2012-18003
Federal Register, Volume 77 Issue 156 (Monday, August 13, 2012)[Federal Register Volume 77, Number 156 (Monday, August 13, 2012)]
[Rules and Regulations]
[Pages 48207-48366]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2012-18003]
[[Page 48207]]
Vol. 77
Monday,
No. 156
August 13, 2012
Part II
Commodity Futures Trading Commission
17 CFR Part 1
Securities and Exchange Commission
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17 CFR Parts 230, 240 and 241
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Further Definition of ``Swap,'' ``Security-Based Swap,'' and
``Security-Based Swap Agreement''; Mixed Swaps; Security-Based Swap
Agreement Recordkeeping; Final Rule
Federal Register / Vol. 77, No. 156 / Monday, August 13, 2012 / Rules
and Regulations
[[Page 48208]]
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COMMODITY FUTURES TRADING COMMISSION
17 CFR Part 1
RIN 3038-AD46
SECURITIES AND EXCHANGE COMMISSION
17 CFR Parts 230, 240 and 241
[Release No. 33-9338; 34-67453; File No. S7-16-11]
RIN 3235-AK65
Further Definition of ``Swap,'' ``Security-Based Swap,'' and
``Security-Based Swap Agreement''; Mixed Swaps; Security-Based Swap
Agreement Recordkeeping
AGENCY: Commodity Futures Trading Commission; Securities and Exchange
Commission.
ACTION: Joint final rule; interpretations; request for comment on an
interpretation.
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SUMMARY: In accordance with section 712(a)(8), section 712(d)(1),
sections 712(d)(2)(B) and (C), sections 721(b) and (c), and section
761(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act
(``Dodd-Frank Act''), the Commodity Futures Trading Commission
(``CFTC'') and the Securities and Exchange Commission (``SEC'')
(collectively, ``Commissions''), in consultation with the Board of
Governors of the Federal Reserve System (``Board''), are jointly
adopting new rules and interpretations under the Commodity Exchange Act
(``CEA'') and the Securities Exchange Act of 1934 (``Exchange Act'') to
further define the terms ``swap,'' ``security-based swap,'' and
``security-based swap agreement'' (collectively, ``Product
Definitions''); regarding ``mixed swaps;'' and governing books and
records with respect to ``security-based swap agreements.'' The CFTC
requests comment on its interpretation concerning forwards with
embedded volumetric optionality, contained in Section II.B.2.(b)(ii) of
this release.
DATES: Effective date: October 12, 2012.
Compliance date: The applicable compliance dates are discussed in
the section of the release titled ``IX. Effective Date and
Implementation''.
Comment date: Comments on the interpretation regarding forwards
with embedded volumetric optionality must be received on or before
October 12, 2012.
ADDRESSES: You may submit comments, identified by RIN number 3038-AD46,
by any of the following methods:
CFTC Web Site: via its Comments Online process: http://comments.cftc.gov. Follow the instructions for submitting comments
through the Web site.
Mail: Address to David A. Stawick, Secretary of the
Commission, Commodity Futures Trading Commission, Three Lafayette
Centre, 1155 21st Street NW., Washington, DC 20581.
Hand Delivery/Courier: Same as mail above.
Federal eRulemaking Portal: http://www.regulations.gov.
Follow the instructions for submitting comments.
All comments must be submitted in English or, if not, accompanied
by an English translation. Comments will be posted as received to
http://www.cftc.gov. You should submit only information that you wish
to make available publicly. If you wish the CFTC to consider
information that is exempt from disclosure under the Freedom of
Information Act, a petition for confidential treatment of the exempt
information may be submitted according to the procedures established in
Sec. 145.9 of the CFTC's Regulations.\1\
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\1\ 17 CFR 145.9.
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The CFTC reserves the right, but shall have no obligation, to
review, pre-screen, filter, redact, refuse or remove any or all of your
submission from http://www.cftc.gov that it may deem to be
inappropriate for publication, such as obscene language. All
submissions that have been redacted or removed that contain comments on
the merits of the interpretation will be retained in the public comment
file and will be considered as required under the Administrative
Procedure Act and other applicable laws, and may be accessible under
the Freedom of Information Act.
FOR FURTHER INFORMATION CONTACT: CFTC: Julian E. Hammar, Assistant
General Counsel, at 202-418-5118, [email protected], Lee Ann Duffy,
Assistant General Counsel, at 202-418-6763, [email protected]; Mark
Fajfar, Assistant General Counsel, at 202-418-6636, [email protected],
or David E. Aron, Counsel, at 202-418-6621, [email protected], Office of
General Counsel, Commodity Futures Trading Commission, Three Lafayette
Centre, 1155 21st Street NW., Washington, DC 20581; SEC: Donna M.
Chambers, Special Counsel, at 202-551-5870, or John Guidroz, Attorney-
Adviser, at 202-551-5870, Division of Trading and Markets, or Andrew
Schoeffler, Special Counsel, at 202-551-3860, Office of Capital Markets
Trends, Division of Corporation Finance, or Wenchi Hu, Senior Special
Counsel, at 202-551-5870, Office of Compliance, Inspections and
Examinations, Securities and Exchange Commission, 100 F Street NE.,
Washington, DC 20549.
