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Joint Rulemaking on the Definition of Product Terms Under Title VII
July 31, 2012
CFTC and SEC Finalize Product Definitions Rules under Title VII of the Dodd-Frank Act
Key Takeaways:
> The CFTC and the SEC significantly clarified the scope of the definitions of “swap,” “security-
based swap” and “mixed swap” under Title VII of the Dodd-Frank Act.
> Traditional insurance products that satisfy criteria established for a safe harbor are outside of
the scope of Title VII, as are insurance agreements entered into before the effective date of
the product definitions rules and the providers of which meet certain criteria.
> Guarantees of swaps are part of swaps while guarantees of security-based swaps are not
part of security-based swaps or treated as separate security-based swaps.
> Many types of consumer products (e.g., mortgages, consumer loans) and commercial
agreements (e.g., employment agreements, distribution contracts) which might otherwise fit
within the broad statutory definition of “swap” are exempted from the reach of Title VII.
> Loan participations that “reflect” an ownership interest in the underlying loan will not be
considered swaps or security-based swaps, provided that they meet certain criteria. Both
LSTA- and LMA-style loan participations should be outside of Title VII.
> The Commissions provided significant guidance regarding the statutory forward contract
exclusion in the definition of “swap.” The CFTC affirmed that it would apply the existing
precedent in conducting a “facts and circumstances” analysis of whether a forward contract
was outside the scope of Title VII. It also expanded an existing interpretation permitting
parties to a forward contract to “book-out” the delivery requirement without upsetting the
contract’s status as exempt. The CFTC provided guidance on whether a forward contract
with embedded optionality would be within Title VII’s reach.
> Many types of foreign exchange derivatives are “swaps,” though some physically settled FX
products may be exempted from certain aspects of Title VII by the Secretary of the Treasury.
> The Commissions clarified that swaptions, forward swaps, forward rate agreements, contracts
for differences and commodity options are all “swaps” under Title VII.
> The Commissions provided extensive guidance on whether a particular instrument is
considered a swap, a security-based swap or a mixed swap. Such determinations are made
prior to execution and, subject to certain exceptions, status generally does not change during
the contract’s life.
> Derivatives overlying interest or monetary rates are generally swaps while derivatives
overlying yields on securities (other than certain exempt securities) are generally security-
based swaps.
Contents Introduction ........................................... 2
Background ..................................... 2 The Product Definitions Rule .......... 3
Statutory definitions of swap, security-based swap and mixed swap ............... 3
Swap ............................................... 3 Security-based swap ....................... 4 Mixed swap ..................................... 4
Which products are outside Title VII notwithstanding broad statutory definitions? ........................................... 4
Insurance products .......................... 5 Insurance Safe Harbor .................... 6 Insurance Grandfathering ............... 6 Consumer and commercial agreements ..................................... 8 Loan participations ........................ 10 Forward contracts ......................... 10
Which products are within Title VII’s reach? ................................................. 14
Foreign exchange products .......... 14 Guarantees of Title VII Derivatives 15 Swaptions, forward swaps, forward rate agreements and contracts for differences ..................................... 15
How to know if a Title VII Derivative is a swap, SBS or MS? ............................. 16
Rates vs. yields ............................. 16 Treatment of total return swaps containing references to interest rates .............................................. 17 Typical TRS scenario – SBS (single share) ............................................ 17 TRS – MS scenario (single share with unrelated currency exposure) 17 ....................................................... 17 Derivatives overlying futures ......... 18 Narrow-Based Security Indexes ... 18 Index CDS ..................................... 20
How are mixed swaps treated? .......... 22 Obtaining guidance as to a particular transaction’s status?........................... 23 Anti-Evasion Rules ............................. 23 What happens next? .......................... 24 Final reflections .................................. 24 Appendix 1.......................................... 27 Appendix 2.......................................... 32
Joint Rulemaking on the Definition of Product Terms Under Title VII 2
> The Commissions established criteria for determining whether an index credit default swap
will be considered a swap or a security-based swap, establishing tests based on the number
or concentration of the underlying index’s components and the amount of public information
available about such components.
> The Commissions adopted procedures that will allow market participants to obtain
determinations from the Commissions as to whether a particular agreement is a swap, a
security-based swap or a mixed swap.
> The CFTC adopted (and provided guidance concerning) anti-evasion rules that treat as swaps
transactions that are willfully structured to evade Title VII while the SEC declined to adopt any
such rules, instead relying on existing anti-fraud and anti-manipulation provisions of the
federal securities laws that are applicable to security-based swaps.
Introduction
Background
Under Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection
Act (the “Dodd-Frank Act”),1 the Securities and Exchange Commission’s (the
“SEC”) and the Commodity Futures Trading Commission’s (the “CFTC,” together
with the SEC, the “Commissions”) regulatory authority over derivatives and
related matters is keyed to particular product categories. The CFTC has
authority over “swaps.” The SEC has authority over “security-based swaps”
(“SBSs”).2 The Commissions share jurisdiction over mixed swaps (“MSs”).
3
These terms permeate nearly all of Title VII’s operative provisions and their
scope dictates not only which agency regulates a given product, but also whether
a particular product will be subject to regulation under Title VII at all.
Understanding the parameters of these terms is critical in analyzing and
understanding virtually every aspect of Title VII and the rules thereunder. Indeed,
this is why so much of the timing for various compliance requirements has been
keyed to the final entity definitions rule previously adopted by the Commissions
(the “Entity Definitions Rule”)4 and the final product definitions rule (the
“Product Definitions Rule”), which is the subject of this note.5
1 Pub. L. 111-4173, 124 Stat. 1376 (2010).
2 Authority over “security-based swap agreements” (“SBSAs”) is split, though in a different manner
than is applicable to MSs. An SBSA is an agreement of which “a material term is based on the price, yield, value or volatility of any security or any group or index of securities, including any interest therein,” but which is not an SBS. For instance, swaps overlying a broad-based index of securities or swaps overlying U.S. treasuries (which are exempted securities under the federal securities laws) are SBSAs. The CFTC has general regulatory and enforcement authority over SBSAs, but the SEC also has antifraud and certain other authority. The Commissions emphasized that SBSAs will only be subject to the books and records requirements applicable to swaps under CFTC rules. Product Definitions Rule at 320-24.
3 Dodd-Frank Act § 712(a)(8).
4 See Noah Melnick, Caird Forbes-Cockell, Jeff Cohen, Robin Maxwell & Jacques Schillaci, CFTC
and SEC Finalize a Key Piece of the Dodd-Frank Act Registration Requirements Puzzle with the Final Entity Definitions Rules, but Many Pieces of the Puzzle Remain Missing, 32 Future & Derivatives L. Rep’t 15 (June 2012).
5 Among other things, swap dealers (“SDs”) and major swap participants (“MSPs”) must register with
the CFTC by no later than the effective date of the Product Definitions Rule. The SEC has yet to adopt regulations on the registration of security-based swap dealers and major security-based swap participants, and so no registration timetable is available for such entities.
Joint Rulemaking on the Definition of Product Terms Under Title VII 3
The statutory definitions of swap, SBS and MS are exceptionally broad although
they do include some carve-outs and contemplate other carve-outs to be effected
by way of rulemaking. Nevertheless, in light of the requirement for rules further
defining them and the Commissions being empowered to adopt regulations
affecting them,6 there has been significant debate about their scope since the
Dodd-Frank Act was first enacted.
The Product Definitions Rule
In separate votes held on July 6 and July 10, 2012, the SEC and the CFTC,
respectively, approved a final version of the Product Definitions Rule.7 While Title
VII of the Dodd-Frank Act defines many of these terms, it also requires, in some
cases, the Commissions to adopt regulations “further defining” various terms and,
in other cases, permits them to do so. A previous advanced notice of rulemaking
and notice of proposed rulemaking shed some light on the Commissions'
thinking, but only with the adoption of the final Product Definitions Rule is their
approach clear. Among other things, the Product Definitions Rule provides
guidance on whether certain types of agreements and transactions are within or
outside the definitions of swap and SBS, and provides rules and guidance to help
identify MSs.
This note summarizes the key components of the Product Definitions Rule, but
we begin by discussing the statutory definitions of swap, SBS and MS to provide
the proper context in which to understand the Product Definitions Rule since it
largely comprises a narrowing of the statutory definitions of swap and SBS. For
ease of reference, we have included the full text of the statutory definitions of
swap and SBS, as well as MS, in Appendices 1 and 2, respectively.
