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.
