Final Product Definitions Under Title VII of Dodd-Frank

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www.sullcrom.com

August 27, 2012

Final Product Definitions Under Title VII of Dodd-Frank

CFTC and SEC Adopt Rules and Guidance to Further Define “Swap”, “Security-Based Swap”, “Mixed Swaps” and Other Swap-Related Terms

EXECUTIVE SUMMARY

Pursuant to the regulatory framework established by Title VII of the Dodd-Frank Wall Street Reform and

Consumer Protection Act (“Dodd-Frank”), the Commodity Futures Trading Commission (“CFTC”) has

regulatory authority over swaps under the Commodity Exchange Act (“CEA”), the Securities and

Exchange Commission (“SEC”, and with the CFTC, the “Commissions”) has regulatory authority over

security-based swaps under the Securities Exchange Act of 1934 (the “Exchange Act”), and the

Commissions share jurisdiction with respect to “mixed swaps” (generally, security-based swaps that are

also based on specified elements indicative of swaps). Section 721 of Dodd-Frank sets forth definitions

of the terms “swap” and “mixed swap”, and Section 761 of Dodd-Frank defines a “security-based swap”;

Section 712(d)(1) requires that the Commissions, in consultation with the Board of Governors of the

Federal Reserve System (the “Board”), further define certain terms used in Title VII of Dodd-Frank,

including “swap” and “security-based swap”.

The CFTC and SEC have issued a joint release (the “Adopting Release”)1 adopting final rules (the “Final

Rules”) and interpretive guidance to clarify the treatment of certain agreements, contracts and

transactions under the defined terms.2 The Adopting Release addresses, among other things:

insurance products;

forward contracts (including forward contracts with embedded optionality on certain terms);

consumer and commercial contracts;

loan participations;

-2- Final Product Definitions Under Title VII of Dodd-Frank August 27, 2012

foreign-exchange related instruments;

instruments based on interest rates (or other monetary rates) and yields;

total return swaps (“TRS”);

instruments based on futures contracts;

the definition of a “narrow-based security index” in determining whether an instrument is a swap or security-based swap and the definition of an “index” in connection with an indexed credit-default swap (“index CDS”);

procedures for requesting guidance from the Commissions on the characterization of an instrument; and

“mixed swaps” and the mechanism for evaluating the applicability of certain regulatory requirements to mixed swaps.

The Adopting Release also adopts rules addressing the CFTC’s anti-evasion authority and provides

guidance on how the CFTC will exercise that authority.

The Adopting Release was published in the Federal Register on August 13, 2012. The Final Rules will be

effective October 12, 2012, provided that the “compliance date” with respect to the definition of “security-

based swap” solely for purposes of the Exchange Act Exemptive Order3 and the SB Swaps Interim Final

Rules4 will be December 11, 2012 and the “compliance date” for the interpretation regarding guarantees

of swaps (discussed in Section I. B) will be the same as the effective date of the rules the CFTC will

promulgate to define the obligations applicable to such guarantees. The “swap”, “security-based swap”

and “mixed swap” definitions will determine when the regulatory responsibilities of many market

participants, and compliance with many of the CFTC’s requirements under Title VII will be required.

Compliance with the SEC’s requirements under Title VII will not be required earlier than 180 days after

the effective date.5


Table of Contents I. PRODUCTS NOT DEFINED AS SWAPS OR SECURITY-BASED SWAPS ........................................... 5

A. INSURANCE PRODUCTS ..................................................................................................................... 5

B. TREATMENT OF GUARANTEES OF SWAPS AND SECURITY-BASED SWAPS ............................................. 7

C. THE FORWARD CONTRACT EXCLUSION .............................................................................................. 8 1. Forward Contracts in Nonfinancial Commodities ..................................................................... 8

a. Forward Exclusion from the Swap and Future Delivery Definitions ................................... 8 i. Brent Interpretation ..................................................................................................... 9 ii. Withdrawal of the Energy Exemption ........................................................................ 10 iii. Nonfinancial Commodities ........................................................................................ 10

b. Commodity Options and Commodity Options Embedded in Forward Contracts ............. 10 i. Volumetric Optionality ............................................................................................... 11 ii. Certain Physical Commercial Agreements, Contracts or Transactions ..................... 13

2. Fixed and Contingent Security Forwards ............................................................................... 13

D. CONSUMER AND COMMERCIAL AGREEMENTS ................................................................................... 14

E. LOAN PARTICIPATIONS .................................................................................................................... 16

F. TRANSACTIONS IN REGIONAL TRANSMISSION ORGANIZATIONS AND INDEPENDENT SYSTEM

OPERATORS .................................................................................................................................. 17

II. FOREIGN EXCHANGE AND OTHER FOREIGN CURRENCY TRANSACTIONS ............................... 17

A. FOREIGN EXCHANGE PRODUCTS ..................................................................................................... 17 1. Interpretation Regarding Foreign Exchange Spot Transactions ............................................ 18 2. Retail Foreign Currency Options............................................................................................ 19

III. INTERPRETATION OF SWAP WITH RESPECT TO FORWARD RATE AGREEMENTS, CONTRACTS FOR DIFFERENCES, AND COMBINATIONS AND PERMUTATIONS OF, OR OPTIONS ON, SWAPS AND SECURITY-BASED SWAPS ......................................................... 19

IV. RELATIONSHIP BETWEEN SWAPS AND SECURITY-BASED SWAPS ........................................... 20

A. TITLE VII INSTRUMENTS BASED ON INTEREST RATES, OTHER MONETARY RATES, AND YIELDS ............ 20

B. TOTAL RETURN SWAPS................................................................................................................... 21

C. SECURITY-BASED SWAPS BASED ON A SINGLE SECURITY OR LOAN AND SINGLE-NAME CREDIT

DEFAULT SWAPS ............................................................................................................................ 22

D. TITLE VII INSTRUMENTS BASED ON FUTURES ................................................................................... 23

E. USE OF CERTAIN TERMS AND CONDITIONS IN TITLE VII INSTRUMENTS ............................................... 23

V. THE TERMS “NARROW-BASED SECURITY INDEX” AND “ISSUERS OF SECURITIES IN NARROW-BASED SECURITY INDEX” ......................................................................................... 24

A. APPLICATION OF THE DEFINITION OF “NARROW-BASED SECURITY INDEX” ........................................... 24 1. Statutory Definition of Narrow-Based Security Index ............................................................. 24 2. The 2004 Joint Order Criteria ................................................................................................ 24 3. The 2006 Joint Rules ............................................................................................................. 25 4. The 2009 Joint Order ............................................................................................................. 26

B. INDEX CREDIT DEFAULT SWAPS ...................................................................................................... 27 1. The Number Component and Concentration Components .................................................... 27 2. Affiliation of Reference Entities and Issuers of Securities with Respect to Index CDS .......... 28 3. Public Information Availability Regarding Reference Entities and Securities ......................... 28

C. SECURITY INDEXES AND PORTFOLIOS .............................................................................................. 30

D. INDEXES THAT “MIGRATE” FROM BROAD TO NARROW OR VICE VERSA................................................ 30

E. METHOD OF SETTLEMENT OF INDEX CDS ........................................................................................ 31

VI. MIXED SWAPS ................................................................................................................................... 32


A. SCOPE OF DEFINITION .................................................................................................................... 32

B. APPLICABLE REGULATION ............................................................................................................... 32

VII. SECURITY-BASED SWAP AGREEMENTS ....................................................................................... 33

VIII. PROCESS FOR REQUESTING INTERPRETATIONS CONCERNING THE CHARACTERIZATION OF SWAPS, SECURITY-BASED SWAPS AND MIXED SWAPS ................. 33

IX. ANTI-EVASION ................................................................................................................................... 35

A. TREATMENT OF SWAPS BY THE CFTC ............................................................................................. 35 1. Business Purpose .................................................................................................................. 36 2. Fraud, Deceit, or Unlawful Activity ......................................................................................... 37

B. TREATMENT OF SECURITY-BASED SWAPS BY THE SEC .................................................................... 37


I. PRODUCTS NOT DEFINED AS SWAPS OR SECURITY-BASED SWAPS

A. INSURANCE PRODUCTS

Consistent with the proposing release for the product definitions (the “Proposing Release”),6 the Adopting

Release indicates that “[t]he Commissions are aware of nothing in Title VII to suggest that Congress

intended for traditional insurance products to be regulated as swaps or security-based swaps.” Rather

than extending the insurance exclusion to all products subject to the supervision of insurance regulatory

authorities, which had been the approach suggested by a number of commenters,7 the Commissions set

forth specific criteria that will entitle an agreement to benefit from a non-exclusive “Insurance Safe Harbor”

exclusion from the definitions of swap and security-based swap. These criteria relate to both the type of

product and its provider. Agreements that fall outside of the Insurance Safe Harbor will not automatically

be captured as swaps or security-based swaps; rather they will be subject to a facts and circumstances

analysis to determine whether they are excluded insurance or covered swaps or security-based swaps.

Parties to a transaction may also seek an interpretation from the Commissions as to whether the

transaction is a swap or security-based swap (a process discussed in Section VIII below). Under the pre-

emption provision in Section 722(b) of the Dodd-Frank Act, an agreement that is determined to be a

“swap” will not be considered to be insurance and may not be regulated as an insurance contract under

the law of any state.

The Insurance Safe Harbor applies to any insurance agreement that:

is in a product that either meets certain conditions (the “Product Test”) or is one of a number of listed “traditional” insurance products (“Enumerated Products”); and

meets certain conditions relating to the provider of the product (the “Provider Test”).

The Product Test, which is substantially the same as proposed in the Proposing Release, covers any

agreement that, by its terms or by law, as a condition of performance:

requires the beneficiary of the agreement to have an insurable interest therein and carry the risk of loss continuously throughout the duration of the agreement;

8

requires that a loss occur and be proved, and that any payment or indemnification be limited to the value of the insurable interest;

is not traded, separately from the insured interest, on an organized market or over-the-counter;

9 and

for financial guaranty insurance only, acceleration of the policy in the event of a payment default or insolvency of the obligor must be at the sole discretion of the insurer.


Certain traditional insurance products that are specifically listed are excluded from the definition of “swap”

and “security-based swap”, as long as they meet the Provider Test (discussed below), even if the

“Product Test” is not met. These “Enumerated Products” consist of:

surety bonds;

fidelity bonds;

life insurance;

health insurance;

long-term care insurance;

title insurance;

property and casualty insurance;

annuities (regardless of tax treatment);

disability insurance;

insurance against default on individual residential mortgages (i.e., private mortgage insurance, as distinguished from financial guaranty of mortgage pools); and

reinsurance or retrocession of any Enumerated Products (so long as such reinsurance or retrocession is not accomplished by entering into swaps or security-based swaps).

10

The Commissions, however, declined to cover as Enumerated Products certain other categories of

contracts suggested by some commenters, such as guaranteed investment contracts (“GICs”), synthetic

GICs, funding agreements, structured settlements, deposit administration contracts, immediate

participation guaranty contracts, industry loss warrants, and catastrophe bonds. Such contracts will,

therefore, only constitute insurance (rather than a swap or security-based swap) if they meet the Product

Test and Provider Test, or otherwise qualify as insurance based on a facts and circumstances analysis.

The Provider Test requires that an agreement that either meets the Product Test or is an Enumerated

Product must also:

be provided by a person (whether or not organized as an insurance company)11

that is subject to supervision by the insurance commissioner (or similar official or agency) of any state or by the United States or an agency or instrumentality thereof, and be an agreement regulated as insurance under applicable state law or the laws of the United States; or

be provided, directly or indirectly, by the United States, any State or any of their respective agencies or instrumentalities (including programs provided by such entities but administered by third parties), or pursuant to a statutorily authorized program of the United States, a State or agency or instrumentality; or

in the case of reinsurance only, be provided by a person (wherever incorporated or organized)

12 to another person (i.e., the cedent) that otherwise satisfies the Provider Test,

provided that: (i) the reinsurer is not prohibited by applicable state law or the laws of the United States from offering such agreement to the cedent that satisfies the Provider Test; (ii) the underlying agreement to be reinsured satisfies the Product Test or is one of the Enumerated Products; and (iii) except as otherwise permitted under applicable state law,

13


the total amount reimbursable by all reinsurers for such agreement does not exceed the claims or losses paid by the cedent; or

in the case of non-admitted insurance (which refers to insurance products on a non-admitted basis through surplus lines brokers), be provided by a person who (i) is located outside of the United States and listed on the Quarterly Listing of Alien Insurers as maintained by the International Insurers Department of the National Association of Insurance Commissioners or (ii) meets the eligibility criteria for non-admitted insurers under applicable State law.