Statutory definitions of swap, security-based swap and mixed
swap
Swap
Title VII’s statutory definition of the term “swap” is very broad. The statute
enumerates a number of specific types of derivative products that are within the
definition of “swap,” and includes in the term’s definition any agreement “that is,
or in the future becomes, commonly known to the trade as a swap.” In addition,
the statute defines “swap” to include any contract or transaction that provides for
payment “that is dependent on the occurrence, nonoccurrence, or the extent of
the occurrence of an event or contingency associated with a potential financial,
economic, or commercial consequence.”8 This includes, among other things,
credit default swaps on broad-based indices, various other credit derivatives,
most interest rate swaps and currency swaps. SBSs are generally excluded from
6 Dodd-Frank Act § 712(d)(1).
7 Further Definition of “Swap,” “Security-Based Swap,” and “Security-Based Swap Agreement”;
Mixed Swaps; Security-Based Swap Agreement Recordkeeping, available at http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/federalregister071012c.pdf.
8 Dodd-Frank Act § 721(a)(21). See Appendices 1 and 2 hereto.
Joint Rulemaking on the Definition of Product Terms Under Title VII 4
the definition of “swap” with the exception of MSs, which constitute both swaps
and SBSs. See Appendices 1 and 2 for the full text of the statutory definitions of
these terms.
Security-based swap
SBS is defined as a transaction or contract that would be a swap except that it
overlies a security, loan, narrow-based security index or the occurrence of an
event related to a single issuer of securities or a narrow-based index of securities
issuers.9 For example, single-name credit default swaps (“CDSs”), index CDS
overlying a narrow-based index and total return swaps (“TRSs”) overlying
individual equities are SBSs. See Appendices 1 and 2 for the full text of the
statutory definitions of these terms.
Mixed swap
Under Title VII, an MS is an SBS that is also based on rates, commodities,
currencies and other asset classes or reference subject matter that typically
underlie swaps.10
Although SBSs are generally carved-out of the definition of
“swap,” MSs are exceptions to that carve-out and constitute both SBSs and
swaps. See Appendices 1 and 2 for the full text of the statutory definitions of
these terms.
Which products are outside Title VII notwithstanding broad
statutory definitions?
As the Commissions observed, the definitions of “swap” and SBS (any swap,
SBS or MS, a “Title VII Derivative”) could be read to include a number of
agreements and financial products that have not historically been considered
swaps, SBSs or MSs, including many insurance, consumer and commercial
transactions.11
The Product Definitions Rule explicitly exempts a number of such
transactions from those definitions. The Product Definitions Rule also provides
guidance on the treatment of forward contracts under Title VII, specifically
regarding what types of contracts involve the forward sale of a “nonfinancial
commodity” for physical settlement such that they will be outside of the “swap”
definition, as well as guidance concerning security forwards, loan participations
and various other products.
9 Dodd-Frank Act § 761(a)(6).
10 See 7 U.S.C. § 1a(47)(D); 15 U.S.C. § 78c(a)(68)(D).
11 Product Definitions Rule at 16-17.
Joint Rulemaking on the Definition of Product Terms Under Title VII 5
Examples of products and transactions exempted from Title VII
(each as discussed in more detail below)
> Insurance products that meet certain criteria (or are on a list adopted by the
Commissions) the providers of which satisfy certain requirements
> A broad array of consumer products and transactions (e.g., mortgages,
consumer loans, etc.)
> A number of commercial transactions (e.g., employment agreements, leases,
etc.)
> Loan participations
> Forward contracts overlying nonfinancial commodities (e.g., agricultural
commodities, “intangible” commodities, etc.) that are intended to be settled by
physical delivery
> Security forwards
Insurance products
The Commissions adopted a non-exclusive safe harbor12
for insurance products
that satisfy a two-part test (the “Insurance Safe Harbor”). To satisfy the
Insurance Safe Harbor and thus be outside the definitions of swap and SBS, an
insurance agreement or transaction must (1) either be among those specific
products listed by the Commissions (the “Enumerated Products”) or satisfy a
number of product criteria (the “Product Test”), and (2) be provided by a person
or entity that satisfies various provider criteria (the “Provider Test”). The
Commissions also adopted a grandfathering provision (“Insurance
Grandfathering”) excluding from the definitions of swap and SBS pre-effective
insurance transactions (i.e., entered into on or before the effective date of the
Product Definitions Rule) satisfying the Provider Test.13
12
The mere fact that an insurance contract or transaction does not satisfy the Insurance Safe Harbor does not necessarily make it a Title VII Derivative. Product Definitions Rule at 67.
13 Id. at 57-58.
Joint Rulemaking on the Definition of Product Terms Under Title VII 6
Insurance Safe Harbor
Insurance Grandfathering
Enumerated Products14
> Surety bonds > Health insurance > Property and casualty
insurance
> Fidelity bonds > Long-term care
insurance
> Annuities
> Life insurance15
> Title insurance > Disability insurance
> Default insurance on individual
residential mortgage
> Reinsurance of any of the
foregoing
14
The Commissions expressly declined to include the following types of transaction on the list of Enumerated Products: guaranteed investment contracts, funding agreements, structured settlements, deposit administration contracts, immediate participation guaranty contracts, industry loss warrants and catastrophe bonds. Product Definitions Rule at 41-42.
15 The Commissions noted that certain variable life insurance products and annuities are securities and are, therefore, outside the scope of Title VII regardless of the operation of the Insurance Safe Harbor. Product Definitions Rule at 24 n. 42.
If the Product Test is satisfied or the product is an Enumerated Product and
the Provider Test is satisfied, then
Insurance Safe Harbor applies and product is not a swap or SBS (n.b.
product falling outside the Insurance Safe Harbor is not necessarily a Title VII Instrument).
If entered into on or prior to the effective date of the Product Definitions and
the Provider Test is satisfied, then
Insurance Grandfathering applies and product is not a swap or SBS.
Joint Rulemaking on the Definition of Product Terms Under Title VII 7
Product Test
Product Test is satisfied if ALL of the following are true:
> Beneficiary required to (i) have insurable interest16
in agreement’s subject
matter and (ii) carry risk of loss throughout agreement’s duration
> Loss must occur and be proven before payment, and payment must be
limited to the value of the insurable interest
> Insurance is not traded separately from the insured interest17
> With respect to financial guaranty insurance only, any acceleration of
payment (on obligor default or insolvency) is at insurer’s sole discretion
Provider Test
The insurance product must be provided:
> by a person subject to supervision either by a state insurance commissioner
or by the United States (or an agency or instrumentality of either), provided
that the product is regulated as insurance;
> directly or indirectly, by the United States, a state, or any of their respective
agencies or instrumentalities, or pursuant to a statutorily authorized
program;18
> with respect to reinsurance, by a person (the “Reinsurer”) to another person
(the “Cedant”), where:
> the Cedant satisfies the Provider Test,
> the agreement to be reinsured satisfies the Product Test,
> the Reinsurer is not prohibited by applicable law from offering reinsurance
to the Cedant, and
> the total amount reimbursable by all Reinsurers does not exceed the
claims that could be paid by the Cedant (except as otherwise permitted
under applicable law); or
> with respect to property and casualty insurance placed through a surplus line
broker with a non-admitted insurer, by a person either:
> located outside of the United States and listed on the Quarterly Listing of
Alien Insurers maintained by the National Association of Insurance
16
The Commissions indicated that they would interpret the meaning of “insurable interest” consistent with the law governing the contract at issue, but reserved the right to depart from state law if they became aware of evasive conduct. Product Definitions Rule at 42-43.
17 The assignment of an insurance contract that is typical in the insurance industry and authorized by state law is not “trading” under the Product Test. The “health insurance exchanges” created under the auspices of the Federal Patient Protection and Affordable Care Act would not be “exchanges” under the Product Test. Id. at 28.
18 Some examples offered by the Commissions include deposit insurance, crop insurance, flood insurance, terrorism risk insurance and insurance of pension obligations. Id. at 48.
Joint Rulemaking on the Definition of Product Terms Under Title VII 8
Commissioners; or
> meeting the eligibility criteria for non-admitted insurers under applicable
state law.