SUPPLEMENTARY INFORMATION:
Table of Contents
I. Background
II. Scope of Definitions of Swap and Security-Based Swap
A. Introduction
B. Rules and Interpretations Regarding Certain Transactions
outside the Scope of the Definitions of the Terms ``Swap'' and
``Security-Based Swap''
1. Insurance Products
(a) Types of Insurance Products
(b) Providers of Insurance Products
(c) Grandfather Provision for Existing Insurance Transactions
(d) Alternative Tests
(e) ``Safe Harbor''
(f) Applicability of Insurance Exclusion to Security-Based Swaps
(g) Guarantees
2. The Forward Contract Exclusion
(a) Forward Contracts in Nonfinancial Commodities
(i) Forward Exclusion From the Swap and Future Delivery
Definitions
(ii) Nonfinancial Commodities
(iii) Environmental Commodities
(iv) Physical Exchange Transactions
(v) Fuel Delivery Agreements
(vi) Cleared/Exchange-Traded Forwards
(b) Commodity Options and Commodity Options Embedded in Forward
Contracts
(i) Commodity Options
(ii) Commodity Options Embedded in Forward Contracts
(iii) Certain Physical Commercial Agreements, Contracts or
Transactions
(iv) Effect of Interpretation on Certain Agreements, Contracts
and Transactions
(v) Liquidated Damages Provisions
(c) Security Forwards
3. Consumer and Commercial Agreements, Contracts, and
Transactions
C. Final Rules and Interpretations Regarding Certain
Transactions Within the Scope of the Definitions of the Terms
``Swap'' and ``Security-Based Swap''
1. In General
2. Foreign Exchange Products
(a) Foreign Exchange Products Subject to the Secretary's Swap
Determination: Foreign Exchange Forwards and Foreign Exchange Swaps
(b) Foreign Exchange Products Not Subject to the Secretary's
Swap Determination
(i) Foreign Currency Options
(ii) Non-Deliverable Forward Contracts Involving Foreign
Exchange
(iii) Currency Swaps and Cross-Currency Swaps
(c) Interpretation Regarding Foreign Exchange Spot Transactions
(d) Retail Foreign Currency Options
3. Forward Rate Agreements
4. Combinations and Permutations of, or Options on, Swaps and
Security-Based Swaps
5. Contracts for Differences
D. Certain Interpretive Issues
1. Agreements, Contracts, or Transactions That May Be Called, or
Documented
[[Page 48209]]
Using Form Contracts Typically Used for, Swaps or Security-Based
Swaps
2. Transactions in Regional Transmission Organizations and
Independent System Operators
III. The Relationship Between the Swap Definition and the Security-
Based Swap Definition
A. Introduction
B. Title VII Instruments Based on Interest Rates, Other Monetary
Rates, and Yields
1. Title VII Instruments Based on Interest Rates or Other
Monetary Rates That Are Swaps
2. Title VII Instruments Based on Yields
3. Title VII Instruments Based on Government Debt Obligations
C. Total Return Swaps
D. Security-Based Swaps Based on a Single Security or Loan and
Single-Name Credit Default Swaps
E. Title VII Instruments Based on Futures Contracts
F. Use of Certain Terms and Conditions in Title VII Instruments
G. The Term ``Narrow-Based Security Index'' in the Security-
Based Swap Definition
1. Introduction
2. Applicability of the Statutory Narrow-Based Security Index
Definition and Past Guidance of the Commissions to Title VII
Instruments
3. Narrow-Based Security Index Criteria for Index Credit Default
Swaps
(a) In General
(b) Rules Regarding the Definitions of ``Issuers of Securities
in a Narrow-Based Security Index'' and ``Narrow-Based Security
Index'' for Index Credit Default Swaps
(i) Number and Concentration Percentages of Reference Entities
or Securities
(ii) Affiliation of Reference Entities and Issuers of Securities
With Respect to Number and Concentration Criteria
(iii) Public Information Availability Regarding Reference
Entities and Securities
(iv) Affiliation of Reference Entities and Issuers of Securities
With Respect to Certain Criteria of the Public Information
Availability Test
(v) Application of the Public Information Availability
Requirements to Indexes Compiled by a Third-Party Index Provider
(vi) Treatment of Indexes Including Reference Entities That Are
Issuers of Exempted Securities or Including Exempted Securities
4. Security Indexes
5. Evaluation of Title VII Instruments on Security Indexes That
Move From Broad-Based to Narrow-Based or Narrow-Based to Broad-Based
(a) In General
(b) Title VII Instruments on Security Indexes Traded on
Designated Contract Markets, Swap Execution Facilities, Foreign
Boards of Trade, Security-Based Swap Execution Facilities, and
National Securities Exchanges
H. Method of Settlement of Index CDS
I. Security-Based Swaps as Securities Under the Exchange Act and
Securities Act
IV. Mixed Swaps
A. Scope of the Category of Mixed Swap
B. Regulation of Mixed Swaps
1. Introduction
2. Bilateral Uncleared Mixed Swaps Entered Into by Dually-
Registered Dealers or Major Participants
3. Regulatory Treatment for Other Mixed Swaps
V. Security-Based Swap Agreements
A. Introduction
B. Swaps That Are Security-Based Swap Agreements
C. Books and Records Requirements for Security-Based Swap
Agreements
VI. Process for Requesting Interpretations of the Characterization
of a Title VII Instrument
VII. Anti-Evasion
A. CFTC Anti-Evasion Rules
1. CFTC's Anti-Evasion Authority
(a) Statutory Basis for the Anti-Evasion Rules
2. Final Rules
(a) Rule 1.3(xxx)(6)
(b) Rule 1.6
(c) Interpretation on the Final Rules
3. Interpretation Contained in the Proposing Release
(a) Business Purpose Test
(b) Fraud, Deceit or Unlawful Activity
B. SEC Position Regarding Anti-Evasion Rules
VIII. Miscellaneous Issues
A. Distinguishing Futures and Options From Swaps
B. Transactions Entered Into by Foreign Central Banks, Foreign
Sovereigns, International Financial Institutions, and Similar
Entities
C. Definition of the Terms ``Swap'' and ``Security-Based Swap''
as Used in the Securities Act
IX. Effective Date and Implementation
X. Administrative Law Matters--CEA Revisions
A. Paperwork Reduction Act
B. Regulatory Flexibility Act
C. Costs and Benefits Considerations
XI. Administrative Law Matters--Exchange Act Revisions
A. Economic Analysis
B. Paperwork Reduction Act
C. Regulatory Flexibility Act Certification
XII. Statutory Basis and Rule Text
I. Backbround
On July 21, 2010, President Obama signed the Dodd-Frank Act into
law.\2\ Title VII of the Dodd-Frank Act \3\ (``Title VII'') established
a comprehensive new regulatory framework for swaps and security-based
swaps. The legislation was enacted, among other reasons, to reduce
risk, increase transparency, and promote market integrity within the
financial system, including by: (i) Providing for the registration and
comprehensive regulation of swap dealers, security-based swap dealers,
major swap participants, and major security-based swap participants;
(ii) imposing clearing and trade execution requirements on swaps and
security-based swaps, subject to certain exceptions; (iii) creating
rigorous recordkeeping and real-time reporting regimes; and (iv)
enhancing the rulemaking and enforcement authorities of the Commissions
with respect to, among others, all registered entities and
intermediaries subject to the Commissions' oversight.