14

The Adopting Release also includes a grandfather provision, excluding from the definitions of swap and

security-based swap any agreement entered into on or before the effective date of the Final Rules that, at

the time it was entered into, would have satisfied the Provider Test as of the time of the effectiveness of

the Final Rules.

B. TREATMENT OF GUARANTEES OF SWAPS AND SECURITY-BASED SWAPS

The Adopting Release provides that guarantees of swaps and guarantees of security-based swaps will be

treated differently. An interpretation by the CFTC provides that the term “swap” includes a guarantee of a

swap, to the extent that a counterparty to the guaranteed swap would have recourse against the

guarantor in connection with the position, because a guarantee of a swap is an integral part of the swap.

The CFTC expects to address the practical implications of this interpretation in a separate rulemaking. In

considering the effects this interpretation may have on guarantors, the Adopting Release notes that the

CFTC may “regulate as a swap dealer a parent or other guarantor who guarantees swap positions of

persons who are not subject to capital regulation by the CFTC.”15

The Adopting Release also indicates

that the CFTC anticipates the following future guidance:

proposing real-time and regulatory reporting requirements with respect to guarantees of swaps;

explaining the extent to which the duties and obligations of swap dealers and major swap participants pertaining to guarantees of swaps are already satisfied to the extent such obligations are satisfied with respect to the related guaranteed swaps; and

addressing the effects, if any, of this interpretation on position limits and large trader reporting requirements.

In contrast, consistent with the SEC’s historical treatment of guarantees, the Adopting Release explains

that a guarantee of an obligation under a security-based swap, including financial guaranty insurance of a

security-based swap, will neither constitute a separate security-based swap nor be considered part of the

guaranteed security-based swap. Rather, because guarantees of a security are treated as securities

under the Securities Act of 1933 (the “Securities Act”) and security-based swaps are included in the

definition of “security” contained in the Securities Act and the Exchange Act, a guarantee of a security-

based swap will be a security subject to federal securities law regulation. The SEC plans to address the

reporting of guarantees of security-based swaps in a separate rulemaking.


C. THE FORWARD CONTRACT EXCLUSION

The statutory definitions of the terms “swap” and “security-based swap” under Dodd-Frank exclude “any

sale of a nonfinancial commodity or security for deferred shipment or delivery, so long as the transaction

is intended to be physically settled.” The Adopting Release provides several interpretations as to the

scope of this exclusion.

1. Forward Contracts in Nonfinancial Commodities

Section 1a(47) of the CEA defines “swap” to exclude “any sale of a nonfinancial commodity . . . for

deferred shipment or delivery [where] the transaction is intended to be physically settled” (the “forward

contract exclusion”). The Adopting Release explains that the scope of the forward contract exclusion will

be interpreted in a manner consistent with the CFTC’s historical interpretation of the forward contract

exclusion from the prohibition on off-exchange futures under the CEA, as it existed prior to Dodd-Frank,

including the entire body of precedent distinguishing forwards from futures.

In general, whether a specific transaction meets the forward contract exclusion is to be assessed based

on a facts and circumstances analysis. The interpretations in the Adopting Release provide guidance as

to factors that may be considered for this purpose, as well as the applicability of the forward contract

exclusion in particular contexts (such as where a transaction that provides for physical delivery is

“booked-out” or otherwise settled without physical delivery) and to particular products (by defining the

scope of nonfinancial commodities eligible for the forward contract exclusion).

a. Forward Exclusion from the Swap and Future Delivery Definitions

The CFTC notes in the Adopting Release that its historical interpretation has been that, in order to qualify

as forward contracts under the statutory exclusion, transactions must be “commercial merchandising

transactions.”16

The Adopting Release quotes the so-called “Brent Interpretation”17

as follows: “[t]he

underlying postulate of the [forward] exclusion is that the [CEA’s] regulatory scheme for futures trading

simply should not apply to private commercial merchandising transactions which create enforceable

obligations to deliver but in which delivery is deferred for reasons of commercial convenience or

necessity.”18

An important factor in assessing whether a transaction may qualify for the forward contract

exclusion is whether the parties intend for the transaction to be physically settled. Consistent with the

Proposing Release, the Adopting Release acknowledges that forward contracts that are not actually

physically settled may nevertheless qualify for the exclusion, provided that the parties are commercial

entities entering into the transaction for commercial purposes with the ability and intent to deliver and take

delivery.

In particular, the Adopting Release affirms that the Brent Interpretation will apply to the forward exclusion

from the swap definition. The Brent Interpretation was issued in 1990 to address the practice of “book-

outs” in connection with physical oil transactions and characterized such contracts as forwards eligible for


the forward contract exclusion from the off-exchange futures prohibition. The Adopting Release expands

the Brent Interpretation to apply to all “nonfinancial commodities”, a term explained below, rather than just

oil, as had been the case under the Brent Interpretation. The Adopting Release also expands the Brent

Interpretation with respect to the types of transactions covered, incorporating the relief provided under the

so called “Energy Exemption”, which was issued in 1993 and permits a wider variety of forms of

settlement of forwards without physical delivery.19

As discussed below, the Energy Exemption is

withdrawn in light of this incorporation.

The Adopting Release identifies the following additional factors that may be used when assessing

whether a transaction is eligible for the forward contract exclusion: contract size; demonstrable

commercial need for the product; the underlying purpose of the contract (e.g., whether the purpose of the

claimed forward is to sell physical commodities, hedge risk or speculate); the regular practices of the

commercial entity with respect to its general commercial business and its forward and swap transactions

more specifically; and whether the absence of physical settlement is based on a change in commercial

circumstances.

i. Brent Interpretation

Book-out transactions meeting the requirements specified in the Brent Interpretation that are effectuated

through a subsequent, separately negotiated agreement between the commercial parties to the original

transaction qualify for a safe harbor under the forward contract exclusion. The requirements that must be

met include that:

The agreement provides a binding obligation to make or take delivery without providing any right to offset, cancel, or settle on a payment-of-differences basis;

The book-out is effected through a separate, individually negotiated new agreement;

There is no obligation or arrangement to enter into such book-out and the book-out is not provided for by the terms of the agreement as initially entered into; and

Either party to the initial agreement is entitled to require the other party to make or accept physical delivery, as applicable, in order to meet such other party’s obligations under the initial agreement.

Book-outs may be effected by oral agreement; however, such agreement must be followed in a

commercially reasonable timeframe by a confirmation in some type of written or electronic form.

The Brent Interpretation safe harbor is available only to “commercial market participants that regularly

make or take delivery of the referenced commodity in the ordinary course of their business.”20

The

Adopting Release interprets “commercial” in the context of the Brent Interpretation as: “related to the

business of a producer, processor, fabricator, refiner or merchandiser,”21

clarifying that “[w]hile a market

participant need not be solely engaged in ‘commercial’ activity to be a ‘commercial market participant’

within the meaning of the Brent Interpretation . . . the business activity in which it makes or takes delivery


must be commercial activity for it to be a commercial market participant.”22

As an example of activity that

would not qualify as “commercial”, the Adopting Release points to a hedge fund’s investment activity in

derivatives on physical commodities. Investment activity, at least without some connection to a physical

commodity business, would not qualify as “commercial” and therefore would be inadequate to qualify the

hedge fund as a “commercial market participant” with respect to the relevant commodity; as a result, the

hedge fund would not be able to rely on the Adopting Release interpretations permitting “book-outs” and

other settlements without delivery with respect to contracts referencing such commodity.

ii. Withdrawal of the Energy Exemption

Because the Brent Interpretation is expanded to cover all “nonfinancial commodities”, the Adopting

Release withdraws the Energy Exemption. The Adopting Release preserves the ability of parties to

forward contracts to utilize a variety of settlement mechanisms (e.g., the seller’s passage of title and the

buyer’s payment and acceptance of the underlying commodity; taking delivery of the commodity in some

instances and in others instead passing title to another intermediate purchaser in a chain; physically

exchanging one quality, grade or type of physical commodity for another quality, grade or type of physical

commodity; and physical netting agreements) and bona fide termination rights (including force majeure

provisions and upon counterparty insolvency, default or other inability to perform) that have been

permitted under the Energy Exemption.

iii. Nonfinancial Commodities

The forward contract exclusion is limited to “nonfinancial commodities”. The Adopting Release interprets

“nonfinancial commodity” to include a commodity that can be physically delivered and is an exempt

commodity23

or an agricultural commodity.24

A nonfinancial commodity may also include an “intangible

commodity”, other than an excluded commodity,25

which meets certain conditions. These conditions are

that ownership of the commodity can be conveyed in some manner and the commodity can be

consumed. As examples of intangible commodities that may meet these conditions, the Adopting

Release discusses certain environmental commodities including emission allowances, carbon offsets and

credits, and renewable energy credits.

b. Commodity Options and Commodity Options Embedded in Forward Contracts

The Adopting Release reaffirms that commodity options are swaps under the statutory swap definition,

and does not provide additional interpretation regarding commodity options. The CFTC has previously

adopted rules governing commodity options and, on an interim final basis, providing a trade option

exemption.26

The Adopting Release provides interpretations that would permit certain types of forward contracts to

qualify for the forward contract exemption notwithstanding the fact that they contain embedded

optionality. Specifically, the release provides additional interpretations regarding forwards with embedded


volumetric optionality, optionality in the form of evergreen and renewal provisions, and optionality with

respect to delivery points and delivery dates.

The Adopting Release includes an interpretation that a forward contract that contains one or more

embedded commodity options will be considered an excluded nonfinancial commodity forward contract

(and not a swap) if the embedded options:

may be used to adjust the forward contract price, but do not undermine the overall nature of the contract as a forward contract;

do not target the delivery term, so that the predominant feature of the contract is actual delivery; and

cannot be severed and marketed separately from the overall forward contract in which they are embedded.

In evaluating whether an agreement containing an option qualifies for the forward contract exclusion, the

CFTC will look to the specific facts and circumstances of the transaction as a whole to evaluate whether

the optionality operates on the price or delivery term of the contract, and whether an embedded

commodity option is marketed or traded separately from the underlying contract. Citing a pre-Dodd-Frank

interpretation,27

the Adopting Release notes that an option cannot be a forward under CFTC precedent,

because under the terms of the contract the optionee has the right, but not the obligation, to make or take

delivery, while under a forward contract, both parties must have binding delivery obligations: one to make

delivery and the other to take delivery.

i. Volumetric Optionality

While the Adopting Release confirms that commodity options are generally treated as swaps, the

Adopting Release does provide that embedded optionality with respect to delivery, so called “volumetric”

optionality, would not disqualify the transaction from being eligible for the forward contract exclusion if:

the embedded optionality does not undermine the overall nature of the transaction as a forward contract;

the predominant feature of the transaction is actual delivery;

the embedded optionality cannot be severed and marketed separately from the overall transaction in which it is embedded;

the seller of a nonfinancial commodity underlying the transaction with embedded volumetric optionality intends, at the time it enters into the transaction, to deliver the underlying nonfinancial commodity if the optionality is exercised;

the buyer of a nonfinancial commodity underlying the transaction with embedded volumetric optionality intends, at the time it enters into the transaction, to take delivery of the underlying nonfinancial commodity if it exercises the embedded volumetric optionality;

both parties are commercial parties; and


the exercise or non-exercise of the embedded volumetric optionality is based primarily on physical factors, or regulatory requirements, that are outside the control of the parties and are influencing demand for, or supply of, the nonfinancial commodity.