Consumer and commercial agreements
Noting that the definitions of “swap” and SBS could be read to include many
consumer and commercial agreements, the Commissions enumerate several
types of agreements in the Product Definitions Rule that are not Title VII
Derivatives.
Examples of consumer agreements that are not Title VII Derivatives
> Agreements to acquire or lease real or personal property, to obtain a
mortgage, to provide personal services, or to sell or assign rights owned by a
consumer
> Agreements to purchase products or services for personal or household
purposes at a fixed price or a capped or collared price at a future date or
over a period of time (e.g., agreements to buy home heating fuel)
> Agreements providing an interest rate cap or lock on a consumer loan or
mortgage, provided that the benefit is only realized if the loan or mortgage is
made
> Consumer loans or mortgages with variable rates or embedded interest rate
options, including loans whereby the interest rate changes upon an event
related to the consumer (i.e., in the event of default)
> Consumer product warranties, extended service plans or buyer protection
plans
> Consumer options to acquire, lease or sell real or personal property
> Consumer agreements where the consumer may cancel the transaction
without legal cause
> Consumer guarantees of the credit card debt, automobile loans or mortgage
of a friend or relative
Examples of commercial agreements that are not Title VII Derivatives
> Employment contracts and retirement benefit arrangements
> Sales, servicing and distribution arrangements
> Agreements to effect a business combination (e.g., a merger)
> Agreements to purchase, sell, lease or transfer real property, intellectual
property, equipment or inventory
> Warehouse lending arrangements used to build an inventory of assets in
Joint Rulemaking on the Definition of Product Terms Under Title VII 9
Examples of commercial agreements that are not Title VII Derivatives
anticipation of the securitization of those assets
> Mortgage or mortgage purchase commitments
> Sales of installment loan agreements or receivables
> Commercial loans, including those with embedded interest rate locks, caps
or floors in certain circumstances
> Commercial agreements containing escalation clauses linked to an
underlying commodity, such as an interest rate or the consumer price index
The Commissions emphasized that these lists are not exhaustive, and the
Commissions speculated that “[t]here may be other, similar types of agreements,
contracts, and transactions that also should not be considered” Title VII
Derivatives. The Commissions indicated that they will consider the factors listed
below in determining whether an unenumerated agreement or transaction is or is
not a Title VII Derivative. The Commissions also made clear that a party to an
agreement that is not enumerated and does not satisfy all of the factors below
may seek a determination from the Commissions.19
19
Product Definitions Rule at 142-50.
Factors weighing against finding that a consumer or commercial agreement is a Title VII Derivative
> Payment obligations not severable from the agreement
> It is not traded on an organized market or over the counter
> With respect to consumer agreements, it involves
o an asset consumer owns, is beneficiary of or is
purchasing, and
o a service provided to or by the consumer.
> Re commercial agreements: agreement is entered into by
commercial or non-profit entities as principal to serve an
independent commercial or business purpose and is not
used for speculative purposes
Joint Rulemaking on the Definition of Product Terms Under Title VII 10
Loan participations
Loan participations20
that “reflect” an ownership interest in the underlying loan are
not Title VII Derivatives, provided they satisfy the criteria listed below.
Accordingly, neither LMA-style nor LSTA-style loan participations would be Title
VII Derivatives. This reflects a departure from the proposed rule, which looked to
see whether or not a “true participation” had been achieved.21
Loan Participation Criteria
A loan participation will not be considered a Title VII Derivative if:
> the grantor of the participation is either a lender or a participant in the
underlying loan,
> the aggregate participation in the underlying loan of all participants does not
exceed the principal amount of the loan,
> the grantor of the participation does not grant a greater interest than it holds
in the loan,
> the purchase price of the participation is paid in full and not financed, and
> the participation provides the participant all of the economic benefit and risk
of the portion of the underlying loan that is the subject of the participation.
Forward contracts
Examples of Forward Contracts within the Forward Contract Exclusion
> A forward contract in a nonfinancial commodity intended to be physically
settled is not rendered outside the exclusion if settled by a “book-out” of the
physical settlement requirement.
> Under the Brent Interpretation, an investment fund taking delivery of gold as
part of investment strategy not within the exclusion because its activity would
not be considered “commercial” in nature, a but a gold forward used by a
jewelry manufacturer owned by an investment fund would be within the
exclusion since it is being used to meet the commercial needs of the jewelry
business.
> A forward contract having embedded optionality will be within the exclusion if
it satisfies certain criteria. For example, a forward contract would not fall
outside the exclusion merely because it allows a counterparty the option to
renew or to alter the location of physical delivery.
> Forward contracts with embedded volumetric optionality that meet a set of
20
The Commissions cautioned, however, that a loan participation could be considered a security under the federal securities laws or an “identified banking product” under federal banking laws. Product Definitions Rule at 162.
21 Id. at 161-66.
Joint Rulemaking on the Definition of Product Terms Under Title VII 11
criteria will also be within the exclusion. For instance, a forward contract for a
nonfinancial commodity that allowed a counterparty to alter the volume to be
delivered as a result of changed needs or market conditions would still be
within the exclusion.
> Physical exchange transactions for physical delivery and fuel delivery
transactions are within the forward contract exclusion.
Title VII’s definitions of swap and SBS exclude forward contracts (the “Title VII
Forward Exclusion”), which are defined as “any sale of a nonfinancial
commodity or security for deferred shipment or delivery, so long as the
transaction is intended to be physically settled.”22
The CFTC explained that it
would interpret the Title VII Forward Exclusion in a manner consistent with
existing CFTC guidance and precedents on the exclusion from the scope of
commodity futures for forward contracts, treating them instead as “commercial
merchandising transactions” outside the scope of regulation.23
The CFTC also
specifically discussed and expanded on the “Brent Interpretation”24
and
enumerated several types of commodities that will be considered “nonfinancial”
within the scope of the Title VII Forward Exclusion. The CFTC also withdrew the
“Energy Exemption”25
and provided additional guidance about the treatment of
forwards containing embedded optionality.
Brent Interpretation
Under the Brent Interpretation, as applied to the Title VII Forward Exclusion, a
forward contract remains outside the scope of Title VII even if the parties to the
contract “book-out” the obligation to deliver the nonfinancial commodity at some
time after the forward contract was agreed. Under these circumstances, there
will be no physical delivery of the commodity under the contract, but the CFTC
indicated that such a contract would remain excluded from Title VII, provided that
the parties intended for physical delivery at the time the agreement was signed,
and that the “book-out” was the subject of a subsequent, separately negotiated
agreement.26
The CFTC also expanded the Brent Interpretation, which originally
applied only to forward contracts for oil, to include all nonfinancial commodities.27
According to the CFTC, only contracts for “commercial” purposes are eligible for
the Brent Interpretation, and the term “commercial” in this context means “related
22
7 U.S.C. § 1a(47)(B)(ii). 23
Product Definitions Rule at 74-78. 24
See Statutory Interpretation Concerning Forward Transactions, 55 Fed. Reg. 39188 (Sept. 25, 1990).
25 See Exemption for Certain Contracts Involving Energy Products, 58 Fed. Reg. 21286 (Apr. 20, 1993).
26 The CFTC also noted that the “[i]ntent to make or take delivery can be inferred from the binding delivery obligation for the commodity referenced in the contract and the fact that the parties to the contract do, in fact, regularly make or take delivery of the referenced commodity in the ordinary course of their business.” Product Definitions Rule at 80.
27 Id. at 78-82, 85-86. As noted above, in connection with the expansion of the Brent Interpretation, the CFTC withdrew the “Energy Exemption,” which had previously expanded the Brent Interpretation to forward contracts for energy commodities other than oil. Id. at 83-85.