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\2\ See Dodd-Frank Wall Street Reform and Consumer Protection
Act, Public Law 111-203, 124 Stat. 1376 (2010). The text of the
Dodd-Frank Act is available at http://www.cftc.gov/LawRegulation/OTCDERIVATIVES/index.htm.
\3\ Pursuant to section 701 of the Dodd-Frank Act, Title VII may
be cited as the ``Wall Street Transparency and Accountability Act of
2010.''
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Section 712(d)(1) of the Dodd-Frank Act provides that the
Commissions, in consultation with the Board, shall jointly further
define the terms ``swap,'' ``security-based swap,'' and ``security-
based swap agreement'' (``SBSA'').\4\ Section 712(a)(8) of the Dodd-
Frank Act provides further that the Commissions shall jointly prescribe
such regulations regarding ``mixed swaps'' as may be necessary to carry
out the purposes of Title VII. In addition, sections 721(b) and 761(b)
of the Dodd-Frank Act provide that the Commissions may adopt rules to
further define terms included in subtitles A and B, respectively, of
Title VII, and sections 721(c) and 761(b) of the Dodd-Frank Act provide
the Commissions with authority to define the terms ``swap'' and
``security-based swap,'' as well as the terms ``swap dealer,'' ``major
swap participant,'' ``security-based swap dealer,'' and ``major
security-based swap participant,'' to include transactions and entities
that have been structured to
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evade the requirements of subtitles A and B, respectively, of Title
VII.
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\4\ In addition, section 719(d)(1)(A) of the Dodd-Frank Act
requires the Commissions to conduct a joint study, within 15 months
of enactment, to determine whether stable value contracts, as
defined in section 719(d)(2) of the Dodd-Frank Act, are encompassed
by the swap definition. If the Commissions determine that stable
value contracts are encompassed by the swap definition, section
719(d)(1)(B) of the Dodd-Frank Act requires the Commissions jointly
to determine whether an exemption for those contracts from the swap
definition is appropriate and in the public interest. Section
719(d)(1)(B) also requires the Commissions to issue regulations
implementing the determinations made under the required study. Until
the effective date of such regulations, the requirements under Title
VII do not apply to stable value contracts, and stable value
contracts in effect prior to the effective date of such regulations
are not considered swaps. See section 719(d) of the Dodd-Frank Act.
The Commissions currently are conducting the required joint study
and will consider whether to propose any implementing regulations
(including, if appropriate, regulations determining that stable
value contracts: (i) Are not encompassed within the swap definition;
or (ii) are encompassed within the definition but are exempt from
the swap definition) at the conclusion of that study.
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Section 712(d)(2)(B) of the Dodd-Frank Act requires the
Commissions, in consultation with the Board, to jointly adopt rules
governing books and records requirements for SBSAs by persons
registered as swap data repositories (``SDRs'') under the CEA,\5\
including uniform rules that specify the data elements that shall be
collected and maintained by each SDR.\6\ Similarly, section
712(d)(2)(C) of the Dodd-Frank Act requires the Commissions, in
consultation with the Board, to jointly adopt rules governing books and
records for SBSAs, including daily trading records, for swap dealers,
major swap participants, security-based swap dealers, and security-
based swap participants.\7\
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\5\ 7 U.S.C. 1 et seq.
\6\ The CFTC has issued final rules regarding SDRs and,
separately, swap data recordkeeping and reporting. See Swap Data
Repositories: Registration Standards, Duties and Core Principles, 76
FR 54538 (Sep. 1, 2011); Swap Data Recordkeeping and Reporting
Requirements, 77 FR 2136 (Jan. 13, 2012). The SEC has also issued
proposed rules regarding security-based swap data repositories
(``SBSDRs''), including rules specifying data collection and
maintenance standards for SBSDRs, as well as rules regarding
security-based swap data recordkeeping and reporting. See Security-
Based Swap Data Repository Registration, Duties, and Core
Principles, 75 FR 77306 (Dec. 10, 2010); Regulation SBSR--Reporting
and Dissemination of Security-Based Swap Information, 75 FR 75208
(Dec. 2, 2010).
\7\ The CFTC has issued final rules regarding recordkeeping
requirements for swap dealers and major swap participants. See Swap
Dealer and Major Swap Participant Recordkeeping, Reporting, and
Duties Rules; Futures Commission Merchant and Introducing Broker
Conflicts of Interest Rules; and Chief Compliance Officer Rules for
Swap Dealers, Major Swap Participants, and Futures Commission
Merchants, 77 FR 20128 (Apr. 3, 2012).