The Adopting Release indicates that, where a transaction requires delivery of a “non-nominal” volume of

a nonfinancial commodity, even if an embedded volumetric option is exercised, the predominant feature

of the contract will be viewed as actual delivery.28

As an example, the Adopting Release describes a

forward contract that calls for the delivery of 10,000 bushels of wheat and includes an option for an

additional 5,000 bushels of wheat. With respect to the fourth and fifth elements, the Adopting Release

explains that they are designed to ensure that both parties intend to make or take delivery, subject to the

relevant physical factors or regulatory requirements, which may lead the parties to deliver more or less

than originally intended. The seventh element is designed to ensure that the volumetric optionality is

primarily driven by physical factors or regulatory requirements that influence supply and demand and are

outside of the parties’ control, and that the optionality is a commercially reasonable way to address

uncertainty associated with those factors.

The Adopting Release also addresses several specific contracts and contractual provisions, indicating

that:

Certain full requirements contracts and output contracts will not be viewed as containing embedded volumetric optionality, and would be subject to the same facts and circumstances analysis applicable to other transactions that might be within the forward contract exclusion.

Capacity contracts, transmission (or transportation) services agreements,29

tolling agreements,

30 and peaking supply contracts all must be individually analyzed to determine

whether they satisfy the elements of the “forwards with embedded volumetric options” interpretation set forth above, or may satisfy other portions of the forward contract exclusion interpretation.

Provisions extending the term of the contract (such as evergreen provisions) will not be viewed as providing an option as to delivery.

Provisions permitting alternative delivery points and delivery dates will not cause a transaction that otherwise qualifies as a forward contract to be considered a swap.

A liquidated damages provision will not exclude a contract from qualifying for the forward contract exclusion and the CFTC will utilize a facts and circumstances approach in determining whether the parties to a particular agreement with a liquidated damage provision have the requisite intent to deliver.

Generally, when evaluating whether an agreement with embedded volumetric optionality qualifies for the

forward contract exclusion, the CFTC will look to the relevant facts and circumstances of the transaction

as a whole. This interpretation by the CFTC turns on criteria that market participants may find difficult to

evaluate, including what factors will affect the volume to be delivered. To the extent that the CFTC’s

standard for permitted optionality is not met, the contract may qualify as a trade option under the

regulations previously promulgated by the CFTC.31


The Adopting Release solicits comments relating to the circumstances in which contracts with embedded

volumetric optionality should qualify for the forward contract exclusion. Among other things, comments

are requested on:

whether the elements, and in particular the seventh element, set forth in the interpretation to distinguish forwards with embedded volumetric optionality from commodity options are appropriate and sufficient; and

whether the interpretation is sufficiently clear with respect to capacity contracts, transmission (or transportation) services agreements, peaking supply contracts, and tolling agreements.

ii. Certain Physical Commercial Agreements, Contracts or Transactions

The Adopting Release includes an interpretation that confirms certain commodity-related facility lease-like

transactions will not constitute options, if each transaction satisfies the following three conditions:

the subject of the transaction is usage of a specified facility or part thereof rather than the purchase or sale of the commodity that is to be created, transported, processed or stored using the specified facility;

the transaction grants the buyer the exclusive use of the specified facility or part thereof during its term, and provides for an unconditional obligation on the part of the seller to grant the buyer the exclusive use of the specified facility or part thereof; and

the payment for the use of the specified facility or part thereof represents a payment for its use rather than the option to use it.

In this context, the CFTC would not consider actions such as scheduling electricity transmission, gas

transportation or injection of gas into storage to be exercising an option if all three elements described

above are satisfied. In contrast, if the right to use the specified facility is only obtained via the payment of

a demand charge or reservation fee, and the exercise of the right (or use of the specified facility or part

thereof) entails the further payment of actual storage fees, usage fees, rents, or other analogous service

charges not included in the demand charge or reservation fee, such transaction will be viewed as a

commodity option subject to the swap definition. The Adopting Release notes that in evaluating whether

flexible physical commercial agreements that meet the three-part test qualify for the forward contract

exclusion, the CFTC will look to the specific facts and circumstances of the transaction as a whole. Here

the CFTC has established a standard that is novel and outside the expectations of many market

participants. Many contracts involving storage or pipeline deliveries could be captured by this new

interpretation.

2. Fixed and Contingent Security Forwards

The definitions of “swap” and “security-based swap” exclude “any sale of a . . . security for deferred

shipment or delivery, so long as the transaction is intended to be physically settled” (the “security forward

exclusion”). The Adopting Release adopts the interpretation of the security forward exclusion provided in

the Proposing Release, which restates the statutory exclusion, without modification. Specifically, the


Adopting Release restates that this exclusion involves an agreement to purchase one or more securities,

or groups or indexes of securities, at a future date at a certain price. The Adopting Release points to

security forwards for an example of instruments potentially covered by this exemption, explaining that a

security forward transaction provides for the sale of a security at the time the forward contract is entered

into with the performance of the contract deferred or delayed,32

and that, if such transaction is intended to

be physically settled, the Commissions believe it would be within the security forward exclusion and

therefore outside the swap and security-based swap definitions.

The Adopting Release emphasizes that additional exclusions may apply to transactions in securities. In

particular, the Adopting Release notes that the purchase or sale of one or more securities on a contingent

basis that is subject to the Securities Act and the Exchange Act would be excluded, unless the agreement

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.

The Adopting Release also confirms that forward sales of mortgage backed securities in the “To-Be-

Announced” market would fall within the exclusion for sales of securities on a deferred settlement or

delivery basis (as well as the separate exclusion from the definition of “swap” for the purchase or sale of

one or more securities on a fixed basis or, depending on its terms, a contingent basis) even though an

actual mortgage backed security is not in existence at the time the forward sale is entered into.

D. CONSUMER AND COMMERCIAL AGREEMENTS

The Adopting Release provides interpretive guidance that excludes certain consumer and commercial

agreements from the definitions of swap and security-based swap. The interpretive guidance includes

lists of consumer and commercial agreements that are excluded from those definitions, which lists are the

same as in the Proposing Release except that additional examples are provided, and the interpretive

guidance sets forth standards that can be used to evaluate whether non-enumerated agreements may be

excluded as consumer or commercial agreements.

Consumer agreements that will not be considered swaps or security-based swaps when entered into by

consumers (natural persons) as principals (or by their agents) primarily for personal, family, or household

purposes include:

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 such consumer (such as intellectual property rights);

agreements to purchase products or services at a fixed price or a capped or collared price, at a future date or over a certain time period (such as agreements to purchase for personal use or consumption nonfinancial energy commodities, including agreements to purchase home heating fuel or agreements involving residential fuel storage, in either case, where the consumer takes delivery of and uses the fuel, and the counterparty is a merchant that delivers in the service area where the consumer resides);


agreements that provide for an interest rate cap or lock on a consumer loan or mortgage, where the benefit of the rate cap or lock is realized only if the loan or mortgage is made to the consumer;

consumer loans or mortgages with variable rates of interest or embedded interest rate options, including such loans with provisions for the rates to change upon certain events related to the consumer, such as a higher rate of interest following a default;

service agreements that are consumer product warranties, extended service plans, or buyer protection plans, such as those purchased with major appliances and electronics;

consumer options to acquire, lease, or sell real or personal property, such as options to lease apartments or purchase rugs and paintings, and purchases made through consumer layaway plans;

consumer transactions where, by law or regulation, the consumer may cancel the transaction without legal cause; and

consumer guarantees of credit card debt, automobile loans, and mortgages of a friend or relative.

Commercial agreements involving customary33

business arrangements (whether or not involving a for-

profit entity) that will not be considered swaps or security-based swaps include:

employment contracts and retirement benefit arrangements;

sales, servicing, or distribution arrangements;

agreements for the purpose of effecting a business combination transaction;

the purchase, sale, lease, or transfer of real property, intellectual property, equipment, or inventory;

warehouse lending arrangements in connection with building an inventory of assets in anticipation of a securitization of such assets (such as in a securitization of mortgages, student loans, or receivables);

mortgage or mortgage purchase commitments, or sales of installment loan agreements or contracts or receivables;

fixed or variable interest rate commercial loans or mortgages entered into by banks and non-banks, including the following:

fixed or variable interest rate commercial loans or mortgages entered into by the Farm Credit System institutions and Federal Home Loan Banks;

34

fixed or variable interest rate commercial loans or mortgages with embedded interest rate locks, caps, or floors, provided that such embedded interest rate locks, caps, or floors are included for the sole purpose of providing a lock, cap, or floor on the interest rate on such loan or mortgage and do not include additional provisions that would provide exposure to enhanced or inverse performance, or other risks unrelated to the interest rate risk being addressed;

fixed or variable interest rate commercial loans or mortgages with embedded interest rate options, including such loans or mortgages that contain provisions causing the interest rate to change upon certain events related to the borrower, such as a higher rate of interest following a default, provided that such embedded interest rate options do not include additional provisions that would provide exposure to enhanced or inverse performance, or other risks unrelated to the primary reason the embedded interest rate option is included; and


commercial agreements (including, but not limited to, leases, service contracts, and employment agreements) containing escalation clauses linked to an underlying commodity such as an interest rate or consumer price index.

The Adopting Release makes clear that the lists of excluded consumer and commercial agreements are

not intended to be exhaustive. To determine whether similar types of transactions entered into by

consumers or commercial entities are swaps or security-based swaps, the Commissions will consider the

following characteristics and factors:

whether the agreement contains severable payment obligations, whether or not contingent;

whether the agreement is traded on an organized market or over-the-counter; and

in the case of a consumer arrangement, whether the arrangement involves an asset of which the consumer is the owner or beneficiary, or that the consumer is purchasing, or involves a service provided, or to be provided, by or to the consumer, or

in the case of a commercial arrangement, whether the arrangement is entered into by commercial or non-profit entities as principals (or by their agents) to serve an independent commercial, business, or non-profit purpose, and not for speculative, hedging, or investment purposes.

The Commissions note that the two key components that distinguish consumer and commercial

agreements from swaps and security-based swaps are: (i) the payment provisions of the agreement are

not severable; and (ii) the agreement is not traded on35

an organized market or over-the-counter, and

therefore does not involve risk-shifting arrangements with financial entities. The characteristics and

factors described in the guidance are not intended to be the exclusive means to determine whether a

consumer or commercial arrangement constitutes a swap or security-based swap. If there is a type of

transaction that is not enumerated above, or does not have all the characteristics listed above (including

new types of transactions that may be developed in the future), the Adopting Release explains that such

transaction will be evaluated based on its particular facts and circumstances. Parties to such transactions

may also seek an interpretation from the Commissions as to whether the transactions is a swap or

security-based swap.

E. LOAN PARTICIPATIONS

The Adopting Release notes that, depending on the facts and circumstances, a loan participation may be

excluded from the definition of “swap” on account of (a) constituting a security under the federal securities

laws (and thus falling under the exclusion of purchases and sales of a security on a fixed or contingent

basis from the definition of swap), or (b) being an identified banking product (and thus excluded from

CFTC jurisdiction and from the security-based swap and security-based swap agreement definitions). For

loan participations not excluded as securities or identified banking products, the Adopting Release

provides guidance as to circumstances in which those loan participations would fall outside of the swap

and security-based swap definitions. Specifically, for a loan participation to not be considered a swap or

security-based swap, the loan participation must represent a current or future direct or indirect ownership


interest in the loan or commitment that is the subject of the loan participation. In evaluating whether the

loan participation represents such an ownership interest, the following characteristics should be present:

The grantor of the loan participation is a lender under, or a participant or sub-participant in, the loan or commitment that is the subject of the loan participation;

The aggregate participation in the loan or commitment that is the subject of the loan participation does not exceed the principal amount of such loan or commitment. Further, the loan participation does not grant, in the aggregate, to the participant in such loan participation a greater interest than the grantor holds in the loan or commitment that is the subject of the loan participation;

The entire purchase price for the loan participation is paid in full when acquired and not financed. The Commissions believe a purchase price would not be paid in full if the grantor of the loan participation extends financing to the participant or if such participant leverages its purchase, including by posting collateral to secure a future payment obligation; and

The loan participation provides the participant all of the economic benefit and risk of the whole or part of the loan or commitment that is the subject of the loan participation.