Joint Rulemaking on the Definition of Product Terms Under Title VII 12
to the business of a producer, process, fabricator, refiner or merchandiser.” The
agency noted that, while an enterprise need not be engaged solely in commercial
activity for its forward contracts to be within the Title VII Forward Exclusion, it
would abide by its longstanding view of the Brent Interpretation that a hedge
fund’s investment activity is not commercial activity. Thus, the CFTC explained
that if an investment vehicle takes delivery of gold as part of an investment
strategy, that activity would not be considered a commercial merchandising
transaction and would not be covered by the Brent Interpretation. If, however,
the investment vehicle used a forward contract for gold to supply the raw
materials to support a business (e.g., a jewelry manufacturer) that it owned, such
a contract could satisfy the Brent Interpretation.28
Nonfinancial commodities
The CFTC also provided significant guidance as to which commodities would be
considered “nonfinancial” and thus eligible for the Title VII Forward Exclusion. It
explained that a “nonfinancial” commodity is:
> one that can be physically delivered and
> is an exempt commodity29
or an agricultural commodity.30
The CFTC also stated that an intangible commodity is also a nonfinancial
commodity if it:
> is not an “excluded commodity,”31
> can be physically delivered,
> can be “conveyed in some manner,” and
> can be consumed.32
The CFTC also clarified that “environmental commodities” are intangible
commodities (and thus, nonfinancial commodities), though it declined to provide a
definition of “environmental commodity.”33
The CFTC also interpreted forward
contracts for nonfinancial commodities to include physical exchange transactions
and fuel delivery agreements.34
Forwards with embedded optionality
Commodity options are explicitly included within the definition of “swap.”35
The
Commissions, however, provided guidance with respect to whether a forward
28
Product Definitions Rule at 81-82. 29
The Commodity Exchange Act defines an “exempt commodity” as one that is neither an “excluded commodity or an agricultural commodity. 7 U.S.C. § 1a(20). Excluded commodities include interest rates, currency, security indexes, commercial indexes, etc. 7 U.S.C. § 1a(19).
30 The CFTC has defined the term “agricultural commodity” by regulation. See 17 C.F.R. § 1.3(zz).
31 See note 29.
32 Product Definitions Rule at 93-95.
33 Id. at 95-99.
34 Id. at 104-07.
35 The CFTC has proposed revisions to its options rules, but did not provide additional guidance with respect to the treatment of commodity options in the Product Definitions Rule.
Joint Rulemaking on the Definition of Product Terms Under Title VII 13
contract over a nonfinancial commodity with “embedded optionality” will be
considered within the Title VII Forward Exclusion.36
The CFTC also provided guidance with respect to forward contracts with
“volumetric optionality” that grant a party the option to adjust the amount of a
commodity to be delivered.37
Security forwards
Title VII expressly excludes purchases and sales of securities on a fixed or
contingent basis and sales of securities for deferred shipment or delivery that are
intended to be physically settled (i.e., forward contracts on securities) from the
definition of swap and SBS. With respect to security forwards, the sale occurs at
the time the contract is entered into with performance deferred or delayed, and if
intended to be physically settled, such contracts are within the security forward
exclusion to the swap and SBS definitions.38
These contracts could also fit within
the other statutory carve-out for certain purchases and sales of securities on a
fixed or contingent basis from the definitions of swap and SBS.39
In addition to
36
The CFTC specified that a renewal option in a forward contract would not be considered an embedded option. Product Definitions Rule at 122.
37 The CFTC explicitly stated that “requirements” and “outputs” forward contracts do not contain volumetric optionality and are within the Title VII Forward Exclusion. Id. at 119-20.
38 Id. at 138.
39 Id.
Forward contract with embedded optionality will not be a swap if the embedded option:
> may be used to adjust the forward contract price, but does not change the
contract’s overall nature as a forward;
> does not affect the delivery term, such that the “predominant feature” of the
forward contract is actual delivery; and
> cannot be severed and marketed separately from the forward contract.
Forward contract with volumetric optionality will not be a swap if:
> the optionality does not undermine the nature of the contract as a forward;
> the “predominant feature” of the forward contract is actual delivery;
> the optionality cannot be severed and marketed separately from the forward;
> at the time of the agreement, the seller of the underlying commodity intends to
deliver that commodity if the optionality is exercised;
> both counterparties are “commercial parties;” and
> the decision to exercise the optionality is based on physical factors or
regulatory requirements that are outside the parties’ control and that are
influencing demand for or supply of the commodity.
Joint Rulemaking on the Definition of Product Terms Under Title VII 14
restating this, the Commissions provided guidance that contracts for the future
delivery of mortgage-backed securities purchased through the “To-Be-
Announced” market are considered security forwards.40
Which products are within Title VII’s reach?
In addition to explicitly carving out a number of categories of agreements and
transactions, the Commissions adopted regulations and provided guidance with
respect to certain groups of transactions that are Title VII Derivatives.
Agreements and transactions considered Title VII Derivatives and
discussed in the Product Definitions Rule
> Foreign exchange swaps and foreign exchange forwards (unless exempted
by the Secretary of the Treasury)
> Foreign currency options
> Non-deliverable foreign currency forwards
> Currency swaps and cross-currency swaps
> Guarantees of swaps, but not guarantees of SBS (though SBS guarantees
are securities)
> Swaptions (options on swaps)
> Forward swaps
> Forward rate agreements
> Contracts for differences and total return swaps
> Commodity options, but not forward contracts with embedded optionality that
meet certain conditions (discussed above)
Foreign exchange products
Under the Product Definitions Rule, a wide variety of forex transactions would be
considered swaps. Under the Dodd-Frank Act, “foreign exchange forwards” and
“foreign exchange swaps,” both of which are defined to involve the actual
exchange of two currencies, are within the definition of “swap” unless the
Secretary of the Treasury issues a determination that they should not be
regulated as swaps. The Secretary has proposed to make such a determination,
but has not yet finalized it.41
The Commissions adopted rules that would define
“swap” to include both foreign exchange forwards and swaps, noting that they
40
Product Definitions Rule at 137-40. The Commissions indicated that the To-Be-Announced market “allows mortgage lenders essentially to sell the loans they intend to fund even before the loans are closed.” In this market, lenders enter into forwards to deliver mortgage-backed securities for mortgage loans which they have not yet made. Id. at 139.
41 Determination of Foreign Exchange Swaps and Foreign Exchange Forwards under the Commodity Exchange Act, available at http://www.treasury.gov/initiatives/wsr/Documents/FX%20Swaps%20 and%20Forwards%20NPD.pdf.
Joint Rulemaking on the Definition of Product Terms Under Title VII 15
would cease to be regulated as such if the Treasury finalizes its determination
although they would still be subject to various other requirements under Title
VII.42
In addition, the Commissions adopted rules defining the term “swap” to include
other forex products, including foreign currency options,43
non-deliverable foreign
currency forwards (“NDFs”),44
currency swaps and cross-currency swaps.45
The Commissions did acknowledge that certain types of forex transactions are
excluded from Title VII. The Commissions stated that Title VII’s definition of
“foreign exchange forward” could be read to include some foreign exchange spot
transactions, which typically settle two days after the trade date, but reasoned
that Congress had not intended Title VII to reach such spot trades. They
concluded that bona fide forex spot transactions would not be considered
swaps.46
In addition, the CFTC explained that retail foreign currency options that
are executed off of an exchange by non-ECPs pursuant to Section 2(c)(2)(B) of
the Commodity Exchange Act would be considered outside the definition of
“swap.”47
Guarantees of Title VII Derivatives
Under the Product Definitions Rule, the term “swap” includes a guarantee of a
swap if the counterparty would have recourse to the guarantor.48
The CFTC
indicated that it will issue a separate release discussing the practical implications
of including guarantees within the definition of “swap.” Conversely, the guarantee
of an SBS is not itself an SBS or part of the guaranteed SBS. The SEC will
consider issuing rules on the reporting of such guarantees and the impact of SBS
guarantees on the extraterritorial reach of its Title VII regulations. Additionally, a
guarantee of an SBS is a security under the Securities Act of 1933 (the “1933
Act”).49
Swaptions, forward swaps, forward rate agreements and contracts for
differences
The Commissions also provided interpretations that a number of other derivative
products would be considered Title VII Derivatives. Under the Product Definitions
Rule, both options and forwards on Title VII Derivatives would themselves be
42
Product Definitions Rule at 168-70. 43
Forex options that are traded on a national securities exchange are securities under the federal securities laws, and are thus not Title VII Derivatives. Id. at 174.
44 Unlike a foreign exchange forward, under an NDF, the parties do not physically deliver the underlying currencies, but instead settle the contract in a reserve currency. The Commissions determined that NDFs do not meet the statutory definition of foreign exchange forwards and are thus not subject to the Secretary of the Treasury’s exemptive authority. They also determined that NDFs are outside of the scope of the Title VII Forward Exclusion. Id. at 175-77.