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Under the comprehensive framework for regulating swaps and
security-based swaps established in Title VII, the CFTC is given
regulatory authority over swaps,\8\ the SEC is given regulatory
authority over security-based swaps,\9\ and the Commissions shall
jointly prescribe such regulations regarding mixed swaps as may be
necessary to carry out the purposes of Title VII.\10\ In addition, the
SEC is given antifraud authority over, and access to information from,
certain CFTC-regulated entities regarding SBSAs, which are a type of
swap related to securities over which the CFTC is given regulatory
authority.\11\
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\8\ Section 721(a) of the Dodd-Frank Act defines the term
``swap'' by adding section 1a(47) to the CEA, 7 U.S.C. 1a(47). This
new swap definition also is cross-referenced in new section 3(a)(69)
of the Exchange Act, 15 U.S.C. 78c(a)(69). Citations to provisions
of the CEA and the Exchange Act, 15 U.S.C. 78a et seq., in this
release refer to the numbering of those provisions after the
effective date of Title VII, except as indicated.
\9\ Section 761(a) of the Dodd-Frank Act defines the term
``security-based swap'' by adding new section 3(a)(68) to the
Exchange Act, 15 U.S.C. 78c(a)(68). This new security-based swap
definition also is cross-referenced in new CEA section 1a(42), 7
U.S.C. 1a(42). The Dodd-Frank Act also explicitly includes security-
based swaps in the definition of security under the Exchange Act and
the Securities Act of 1933 (``Securities Act''), 15 U.S.C. 77a et
seq.
\10\ Section 721(a) of the Dodd-Frank Act describes the category
of ``mixed swap'' by adding new section 1a(47)(D) to the CEA, 7
U.S.C. 1a(47)(D). Section 761(a) of the Dodd-Frank Act also includes
the category of ``mixed swap'' by adding new section 3(a)(68)(D) to
the Exchange Act, 15 U.S.C. 78c(68)(D). A mixed swap is defined as a
subset of security-based swaps that also are based on the value of 1
or more interest or other rates, currencies, commodities,
instruments of indebtedness, indices, quantitative measures, other
financial or economic interest or property of any kind (other than a
single security or a narrow-based security index), or the
occurrence, non-occurrence, or the extent of the occurrence of an
event or contingency associated with a potential financial,
economic, or commercial consequence (other than the occurrence, non-
occurrence, or extent of the occurrence of an event relating to a
single issuer of a security or the issuers of securities in a
narrow-based security index, provided that such event directly
affects the financial statements, financial condition, or financial
obligations of the issuer).
\11\ Section 761(a) of the Dodd-Frank Act defines the term
``security-based swap agreement'' by adding new section 3(a)(78) to
the Exchange Act, 15 U.S.C. 78c(a)(78). The CEA includes the
definition of ``security-based swap agreement'' in subparagraph
(A)(v) of the swap definition in CEA section 1a(47), 7 U.S.C.
1a(47). The only difference between these definitions is that the
definition of SBSA in the Exchange Act specifically excludes
security-based swaps (see section 3(a)(78)(B) of the Exchange Act,
15 U.S.C. 78c(a)(78)(B)), whereas the definition of SBSA in the CEA
does not contain a similar exclusion. Instead, under the CEA, the
exclusion for security-based swaps is placed in the general
exclusions from the swap definition (see CEA section 1a(47)(B)(x), 7
U.S.C. 1a(47)(B)(x)). Although the statutes are slightly different
structurally, the Commissions interpret them to have consistent
meaning that the category of security-based swap agreements excludes
security-based swaps.
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To assist the Commissions in further defining the Product
Definitions (as well as certain other definitions) and in prescribing
regulations regarding mixed swaps as may be necessary to carry out the
purposes of Title VII, the Commissions published an advance notice of
proposed rulemaking (``ANPR'') in the Federal Register on August 20,
2010.\12\ The comment period for the ANPR closed on September 20,
2010.\13\ The Commissions received comments addressing the Product
Definitions and/or mixed swaps in response to the ANPR, as well as
comments in response to the Commissions' informal solicitations,\14\
from a wide range of commenters. Taking into account comments received
on the ANPR, the Commissions published a notice of proposed rulemaking
in the Federal Register on May 23, 2011.\15\ The comment period for the
Proposing Release closed on July 22, 2011.\16\ Together, the
Commissions received approximately 86 written comment letters in
response to the Proposing Release.
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\12\ See Definitions Contained in Title VII of Dodd-Frank Wall
Street Reform and Consumer Protection Act, 75 FR 51429 (Aug. 20,
2010). The ANPR also solicited comment regarding the definitions of
the terms ``swap dealer,'' ``security-based swap dealer,'' ``major
swap participant,'' ``major security-based swap participant,'' and
``eligible contract participant.'' These definitions are the subject
of a separate joint rulemaking by the Commissions. See Further
Definition of ``Swap Dealer,'' ``Security-Based Swap Dealer,''
``Major Swap Participant,'' ``Major Security-Based Swap
Participant'' and ``Eligible Contract Participant,'' 77 FR 30596
(May 23, 2012) (``Entity Definitions Release''). The Commissions
also provided the public with the ability to present their views
more generally on implementation of the Dodd-Frank Act through their
Web sites, dedicated electronic mailboxes, and meetings with
interested parties. See Public Comments on SEC Regulatory
Initiatives Under the Dodd-Frank Act/Meetings with SEC Officials,
located at http://www.sec.gov/spotlight/regreformcomments.shtml;
Public Submissions, located at http://comments.cftc.gov/PublicComments/ReleasesWithComments.aspx; External Meetings, located
at http://www.cftc.gov/LawRegulation/DoddFrankAct/ExternalMeetings/index.htm.