The Adopting Release confirms that a loan participation does not have to be a “true participation” in order

for the loan participation to fall outside the swap and security-based swap definitions.36

The Adopting

Release also clarifies that the interpretation applies to loan participations that are entered into both with

respect to outstanding loans and with respect to a lender’s commitments to lend and fund letters of credit

(e.g., under a revolving credit facility).

F. TRANSACTIONS IN REGIONAL TRANSMISSION ORGANIZATIONS AND INDEPENDENT SYSTEM OPERATORS

The Adopting Release notes that, to the extent that transactions occur through Regional Transmission

Organizations or Independent System Operators, or are entered into between entities described in

Section 201(f) of the Federal Power Act, they may be subsequently addressed through the public interest

waiver process in CEA section 4(c)(6). The Adopting Release does not take up commenters’ requests

that the Commissions exclude such transactions by rule from the definition of swap.

II. FOREIGN EXCHANGE AND OTHER FOREIGN CURRENCY TRANSACTIONS

A. FOREIGN EXCHANGE PRODUCTS

The Adopting Release includes interpretive clarifications of the status of products related to foreign

currencies (including foreign exchange rates). With respect to these products, the Adopting Release

follows the Proposing Release except in providing additional interpretations regarding foreign exchange

spot transactions and retail foreign currency options.

As adopted, the Final Rules explicitly define the term “swap” to include cross-currency swaps, currency

options, foreign currency options, foreign exchange options, foreign exchange rate options, foreign


exchange forwards, foreign exchange swaps and non-deliverable forwards involving foreign exchange.

The Adopting Release cautions that this list is non-exclusive.

With respect to “foreign exchange forwards” and “foreign exchange swaps” (“FX Products”), the Adopting

Release confirms that these products will be considered swaps unless the United States Secretary of the

Treasury (“Secretary”) issues a written determination that either or both should be exempted from the

definition. Notwithstanding such determination, FX Product transactions will still be subject to certain

requirements, including regulatory and historic reporting requirements under Section 4r of the CEA and,

when entered into by a swap dealer or major swap participant, the business conduct standards under

Section 4s(h) of the CEA. The Final Rules clarify that the following products will not qualify as FX

Products: currency swaps, cross-currency swaps, currency options, foreign currency options, foreign

exchange options, foreign exchange rate options and non-deliverable forwards involving foreign

exchange.

1. Interpretation Regarding Foreign Exchange Spot Transactions

Comments on the Proposing Release identified concerns that certain spot market currency transactions,

including those involved in effecting purchases of foreign securities, may be captured within the definition

of “swap” and thus subject to regulation. In response to these concerns, the Adopting Release includes

an interpretation that a “bona fide foreign exchange spot transaction”, which is defined as “a foreign

exchange transaction that is settled on the customary timeline of the relevant spot market”, is not within

the definition of the term “swap”.37

The interpretation explains that, generally, a foreign exchange

transaction will be considered a bona fide foreign exchange spot transaction if it settles via an actual

delivery of the relevant currencies within two business days. However, a foreign exchange transaction

with a longer settlement period concluding with the actual delivery of the relevant currencies may be

considered a bona fide spot transaction depending on the customary timeline of the relevant market. To

assess whether a transaction qualifies as a bona fide foreign exchange spot transaction, the

Commissions will look at the relevant facts and circumstances. The Adopting Release notes that an

unintentional settlement failure or delay for operational reasons or due to a market disruption is not

expected to undermine the character of a bona fide spot foreign exchange transaction as such.

The Adopting Release provides interpretive relief to certain foreign currency transactions that are entered

into in connection with foreign security transactions. Under the interpretation, a purchase or sale of an

amount of foreign currency solely to effect the purchase or sale of a foreign security, where the amount of

the foreign currency is equal to the amount needed to purchase, or to be received upon the sale of, such

foreign security will be a bona fide spot foreign exchange transaction (and therefore exempted from the

definition of a “swap”) if:

the security and related foreign currency transactions are executed contemporaneously in order to effect delivery by the relevant securities settlement date, and


actual delivery of the foreign security and foreign currency occurs by such deadline (such transaction, a “Securities Conversion Transaction”).

The Adopting Release views the “customary timeline” of foreign security transactions as the settlement

date for the relevant securities, so that the exemption for foreign securities is consistent with the above

general exemption for spot currency markets that take longer than two days to settle. The interpretation

also provides that a Securities Conversion Transaction will not be considered leveraged, margined or

financed within the meaning of section 2(c)(2)(C) of the CEA, which imposes restrictions on leveraged,

margined and financed transactions in foreign currency with persons who are not eligible contract

participants (“ECPs”).38

2. Retail Foreign Currency Options

The Adopting Release provides that foreign currency options described in Section 2(c)(2)(B) of the CEA

will not constitute swaps. Section 2(c)(2)(B) of the CEA would permit certain off-exchange foreign

currency options to be entered into between non-ECPs and enumerated regulated entities. The CFTC

stated that this interpretation was intended to cure a “scrivener’s error” in Dodd-Frank, which otherwise

would have created a conflict between Section 2(c)(2)(B) of the CEA (which permits certain off-exchange

foreign currency options entered into by non-ECPs under specified conditions) and Section 2(e) of the

CEA (which otherwise would have prohibited such retail off-exchange foreign currency options with non-

ECPs).39

III. INTERPRETATION OF SWAP WITH RESPECT TO FORWARD RATE AGREEMENTS, CONTRACTS FOR DIFFERENCES, AND COMBINATIONS AND PERMUTATIONS OF,

OR OPTIONS ON, SWAPS AND SECURITY-BASED SWAPS

Consistent with the Proposing Release, the Adopting Release clarifies the status of forward rate

agreements and provides interpretations regarding: (i) combinations and permutations of, or options on,

swaps or security-based swaps; and (ii) contracts for differences (“Cedes”) as follows:

The term “swap” is explicitly defined to include forward rate agreements (“FRAs”). As with the foreign exchange-related products discussed above, the Final Rules provide that FRAs are not swaps if they fall within one of the specific exclusions set forth in the “swap” definition.

An interpretation in the Adopting Release clarifies that an option or forward on a swap or security-based swap would, respectively, constitute a swap or security-based swap.

The Adopting Release also clarifies that CFDs, unless otherwise excluded, will fall within the scope of either the swap or security-based swap definition. Whether a CFD is a swap or security-based swap will depend on the underlying product of that particular CFD transaction. The Adopting Release explains that because CFDs are highly variable and a CFD can contain a variety of elements that would affect its characterization, market participants should analyze the features of the underlying product of any particular CFD in order to determine whether the CFD is a swap or a security-based swap.


IV. RELATIONSHIP BETWEEN SWAPS AND SECURITY-BASED SWAPS

Title VII of Dodd-Frank provides the CFTC with jurisdiction over swaps and the SEC with jurisdiction over

security-based swaps (swaps and security-based swaps are referred to herein as “Title VII

Instruments”).40

The Commissions indicate that the determination of whether a Title VII Instrument is a

swap or security-based swap should be made prior to execution, but no later than the date that the

parties offer to enter into the instrument. As a general rule, the Commissions have determined that so

long as the instrument’s terms are not amended, modified or otherwise adjusted during the tenor of the

instrument, such instrument will remain a swap or security-based swap, as applicable initially, throughout

its lifetime.

The Exchange Act defines a security-based swap as any swap that is based on:

an index that is a narrow-based security index (the “first prong”);

a single security or loan (the “second prong”); or

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 (the “third prong”).

Any security-based swap that also has components of a typical swap under the jurisdiction of the CFTC is

a mixed swap. The regulation of such mixed swaps will be discussed under section VI. below.

In the Adopting Release, the Commissions explain that each individual transaction executed under the

same ISDA Master Agreement or Master Confirmation, even if entered into concurrently, should be

analyzed separately as to whether it is a swap or a security-based swap, so long as a separate

confirmation is sent for each such transaction. Accordingly, separately confirmed credit default swaps

(“CDSs”), TRSs or other instruments would not be aggregated into a single instrument that is based on

one index or group of securities (and the group or index that would have resulted from such an

aggregation would not need to be tested under the “narrow-based index” definition). The Commissions

have adopted this interpretation as a bright-line rule in order to reduce costs associated with determining

whether an instrument is a swap or security-based swap.

A. TITLE VII INSTRUMENTS BASED ON INTEREST RATES, OTHER MONETARY RATES, AND YIELDS

In the Adopting Release, the Commissions provide guidance for determining whether an instrument on an

interest rate, a monetary rate or a yield will be a swap or a security-based swap. If an instrument is based

on the level of a specific interest rate or other monetary rate that is not itself based on one or more

securities, the instrument would be a swap and not a security-based swap. The Adopting Release

indicates that a rate swap may require payment based on differences between two floating rates, or

require payment to be made based on the occurrence of an agreed upon event with respect to an interest


or other monetary rate (such as when a rate surpasses a threshold or when the spread between two rates

reaches a specified level). The Adopting Release provides the following examples of interest and

monetary rates:

an interbank offered rate (an average of rates charged by a group of banks for lending money to each other or other banks over various periods of time);

a money market rate (a rate established or determined based on actual lending or money market transactions);

a government target rate (a rate established or determined based on guidance established by a central bank);

a general lending rate;

an index of rates (a rate derived from an index of any of the foregoing rates, averages, or indexes); and

any other interest or monetary rate, such as the Consumer Price Index or the volatility, variance or rate of change of any of the foregoing rates, an average of two rates.

On the other hand, a Title VII Instrument that is based on the price or value of a debt security (other than

an exempted security as discussed below) would be a security-based swap. Any instrument based on

the “yield” of a debt security (other than an exempted security as discussed below), loan or narrow-based

security index, where the yield is a proxy for its price or value, would generally be treated as a security-

based swap. The security-based swap definition excludes any transaction that meets the definition only

because it references an exempted security under section 3(a)(12) of the Exchange Act on the effective

date of the Futures Trading Act of 1982 (the “FTA date”), other than a municipal security, unless such

transaction is of the character of, or is commonly known in the trade as, a put, call, or other option. Thus,

a Title VII Instrument referencing the price or yield of a U.S. Treasury security would be a swap.41

B. TOTAL RETURN SWAPS

The Commissions describe a TRS as a Title VII Instrument “in which one counterparty, the seller of the

TRS, makes a payment that is based on the price appreciation and income from an underlying security or

security index”, a single loan, two or more loans or other underliers. The buyer of the TRS makes a

financing payment (typically, based on a variable interest rate) and pays for any price depreciation of the

underlying reference. The Adopting Release provides that a TRS will be a security-based swap if the

total return will be the price appreciation or depreciation, plus any interest or income payments, and the

underlying reference instrument is:

a single security;

a single loan; or

a narrow-based security index.

Conversely, a similarly structured TRS will be a swap if such TRS has an underlying reference that is:


a broad-based security index;

two or more non-security loans; or

an exempted security (other than municipal securities).

The interpretation indicates that, generally, a variable interest rate component which acts merely as a

financing component of a TRS will not cause such TRS to be characterized as a mixed swap if it is

otherwise a security-based swap.42

However, in situations where such variable interest rate payment

component exposes the counterparties to the TRS (which, absent these additional components, would be

a security-based swap) to additional interest rate or currency exposures that are unrelated to the

financing of the TRS or otherwise shift or limit risks relating to the financing of the TRS, such TRS is a

mixed swap.

The Commissions also provide an interpretation, which was not included in the Proposing Release, with

respect to quanto equity swaps.43

A quanto equity swap will be treated as a security-based swap and not

a mixed swap if:

(i) the purpose of the quanto equity swap is to transfer exposure to the return of a security or security index without transferring exposure to any currency or exchange rate risk; and

(ii) any exchange rate or currency risk exposure incurred by the dealer due to a difference in the currency denomination of the quanto equity swap and of the underlying security or security index is incidental to the quanto equity swap and arises from the instrument(s) the dealer chooses to use to hedge the quanto equity swap and is not a direct result of any expected payment obligations by either party under the quanto equity swap.