45 Id. at 173-83.
46 Id. at 183-86.
47 The CFTC explained that the Dodd-Frank Act’s failure to expressly exclude such transactions from the definition of “swap” appears to be a scrivener’s error. Product Definitions Rule 187-90.
48 Financial guaranty insurance in respect of a swap will be treated like any other swap guarantee. Id. at 68. Even a guarantee offered only partial recourse to the guarantor is within the definition of “swap.” Id. at 69-70.
49 Id. at 73-74.
Joint Rulemaking on the Definition of Product Terms Under Title VII 16
Title VII Derivatives.50
Forward rate agreements, which “provid[e] for the future
(executory) payment based on the transfer of interest rate risk between the
parties” are swaps under Title VII.51
Finally, a contract for differences, “an
agreement to exchange the difference in value of an underlying asset between
the time at which [the contract] is established and the time at which it is
terminated,” is a Title VII Derivative.52
How to know if a Title VII Derivative is a swap, SBS or MS?
Determining what type of Title VII Derivative (i.e., swap, SBS or MS) a product is
dictates whether the CFTC’s or the SEC’s regulations (or both) will apply to a
particular transaction or market participant. The Product Definitions Rule
provides guidance to assist counterparties in making this determination.
According to the Commissions, market participants should make a determination
as to whether a Title VII Derivative is a swap, an SBS or an MS prior to execution
“but no later than when the parties offer to enter into” the Title VII Derivative.53
Such a determination generally lasts throughout the term of a transaction, even if
the asset underlying the derivative changes in certain circumstances (although
any amendment will be treated as a new transaction and require a new
determination to be made), subject to certain exceptions (as discussed in more
detail below).
Rates vs. yields
Under the Product Definitions Rule, Title VII Derivatives overlying interest or
other monetary rates54
are generally swaps, while such instruments overlying the
yield, price or value of a single security, loan or a narrow-based security index
are generally SBSs. Thus, for instance, an instrument referencing the London
Interbank Offer Rate (“LIBOR”) would be a swap, but an instrument referencing
the yield on a corporate note by reference to that note would be an SBS.55
If a
rate contained in a Title VII Derivative references a security yield but is fixed at
the time of execution, however, that instrument would be a swap (assuming it
does not otherwise reference a security, loan or narrow-based index) and not an
SBS or an MS, though if that rate were to fluctuate or “reset” during the life of the
instrument, it would be an SBS or an MS.56
50
Product Definitions Rule at 192-93. 51
Id. at 190-92. 52
Id. at 193-95. 53
Id. at 202. 54
Among the types of monetary rates, the Commissions list interbank offered rates (e.g., LIBOR, Euribor), money market rates (e.g., the Federal Funds Effective Rate), government target rates (e.g., the Federal Reserve’s discount rate), general lending rates (e.g., the prime rate, rates in the commercial paper market) and rates derived from indexes of other rates.
55 If, however, a Title VII Derivative references the yield of a U.S. treasury or other “exempted securities” (as referenced in Section 3(a)(12) of the Securities Exchange Act of 1934 as of January 11, 1983) or an index comprised solely of such exempted securities, it is a swap. Product Definitions at 203-10.
56 Product Definitions Rule at 232-34.
Joint Rulemaking on the Definition of Product Terms Under Title VII 17
Treatment of total return swaps containing references to interest rates
The Commissions set forth considerable guidance on how total return swaps
(“TRSs”) that are SBSs (e.g., a TRS on a single loan, security or narrow-based
index), but which contain references to interest rates, should be treated.
Generally, where a TRS buyer’s (i.e., the total return receiver’s) financing
payment is calculated with reference to a rate such as LIBOR, that TRS may still
be considered an SBS if it otherwise would be (i.e., if it references a security,
loan or narrow-based index).57
If, however, a TRS creates “additional interest
rate or currency exposures that are unrelated to the financing of the SBS, or
otherwise shift[s] or limit[s] risks that are related to the financing of the SBS,” the
TRS will be considered an MS.58
Typical TRS scenario – SBS (single share)
TRS – MS scenario (single share with unrelated currency exposure)
In response to comments, the Commissions also provided guidance with respect
to quanto equity59
and compo equity60
swaps. Because the exchange rate
exposure in a quanto equity swap is “incidental” to the exposure to the underlying
57
The Commissions noted that the calculation of a financing rate in a currency other than that of the underlying asset also would not cause a TRS to become a mixed swap. Product Definitions Rule at 212.
58 Product Definitions Rule at 210-13. As an example, the Commissions point out that if counterparties include interest rate caps, collars, calls or puts in the terms of a TRS that would otherwise be an SBS, it would be considered an MS. If the two branches of such a TRS were documented separately, however, they would likely be considered a separate swap and an SBS.
59 A quanto equity swap is one that “provide[s] a U.S. investor with currency-protected exposure to a non-U.S. equity index by translating the percentage equity return in the currency of such non-U.S. equity index into U.S. dollars.” Id. at 213.
60 A compo equity swap is one in which “the parties assume exposure to, and the total return is calculated based on, both the performance of specified foreign stocks and the change in the relevant exchange rate.” Id. at 215.
Final Exchange of € for £, settled in ¥
Initial Exchange of Forward € for £
Depreciation
Appreciation + Dividends
LIBOR + X%
Total Return Receiver
Total Return Payer
Depreciation
Appreciation + Dividends
LIBOR + X% Total Return
Receiver Total Return
Payer
Joint Rulemaking on the Definition of Product Terms Under Title VII 18
security index, a quanto equity swap is considered an SBS where the underlying
index is narrow-based. In contrast, because a compo equity swap offers the TRS
buyer exposure to that currency risk, it will be considered an MS (to the extent
that, without the currency aspect, it would be considered an SBS).61
The
Commissions also explained that, while a TRS overlying a single loan is an SBS,
a TRS overlying more than one loan is a swap.62
Derivatives overlying futures
Generally, a Title VII Derivative overlying a security future (including a future on a
narrow-based index of securities) is an SBS, but such an instrument overlying
any other type of future is a swap. However, the treatment of Title VII Derivatives
overlying a future on a foreign government debt security is more complicated.
Under SEC Rule 3a12-8, futures on the government securities of 21 different
nations63
are carved out of the definition of “security future” and are thus subject
to CFTC regulation. A Title VII Derivative overlying futures contracts on those 21
nations’ debt securities are swaps, not SBSs, if they satisfy a number of criteria
identified by the Commissions.64
Title VII Derivatives overlying the actual debt
securities of those nations, however, are SBSs.65
Narrow-Based Security Indexes
One of the more complicated topics discussed by the Commissions in the
Product Definitions Rule is what constitutes a narrow-based security index. As
noted above, a Title VII Derivative that overlies a narrow-based security index is
an SBS, while such an instrument overlying a broad-based security index is a
swap. Under the Commodity Exchange Act and the Securities Exchange Act of
1934 (the “1934 Act”), an index is considered narrow-based if any of the
following are true:
> It has nine or fewer components
> Any single component comprises > 30% of its weighting
> Its five highest-weight components comprise > 60% of its weighting
> The lowest-weighted component securities comprising 25% of the index’s
weighting have an aggregate dollar value of average daily trading volume
< $50 million (or < $30 million if the index has > 15 components)66
The Commissions discussed previous joint guidance as to whether a volatility
index or an index of debt securities are considered narrow-based and concluded
61
Product Definitions Rule at 213-15. 62
Id. at 216. 63
Those nations include the United Kingdom, Canada, Japan, France and Switzerland. See 17 C.F.R. § 240.3a12-8(a)(1).
64 In order to qualify as a swap (rather than an SBS), such a Title VII Derivative must (1) reference a “qualifying foreign futures contract” as defined in Rule 3a12-8, (2) be traded on or through a board of trade, (3) be cash settled, (4) not be entered into by the foreign country issuer referenced by the futures contract, and (5) the foreign government’s debt securities must not be registered under the Securities Act of 1933 or be the subject of a registered American Depository Receipt. Id. at 227.
65 Id. at 223-31.
66 15 U.S.C. 78c(a)(55)(B).
