations from the guaranteed obligations of non-ECPs. The Loan Syndications and Trading Association (LSTA) released a market advisory in February 2013 recommending inclusion of the following defined terms in a guaranty to exclude swap obligations from other guaranteed obligations:
‘Commodity Exchange Act‘ means the Commodity Exchange Act (7 U.S.C. § 1 et seq.), as amended from time to time, and any successor statute.
‘Excluded Swap Obligation‘ means, with respect to any Guarantor, any Swap Obligation if, and to the extent that, all or a portion of the Guarantee of such Guarantor of, or the grant by such Guarantor of a security interest to secure, such Swap Obligation (or any Guarantee thereof) is or becomes illegal under the Commodity Exchange Act or any rule, regulation or order of the Commodity Futures Trading Commission (or the application or official interpretation of any thereof) by virtue of such Guarantor’s failure for any reason to constitute an ‘eligible contract participant’ as defined in the Commodity Exchange Act and the regulations thereunder at the time the Guarantee of such Guarantor or the grant of such security interest becomes effective with respect to such Swap Obligation. If a Swap Obligation arises under a master agreement governing more than one swap, such exclusion shall apply only to the portion of such Swap Obligation that is attributable to swaps for which such Guarantee or security interest is or becomes illegal.
‘Swap Obligation‘ means, with respect to any Guarantor, any obligation to pay or perform under any agreement, contract or transaction that constitutes a ‘swap’ within the meaning of Section 1a(47) of the Commodity Exchange Act.
3. For loan documents with waterfall distribution provisions, language prohibiting swap providers from receiving payments under guarantees by non-ECP guarantors.
4. Severability provisions in guarantees providing that a loan party’s non-ECP status would not affect non-swap obligations under the guaranty.
5. Keepwell language whereby the ECP agrees to unconditionally and irrevocably provide funds or other support to the non-ECP guarantor to enable that guarantor to honor its obligations under the loan documents. A keepwell arrangement in certain circumstances will confer ECP status upon a non-ECP guarantor by agreeing to provide keepwell support to the non-ECP guarantor. The LSTA recommends that the following keepwell language be included in a guaranty:
‘Each Qualified ECP Guarantor hereby jointly and severally absolutely, unconditionally and irrevocably undertakes to provide such funds or other support as may be needed from time to time by each other [Loan Party] to honor all of its obligations under this Guaranty in respect of Swap Obligations (provided, however, that each Qualified ECP Guarantor shall only be liable under this Section [___] for the maximum amount of such liability that can be hereby incurred without rendering its obligations under this Section [___], or otherwise under this Guaranty, as it relates to such other [Loan Party], voidable under applicable law relating to fraudulent conveyance or fraudulent transfer, and not for any greater amount). The obligations of each Qualified ECP Guarantor under this Section shall remain in full force and effect until a [Discharge of Guaranteed Obligations]. Each Qualified ECP Guarantor intends that this Section [___] constitute, and this Section [___] shall be deemed to constitute, a ‘keepwell, support, or other agreement’ for the benefit of each other [Loan Party] for all purposes of Section 1a(18)(A)(v)(II) of the Commodity Exchange Act.’
‘Qualified ECP Guarantor‘ means, in respect of any Swap Obligation, each [Loan Party] that has total assets exceeding $10,000,000 at the time such Swap Obligation is incurred or such other person as constitutes an ECP under the Commodity Exchange Act or any regulations promulgated thereunder and can cause another person to qualify as an “eligible contract participant” at such time by entering into a keepwell under Section 1a(18)(A)(v)(II) of the Commodity Exchange Act.
It is advisable that borrowers and lenders review their loan documents to identify non-ECP guarantors of swap obligations and consult with counsel to ensure compliance with Dodd-Frank requirements affecting guarantees of swap obligations.