44

On the other hand, a Title VII Instrument on foreign equities pursuant to 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” (i.e., a so-called compo equity swap) would be a mixed

swap. With respect to such an instrument, the Commissions indicate that currency exposure is not

incidental to the equity exposure.

C. SECURITY-BASED SWAPS BASED ON A SINGLE SECURITY OR LOAN AND SINGLE-NAME CREDIT DEFAULT SWAPS

Single name credit default swaps (“CDS”), which are CDS that are based on a single reference obligation

or entity, would be security-based swaps under the second prong of the security-based swap definition.

Moreover, any CDS which is triggered by an event relating to financial statements, financial condition or

financial obligations of a single security issuer (such as a bankruptcy of an issuer, or a default on one of

the issuer’s debt securities or non-security loans) would be a security-based swap.


D. TITLE VII INSTRUMENTS BASED ON FUTURES

The Commissions adopted an interpretation, consistent with the Proposing Release, that a Title VII

Instrument based on a security future is a security-based swap while a Title VII Instrument based on a

non-security futures contract is a swap.

The Adopting Release notes that Dodd-Frank did not exclude foreign government securities generally

from the “security-based swap” definition. Accordingly, a Title VII Instrument based directly on foreign

government debt securities would be analyzed the same as any other Title VII Instrument based on

securities. However, Exchange Act Rule 3a12-8 provides certain exemptions from Exchange Act

requirements in connection with futures contracts on the debt securities of 21 enumerated foreign

governments. To provide consistency with Rule 3a12-8, the Final Rules provide that a Title VII

Instrument based on a futures contract referencing the debt securities of one of those foreign

governments will be a swap, if:

the futures contract qualifies under Rule 3a12-8;

the Title VII Instrument is traded on or through a board of trade;

the underlying debt securities are not covered by an effective registration statement or American Depositary Receipts registered under the Securities Act;

the Title VII Instrument is cash settled; and

none of the issuer of the underlying debt securities, any affiliate of the issuer or underwriter of the debt securities is a counterparty to the Title VII Instrument.

E. USE OF CERTAIN TERMS AND CONDITIONS IN TITLE VII INSTRUMENTS

The Commissions note that market participants may set a fixed term or condition of the instrument based

on the value of a security, rate or other commodity at the time of execution. As was the case in the

Proposing Release, the Commissions have determined that the nature of the security, rate or other

commodity that informed the setting of the fixed term or condition of the Title VII Instrument does not

affect the determination as to whether such instrument is a swap or security-based swap, so long as the

term or condition is fixed at execution. Thus, for example, the fact that the notional amount, fixed rate

payment and amortization schedule of an interest rate swap is set by reference to a debt issuance would

not result in the interest rate swap being treated as a security-based swap. However, if the interest rate

swap contained terms that were contingent upon a characteristic of a debt security that may change in

the future or the future value of the debt security, then the interest rate swap would be a mixed swap.


V. THE TERMS “NARROW-BASED SECURITY INDEX” AND “ISSUERS OF SECURITIES IN NARROW-BASED SECURITY INDEX”

A. APPLICATION OF THE DEFINITION OF “NARROW-BASED SECURITY INDEX”

A Title VII Instrument based on a narrow-based security index will be a security-based swap whereas a

Title VII Instrument based on a security index that is not narrow-based (often referred to as a broad-

based security index) will be a swap. In determining whether an index that underlies an instrument (other

than an index CDS) is based on a narrow-based or broad-based security index, market participants

should look to the statutory definition and the following guidance:

a joint order issued by the Commissions in 2004 with respect to volatility indexes (the “2004 Joint Order”);

45

joint rules adopted by the Commissions in 2006 with respect to debt securities indexes (the “2006 Joint Rules”);

46 and

a joint order issued by the Commissions in 2009 with respect to volatility indexes on foreign equity indexes (the “2009 Joint Order”).

47

1. Statutory Definition of Narrow-Based Security Index

Under the statutory definition in the CEA,48

a security index is a narrow-based security index if, among

other things, it meets any one of the following four criteria:

It has nine or fewer component securities;

A component security comprises more than 30% of the index’s weighting;

The five highest weighted component securities in the aggregate comprise more than 60% of the index’s weighting; or

The lowest weighted component securities comprising, in the aggregate, 25% of the index’s weighting have an aggregate dollar value of average daily trading volume of less than $50,000,000 (or in the case of an index with more than 15 component securities, $30,000,000), except that if there are two or more securities with equal weighting that could be included in the calculation of the lowest weighted component securities comprising, in the aggregate, 25% of the index’s weighting, such securities will be ranked from lowest to highest dollar value of average daily trading volume and will be included in the calculation based on their ranking starting with the lowest ranked security.

2. The 2004 Joint Order Criteria

Under the 2004 Joint Order, the Commissions would consider a security index to not be a narrow-based

security index if the index met the following seven criteria:

The index measures the magnitude of changes in the level of an underlying broad-based security index that is not a narrow-based security index as that term is defined in Section 1(a)(25) of the CEA and Section 3(a)(55) of the Exchange Act over a defined period of time, which magnitude is calculated using the prices of options on the underlying broad-based security index and represents (A) an annualized standard deviation of percent changes in the level of the underlying broad-based security index; (B) an annualized variance


of percent changes in the level of the underlying broad-based security index; or (C) on a non-annualized basis either the standard deviation or the variance of percent changes in the level of the underlying broad-based security index;

The index has more than nine component securities, all of which are options on the underlying broad-based security index;

No component security of the index comprises more than 30% of the index’s weighting;

The five highest weighted component securities of the index in the aggregate do not comprise more than 60% of the index’s weighting;

The average daily trading volume of the lowest weighted component securities in the underlying broad-based security index upon which the index is calculated (those comprising, in the aggregate, 25% of the underlying broad-based security index’s weighting) has a dollar value of more than $50,000,000 (or $30,000,000 in the case of an underlying broad-based security index with 15 or more component securities), except if there are two or more securities with equal weighting that could be included in the calculation of the lowest weighted component securities comprising, in the aggregate, 25% of the underlying broad-based security index’s weighting, such securities will be ranked from lowest to highest dollar value of average daily trading volume and will be included in the calculation based on their ranking starting with the lowest ranked security;

Options on the underlying broad-based security index are listed and traded on a national securities exchange registered under the Exchange Act; and

The aggregate average daily trading volume in options on the underlying broad-based security index is at least 10,000 contracts calculated as of the preceding six full calendar months.

3. The 2006 Joint Rules

Under the 2006 Joint Rules, the Commissions would consider a security index to not be a narrow-based


Each of the securities of an issuer included in the index is a security that is a note, bond, debenture, or evidence of indebtedness;

None of the securities of an issuer included in the index is an equity security;

The index is comprised of more than nine securities that are issued by more than nine non-affiliated issuers;

The securities of any issuer included in the index do not comprise more than 30% of the index’s weighting;

The securities of any five non-affiliated issuers included in the index do not comprise more than 60% of the index’s weighting;

Except as provided below, for each security of an issuer included in the index one of the following criteria is satisfied:

The issuer of the security is required to file reports under the Exchange Act;

The issuer of the security has a worldwide market value of its outstanding common equity held by non-affiliates of $700 million or more;

The issuer of the security has outstanding securities that are notes, bonds, debentures, or evidences of indebtedness having a total remaining principal amount of at least $1 billion;


The security is an exempted security as defined in section 3(a)(12) of the Exchange Act and the rules promulgated thereunder; or

The issuer of the security is a government of a foreign country or a political subdivision of a foreign country; and

Except as provided below, for each security of an issuer included in the index one of the following criteria is satisfied:

The security has a total remaining principal amount of at least $250,000,000; or

The security is a municipal security (as defined in section 3(a)(29) of the Exchange Act and the rules promulgated thereunder) that has a total remaining principal amount of at least $200,000,000 and the issuer of such municipal security has outstanding securities that are notes, bonds, debentures, or evidences of indebtedness having a total remaining principal amount of at least $1 billion.

The two conditions set forth in the last two bullet points above will not apply to securities of an issuer

included in the index if:

All securities of such issuer included in the index represent less than 5% of the index’s weighting; and

Securities comprising at least 80% of the index’s weighting satisfy the provisions of the two conditions set forth above.

4. The 2009 Joint Order

Under the 2009 Joint Order, the Commissions would consider a security index to not be a narrow-based


The index measures the magnitude of changes in the level of an underlying broad-based security index that is not a narrow-based security index over a defined period of time, which magnitude is calculated using the prices of options on the underlying broad-based security index and represents (a) an annualized standard deviation of percent changes in the level of the underlying broad-based security index, (b) an annualized variance of percent changes in the level of the underlying broad-based security index, or (c) on a non-annualized basis, either the standard deviation or the variance of percent changes in the level of the underlying broad-based security index;

The volatility index has more than nine component securities, all of which are options on the underlying broad-based security index;

No component security of the volatility index comprises more than 30% of the volatility index’s weighting;

The five highest weighted component securities of the volatility index in the aggregate do not comprise more than 60% of the volatility index’s weighting;

The average daily trading volume of the lowest weighted component securities in the underlying broad-based security index upon which the volatility index is calculated (those comprising, in the aggregate, 25% of the underlying broad-based security index’s weighting) has a dollar value of more than $50,000,000 (or $30,000,000 in the case of an underlying broad-based security index with 15 or more component securities), except if there are two or more securities with equal weighting that could be included in the calculation of the lowest weighted component securities comprising, in the aggregate, 25% of the underlying broad-based security index’s weighting, such securities will be ranked from lowest to highest dollar


value of average daily trading volume and will be included in the calculation based on their ranking starting with the lowest ranked security;

The index options used to calculate the magnitude of change in the level of the underlying broad-based security index are listed for trading on an exchange and pricing information for the underlying broad-based security index, and options on such index, is computed and disseminated in real time through major market data vendors; and

The aggregate average daily trading volume in options on the underlying broad-based security index is at least 10,000 contracts calculated as of the preceding six full calendar months.

B. INDEX CREDIT DEFAULT SWAPS

The statutory definition of a security-based swap includes:

a CDS based on a single entity or based on the obligations of a single entity (a single-name CDS); or

a CDS based on a narrow-based security index or the issuers of securities in a narrow-based security index (each an index CDS).

For purposes of determining whether the reference entities or issuers of securities on which an index

CDS is based constitute a narrow-based security index, the Commissions adopted a modified version of

the 2006 Joint Rules. The Final Rules differ from the 2004 Joint Order and 2009 Joint Order in that,

rather than require a certain volume of trading in the components of a broad-based security index, the

Commissions will require that public information be available with respect to a predominant portion of any

index underlying an index CDS that is a swap. The Commissions also explained that these Final Rules

only apply to indexed CDS and not any other instruments.

1. The Number Component and Concentration Components

For an index CDS based on the issuers of securities in a security index, the underlying index will be a

narrow-based security index if:

there are nine or fewer non-affiliated issuers of securities that are referenced in the index;49

the notional amount allocated to any entity included in the index comprises more than 30% of the index’s weighting; or

the notional amount allocated to any five non-affiliated entities included in the index comprises more than 60% of the index’s weighting.

These same criteria apply for purposes of determining whether an index CDS based on issuers or

reference entities is a security-based swap based on a narrow-based security index. For purposes of

both sets of criteria above, the Final Rules require that the securities of an issuer be aggregated with its

own securities or securities of an affiliate also included in the index for determining whether an index

meets any of the above criteria.


