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Update on the current board issues: July 2013

July 2013
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To achieve diversity, boards may have to shake things up

At a glance

Boards of non-financial companies that use over-the-counter derivatives to hedge risk will have to make many decisions as new rules come into effect.

Issue in focus

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Boards need to know about corporates’ use of derivatives

Non-financial companies that use over-the-counter (OTC) derivatives to hedge risks, such as currency, interest rates, and fuel costs, are facing myriad decisions regarding the execution and management of those financial tools under the Dodd-Frank Wall Street Reform and Consumer Protection Act.

While management is still responsible for making the business decisions, under Dodd Frank the board is now charged with some specific oversight responsibilities. The regulatory reform, which is going into effect in phases this year, will lead to changes in business strategy, funding, operations, and accounting related to the use of derivatives.

Derivatives are agreements between a corporation and a bank that derive their value from underlying assets, such as interest rate payments, currency, commodities, stock, or any other financial instruments that can be traded. Meant to manage future uncertainty, derivatives often occur in the form of swaps and futures. The Dodd-Frank reforms, which include SEC and Commodities Futures Trading Commission (CFTC) rules, regulate the swap market. The futures market is already regulated by the CFTC.

Some in the political and regulatory communities perceive derivatives as a key contributor to the 2008 financial crisis. One of the goals of the Dodd-Frank derivatives provisions is to lessen risk and increase stability in the market. This comes with increased compliance, reporting, and recordkeeping requirements, which will lead to increased costs and changes related to the use of derivatives.

“Non-financial companies have to deal with changes Dodd-Frank made to the derivatives market,” Ray Beier, a partner in PwC’s Financial Services practice, said in a PwC video. “Corporates use the products that the financial institutions sell. And Congress wanted to create a mechanism to drive more transparency in the markets.”

The rules call for company boards to:

  • Decide if it is appropriate to use OTC derivatives in light of increased costs under the reform rules
  • Determine how the company is going to financially support the derivative and meet any cash payments required by the derivative
  • Determine and approve whether the company should declare itself an end-user and avail itself of the end-user exemption (Discussed below).

Chris Rhodes, a partner in PwC’s Transaction Services practice, summarized the situation for non-financial companies with two points. “Those companies need to report all their trades to a central repository so the regulator has an awareness of the open positions and can see where the risk pockets are,” Rhodes said. “Andthere is a mandate for financial institutions and a strong bias for everyone else to post collateral.”

Fred Weiss, an audit committee chair for several BlackRock mutual funds and Actavis Inc., described how his boards have used derivatives to mitigate interest rate and currency risks, including a situation related to an acquisition.

“We have used derivatives to be able to create a financial structure of borrowing that is better than plain vanilla loans,” he said. “In the case of an acquisition of a European company, the audit committee and board got involved in the vetting of the derivatives we put in place as we were trying to lock in the price in dollars.”

With these new rules, if a company uses derivatives in its risk management program it has to determine if it qualifies as a commercial end-user. If it believes it does, then the company has to decide if it makes sense to file for an end-user exemption, which allows the company to use a clearinghouse for its derivatives transactions instead of having to trade on an exchange. Then it has to decide if it is appropriate to continue using those derivatives in light of the increased costs and whether it has the funding to support the derivatives.

“Boards should ask for an early report from the chief corporate counsel and risk management about why the company should be entitled to take that exemption,” said John Manley, a director who is on the audit committee of World Fuel Services Corp. “By requesting that, the board is forcing management to see if the exemption applies to the company.”

Manley, who has served as chief accountant of the CFTC and director of the CFTC’s Division of Trading and Markets, believes even if a company takes the exemption it will most assuredly face higher derivatives costs. Part of those costs would most likely include hiring consultants, he said.

“To develop the reporting requirement regimen, you would almost have to have an outside source to make sure you’re doing it right,” Manley said.

In its 10Minutes on derivatives reform for non-financial services companies PwC developed a short four-question test to determine if a company qualifies for the commercial end user exemption:

  • Are you a financial entity?
  • Are you using derivatives to hedge or mitigate commercial risk?
  • Have you obtained the approval of your board of directors to apply for the end-user exemption?
  • Have the appropriate regulators (i.e., CFTC or SEC) been notified of your plans to use the end-user exemption?

If a company answers “no” to the first question and “yes” to the other questions, then that company would qualify for the exemption.

As for the new recordkeeping and trading regulations, companies using the end-user exemption will have to disclose those activities in their SEC filings.

Under the old regime, companies that used derivatives weren’t required to have any kind of recordkeeping for regulatory purposes. “Under Dodd-Frank, they will be required to maintain certain records. And either they or their counterparty, depending upon who their counterparty is, will be required to report certain features of those derivatives on their behalf,” said Ed Heitin, a partner with PwC’s Financial Services practice.

Generally, companies using derivatives should plan on including the following items in those disclosures:

  • The board’s plan to oversee the use of derivatives and how those derivatives will be used to mitigate risk
  • The attributes of the transactions (i.e., collateralized or non-collateralized)
  • The effective dates.