Joint Rulemaking on the Definition of Product Terms Under Title VII 19
that this guidance applies in the Title VII context, except to the extent it conflicts
with the Commissions’ new rules on index credit default swaps (“CDS”).67
Indexes that “migrate”
In most cases, it should be relatively simple to determine whether a transaction is
a swap, SBS or MS, but with respect to certain categories of products, the
determination can be a bit tricky. This is particularly true where the relevant
product has the potential to evolve or change over time. Under the Product
Definitions Rule, a Title VII Derivative overlying an index may, in certain
circumstances, move from being a swap to being an SBS (or vice versa) if
components of that underlying index change in number, composition or
concentration, causing the index to “migrate” from broad- to narrow-based (or
vice versa). In such cases, it is necessary to consider the basis on which such
migration can occur, e.g., is it pursuant to a predetermined formula the
application of which could lead to varying outcomes, can one or both parties
actively make modifications to its composition that could change its
characterization and so on and so forth. The table below summarizes the
circumstances in which migration of index-based products would lead to
recharacterization.
“Migrating” Indexes
If the following concerning the
index underlying the Title VII
Derivative is true …
then that Title VII Derivative is …
> It contains a provision granting
either party or both parties the
discretionary authority to change
the composition or weighting of the
index
> an SBS.68
> It contains predetermined criteria or
a formula intentionally designed
to “migrate” the index from narrow-
based to broad-based or vice versa
> an MS.69
> It contains predetermined criteria or
a formula not intentionally
designed to “migrate” the index,
but which could have the effect of
causing such a migration
> a swap, an SBS or an MS,
depending on its characteristics at
the outset, and it remains the same
throughout the life of the
transaction.
67
Product Definitions Rule at 238-41. 68
Id. at 288-92. The Product Definitions Rule also establishes certain “tolerance periods” and grace periods to allow swap execution facilities, designated contract markets and other trading platforms the ability to continue trading a given instrument even if the underlying index migrates from narrow- to broad-based. Id. at 298-304.
69 Id. at 293-96.
Joint Rulemaking on the Definition of Product Terms Under Title VII 20
“Migrating” Indexes
If the following concerning the
index underlying the Title VII
Derivative is true …
then that Title VII Derivative is …
> The parties amend or modify the
Title VII Derivative during its life
> a swap, an SBS or an MS,
depending on its characteristics at
the time of the amendment or
modification.
Index CDS
An index CDS offers credit protection on a basket of reference entities or
reference obligations rather than a single entity, loan or security. Like other Title
VII Derivatives, if an index CDS references either an index of securities or the
occurrence or non-occurrence of a credit event relating to issuers of securities in
a narrow-based index, it would be an SBS, though if it references a broad-based
index, it would be a swap. In the Product Definitions Rule, the Commissions
provide further definition of the terms “narrow-based security index” and “issuers
of securities in a narrow-based security index” with respect to index CDS.
Specifically, they indicate that if an index CDS is based on an index of loans that
are not securities, an event relating to one of those loans would be considered an
event relating to the borrower. If that borrower is an issuer of securities, the
index CDS based on that index of loans may be considered an SBS if the index
of loans is narrow-based. Such an index of loans would be considered an “index
of issuers” under the SBS definition.70
The Commissions also provide extensive guidance on the conditions under which
an index of securities or an index of issuers of securities underlying an index
CDS will be considered narrow-based. First, an index will be considered narrow-
based if it satisfies any of the three prongs borrowed from the Commissions’ debt
security index test (the “Numbers and Concentration Test”). Even if an index is
not narrow-based under the Numbers and Concentration Test, it will be
considered narrow-based if at least 80% of its components meet at least one of
the criteria established by the Commissions to ensure that adequate public
information concerning those components is available (the “Public Information
Availability Test”), and no single component that does not satisfy the Public
Information Availability Test represents 5% or more of the index’s weighting.71
The details of these tests are contained in the table below.
70
Product Definitions Rule at 245-47. 71
The Commissions indicated that the Public Information Availability Test is designed in part to ensure that indexes are not constructed in a manner to allow their component entities to circumvent the disclosure and reporting requirements of the federal securities laws. Id. at 267.
Joint Rulemaking on the Definition of Product Terms Under Title VII 21
Numbers and Concentration Test
If an index has any of the following characteristics, it is a narrow-based
index, and the overlying index CDS is an SBS:72
With respect to indexes of
securities…
With respect to indexes of issuers of
securities…
> Nine or fewer securities (count
securities issued by affiliated
issuers as one) in the index
(security only considered an index
component if credit event with
respect to it or its issuer results in
or affects payments under the
index CDS)
> Effective notional amount of any
issuer’s securities > 30% of the
index’s weighting
> Aggregate effective notional
amount allocated to the securities
of any five non-affiliated issuers >
60% of the index’s weighting
> Nine or fewer non-affiliated issuers
of securities in the index (issuer
only considered index component if
credit event with respect to it
results in or affects payments
under the index CDS)
> Effective notional amount of any
reference entity > 30% of the
index’s weighting
> Aggregate effective notional
amount of any five non-affiliated
reference entities > 60% of the
index’s weighting
Even if an index is not deemed narrow-based under the Numbers and
Concentration Test, it may be found to be so under the Public Information
Availability Test.
Public Information Availability Test
Determine which of the reference entities (for an index of issuers of securities)
or issuers of reference securities (for an index of securities) satisfy at least one
of the following criteria:
N.b., if at least 80% of the notional amounts of the index are allocated to
reference entities or securities whose issuers satisfy one of the criteria
below, and any individual entity or issuer does not satisfy the below
criteria represents 5% or less of the notional amount of the index, then
the index will be considered narrow-based, and the index CDS overlying
it will be an SBS.
Otherwise, the index will be considered broad-based and the overlying
72
In applying the Numbers and Concentration Test, market participants should treat an issuer of a security or a reference entity, along with all of its affiliates, as a single entity, except with respect to issuers of asset-backed securities (“ABS”), each of which are treated as a separate reference entity or reference obligation. For instance, if an index references multiple affiliates that collectively comprise 30% of an index’s weighting, those affiliates would be considered a single component in the index and the second prong of the Numbers and Concentration Test would be met. Product Definitions Rule at 257-59.
Joint Rulemaking on the Definition of Product Terms Under Title VII 22
Public Information Availability Test
index CDS will be a swap.
> The reference entity or the reference obligation issuer is subject to periodic
reporting under the 1934 Act;73
> The reference entity or the reference obligation issuer is a foreign private
issuer eligible to rely on the exemption provided by Rule 12g3-2(b) under the
1934 Act;
> The reference entity or the reference obligation issuer has a worldwide
market value of outstanding common equity held by non-affiliates ≥ $700mm;
> A non-ABS reference entity or non-ABS reference obligation issuer has
outstanding notes, bonds, debentures, loans or evidences of indebtedness
(other than revolving credit facilities) > $1 billion;
> The reference obligation is an exempted security or the reference entity
issues an exempted security;
> The reference entity or the reference obligation issuer is a government or
political subdivision of a foreign country;
> With respect to an ABS reference entity or ABS reference obligation issuer,
such ABS was registered under the 1933 Act and has publicly available
distribution reports; or
> With respect to index CDS transactions between ECPs,
> for non-ABS, the reference entity or the reference obligation issuer, makes
available to the public or the ECP information required by Rule
144A(d)(4);74
> for non-ABS, financial information about the reference entity or the
reference obligation issuer is otherwise publicly available; or
> for ABS, information of the type and level included in public distribution
reports for similar ABS is publicly available about the ABS and its issuer.
How are mixed swaps treated?
According to the Product Definitions Rule, the category of MSs is intentionally
narrow under Title VII and was designed to prevent gaps in the regulation of
swaps and SBSs. The Commissions adopted a regulation that lays out which of
each agency’s rules will apply with respect to uncleared bilateral transactions in
MSs entered into by at least one counterparty that is dual registered as (1) either
73
With respect to the first four prongs of the Public Information Availability test, a component reference entity or issuer of securities may determine whether they meet the criteria by looking to both themselves and their affiliates. Thus, if a reference entity is not a reporter under the Exchange Act, it will nonetheless satisfy the first prong of the test if one of its affiliates is. Similarly, in determining whether it has a worldwide market value of $700 million, an issuer would add its worldwide market value to that of all of its affiliates. Product Definitions Rule at 278-82.
74 Market participants may apply the same affiliation standard described in note 73 with respect to the first two prongs of the special tests for index CDS transactions between ECPs. Id. at 279.