2. Affiliation of Reference Entities and Issuers of Securities with Respect to Index CDS

When determining the concentration and number of issuers or securities underlying an index CDS,

affiliated issuers and securities of affiliated issuers or the same entities will be aggregated together. With

respect to asset-backed securities, each reference entity or issuer of asset-backed securities included in

the index will be considered a separate reference entity or issuer and will not be considered affiliated with

other reference entities or issuers of securities included in the index. For purposes of the rules relating to

the definition of narrow-based security index for index CDS, a reference entity or issuer of a security

included in the index is affiliated with another reference entity or issuer if it controls, is controlled by, or is

under common control with, that other reference entity or issuer. Unlike the Proposed Rules, which

provided for a control threshold of 20% ownership, the Final Rules define control as:

ownership of more than 50% of a reference entity’s or issuer’s equity; or

the ability to direct the voting of more than 50% of a reference entity’s or issuer’s voting equity.

3. Public Information Availability Regarding Reference Entities and Securities

Rather than an average daily trading volume test in the definition of narrow-based security index for index

CDS, the Commission will require a public information availability test. The average daily trading volume

provisions of the statutory definition and the 2004 Joint Order and 2009 Joint Order were intended for

trading of individual stocks and are not, in the Commissions’ opinion, “useful for purposes of determining

the status of the index on which the index CDS is based” because index CDS often reference untraded

entities or unlisted debt instruments.50

However, the underlying rationale for the average daily trading

volume is to ensure that there is publicly available information concerning the reference entities or issuers

of securities in the index. Therefore, the Final Rules incorporate a test aimed at ensuring adequate public

information is available about a substantial number of constituents of a broad-based security index

underlying an index CDS.

Under the Final Rules, an index CDS will be based on a narrow-based security index if any reference

entity or issuer of a security included in the index does not meet any of the following:

it is required to file Exchange Act reports;

it is eligible for an exemption pursuant to Exchange Act Rule 12g3-2(b);

it has a worldwide market value of outstanding common equity held by non-affiliates of $700 million or more;

other than a reference entity in an index that is the issuing entity of asset-backed securities, it has outstanding notes, bonds, debentures, loans or evidence of indebtedness (other than revolving credit facilities) with an aggregate outstanding principal amount of at least $1 billion;

it is an issuer of an exempted security, other than a municipal security, as defined in section 3(a)(12) of the Exchange Act, or an exempted security other than a municipal security is included in the index;


it is a government of a foreign country or political subdivision thereof; or

it is an issuer of registered asset-backed securities with publicly available distribution reports.

However, if at least 80% of the reference entities or issuers of the securities included in such index satisfy

any of the above mentioned criteria and no reference entity or issuer of a security included in the index

which does not satisfy any of the criteria has more than 5% of the notional value attributed to it, the index

CDS could still be narrow-based.

The Final Rules also provide for an alternative to the public information availability test for index CDS

entered into solely between ECPs. Under this alternative test, an index underlying a CDS entered into

solely between ECPs would be considered narrow-based so long as, in addition to the seven criteria

discussed above, no reference entity or issuer of a security included in the index:

makes information public about itself pursuant to Rule 144A(d)(4);

for a non-asset-backed security issuer, has financial information about itself otherwise publicly available; or

for an asset-backed security issuer, has publicly available information about itself that is similar to the information included in public distribution reports.

When determining whether a reference entity or issuer of securities included in the index satisfies the

public information availability test, market participants should look to whether the reference entity or

issuer, when aggregated with its affiliates, satisfies any of the criteria of the test. That is, an index CDS

will not be based on a narrow-based security index so long as no reference entity or issuer of securities

included in the index or any affiliate of such entity or issuer:

is required to file reports under the Exchange Act;

is eligible to rely on a foreign private issuers exemption under the Exchange Act;

has, when aggregated with affiliates, outstanding common equity held by non-affiliates of $700 million or more;

has, when aggregated with affiliates, notes, bonds, debentures, loans, or evidence of indebtedness (other than revolving credit facilities) of at least $1 billion.

In the case of asset-backed securities, however, the issuing entity that is a reference entity or an issuer of

such securities included in the index underlying the CDS is looked at individually and is not aggregated

with its affiliates to determine if it satisfies one of the public information availability tests above.

The Commissions have determined not to allow an index to avoid the public information availability test if

a third-party index provider compiles information about an index. Commenters did not convince the

Commissions that an index provider would necessarily be able to provide information about the

underlying securities or issuers in the index.


The Final Rules exclude from consideration exempted securities which were exempt as of the FTA date,

and issuers thereof, when determining whether an index underlying a CDS is a narrow-based security

index. Thus, an index CDS based solely on an index consisting only of exempted securities (other than

municipal securities) will be a swap subject to the jurisdiction of the CFTC. However, if some, but not all,

of the index components are exempted securities (other than municipal securities), such index would be a

narrow-based security index only if the index would be a narrow-based security index when those

exempted securities are ignored.

C. SECURITY INDEXES AND PORTFOLIOS

Security indexes may be established and maintained by recognized index providers or may be created by

the parties to an instrument or created by a third-party index provider at the request of the parties.

Alternatively, the parties may permit a third-party provider to select an initial portfolio of securities and

change the portfolio components in accordance with agreed upon guidelines. In situations where one

counterparty has, or both counterparties have, directly or indirectly, including through an investment

advisor or third-party index provider, the discretionary authority to change the composition of the security

portfolio or index, such index or security portfolio would be a narrow-based security index and any Title

VII Instrument based on such index would be a security-based swap. On the other hand, if the

composition of an index is determined prior to execution or may change only pursuant to pre-determined

criteria or a pre-determined self-executing formula such index would be:

a narrow-based security index if it was a narrow-based security index at execution; or

a broad-based security index if it was a broad-based security index at execution.

In discussing this interpretation, the Commissions stress that the pre-determined criteria or self-executing

formula must:

not be subject to change or modification through the life of the instrument; and

not be influenced by the parties to the instrument, their agents or a third-party index provider having discretionary authority to change the index.

D. INDEXES THAT “MIGRATE” FROM BROAD TO NARROW OR VICE VERSA

The determination as to whether an instrument is a swap or security-based swap is made no later than

the time at which the counterparties offer to enter into the transaction. If a Title VII Instrument is based on

a broad-based security index that migrates to being a narrow-based security index, such instrument will

remain a swap. The same is true for a Title VII Instrument based on a narrow-based security index that

becomes a broad-based security index during the life of the security-based swap; the instrument remains

a security-based swap. If certain criteria of a security portfolio or index would cause a broad-based

security index to migrate to being a narrow-based security index, or vice versa, and that migration is

known at execution, that Title VII Instrument would be a mixed swap for the life of the instrument. The


Commissions indicate that for this purpose the criteria or formula must “intentionally [be] designed to

change the index from narrow to broad, or vice versa.”51

The Commissions have also determined to adopt tolerance and grace periods for Title VII Instruments

based on security indexes traded on designated contract markets (“DCMs”), swap execution facilitates

(“SEFs”), foreign boards of trade (“FBOTs”), security-based SEFs and national securities exchanges

(“NSEs”). A swap may only be traded on a DCM, SEF or FBOT and a security-based swap may only be

traded on a security-based SEF or an NSE. Without these tolerance or grace periods, when a security

index underlying a Title VII Instrument migrates from narrow-based to broad-based, or vice versa, the

instrument would not be permitted to trade on the market it had traded on prior to the migration. The

Commissions note that this could disrupt the ability of market participants to effect or enter into new

transactions on trading platforms when the migration occurs. To alleviate this potential disruption the

Final Rules provide that a broad-based security index that migrates to being a narrow-based security

index will not be considered a narrow-based security index, so long as:

It meets at least one of the two following criteria:

the underlying index was not narrow-based during the first thirty days of trading; or

the underlying index was not narrow-based at any time during a six-month period prior to a date that is no earlier than thirty days prior to commencement of trading on the DCM, SEF or FBOT; and

the underlying index has not been a narrow-based security index for more than forty-five days over three consecutive calendar months.

The converse test applies to a security-based swap on a narrow-based security index traded on a

security-based SEF or an NSE that becomes a broad-based security index.

The Final Rules also provide a three-month grace period for a swap on a broad-based security-index

which becomes narrow-based for more than forty-five business days over three consecutive calendar

months, to the extent that such swap is executed subject to the rules of a DCM, SEF or FBOT. The

converse test applies to a security-based swap on a narrow-based security index traded on a security-

based SEF or NSE. At the expiration of this grace period, a security index must satisfy the tolerance

period criteria set forth above in order to trigger a new tolerance period; there is no overlap between the

tolerance and the grace period or retriggering of the tolerance period.

E. METHOD OF SETTLEMENT OF INDEX CDS

In the Adopting Release, the Commissions have provided an interpretation for determining whether an

index CDS is a swap or security-based swap based on its method of settlement. If an index CDS is on a

broad-based security index and includes a mandatory settlement provision requiring the delivery of a non-

exempted security or a loan, such index CDS would be a mixed swap. On the other hand, if an index

CDS on a broad-based security index includes mandatory cash settlement, such index CDS is a swap,


regardless of whether the cash settlement is based on the value of a non-exempted security or loan. The

Commissions specifically note that the cash settlement of a CDS on a broad-based security index through

an auction process, such as that contemplated by 2009 ISDA Credit Derivatives Determinations

Committees, Auction and Restructuring CDS Protocol, will be a swap and will not be considered a

security-based swap or mixed swap.

VI. MIXED SWAPS

A. SCOPE OF DEFINITION

A mixed swap is a narrow category of instruments created by Dodd-Frank to ensure that all swaps and

security-based swaps are subject to regulation by one of the Commissions. In general, a mixed swap is

an instrument that is both a security-based swap and a swap. For example, an instrument in which the

underlier references both the value of an oil corporation’s stock and the price of oil would be a mixed

swap. Likewise, a “best of” or “out performance” swap that requires payment based on the higher of the

performance of a security and a commodity would be a mixed swap.

Consistent with the Commissions’ view that the category of mixed swaps is to be “narrow”, the

Commissions indicate that use of certain market standard agreements will not in and of itself transform a

Title VII Instrument into a mixed swap. Thus, standard termination and event of default provisions, such

as bankruptcy, breach of agreement, cross default to other indebtedness and misrepresentation, even if

referencing entities that do not issue securities, will not affect the characterization of the instrument for

Title VII purposes.

B. APPLICABLE REGULATION

The Final Rules provide that a mixed swap that is entered into bilaterally, is not cleared and has at least

one counterparty registered as both a security-based swap dealer or a major security-based swap

participant and a swap dealer or a major swap participant, must comply with all applicable provisions of

the federal securities laws and the following CEA requirements:

examinations and information sharing;

enforcement;

reporting to a SDR;

real-time reporting;

capital; and

position limits.

All other mixed swaps generally must comply with both the CEA and the Exchange Act relating to swaps

and security-based swaps, unless the mixed swap is subject to a joint rule or order from the


Commissions. The Final Rules provide that any person intending to list, trade or clear a mixed swap

“may request the Commissions to publicly issue a joint order permitting such person (and any other

person or persons that subsequently lists, trades, or clears that class of mixed swap) to comply, as to

parallel provisions only, with the specified parallel provision” instead of all the relevant provisions of both

the CEA and the Exchange Act. For this purpose, “parallel provisions” is defined as the comparable

provisions of the Exchange Act and CEA that were added or amended by Title VII. The Commissions will

have 120 days52

following the receipt of a complete request to either provide a joint order or publicly

provide the reasons for not adopting a joint order. The Final Rules expressly provide that the

Commissions are not required to issue a joint order.

VII. SECURITY-BASED SWAP AGREEMENTS

A security-based swap agreement (“SBSA”) is defined as a “swap agreement” (as defined in section

206A of the Gramm-Leach-Bliley Act) that is not a security-based swap and that has “a material term . . .

based on the price, yield, value, or volatility of any security or any group or index of securities, including

any interest therein”. The CFTC has regulatory and enforcement authority over SBSAs and the SEC has

antifraud, anti-manipulation and certain other authority over SBSAs.

