Audit and Enterprise Risk Services

 

SEC Staff Clarifies Hedging Ramifications of Modifications to Derivative Contracts Made in Response to the Dodd-Frank Act

 

Financial Reporting Alert 12-3

May 15, 2012

In a recent letter to the International Swaps and Derivatives Association, the staff of the SEC’s Office of the Chief Accountant clarified whether certain modifications made to derivative contracts in response to provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Act”) would affect an entity’s hedging relationships. 

The question posed to the staff stems from the requirement in ASC 815-25-401 and ASC 815-30-40 under which a hedging relationship must be discontinued when the hedging derivative “expires or is sold, terminated, or exercised.” The letter describes the following situations in which an entity may legally change or “novate” the counterparties to the hedging derivative contract:

·       Title VII of the Act may require an entity to clear certain derivatives through a central counterparty (e.g., through a clearing organization or agency). To do so, the entity may need to novate derivatives executed in the over-the-counter (OTC) market to replace the original counterparties to the contract with the central counterparty. Furthermore, although the Act does not require clearing of preexisting contracts, an entity still may choose to clear such contracts through a central counterparty.

·       Under Section 716 of the Act, to maintain “federal assistance,” certain entities2 will be prohibited from participating in certain types of derivative transactions. To achieve operational efficiencies, an entity may choose to move existing derivative portfolios from one separate legal entity to another within its consolidated group that is permitted to participate in those types of derivative transactions. Such a move may require the entity to novate the contracts to change the legal counterparties.

The question is whether, under ASC 815, such changes of the legal counterparties to a hedging derivative contract should be treated as a contract termination and trigger discontinuation of the existing hedging relationship. 

In the letter, the SEC staff indicated that a novation of a bilateral OTC derivative contract “on the same financial terms” would not have to be deemed a termination, and that existing hedging relationships could continue, in the following situations “provided that other terms . . . of the contract have not been changed . . . :

·       For an OTC derivative transaction entered into prior to the application of the mandatory clearing requirements [of the Act], an entity voluntarily clears the underlying OTC derivative contract through a central counterparty, even though the counterparties had not agreed in advance (i.e., at the time of entering into the transaction) that the contract would be novated to effect central clearing.

·       For an OTC derivative transaction entered into subsequent to the application of the mandatory clearing requirements [of the Act], the counterparties to the underlying contract agree in advance that the contract will be cleared through a central counterparty in accordance with standard market terms and conventions and the hedging documentation describes the counterparties’ expectations that the contract will be novated to the central counterparty.

·       A counterparty to an OTC derivative transaction who is prohibited by Section 716 of the Act (or expected to be so prohibited) from engaging in certain types of derivative transactions novates the underlying contract to a consolidated affiliate that is not insured by the FDIC and does not have access to Federal Reserve credit facilities.”

In applying this guidance, a registrant should remember the following:

·       Changes to an OTC contract’s terms that result directly from a novation would not trigger discontinuance of hedge accounting (e.g., if the collateral requirements changed because the central counterparty has different requirements than the original counterparties to the derivative contract).

·       This staff guidance could be affected by the FASB’s deliberations in its project on accounting for financial instruments and hedging. The staff has requested the FASB to consider these issues in its deliberations.

Registrants are encouraged to discuss any questions about this guidance with their professional advisers.

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1   For titles of FASB Accounting Standards Codification references, see Deloitte’s "Titles of Topics and Subtopics in the FASB Accounting Standards Codification."

2   The limitation applies to certain FDIC-insured institutions and other entities that have access to “federal assistance,” including banks, thrifts, and U.S. branches of foreign banks.