Over the last several decades, the use of derivatives as a tool to mitigate and control risk has expanded significantly. Despite well-publicized abuses involving derivatives, the efficacy of derivatives as a means of managing economic and other forms of risk remains widely accepted. The evolving mix of users of derivatives in the last ten years has also impacted the derivatives landscape. Traditionally, commercial hedgers such as processors, mills and large corporations used derivatives to manage risks; today, while commercial hedgers remain active,much of the increase in volume in derivatives is attributable to non-traditional end-users, such as public companies, which have been active users of derivatives, most notably interest rate and foreign currency hedging instruments.
This article provides a brief primer on the various uses of derivatives, including the use of derivatives by public companies to manage risks. It also addresses a number of questions arising out of the Dodd-Frank Act, which provides a new level of regulation over derivatives.
1. What is a Derivative?
Put simply, a derivative is a contract whose value is based upon (or derived from) the value of something else. Virtually every derivative, from the most complex to the most mundane, falls within this definition. The “something else,” which is often referred to as the “underlying” or the “commodity,” can be a security (e.g., a share of company stock or a U.S. Treasury note), a commodity (e.g., gold, soybeans or cattle), an index (e.g., the S&P 500 index), a reference rate (e.g., LIBOR), or virtually anything else to which a value can be assigned and validated. As long as the value of the contract is based on or “derived” from the value of something else, the contract is a derivative.
2. Types of Derivatives
Conceptually, derivatives take many different forms. At the highest and broadest level, there are two types of derivatives: (1) exchange-traded derivatives, and (2) over-the-counter, or “OTC,” derivatives, which are not traded an exchange.
Exchange-traded derivatives include futures, options on futures, security futures and listed equity options. OTC derivatives are privately negotiated contracts conducted almost entirely between institutions on a principal-to-principal basis and designed to permit customers to adjust individual risk positions with greater precision. OTC derivatives include swaps, options, forwards and hybrids of these instruments.
3. Dodd-Frank Act
In July 2010, President Obama signed into law the Dodd-Frank Act. Title VII of the Dodd-Frank Act imposes a new regulatory regime on OTC derivativesand the market for those derivatives. The primary regulators are the Commodity Futures Trading Commission (“CFTC”) for “swaps” and the SEC for “security-based swaps.” Subject to certain exceptions,  the term “swap” is broadly defined to include most types of products now known as OTC derivatives, including interest rate, currency, credit default and energy swaps. “Security-based swap” is a much narrower category of transactions based on a single security or loan or a “narrow-based security index” (as defined under the Commodity Exchange Act or “CEA”).
The CFTC’s general directive from Congress under the Dodd-Frank Act is to cause as many swaps as possible to be cleared by central clearing entities in order to reduce “systemic risk” to the financial markets, and to have as many swaps as possible traded on CFTC-regulated exchanges, or on or through other CFTC-regulated entities, in order to increase transparency in the markets. The Dodd-Frank Act thus makes it unlawful for a person to enter into a swap without complying with the Commodity Exchange Act and the rules published by the CFTC.
Fortunately, most public company users of derivatives can make use of an exemption under the Dodd-Frank Act. Under Title VII, an “end user” generally means a company that is not a “financial entity” and that uses derivatives to hedge or mitigate commercial risk. The concept is intended to include industrial corporations and other non-financial enterprises that use swaps on interest rates, foreign currencies, energy, commodities and other derivatives, as appropriate to their businesses, to hedge their business risks. A so-called “end-user exemption” from the clearing and exchange trading requirements is generally available to counterparties that (1) are not financial entities, (2) are hedging their own commercial risks and (3) notify the CFTC or SEC, as applicable, how they generally meet their financial obligations associated with entering into uncleared swaps. A public company that relies on the exemption is also required to obtain the approval of its board of directors or other governing body.
4. Use of Derivatives by Public Companies
As end-users, public companies often use derivatives to manage various risks associated with running a large enterprise, including interest rate, foreign currency and commodity risk. According to a recent study, 29 of the 30 companies that comprise the Dow Jones Industrial Average (DJIA) use derivatives. Similarly, a study has found that two-thirds of companies with sales of more than $2 billion use OTC derivatives and more than half of all companies that have sales between $500 million and $2 billion are “very active” in derivatives markets.
Further, the International Swaps and Derivatives Association conducted a survey on the use of derivatives by Fortune Global 500 companies and found that 94% of these companies use derivatives to manage business and macroeconomic risks. According to the survey, the most widely used instruments were foreign exchange and interest rate derivatives. Many industries reported participation at rates greater than 90%, including financial companies (98%), basic materials companies (97%), technology companies (95%), and health care, industrial goods and utilities (92%).
Public companies typically use derivatives to manage interest rate risk and foreign currency risk and to minimize accounting earnings volatility and the present value of their tax liabilities. A company, for instance, may use derivatives to offset increases in the price of commodities it uses in manufacturing or its other operations. Further, large public companies borrow and lend substantial amounts in credit markets. In doing so, they are exposed to significant interest rate risk — they face substantial risk that the fair values or cash flows of interest sensitive assets or liabilities will change if interest rates increase or decrease. These companies also have significant international operations. As a result, they are also exposed to exchange rate risk — the risk that changes in foreign currency exchange rates will negatively impact the profitability of their international businesses. To reduce these risks, companies enter into interest rate and foreign currency swaps, forwards and futures as a hedge against potential exposures.
As a result of the Dodd-Frank Act’s regulation of derivatives, a number of questions arise that public companies must consider (and revisit often as the regulatory landscape changes):
- What are the implications of having our swaps — which were previously unregulated — executed on a regulated exchange or facility and cleared through a regulated clearinghouse?
- How do we assure compliance with Section 723(b) of the Dodd-Frank Act, which provides that a public company may not enter into non-cleared swaps unless an “appropriate committee of the issuer’s board or governing body has reviewed and approved its decision to enter into swaps that are subject to such exemptions” and other aspects of the end-user exemption? A similar requirement for “approval by an appropriate committee” is included for security-based swaps under the SEC’s jurisdiction.
- Are we able to continue to effect bilateral, uncleared swap transactions in the same manner as we have historically done? What alternatives are there to hedge risk?
- How will our relationship with our banks change as a result of these evolving regulatory requirements?
- To what extent are our transactions in swaps subject to CFTC or SEC jurisdiction and oversight? How does that change over time as new regulations and rules are imposed and the regulatory regime evolves?
- How do these rules impact our inter-affiliate transactions?
- What type of derivatives risk management infrastructure and compliance monitoring protocol should we have in place?
In light of the Dodd-Frank Act and various rulemakings of the CFTC and SEC since its passage, the derivatives markets are undergoing an unprecedented regulatory and structural evolution that will present public company end-users of derivatives with both compliance and disclosure challenges, as well as new opportunities. Public companies should continually assess their use of derivatives and the potential implications under the Dodd-Frank Act as this regulatory regime continues to evolve.
1 Among the excepted categories are options on securities subject to the Securities Act of 1933 and the Securities Exchange Act of 1934, contracts for the sale of commodities for future delivery and certain physically settled forward contracts.
© 2012 Schiff Hardin LLP