The Commissions indicate that they do not believe that it is possible to provide a bright-line test to define

SBSA. However, the Commissions identify certain types of swaps that “clearly fall within the definition of

SBSA” in a series of examples that were first published in the Proposing Release. Such swaps include:

a swap based on a broad-based index of securities;

an index CDS that is based on a broad-based security index; and

a swap based on a U.S. Treasury security or on certain other exempted securities other than municipal securities.

The Commissions offered no further guidance to define SBSA.

Section 712 of the Dodd-Frank Act requires the Commissions, in consultation with the Board, to jointly

adopt rules governing books and records requirements for SBSAs applicable to certain market

participants. The Adopting Release provides “that there will not be additional books and records

requirements regarding SBSAs other than those that are required for swaps.”53

VIII. PROCESS FOR REQUESTING INTERPRETATIONS CONCERNING THE CHARACTERIZATION OF SWAPS, SECURITY-BASED SWAPS AND MIXED SWAPS

The Commissions recognize that market participants may have difficulty in categorizing a Title VII

Instrument as a swap, security-based swap or a mixed swap. Consistent with the Proposed Rules, the

Final Rules establish a process for market participants to request a joint interpretation by the


Commissions regarding whether a particular Title VII Instrument (or class of Title VII Instruments) is a

swap, security-based swap, or a mixed swap. The Final Rules draw upon various attributes of

section 718 of Dodd-Frank, which establishes a process for determining the status of “novel derivative

products” that may have elements of both securities and futures contracts. However, the Commissions

explain that any future interpretation involving the process under section 718 would not affect the process

adopted in the Final Rules, and vice versa.

Under the Final Rules, any person may request from the Commissions a public joint interpretation of

whether a particular Title VII Instrument (or class of Title VII Instruments) is a swap, a security-based

swap, or a mixed swap by providing the Commissions with:

all material information regarding the terms of the instrument (or class of instruments);

a statement of the economic characteristics and purpose of the instrument (or class of instruments);

the requesting person’s determination as to whether the instrument (or class of instruments) should be characterized as a swap, a security-based swap, or a mixed swap, including the basis for such determination; and

such other information as may be requested by either Commission.

A person who submits a request for interpretation may withdraw the request at any time prior to the

issuance of a joint interpretation or joint notice of proposed rulemaking by the Commissions. However,

even if a request for an interpretation is withdrawn, the Commissions may still adopt an interpretation

regarding the characterization of the Title VII Instrument (or class of Title VII Instruments). Thus, the

requesting person may lose control of the process once the request is made. It will remain to be seen

whether this loss of control will reduce the number of requests that will be made to the Commissions for a

joint order.

Even in the absence of a request for a joint interpretation, the Final Rules provide that either Commission,

or their Chairmen jointly, may submit a request for a joint interpretation as to the characterization of a

Title VII Instrument. Consistent with this authority, the Final Rules require each Commission to notify the

other if there is a proposal to list, trade or clear an instrument (or class) that raises issues as to the

appropriate characterization of the instrument as a swap, security-based swap or mixed swap.

Like the Final Rules governing the process for obtaining a joint order for mixed swaps, the Final Rules do

not require the Commissions to issue a joint interpretation in response to a request for interpretation.

However, upon receipt of such a request, the Commissions must either:

issue a joint interpretation within 120 days54

of receipt of the completed request for interpretation;

provide the reasons for not providing such an interpretation if the Commissions do not issue a joint interpretation within 120 days

55 of receipt of the request for interpretation; or


issue a joint notice of proposed rulemaking, in consultation with the Board, to further define one or more of the terms “swap,” “security-based swap,” or “mixed swap” within 120 days

56 of

receipt of the request for interpretation.

Finally, the Commissions clarify that requesting parties may seek confidential treatment for joint

interpretive requests from the SEC and the CFTC in accordance with the applicable existing rules relating

to confidential treatment of information. However, regardless of whether a requesting party seeks

confidential treatment of its request, all joint interpretive requests, as well as all joint interpretations and

any decisions not to issue a joint interpretation (along with the explanation of the grounds for such

decision), will be made publicly available at the conclusion of the review period.57

The SEC estimates that there will be 50 requests for joint interpretations in the first year and 10 requests

on average in each ensuing year. In light of the length of time to receive a joint interpretation — 4 months

in the best case, the possibility of not receiving any guidance and the inability to effectively withdraw a

request, we agree with the SEC that the number of requests for joint interpretations will likely be limited.

IX. ANTI-EVASION

A. TREATMENT OF SWAPS BY THE CFTC

Dodd-Frank contains various provisions designed to capture transactions and entities that have been

structured to evade certain requirements of Dodd-Frank, and the CFTC is given the authority to

promulgate anti-evasion rules.

The CFTC, consistent with the Proposed Rules, adopted two Final Rules to address its anti-evasion

authority.

First, CFTC Rule 1.3(xxx)(6) generally provides that a transaction is a swap if it is willfully structured to

evade any provision of Title VII of Dodd-Frank governing the regulation of swaps. This rule includes

specific provisions relating to currency and interest rate swaps that are willfully structured as foreign

exchange forwards or foreign exchange swaps, and certain instruments willfully structured as identified

banking products, in each case to evade the provisions of Dodd Frank.

Second, CFTC Rule 1.6 prohibits activities conducted outside the U.S., including entering into

transactions and structuring entities, to willfully evade or attempt to evade any provision of Subtitle A of

Title VII or the rules and regulations promulgated by the CFTC thereunder.

In the case of both anti-evasion Final Rules, the Adopting Release clarifies that the CFTC will interpret a

person to have acted “willfully” when the person has acted either intentionally or with reckless disregard.

Any transaction that was willfully structured to evade Dodd-Frank will be considered in determining

whether a person is a swap dealer or major swap participant, and any non-U.S. activity designed to


evade Dodd-Frank will be subject to the swap provisions of the CEA enacted under Dodd-Frank. In

response to comments, the Adopting Release clarifies that in the “rare situation” where only one of the

counterparties to a transaction has willfully structured the transaction to evade Dodd-Frank, the

transaction will be subject to all CEA provisions and related regulations (as applied to the willful evader),

but will not be considered for the purposes of determining whether the non-evading party is a swap dealer

or major swap participant, and sanctions will only be imposed on the willful evader. However, as against

both the willful evader and the “innocent party”, the CFTC will consider the underlying transaction or

instrument to be a swap for Dodd-Frank purposes on a prospective basis.

The anti-evasion rules do not apply to any agreement structured as a security (including a security-based

swap) under the securities laws. The Adopting Release also notes that entering into transactions that

qualify for the forward exclusion from the “swap” definition will not be considered evasive, nor will the

execution of transactions that have been self-certified by a SEF or DCM, or pre-approved by the CFTC.

The Adopting Release also clarifies that a transaction that violates the anti-evasion rules will only be

considered a “swap” if it otherwise meets the definition of “swap”.

In determining whether a transaction has been willfully structured to evade Dodd-Frank, the Adopting

Release notes that, consistent with the CFTC’s case law in the context of determining whether a contract

is a futures contract and interpretations regarding swaps in the Adopting Release, the CFTC will look

beyond the form of the transaction to examine its actual substance. The CFTC also provides interpretive

guidance, based on legislative, administrative, and judicial precedent with respect to the anti-evasion

provisions in other federal statutes, as to certain types of circumstances that may constitute an evasion of

the requirements of Dodd-Frank. However, the Adopting Release states that, notwithstanding this

guidance, the CFTC will maintain its ability to determine, on a case-by-case basis, whether a transaction

or activity constitutes an evasion of Dodd-Frank.

1. Business Purpose

The Adopting Release notes that, in evaluating whether a person is evading or attempting to evade Dodd-

Frank, the CFTC will consider the extent to which a person has a legitimate business purpose for

structuring the instrument or entity or entering into the transaction in that particular manner. Absent other

indicia of evasion, the CFTC will not consider transactions, entities, or instruments structured in a manner

solely motivated by a legitimate business purpose to constitute evasion. The Adopting Release notes

that a person’s specific consideration of regulatory burdens, or avoidance thereof, is not dispositive that a

person is acting without a legitimate business purpose in a given instance. In addition, the Adopting

Release notes that, while the CFTC’s guidance on business purpose references the use of the business

purpose test in the tax law context, the CFTC is not bound to use the business purpose consideration in

the same manner as the Internal Revenue Service (the “IRS”), and is not adopting the IRS’s

interpretation.


2. Fraud, Deceit, or Unlawful Activity

The Adopting Release notes that the IRS has distinguished between tax evasion and legitimate means

for citizens to minimize, reduce, avoid, or alleviate the tax that they pay under the Internal Revenue Code,

and the CFTC indicates that this framework provides a useful guidepost for determining which types of

activities should be considered to constitute an evasion of Dodd-Frank. A permissible method of reducing

tax is associated with full disclosure and explanation of why the tax should be reduced under law.

However, tax evasion consists of the willful attempt to evade tax liability, and generally involves deceit,

subterfuge, camouflage, concealment, or some attempt to color or obscure events or to make things

seem other than they are.58

Therefore, in determining whether a particular transaction or activity is

designed to evade Dodd-Frank, the CFTC will consider the extent to which the conduct involves deceit,

deception, or other unlawful or illegitimate activity. However, a finding of deceit, deception, or other

unlawful or illegitimate activity will not be a prerequisite to an evasion finding.

B. TREATMENT OF SECURITY-BASED SWAPS BY THE SEC

Section 761(b)(3) of Dodd-Frank grants the SEC discretionary authority to define “security-based swap” to

capture transactions that have been structured to evade Subtitle B of Title VII. However, the SEC did not

propose any anti-evasion rules under Section 761(b)(3). In the Adopting Release, the SEC explains that

it was not necessary to do so, because security-based swaps are “securities” for the purposes of the

federal securities law (unless the SEC grants an exemption) and therefore existing regulations, including

anti-fraud and anti-manipulation provisions, will apply to such instruments.

* * *

Copyright © Sullivan & Cromwell LLP 2012


ENDNOTES

1 See “Further Definition of ‘Swap,’ ‘Security-Based Swap,’ and ‘Security-Based Swap Agreement’;

Mixed Swaps; Security-Based Swap Agreement Recordkeeping”, 77 Fed. Reg. 48207 (August 13, 2012), available at http://www.cftc.gov/ucm/groups/public/@lrfederalregister/ documents/file/2012-18003a.pdf.

2 The terms “agreement”, “contract” and “transaction” are used interchangeably throughout this

memorandum.

3 See SEC, “Order Granting Temporary Exemptions under the Exchange Act in Connection with

the Pending Revision of the Definition of ‘Security‘ to Encompass Security-Based Swaps, and Request for Comment”, Release No. 34-64795 (July 1, 2011), 77 Fed. Reg. 39927 (July 7, 2011), available at http://sec.gov/rules/exorders/2011/34-64795.pdf. For more information on this order, see our Memorandum to Clients, dated July 8, 2011, “SEC Exemptive Relief in Connection with Effective Date of Title VII of Dodd-Frank: SEC Issues Interim Final Rules and Order to Provide Relief from Certain Provisions That Would Be Effective on July 16, 2011”.

4 See SEC, “Exemptions for Security-Based Swaps”, Release Nos. 33-9231, 34-64794 and 39-

2475 (July 1, 2011), 77 Fed. Reg. 40605 (July 11, 2011), available at http://sec.gov/rules/interim/2011/33-9231.pdf. For more information on these interim final rules, see our Memorandum to Clients, dated July 8, 2011, “SEC Exemptive Relief in Connection with Effective Date of Title VII of Dodd-Frank: SEC Issues Interim Final Rules and Order to Provide Relief from Certain Provisions That Would Be Effective on July 16, 2011”.

5 In addition, see SEC, “Order Pursuant to Sections 15F(b)(6) and 36 of the Exchange Act Granting

Temporary Exemptions and Other Temporary Relief, Together With Information on Compliance Dates for New Provision of the Exchange Act Applicable to Security-Based Swaps, and Request for Comments”, Release No. 34-64795 (June 15, 2011), 76 Fed. Reg. 36287 (June 22, 2011), available at http://sec.gov/rules/exorders/2011/34-64678.pdf. For more information on this order, see our Memorandum to Clients, dated June 22, 2011, “SEC Exemptive Relief in Connection with Effective Date of Title VII of Dodd-Frank: SEC Issues Order to Provide Relief from Certain Provisions of Title VII That Would Be Effective on July 16, 2011”.