\13\ Copies of all comments received by the SEC on the ANPR are
available on the SEC's Internet Web site, located at http://www.sec.gov/comments/s7-16-10/s71610.shtml. Comments are also
available for Web site viewing and printing in the SEC's Public
Reference Room, 100 F Street NE., Washington, DC 20549, on official
business days between the hours of 10 a.m. and 3 p.m. Copies of all
comments received by the CFTC on the ANPR are available on the
CFTC's Internet Web site, located at http://www.cftc.gov/LawRegulation/DoddFrankAct/OTC_2_Definitions.html.
\14\ See supra note 12.
\15\ See Further Definition of ``Swap,'' ``Security-Based
Swap,'' and ``Security-Based Swap Agreement''; Mixed Swaps;
Security-Based Swap Agreement Recordkeeping, 76 FR 29818 (May 23,
2011) (``Proposing Release'').
\16\ Id.
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The Commissions have reviewed and considered the comments received,
and the staffs of the Commissions have met with many market
participants and other interested parties to discuss the
definitions.\17\ Moreover, the Commissions' staffs have consulted
extensively with each other as required by sections 712(a)(1) and (2)
of the Dodd-Frank Act and have consulted with staff of the Board as
required by section 712(d) of the Dodd-Frank Act.
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\17\ Information about meetings that CFTC staff have had with
outside organizations regarding the implementation of the Dodd-Frank
Act is available at http://www.cftc.gov/LawRegulation/DoddFrankAct/ExternalMeetings/index.htm. Information about meetings that SEC
staff have had with outside organizations regarding the product
definitions is available at http://www.sec.gov/comments/s7-16-10/s71610.shtml#meetings.
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Based on this review and consultation, the Commissions are adopting
rules and interpretations regarding, among other things: (i) The
regulatory treatment of insurance products; (ii) the exclusion of
forward contracts from the swap and security-
[[Page 48211]]
based swap definitions; (iii) the regulatory treatment of certain
consumer and commercial contracts; (iv) the regulatory treatment of
certain foreign-exchange related and other instruments; (v) swaps and
security-based swaps involving interest rates (or other monetary rates)
and yields; (vi) total return swaps (``TRS''); (vii) Title VII
instruments based on futures contracts; (viii) the application of the
definition of ``narrow-based security index'' in distinguishing between
certain swaps and security-based swaps, including credit default swaps
(``CDS'') and index CDS; and (ix) the specification of certain swaps
and security-based swaps that are, and are not, mixed swaps. In
addition, the Commissions are adopting rules: (i) To clarify that there
will not be additional books and records requirements applicable to
SBSAs other than those required for swaps; (ii) providing a mechanism
for requesting the Commissions to interpret whether a particular type
of agreement, contract, or transaction (or class of agreements,
contracts, or transactions) is a swap, security-based swap, or both
(i.e., a mixed swap); and (iii) providing a mechanism for evaluating
the applicability of certain regulatory requirements to particular
mixed swaps. Finally, the CFTC is adopting rules to implement the anti-
evasion authority provided in the Dodd-Frank Act.
Overall Economic Considerations
The Commissions are sensitive to the costs and benefits of their
rules. In considering the adoption of the Product Definitions, the
Commissions have been mindful of the costs and benefits associated with
these rules, which provide fundamental building blocks for the Title
VII regulatory regime. There are costs, as well as benefits, arising
from subjecting certain agreements, contracts, or transactions to the
regulatory regime of Title VII.\18\ Additionally, there are costs that
parties will incur to assess whether certain agreements, contracts, or
transactions are indeed subject to the Title VII regulatory regime,
and, if so, the costs to assess whether such Title VII instrument is
subject to the regulatory regime of the SEC or the CFTC.\19\
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\18\ The Commissions refer to these costs and benefits as
programmatic costs and benefits.
\19\ The Commissions refer to these costs as assessment costs.
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Title VII created a jurisdictional division between the CFTC and
SEC. The costs and benefits flowing from an agreement, contract, or
transaction being subject to the regulatory regime of the CFTC or the
SEC may be impacted by similarities and differences in the Commissions'
regulatory programs for swaps and security-based swaps. Title VII calls
on the SEC and the CFTC to consult and coordinate for the purposes of
assuring regulatory consistency and comparability to the extent
possible.\20\ Title VII also calls on the agencies to treat
functionally or economically similar products or entities in a similar
manner, but does not require identical rules.\21\ Although the
Commissions may differ on certain rulemakings, as the relevant
products, entities and markets are different, the Commissions believe
that, as the CFTC and SEC regulatory regimes share a statutory basis in
Title VII, the costs and benefits of their respective regimes should be
broadly similar and complementary.
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\20\ See sections 712(a)(1) and (a)(2) of the Dodd-Frank Act.
\21\ See sections 712(a)(7)(A) and (B) of the Dodd-Frank Act.
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In acknowledging the economic consequences of the final rules, the
Commissions recognize that the Product Definitions do not themselves
establish the scope or nature of those substantive requirements or
their related costs and benefits. In determining the appropriate scope
of these rules, the Commissions consider the types of agreement,
contract, or transaction that should be regulated as a swap, security-
based swap, or mixed swap under Title VII in light of the purposes of
the Dodd-Frank Act. The Commissions have sought to further define the
terms ``swap,'' ``security-based swap,'' and ``mixed swap'' to include
agreements, contracts, and transactions only to the extent that
capturing these agreements, contracts, and transactions is necessary
and appropriate given the purposes of Title VII, and to exclude
agreements, contracts, and transactions to the extent that the
regulation of such agreements, contracts, and transactions does not
serve the statutory purposes of Title VII, so as not to impose
unnecessary burdens for agreements, contracts, and transactions whose
regulation may not be necessary or appropriate to further the purposes
of Title VII.