Joint Rulemaking on the Definition of Product Terms Under Title VII 23
an SD or MSP and (2) either an SBS dealer or major SBS participant. The
regulation specifies that such transactions will generally be subject to SEC rules,
but will also be subject to CFTC rules regarding capital, reporting, examinations,
position limits and enforcement. The Commissions also established a procedure
by which exchanges and clearing organizations that wish to list, trade or clear an
MS may obtain a determination from them that such an organization may comply
with only one Commission’s rules rather than attempting to comply with both.75
Obtaining guidance as to a particular transaction’s status?
The Product Definitions Rule creates a procedure to seek a joint interpretation
from the Commissions as to whether a particular instrument is a swap, an SBS or
an MS. To obtain such a determination, a market participant must submit (1)
material information about the instrument in question, (2) a statement of the
instrument’s economic purposes and characteristics, and (3) the requestor’s own
determination of whether the instrument is a swap, an SBS or an MS. The rule
generally requires the Commissions to provide an interpretation within 120 days
or to provide a written explanation for why they have not issued such an
interpretation.76
Anti-Evasion Rules
In the Product Definitions Rule, the CFTC adopted broad anti-evasion rules that
include within the definition of swaps “transactions that are willfully structured to
evade the provisions of Title VII.” In addition to a general anti-evasion provision,
the CFTC’s anti-evasion rules specifically target transactions designed to
disguise swaps as identified banking products or foreign exchange swaps and
forwards subject to the Treasury Department exclusion discussed above.
Further, the CFTC adopted a rule making it illegal to enter into a transactions
outside of the United States “to willfully evade or attempt to evade” Title VII, and
considering such transactions subject to Title VII.77
Evasive transactions will also
be included in determining whether a person should register as an SD or MSP.78
In determining whether a transaction is evasive, the CFTC emphasized that it
would not consider the form or documentation of a transaction dispositive, but
would instead “examine its actual substance and purpose.” The CFTC also
provided guidance indicating that it would not consider willfully evasive
transactions that were structured in a certain manner for a “legitimate business
purpose.” It also indicated it would consider the extent to which a transaction
involved fraud or deceit in determining whether it was willfully evasive. The
agency specified that transactions that fall within the Title VII Forward Exclusion
would not be considered evasive, and that where one party to an evasive
75
Product Definitions Rule at 310-18. 76
Id. at 324-29. 77
Id. at 334-41. 78
Id. at 343.
Joint Rulemaking on the Definition of Product Terms Under Title VII 24
transaction was innocent and did not partake of the effort to evade Title VII, the
CFTC would only impose sanctions on the guilty party.79
The SEC declined to adopt any anti-evasion rules under Title VII, noting that SBS
are “securities” and are subject to the full panoply of anti-fraud and anti-
manipulation rules of the federal securities laws.80
What happens next?
The compliance deadlines or effective dates of many of the final rules previously
adopted by the CFTC are triggered by the effectiveness of the Product Definitions
Rule and the Entities Definitions Rule, the latter of which is already effective.
Among others things, by the effective date of the Product Definitions Rule, SDs
and MSPs must register with the CFTC, comply with internal business conduct
standards, and commence real-time reporting of swap transactions. The
effective date of the Product Definitions Rule is 60 days after its publication in the
Federal Register. Assuming that the Product Definitions Rule are soon
published, that registration deadline will be in late September or early October
2012.
Notably, the CFTC only issued proposed guidance on whether non-U.S. swap
market participants will be required to register on June 29, 2012.81
The comment
period on that guidance extends until August 27, 2012, and it is unlikely that the
CFTC will finalize it by the registration deadline. In the absence of final guidance,
it is unclear how non-U.S. entities should determine what their registration and
compliance obligations are. While there is a reasonable possibility that the CFTC
will grant no-action relief to non-U.S. entities until the guidance is finalized, at the
moment, foreign market participants are at a disadvantage in terms of knowing
how to proceed.
Final reflections
More than two years following the enactment of the Dodd-Frank Act, significant
rulemaking progress has been made, but much remains to be done. While the
adoption of final entity and product definitions is a significant step in the right
direction, we have yet to see a host of very important rules from the
Commissions. In particular, the CFTC’s proposed guidance on the extraterritorial
application of Title VII is very clearly in the proposal stage, and we have yet to
see similar guidance from the SEC. The SEC also continues to lag behind the
CFTC on a number of other important rulemaking topics. Additionally, virtually no
progress has been made in the area of international harmonization and we have
already begun to see adverse reactions from regulators abroad in response to
the CFTC’s proposed guidance on the extraterritorial application of Title VII. As
79
Product Definitions Rule at 341-55. 80
Id. at 355-56. 81
Cross-Border Application of Certain Swaps Provisions of the Commodity Exchange Act, 77 Fed. Reg. 41214 (July 12, 2012), available at http://www.cftc.gov/ucm/groups/public/@lrfederalregister/documents/file/2012-16496a.pdf.
Joint Rulemaking on the Definition of Product Terms Under Title VII 25
such, we expect it to be quite some time before the full parameters of the
international regulatory landscape become clear even as significant progress
continues to be made domestically in the United States.
Joint Rulemaking on the Definition of Product Terms Under Title VII 26
//
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Appendix 1
“Swap”: Section 721(a)(21) of the Dodd-Frank Act: “(47) SWAP.—
(A) IN GENERAL.—Except as provided in subparagraph (B), the term ‘swap’
means any agreement, contract, or transaction—
(i) that is a put, call, cap, floor, collar, or similar option of any kind that is
for the purchase or sale, or based on the value, of 1 or more interest
or other rates, currencies, commodities, securities, instruments of
indebtedness, indices, quantitative measures, or other financial or
economic interests or property of any kind;
(ii) that provides for any purchase, sale, payment, or delivery (other than
a dividend on an equity security) that is dependent on the
occurrence, nonoccurrence, or the extent of the occurrence of an
event or contingency associated with a potential financial, economic,
or commercial consequence;
(iii) that provides on an executory basis for the exchange, on a fixed or
contingent basis, of 1 or more payments based on the value or level
of 1 or more interest or other rates, currencies, commodities,
securities, instruments of indebtedness, indices, quantitative
measures, or other financial or economic interests or property of any
kind, or any interest therein or based on the value thereof, and that
transfers, as between the parties to the transaction, in whole or in
part, the financial risk associated with a future change in any such
value or level without also conveying a current or future direct or
indirect ownership interest in an asset (including any enterprise or
investment pool) or liability that incorporates the financial risk so
transferred, including any agreement, contract, or transaction
commonly known as—
(a) an interest rate swap;
(b) a rate floor;
(c) a rate cap;
(d) a rate collar;
(e) a cross-currency rate swap;
(f) a basis swap;
(g) a currency swap;
(h) a foreign exchange swap;
(i) a total return swap;
(j) an equity index swap;
(k) an equity swap;
(l) a debt index swap;
(m) a debt swap;
(n) a credit spread;
(o) a credit default swap;
(p) a credit swap;
(q) a weather swap;
(r) an energy swap;
(s) a metal swap;
(t) an agricultural swap;
(u) an emissions swap; and
(v) a commodity swap;
(iv) that is an agreement, contract, or transaction that is, or in the future
becomes, commonly known to the trade as a swap;
(v) including any security-based swap agreement which meets the
definition of ‘swap agreement’ as defined in section 206A of the
GrammLeach-Bliley Act (15 U.S.C. 78c note) of which a material
term is based on the price, yield, value, or volatility of any security or
any group or index of securities, or any interest therein; or
(vi) that is any combination or permutation of, or option on, any
agreement, contract, or transaction described in any of clauses (i)
through (v).