6 See “Further Definition of ‘Swap,’ ‘Security-Based Swap,’ and ‘Security-Based Swap Agreement’;

Mixed Swaps; Security-Based Swap Agreement Recordkeeping”, 76 Fed. Reg. 29818 (May 23, 2011). For further information on the Proposing Release, see our Memorandum to Clients, dated May 12, 2011, entitled “Proposed Product Definitions Under Title VII of Dodd-Frank: CFTC and SEC Propose Rules and Guidance to Further Define the Terms, ‘Swap,’ ‘Security-Based Swap,’ and ‘Mixed Swaps’.

7 The Commissions also declined to adopt an approach, proposed by other commenters, that

would have relied on the insurance product exclusion set forth in Section 3(a)(8) of the Securities Act. See 77 Fed. Reg. 48,208, 48224 (August 12, 2012)

8 In response to comments, the Adopting Release clarifies in interpretive guidance that reinsurance

and retrocession transactions fall within the scope of the Product Test, since “these transactions have insurable interests … if they have issued insurance policies covering the risks that they wish to insure (and reinsure).” See 77 Fed. Reg. at 48,215.

9 In response to comments, the Adopting Release clarifies in interpretive guidance that “the

assignment of an insurance contract as permitted or required by state law, or the purchase or assignment of an insurance contract on an insurance exchange or otherwise, does not constitute trading an agreement separately from the insured interest and would not violate the trading restriction in the Product Test.” 77 Fed. Reg. at 48,215.

10 Unlike in the Proposing Release, the Enumerated Products are now defined in the rule itself,

rather than included in the Adopting Release as interpretive guidance.

http://www.cftc.gov/ucm/groups/public/@lrfederalregister/documents/file/2012-18003a.pdf


http://sec.gov/rules/exorders/2011/34-64795.pdf

http://sec.gov/rules/interim/2011/33-9231.pdf

http://sec.gov/rules/exorders/2011/34-64678.pdf


ENDNOTES CONTINUED

11 The Adopting Release eliminates a requirement in the Proposing Release that the insurance

provider be organized as an insurance company and have as its primary and predominant activity the writing of insurance or reinsurance, to address commenters’ concerns that this requirement could have excluded foreign providers of insurance and allowed providers of insurance products to evade state insurance regulation by intentionally failing the Provider Test (i.e., marketing the

insurance products as swaps or security-based swaps in order to avoid state insurance supervision).

12 The Adopting Release removed the phrase “located outside the United States” contained in the

Proposing Release with respect to reinsurers in order to encompass all reinsurers and not just those based outside of the United States.

13 Such as, for example, in respect of state law provisions pertaining to the calculation of amounts

reimbursable under reinsurance contracts.

14 This test for non-admitted insurance did not appear in the Proposing Release but was added in

the Adopting Release.

15 77 Fed. Reg. at n 188.

16 77 Fed. Reg. at 48,228.

17 Statutory Interpretation Concerning Forward Transactions, 55 Fed. Reg. 39188 (Sep. 25, 1990)

(“Brent Interpretation”).

18 77 Fed. Reg. at 48,228 (quoting the Brent Interpretation).

19 Exemption for Certain Contracts Involving Energy Products, 58 FR 21286-02 (Apr. 20, 1993)

(“Energy Exemption”).

20 77 Fed. Reg. at 48229. Under the Brent Interpretation, intent 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 reference commodity in the ordinary course of their business.

21 Id. (quoting the Brent Interpretation).

22 Id.

23 The term “exempt commodity” is defined by the CEA to mean a commodity that is neither an

agricultural commodity nor an excluded commodity as defined in n. 24 and n. 25, infra, respectively. Exempt commodities include certain energy and metal commodities.

24 The term “agricultural commodity” has been defined by CFTC rulemaking. See Agricultural

Commodity Definition, 76 Fed. Reg. 41048 (July 13, 2011). The term means:

The following commodities specifically enumerated in the definition of a ‘‘commodity’’ found in section 1a of the CEA: Wheat, cotton, rice, corn, oats, barley, rye, flaxseed, grain sorghums, mill feeds, butter, eggs, Solanum tuberosum (Irish potatoes), wool, wool tops, fats and oils (including lard, tallow, cottonseed oil, peanut oil, soybean oil and all other fats and oils), cottonseed meal, cottonseed, peanuts, soybeans, soybean meal, livestock, livestock products, and frozen concentrated orange juice, but not onions;

All other commodities that are, or once were, or are derived from, living organisms, including plant, animal and aquatic life, which are generally fungible, within their respective classes, and are used primarily for human food, shelter, animal feed or natural fiber;

Tobacco, products of horticulture, and such other commodities used or consumed by animals or humans as the CFTC may by rule, regulation or order designate after notice and opportunity for hearing; and


ENDNOTES CONTINUED

Commodity-based indexes based wholly or principally on underlying agricultural commodities.

25 The term “excluded commodity” is defined by the CEA to mean: (i) an interest rate, exchange

rate, currency, security, security index, credit risk or measure, debt or equity instrument, index or measure of inflation, or other macroeconomic index or measure; (ii) any other rate, differential, index, or measure of economic or commercial risk, return, or value that is (I) not based in substantial part on the value of a narrow group of commodities not described in clause (i), or (II) based solely on one or more commodities that have no cash market; (iii) any economic or commercial index based on prices, rates, values, or levels that are not within the control of any party to the relevant agreement; or (iv) an occurrence, extent of an occurrence, or contingency (other than a change in the price, rate, value, or level of a commodity not described in clause (i)) that is beyond the control of the parties to the relevant agreement, and is associated with a financial, commercial, or economic consequence.

26 See CFTC, Commodity Options, 77 Fed. Reg. 25320 (April 27, 2012).

27 See Characteristics Distinguishing Cash and Forward Contracts and “Trade Options”, 50 Fed.

Reg. 39656 (Sept. 30, 1985).

28 77 Fed. Reg. at 48239.

29 Transmission (or transportation) services agreements generally refer to agreements for the use of

electricity transmission lines (or gas pipelines) that allow a power generator to transmit electricity (or gas supplier to transport gas) to a specific location.

30 Tolling agreements generally refer to agreements that provide a purchaser the right to the

capacity, energy, ancillary services and any other product derived from a specified generating unit, all based upon a delivered fuel price and agreed heat rate.

31 See Commodity Options, 77 Fed. Reg. 25320 (April 27, 2012).

32 The Adopting Release notes that this timing of sale analysis applies even if the forward contract

is cash settled.

33 The Adopting Release clarifies that use of the term “customary” is not intended to limit the

interpretation, but rather describes certain types of arrangements that consumers and businesses may normally or generally enter into.

34 The Adopting Release includes an acknowledgement that the CEA does not apply to, and the

CFTC may not exercise regulatory authority over, identified banking products, and that the definitions of “security-based swap” and “security-based swap agreement” do not include identified banking products. See 77 Fed. Reg. at 48247, n. 433; see also 77 Fed. Reg. 48251, n. 488. See Section IX, infra, on applicability of anti-evasion authority to identified banking products. The Commissions note that commercial loans and mortgages may not qualify as identified banking products when entered into by certain institutions because these institutions do not satisfy the definition of bank for purposes of the “identified banking products” definition.

35 The Commissions indicate that merely because a contract is assignable does not mean that it is

“traded”. However, the Commissions note that the assignment must be analyzed to ensure that it does not “sever the payment obligations”.

36 The Adopting Release explains that the “true participation” analysis is used to determine whether

a transaction has resulted in the underlying assets being legally isolated from a transferor’s creditors for U.S. bankruptcy law purposes.

37 77 Fed. Reg. at 48,257.


ENDNOTES CONTINUED

38 The Commissions previously adopted rules further defining “eligible contract participant” as well

as other terms under Title VII. See Further Definition of “Swap Dealer,” “Security-Based Swap Dealer,” “Major Swap Participant,” “Major Security-Based Swap Participant” and “Eligible Contract Participant,” 77 Fed. Reg. 30596 (May 23, 2012) available at http://www.cftc.gov/ucm/ groups/public/@lrfederalregister/documents/file/2012-10562a.pdf. For further information on these rules, see our Memorandum to Clients, dated June 8, 2012, entitled “CFTC and SEC Issue Final Swap-Related Rules Under Title VII of Dodd-Frank”.

39 77 Fed. Reg. at 48,258.

40 Certain Title VII Instruments may be “mixed swaps” (as discussed in VI.

41 Foreign government securities were not exempt as of the FTA date and, therefore, are not

excluded from the definition of security-based swap under this test.

42 The Commissions indicate that any quantitative or qualitative analysis may be used to

demonstrate that the variable interest component is solely financing related. According to the Commissions, the financing leg of a TRS may reflect:

the dealer’s financing costs on a one-to-one basis;

a spread consistent with the dealer’s costs of dealing with respect to a particular TRS or counterparty; or

an “off-market” spread if explained by factors unique to the dealer or the securities underlying the TRS (such as illiquidity).

43 A quanto equity swap is an equity swap where the underlying reference instrument is

denominated in a foreign currency and the final value of the underlying instrument is paid out in a domestic currency at a rate determined at the outset of the quanto equity swap.

44 77 Fed. Reg. at 48265.

45 See “Joint Order Excluding Indexes Comprised of Certain Index Options From the Definition of

Narrow-Based Security Index”, 69 Fed. Reg. 16900 (Mar. 31, 2004).

46 See “Joint Final Rules: Application of the Definition of Narrow-Based Security Index to Debt

Securities Indexes and Security Futures on Debt Securities”, 71 Fed. Reg. 39534 (July 13, 2006).

47 See “Joint Order To Exclude Indexes Composed of Certain Index Options From the Definition of

Narrow-Based Security Index”, 74 Fed. Reg. 61116 (Nov. 23, 2009).

48 See Section 1a(35) of thte CEA. A parallel definition is included in the Exchange Act. See

Section 3(a)(55)(B) of the Exchange Act.

49 An issuer of securities will only be deemed to be included in the index if:

a credit event in relation to that issuer would result in a payment from one counterparty to the other based on the notional amount allocated to that issuer; or

a credit event in relation to that issuer would be taken into account in determining whether to make future payments under the index CDS in relation to future credit events.

50 See 77 Fed. Reg. at 48278.

51 77 Fed. Reg. at 48287.

52 The 120-day period is tolled during the pendancy of any public comment period.

53 77 Fed. Reg. at 48294.




ENDNOTES CONTINUED

54 However, such period will be tolled during the public comment period, if the Commissions seek

public comment.

55 Unlike the 120-day period with respect to the issuance of a joint interpretation, the Final Rules do

not provide that this 120-day period is tolled for any public comment period. Based on statements in the Adopting Release, this would seem to be an inadvertent omission from the Final Rules.

56 Unlike the 120-day period with respect to the issuance of a joint interpretation, the Final Rules do

not provide that this 120-day period is tolled for any public comment period. Based on statements in the Adopting Release, this would seem to be an inadvertent omission from the Final Rules.

57 The CFTC notes that while section 8 of the CEA prohibits the CFTC from publishing information

that would separately disclose business transactions or market positions of any person or trade secrets or names of customers, section 8 does not apply to the SEC. Accordingly, the CFTC recommends that market participants do not include any information covered by section 8 in their joint interpretation requests.

58 The Adopting Release notes that the Internal Revenue Manual of the IRS states “One who avoids

tax does not conceal or misrepresent. He/she shapes events to reduce or eliminate tax liability and, upon the happening of the events, makes a complete disclosure. Evasion, on the other hand, involves deceit, subterfuge, camouflage, concealment, some attempt to color or obscure events or to make things seem other than they are.” 77 Fed. Reg. at 48302 at n. 1055.

Final Product Definitions Under Title VII of Dodd-Frank August 27, 2012 SC1:3280959.3

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