II. Scope of Definitions of Swap and Security-Based Swap
A. Introduction
Title VII of the Dodd-Frank Act applies to a wide variety of
agreements, contracts, and transactions classified as swaps or
security-based swaps. The statute lists these agreements, contracts,
and transactions in the definition of the term ``swap.'' \22\ The
statutory definition of the term ``swap'' also has various
exclusions,\23\ rules of construction, and other provisions for the
interpretation of the definition.\24\ One of the exclusions to the
definition of the term ``swap'' is for security-based swaps.\25\ The
term ``security-based swap,'' in turn, is defined as an agreement,
contract, or transaction that is a ``swap'' (without regard to the
exclusion from that definition for security-based swaps) and that also
has certain characteristics specified in the statute.\26\ Thus, the
statutory definition of the term ``swap'' also determines the scope of
agreements, contracts, and transactions that could be security-based
swaps.
---------------------------------------------------------------------------
\22\ See CEA section 1a(47)(A), 7 U.S.C. 1a(47)(A). This swap
definition is also cross-referenced in new section 3(a)(69) of the
Exchange Act, 15 U.S.C. 78c(a)(69).
\23\ See CEA section 1a(47)(B), 7 U.S.C. 1a(47)(B), clauses (i)-
(x).
\24\ See CEA sections 1a(47)(C)-(F), 7 U.S.C. 1a(47)(C)-(F).
\25\ See CEA section 1a(47)(B)(x), 7 U.S.C. 1a(47)(B)(x).
\26\ See section 3(a)(68) of the Exchange Act, 15 U.S.C.
78c(a)(68).
---------------------------------------------------------------------------
The statutory definitions of the terms ``swap'' and ``security-
based swap'' are detailed and comprehensive, and the Commissions
believe that extensive ``further definition'' of the terms by rule is
not necessary. Nevertheless, the definitions could be read to include
certain types of agreements, contracts, and transactions that
previously have not been considered swaps or security-based swaps, and
nothing in the legislative history of the Dodd-Frank Act appears to
suggest that Congress intended such agreements, contracts, or
transactions to be regulated as swaps or security-based swaps under
Title VII. The Commissions thus believe that it is important to further
clarify the treatment under the definitions of certain types of
agreements, contracts, and transactions, such as insurance products and
certain consumer and commercial contracts.
In addition, commenters also raised questions regarding, and the
Commissions believe that it is important to clarify: (i) The exclusion
for forward contracts from the definitions of the terms ``swap'' and
``security-based swap;'' and (ii) the status of certain commodity-
related products (including various foreign exchange products and
forward rate agreements) under the definitions of the terms ``swap''
and ``security-based swap.'' Finally, the Commissions are providing
[[Page 48212]]
interpretations related to the definitions.\27\
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\27\ In response to the ANPR, some commenters raised concerns
regarding the treatment of inter-affiliate swaps and security-based
swaps. See, e.g., Letter from Edward J. Rosen, Cleary Gottlieb Steen
& Hamilton LLP, Sep. 21, 2010 (``Cleary ANPR Letter''); Letter from
Coalition for Derivatives End Users, Sep. 20, 2010 (``CDEU ANPR
Letter''); Letter from Robert Pickel, Executive Vice President,
International Swaps and Derivatives Association, Inc. (``ISDA''),
Sep. 20, 2010; Letter from Richard A. Miller, Vice President and
Corporate Counsel, Prudential Financial Inc., Sep. 17, 2010; Letter
from Richard M. Whiting, The Financial Services Roundtable, Sep. 20,
2010. A few commenters suggested that the Commissions should further
define the term ``swap'' or ``security-based swap'' to exclude
inter-affiliate transactions. See Cleary ANPR Letter and CDEU ANPR
Letter. The Commissions are considering whether inter-affiliate
swaps or security-based swaps should be treated differently from
other swaps or security-based swaps in the context of the
Commissions' other Title VII rulemakings.
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B. Rules and Interpretations Regarding Certain Transactions Outside the
Scope of the Definitions of the Terms ``Swap'' and ``Security-Based
Swap''
1. Insurance Products
The statutory definition of the term ``swap'' includes, in part,
any agreement, contract or transaction ``that provides for any
purchase, sale, payment or delivery (other than a dividend on an equity
security) that is dependent on the occurrence, nonoccurrence, or the
extent of the occurrence of an event or contingency associated with a
potential financial, economic, or commercial consequence.'' \28\ As
stated in the Proposing Release, the Commissions do not interpret this
clause to mean that products historically treated as insurance products
should be included within the swap or security-based swap
definitions.\29\ The 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. Moreover, the fact that
swaps and insurance products are subject to different regulatory
regimes is reflected in section 722(b) of the Dodd-Frank Act which, in
new section 12(h) of the CEA, provides that a swap ``shall not be
considered to be insurance'' and ``may not be regulated as an insurance
contract under the law of any State.'' \30\ Accordingly, the
Commissions believe that state or Federally regulated insurance
products that are provided by persons that are subject to state or
Federal insurance supervision, that otherwise could fall within the
definitions should not be considered swaps or security-based swaps so
long as they satisfy the requirements of the Insurance Safe Harbor (as
defined below). At the same time, however, the Commissions are
concerned that certain agreements, contracts, or transactions that are
swaps or security-based swaps might be characterized as insurance
products to evade the regulatory regime under Title VII of the Dodd-
Frank Act.
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\28\ CEA section 1a(47)(A)(ii), 7 U.S.C. 1a(47)(A)(ii).
\29\ See Proposing Release at 29821. The Commissions continue to
believe that it was not the intent of Congress through the swap and
security-based swap definitions to preclude the provision of
insurance to individual homeowners and small businesses that
purchase property and casualty insurance. See section 2(e) of the
CEA, 7 U.S.C. 2(e), and section 6(l) of the Exchange Act, 15 U.S.C.