(B) EXCLUSIONS.—The term ‘swap’ does not include—
(i) any contract of sale of a commodity for future delivery (or option on
such a contract), leverage contract authorized under section 19,
security futures product, or agreement, contract, or transaction
described in section 2(c)(2)(C)(i) or section 2(c)(2)(D)(i);
(ii) any sale of a nonfinancial commodity or security for deferred
shipment or delivery, so long as the transaction is intended to be
physically settled;
(iii) any put, call, straddle, option, or privilege on any security, certificate
of deposit, or group or index of securities, including any interest
therein or based on the value thereof, that is subject to—
(a) the Securities Act of 1933 (15 U.S.C. 77a et seq.); and
(b) the Securities Exchange Act of 1934 (15 U.S.C. 78a et seq.);
(iv) any put, call, straddle, option, or privilege relating to a foreign
currency entered into on a national securities exchange registered
pursuant to section 6(a) of the Securities Exchange Act of 1934 (15
U.S.C. 78f(a));
(v) any agreement, contract, or transaction providing for the purchase or
sale of 1 or more securities on a fixed basis that is subject to—
(a) the Securities Act of 1933 (15 U.S.C. 77a et seq.); and
(b) the Securities Exchange Act of 1934 (15 U.S.C. 78a et seq.);
(vi) any agreement, contract, or transaction providing for the purchase or
sale of 1 or more securities on a contingent basis that is subject to
the Securities Act of 1933 (15 U.S.C. 77a et seq.) and the Securities
Exchange Act of 1934 (15 U.S.C. 78a et seq.), unless the agreement,
contract, or transaction predicates the purchase or sale on the
occurrence of a bona fide contingency that might reasonably be
expected to affect or be affected by the creditworthiness of a party
other than a party to the agreement, contract, or transaction;
(vii) any note, bond, or evidence of indebtedness that is a security, as
defined in section 2(a)(1) of the Securities Act of 1933 (15 U.S.C.
77b(a)(1));
(viii) any agreement, contract, or transaction that is—
(a) based on a security; and
(b) entered into directly or through an underwriter (as defined in
section 2(a)(11) of the Securities Act of 1933 (15 U.S.C.
77b(a)(11)) by the issuer of such security for the purposes of
raising capital, unless the agreement, contract, or transaction is
entered into to manage a risk associated with capital raising;
(ix) any agreement, contract, or transaction a counterparty of which is a
Federal Reserve bank, the Federal Government, or a Federal agency
that is expressly backed by the full faith and credit of the United
States; and
(x) any security-based swap, other than a security-based swap as
described in subparagraph (D).
(C) RULE OF CONSTRUCTION REGARDING MASTER AGREEMENTS.—
(i) IN GENERAL.—Except as provided in clause (ii), the term ‘swap’
includes a master agreement that provides for an agreement,
contract, or transaction that is a swap under subparagraph (A),
together with each supplement to any master agreement, without
regard to whether the master agreement contains an agreement,
contract, or transaction that is not a swap pursuant to subparagraph
(A).
(ii) EXCEPTION.—For purposes of clause (i), the master agreement
shall be considered to be a swap only with respect to each
agreement, contract, or transaction covered by the master
agreement that is a swap pursuant to subparagraph (A).
(D) MIXED SWAP.—The term ‘security-based swap’ includes any agreement,
contract, or transaction that is as described in section 3(a)(68)(A) of the
Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(68)(A)) and also is
based on the value of 1 or more interest or other rates, currencies,
commodities, instruments of indebtedness, indices, quantitative
measures, other financial or economic interest or property of any kind
(other than a single security or a narrow-based security index), or the
occurrence, non-occurrence, or the extent of the occurrence of an event
or contingency associated with a potential financial, economic, or
commercial consequence (other than an event described in subparagraph
(A)(iii)).
(E) TREATMENT OF FOREIGN EXCHANGE SWAPS AND FORWARDS.—
(i) IN GENERAL.—Foreign exchange swaps and foreign exchange
forwards shall be considered swaps under this paragraph unless the
Secretary makes a written determination under section 1b that either
foreign exchange swaps or foreign exchange forwards or both—
(a) should be not be regulated as swaps under this Act; and
(b) are not structured to evade the Dodd-Frank Wall Street Reform
and Consumer Protection Act in violation of any rule
promulgated by the [Commodity Futures Trading] Commission
pursuant to section 721(c) of that Act.
(ii) CONGRESSIONAL NOTICE; EFFECTIVENESS.—The Secretary
shall submit any written determination under clause (i) to the
appropriate committees of Congress, including the Committee on
Agriculture, Nutrition, and Forestry of the Senate and the Committee
on Agriculture of the House of Representatives. Any such written
determination by the Secretary shall not be effective until it is
submitted to the appropriate committees of Congress.
(iii) REPORTING.—Notwithstanding a written determination by the
Secretary under clause (i), all foreign exchange swaps and foreign
exchange forwards shall be reported to either a swap data repository,
or, if there is no swap data repository that would accept such swaps
or forwards, to the [Commodity Futures Trading] Commission
pursuant to section 4r within such time period as the [Commodity
Futures Trading] Commission may by rule or regulation prescribe.
(iv) BUSINESS STANDARDS.—Notwithstanding a written determination
by the Secretary pursuant to clause (i), any party to a foreign
exchange swap or forward that is a swap dealer or major swap
participant shall conform to the business conduct standards
contained in section 4s(h).
(v) SECRETARY.—For purposes of this subparagraph, the term
‘Secretary’ means the Secretary of the Treasury.
(F) EXCEPTION FOR CERTAIN FOREIGN EXCHANGE SWAPS AND
FORWARDS.—
(i) REGISTERED ENTITIES.—Any foreign exchange swap and any
foreign exchange forward that is listed and traded on or subject to the
rules of a designated contract market or a swap execution facility, or
that is cleared by a derivatives clearing organization, shall not be
exempt from any provision of this Act or amendments made by the
Wall Street Transparency and Accountability Act of 2010 prohibiting
fraud or manipulation.
(ii) RETAIL TRANSACTIONS.—Nothing in subparagraph (E) shall affect,
or be construed to affect, the applicability of this Act or the jurisdiction
of the [Commodity Futures Trading] Commission with respect to
agreements, contracts, or transactions in foreign currency pursuant
to section 2(c)(2).”
Appendix 2
“Security-Based Swap”: Section 761(a)(6) of the Dodd-Frank Act: “(68)
SECURITY-BASED SWAP.—
(A) IN GENERAL.—Except as provided in subparagraph (B), the term
‘security-based swap’ means any agreement, contract, or transaction
that—
(i) is a swap, as that term is defined under section 1a of the Commodity
Exchange Act (without regard to paragraph (47)(B)(x) of such
section); and
(ii) is based on—
(I) an index that is a narrow-based security index, including any
interest therein or on the value thereof;
(II) a single security or loan, including any interest therein or on the
value thereof; or
(III) the occurrence, nonoccurrence, or extent of the occurrence of
an event relating to a single issuer of a security or the issuers of
securities in a narrow-based security index, provided that such
event directly affects the financial statements, financial
condition, or financial obligations of the issuer.
(B) RULE OF CONSTRUCTION REGARDING MASTER AGREEMENTS.—
The term ‘security-based swap’ shall be construed to include a master
agreement that provides for an agreement, contract, or transaction that is
a security-based swap pursuant to subparagraph (A), together with all
supplements to any such master agreement, without regard to whether
the master agreement contains an agreement, contract, or transaction
that is not a security-based swap pursuant to subparagraph (A), except
that the master agreement shall be considered to be a security-based
swap only with respect to each agreement, contract, or transaction under
the master agreement that is a security-based swap pursuant to
subparagraph (A).
(C) EXCLUSIONS.—The term ‘security-based swap’ does not include any
agreement, contract, or transaction that meets the definition of a security-
based swap only because such agreement, contract, or transaction
references, is based upon, or settles through the transfer, delivery, or
receipt of an exempted security under paragraph (12), as in effect on the
date of enactment of the Futures Trading Act of 1982 (other than any
municipal security as defined in paragraph (29) as in effect on the date of
enactment of the Futures Trading Act of 1982), unless such agreement,
contract, or transaction is of the character of, or is commonly known in the
trade as, a put, call, or other option.
(D) MIXED SWAP.—The term ‘security-based swap’ includes any agreement,
contract, or transaction that is as described in subparagraph (A) and also
is based on the value of 1 or more interest or other rates, currencies,
commodities, instruments of indebtedness, indices, quantitative
measures, other financial or economic interest or property of any kind
(other than a single security or a narrow-based security index), or the
occurrence, non-occurrence, or the extent of the occurrence of an event
or contingency associated with a potential financial, economic, or
commercial consequence (other than an event described in subparagraph
(A)(ii)(III)).
(E) RULE OF CONSTRUCTION REGARDING USE OF THE TERM
INDEX.—The term ‘index’ means an index or group of securities,
including any interest therein or based on the value thereof.”