Sunday, June 12, 2011

Dodd-Frank, the CFTC, and the Legal Enforceability of Swap Contracts

Last week there were some news articles concerning worry that provisions of the Dodd-Frank Act which come into effect on July 16 may raise uncertainty concerning the legal enforceability of some over the counter swaps. On June 10, a joint letter of concerned trade associations, including the International Swaps and Derivatives Association ("ISDA") and the Securities Industry and Financial Markets Association ("SIFMA"), expressed concern about this and requested that the CFTC issue an interpretation and various orders to remedy the problem. CFTC Chairman Gary Gensler has said that the CFTC will take action prior to July 16 to remove legal uncertainty.

The Dodd-Frank Act repeals some provisions of the Commodity Futures Modernization Act of 2000 ("CFMA") relating to swaps on July 16. Apparently, the concern is that there is no clear way to distinguish between some swaps and futures contracts (and options thereon) for which transactions are required to be conducted on a CFTC-registered board of trade, raising the question whether certain contracts or transactions in the OTC markets are legally enforceable when the repeal becomes effective on July 16.

The Dodd-Frank Act attempted to deal with this issue in section 739, which put the following language into the Commodity Exchange Act ("CEA"):

"No agreement, contract, or transaction between eligible contract participants or persons reasonably believed to be eligible contract participants shall be void, voidable, or unenforceable, and no party to such agreement, contract, or transaction shall be entitled to rescind, or recover any payment made with respect to, the agreement, contract, or transaction under this section or any other provision of Federal or State law, based solely on the failure of the agreement, contract, or transaction—(i) to meet the definition of a swap under section 1a; or (ii) to be cleared in accordance with section 2(h)(1)."

Apparently the provision that says that a swap is still enforceable even if it does not meet the CEA definition of swap does not alleviate all worries, because the transactions might be "futures contracts," which is not a defined term. The concern is that a losing party to a trade might go to court and argue that it did not have to pay because the transaction was illegal under the CEA.

The legal enforceability issue due to the CEA is not a new concern, and the market developed with this hanging over it during the 1980s and managed to thrive. The CFTC and Congress took various actions over the years to provide legal certainty to the swap market, which worked until Brooksley Born became chair. Her desire to regulate a market where she saw dangers raised a legal enforceability issue for some swaps based on securities. After she left the CFTC, the CFMA put these issues to rest.

With regard to the current situation, it would seem that the CFTC could put out orders and an interpretation along the lines the trade associations propose in their letter, or perhaps take a different approach. While parties could still go to court, I would think the courts would give great deference to the CFTC's views ("Chevron deference").

The Wall Street Journal ran an editorial on June 9 on this subject, "The Hangover, Part III: Another unintended Dodd-Frank consequence." In it they say: "…not everyone is convinced that Gary's web posting is going to defuse the bureaucratic bomb that Chris and Barney have programmed to detonate next month. Mr. Gensler can't prevent private lawsuits if the law becomes murky. It doesn't take too much imagination to see trial lawyers trolling the ranks of underachieving municipal finance officials who might want a do-over after some bad derivatives bets. We could immediately be talking about real money."

Also, over at "Seeking Alpha," Craig Pirrong is exceedingly sarcastic about Gary Gensler on this subject ("Witness What the Sorcerer's Apprentices in Charge Hath Wrought"): "…a CFTC web posting or Gary Gensler writing on his Facebook wall or Tweeting that it's all cool or whatever won't deter firms with big losses from taking a punt on a lawsuit."

I would note that Ed Rosen, a partner at Cleary Gottleib who appears to have been the principal drafter of the trade association letter, is an expert in this area of law and has represented derivatives dealers regarding CEA issues for years. (I know him from my days at Treasury when I worked on derivatives issues, but I have not spoken to him about this current matter.) I am sure he carefully considered the suggestions the trade associations made to the CFTC to reduce the legal uncertainty for their members. I do not know whether he thinks it is worth the effort to try to get Congress to pass legislation, as the WSJ editorial suggests.

The basic problem facing the CFTC is the sheer volume of regulatory projects they have underway. As I am sure Gensler has come to appreciate, he cannot always get his way even though he heads the agency. He needs at least two other commissioners to go along with him. This serves as a check on any one person having too much power, but it makes the process of finalizing regulations, some of which are controversial, more difficult and less efficient than at an agency such as Treasury, where the Secretary's decision is final when there is disagreement among the political appointees under him. It is not surprising that the CFTC has not been able to meet all the Dodd-Frank deadlines. But it is in no one's interest at the CFTC or elsewhere for there to be turmoil in the swaps market because a court has found some contracts to be illegal. While there may be disagreements within the CFTC on how tough regulation of this market should be, the commissioners would seem to be able to agree on a way to resolve this legal uncertainty issue.

(As a caution, this is an exceedingly complex and confusing area of law, and I am not a lawyer. The CEA is known for its ambiguity and the Dodd-Frank Act is a complex and voluminous piece of legislation. I have not consulted any lawyers in writing this post, and it is entirely possible that I have missed something. Nothing here should be considered legal advice.)

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