78f(l) (prohibiting individuals and small businesses that do not
meet specified financial thresholds or other conditions from
entering into swaps or security-based swaps other than on or subject
to the rules of regulated futures and securities exchanges).
Historically, insurance has not been regulated as such under the
Federal securities laws or under the CEA. See infra note 1283.
\30\ 7 U.S.C. 16(h). Moreover, other provisions of the Dodd-
Frank Act address the status of insurance more directly, and more
extensively, than Title VII. For example, Title V of the Dodd-Frank
Act requires the newly established Federal Insurance Office to
conduct a study and submit a report to Congress, within 18 months of
enactment of the Dodd-Frank Act, on the regulation of insurance,
including the consideration of Federal insurance regulation.
Notably, the Federal Insurance Office's authority under Title V
extends primarily to monitoring and information gathering; its
ability to promulgate Federal insurance regulation that preempts
state insurance regulation is significantly restricted. See section
502 of the Dodd-Frank Act (codified in various sections of 31
U.S.C.). Title V also addressed non-admitted insurance and
reinsurance. Title X of the Dodd-Frank Act also specifically
excludes the business of insurance from regulation by the Bureau of
Consumer Financial Protection. See section 1027(m) of the Dodd-Frank
Act, 12 U.S.C. 5517(m) (``The [Bureau of Consumer Financial
Protection] may not define as a financial product or service, by
regulation or otherwise, engaging in the business of insurance.'');
section 1027(f) of the Dodd-Frank Act, 12 U.S.C. 5517(f) (excluding
persons regulated by a state insurance regulator, except to the
extent they are engaged in the offering or provision of consumer
financial products or services or otherwise subject to certain
consumer laws as set forth in Title X of the Dodd-Frank Act).
---------------------------------------------------------------------------
Accordingly, the Commissions are adopting final rules that (i)
clarify that certain agreements, contracts, or transactions that
satisfy the requirements of the Insurance Safe Harbor will not be
considered to be swaps or security-based swaps, and (ii) provide an
Insurance Grandfather exclusion from the swap and security-based swap
definitions for any agreement, contract, or transaction entered into on
or before the effective date of the Product Definitions, provided that,
when the parties entered into such agreement, contract, or transaction,
it was provided in accordance with the Provider Test (as defined
below), including a requirement that an agreement, contract or
transaction that is provided in accordance with the first prong of the
Provider Test must be regulated as insurance under applicable state law
or the laws of the United States.
The final rules contain four subparts: The first subpart addresses
the agreement, contract, or transaction; the second subpart addresses
the person \31\ providing that agreement, contract, or transaction; the
third subpart includes a list of traditional insurance products that do
not have to meet the requirements set out in the first subpart; and the
fourth subpart contains the Insurance Grandfather exclusion (as defined
below).
---------------------------------------------------------------------------
\31\ In response to commenters, the Commissions are changing the
word ``company'' from the proposal to ``person.'' Each of the CEA,
the Securities Act, and the Exchange Act contains a definition of a
``person.'' See, e.g., Letter from Carl B. Wilkerson, Vice President
& Chief Counsel, American Council of Life Insurers (``ACLI''), dated
July 22, 2011 (``ACLI Letter'') and Letter from John P. Mulhern,
Dewey & LeBoeuf LLP (``D&L''), dated July 22, 2011 (``D&L Letter'').
---------------------------------------------------------------------------
More specifically, with respect to the first subpart, the
Commissions are adopting paragraph (i)(A) of rule 1.3(xxx)(4) under the
CEA and paragraph (a)(1) of rule 3a69-1 under the Exchange Act (the
``Product Test'') as proposed, with certain modifications to respond to
commenters' concerns. As adopted, the Product Test provides that the
terms ``swap'' and ``security-based swap'' will not include an
agreement, contract, or transaction that, by its terms or by law, as a
condition of performance:
Requires the beneficiary of the agreement, contract, or
transaction to have an insurable interest that is the subject of the
agreement, contract, or transaction and thereby carry the risk of loss
with respect to that interest continuously throughout the duration of
the agreement, contract, or transaction;
Requires that loss to occur and be proved, and that any
payment or indemnification therefor 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; and
With respect to financial guaranty insurance only, in the
event of payment default or insolvency of the obligor, any acceleration
of payments under the policy is at the sole discretion of the insurer.
The Commissions are also adopting paragraph (i)(B) of rule
1.3(xxx)(4) under the CEA and paragraph (a)(2) of rule 3a69-1 under the
Exchange Act (the ``Provider Test'') as proposed, with certain
modifications to respond to commenters' concerns. As adopted, the
Provider Test requires that an agreement, contract, or transaction that
[[Page 48213]]
satisfies the Product Test must be provided:
By a person that is subject to supervision by the
insurance commissioner (or similar official or agency) of any state
\32\ or by the United States or an agency or instrumentality \33\
thereof, and such agreement, contract, or transaction is regulated as
insurance under applicable state law \34\ or the laws of the United
States (the ``first prong'');
---------------------------------------------------------------------------
\32\ The term ``State'' is defined in section 3(a)(16) of the
Exchange Act, 15 U.S.C. 78c(a)(16), to mean ``any State of the
United States, the District of Columbia, Puerto Rico, the Virgin
Islands, or any other possession of the United States.'' The CFTC is
incorporating this definition into rule 1.3(xxx)(4) for purposes of
ensuring consistency between the CFTC and SEC rules further defining
the terms ``swap'' and ``security-based swap.''
\33\ For purposes of this release, the term ``instrumentality''
includes publicly supported, state operated or quasi-state operated
insurance programs that may not be subject to state regulatory
oversight, such as the Illinois Mine Subsidence Insurance Fund and
the Florida Hurricane Catastrophe Fund.
