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Revisiting Interest Rate Swaps

Commercial Lending Bulletin

In 2010, Congress enacted the financial system regulatory overhaul law known as the “Dodd-Frank Wall Street Reform and Consumer Protection Act,” or the “Dodd-Frank Act” as it is commonly known. One area of focus of Dodd-Frank is reform of the financial derivatives markets.

The “derivatives” regulated under Dodd-Frank are virtually all types of swap and hedging contracts including, interest rate swaps that banks use to manage risks associated with floating interest rates. Interest rate swaps typically are used by lenders and borrowers to provide borrowers with the comfort of a fixed rate loan by shifting the costs and benefits of interest rates fluctuations to a third party by “swapping” a variable rate payment based on Libor or some other objective indexed interest rate for a fixed payment from the borrower to a “counterparty.”

When the regulations implementing the Dodd-Frank provisions concerning interest rate swap dealers and swap participants become effective, no person will be permitted to enter into or guaranty an interest rate swap unless (i) the person qualifies as an “eligible contract participant” – an “ECP” – or (ii) the swap is entered into on or subject to the rules of a board of trade designated under the Commodity Exchange Act. The regulations set forth what persons or entities may qualify as ECPs. Eligibility will be restricted to those persons and businesses with sufficient net worth to qualify as ECPs. The provisions currently are scheduled to occur on March 31, 2013.

An additional aspect of Dodd-Frank and the implementing regulations is that unless the swap transaction qualifies as an exempt transaction, it must be “cleared” through an independent registered derivatives clearinghouse. While it is likely that many if not most conventional interest rate swap transactions will qualify for an exemption from the clearing requirements, this is one more hurdle for the lender swapping a fixed interest rate for a floating rate loan.

What does all this mean to a lender? If a bank wishes to enter into an interest rate swap transaction after the effective date of the new regulations, the bank must determine: first, whether the borrower and any guarantor qualifies as an ECP so that it legally can enter into an interest rate swap contract and any guaranty of the borrower’s liability under the interest rate swap contract; and, second, whether the swap must be executed on a specified swap execution facility and thereby “cleared” through a registered derivatives clearinghouse or whether it is exempt from the clearing requirements. Suffice it to say, the process will be considerably more complex for lenders. There will be significant penalties for lenders that violate the regulations.

What is a lender to do? We recommend that lenders contemplating interest rate swaps in conjunction with loan transactions remain in contact with their regulatory counsel in order for their loan documentation to conform to the implementing regulations.

Arnold Spevack is a commercial lending attorney at Lerch, Early & Brewer in Bethesda, Maryland who represents individuals, businesses, lenders and borrowers in financings, closings, negotiations and in the courts. For more information on swaps, contact Arnie at (301) 657-0749 or adspevack@lerchearly.com.

This content is for your information only and is not intended to constitute legal advice. Please consult your attorney before acting on any information contained here.

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