\34\ For purposes of this release, the Commissions anticipate
that the parties to an agreement, contract, or transaction will
evaluate which state law applies prior to entering into such
agreement, contract, or transaction. The Commissions do not
anticipate that the parties' analysis of which state law applies
will change as a result of the adoption of the Insurance Safe
Harbor. In addition, the Commissions will analyze which state law
applies (if necessary, in consultation with state insurance
regulatory authorities) if and when such issues arise that the
Commissions determine to address. The Commissions note that courts
routinely determine what is the ``applicable state law'' when
adjudicating disputes involving insurance.
---------------------------------------------------------------------------
(i) Directly or indirectly by the United States, any state
or any of their respective agencies or instrumentalities, or (ii)
pursuant to a statutorily authorized program thereof ((i) and (ii)
together, the ``second prong''); or
In the case of reinsurance only \35\ by a person to
another person that satisfies the Provider Test, provided that:
---------------------------------------------------------------------------
\35\ For purposes of this release, the term ``reinsurance''
means the assumption by an insurer of all or part of a risk
undertaken originally by another insurer.
---------------------------------------------------------------------------
(i) Such person is not prohibited by applicable state law or the
laws of the United States from offering such agreement, contract, or
transaction to such person that satisfies the Provider Test;
(ii) The agreement, contract, or transaction to be reinsured
satisfies the Product Test or is one of the Enumerated Products (as
defined below); and
(iii) Except as otherwise permitted under applicable state law, the
total amount reimbursable by all reinsurers \36\ for such agreement,
contract, or transaction may not exceed the claims or losses paid by
the cedant \37\ ((i), (ii), and (iii), collectively, the ``third
prong''); or
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\36\ For purposes of this release, the term ``reinsurer'' means
any person who provides reinsurance.
\37\ For purposes of this release, the term ``cedant'' means the
person writing the risk being ceded or transferred to a reinsurer.
---------------------------------------------------------------------------
In the case of non-admitted insurance \38\ by a person
who:
---------------------------------------------------------------------------
\38\ For purposes of this release, the term ``non-admitted
insurance'' means any property and casualty insurance permitted to
be placed directly or through a surplus lines broker with a non-
admitted insurer eligible to accept such insurance.
---------------------------------------------------------------------------
(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 \39\
under applicable state law ((i) and (ii) together, the ``fourth
prong'').
---------------------------------------------------------------------------
\39\ For purposes of this release, the term ``non-admitted
insurer'' means, with respect to any State, an insurer not licensed
to engage in the business of insurance in such State, but does not
include a risk retention group, as that term is defined in section
2(a)(4) of the Liability Risk Retention Act of 1986, 15 U.S.C.
3901(a)(4).
---------------------------------------------------------------------------
In response to commenters' requests that the Commissions codify the
proposed interpretation regarding certain enumerated types of
traditional insurance products in the final rules,\40\ the Commissions
are also adopting paragraph (i)(C) of rule 1.3(xxx)(4) under the CEA
and paragraph (a)(3) of rule 3a69-1 under the Exchange Act. In
addition, in response to comments, the Commissions are expanding and
revising the enumerated types of traditional insurance products. As
adopted, the rule provides that the terms ``swap'' and ``security-based
swap'' will not include an agreement, contract, or transaction that is
provided in accordance with the Provider Test and is any one of the
following (collectively, ``Enumerated Products''): Surety bonds;
fidelity bonds; life insurance; health insurance; long-term care
insurance; title insurance; property and casualty insurance; annuities;
disability insurance; insurance against default on individual
residential mortgages (commonly known as private mortgage insurance, as
distinguished from financial guaranty of mortgage pools); and
reinsurance (including retrocession) of any of the foregoing. The
Commissions note that the inclusion of reinsurance (including
retrocession) as an Enumerated Product is meant to apply to traditional
reinsurance and retrocession contracts. Specifically, traditional
reinsurance and retrocession contracts that reinsure risks ceded under
traditional insurance products included in the Enumerated Product list
and provided in accordance with the Provider test do not fall within
the swap or security-based swap definitions. An agreement, contract, or
transaction that is labeled as ``reinsurance'' or ``retrocession'', but
is executed as a swap or security-based swap or otherwise is structured
to evade Title VII of the Dodd-Frank Act, would not satisfy the
Insurance Safe Harbor, and would be a swap or security-based swap.\41\
---------------------------------------------------------------------------
\40\ See infra notes 88, 89, and 90 and accompanying text.
\41\ For example, if a person uses a weather derivative or
catastrophe swap to assume all or part of the risks contained in a
portfolio of property and casualty insurance policies, that weather
derivative or catastrophe swap would be a Title VII instrument that
is subject to regulation under Title VII.
---------------------------------------------------------------------------
In order for an agreement, contract, or transaction to qualify
under the final rules as an insurance product that would not be a swap
or security-based swap: (i) The agreement, contract, or transaction
must satisfy the criteria in the Product Test or be one of the
Enumerated Products and (ii) the person providing the agreement,
contract or transaction must satisfy one prong of the Provider
Test.\42\ The fact that an agreement, contract, or transaction
satisfies the Product Test or is one of the Enumerated Products does
not exclude it from the swap or security-based swap definitions if it
is not provided by a person that satisfies the Provider Test; nor does
the fact that a product is provided by a person that satisfies the
Provider Test exclude the product from the swap or security-based swap
definitions if the agreement, contract, or transaction does not satisfy
the criteria set forth in the Product Test or is not one of the
Enumerated Products.\43\
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\42\ As was discussed in the Proposing Release, see Proposing
Release at 29822 n. 31, certain variable life insurance products and
annuities are securities and therefore are excluded from the swap
and security-based swap definitions regardless of whether they meet
the requirements under the final rules. See section 1a(47)(B)(v) of
the CEA, 7 U.S.C. 1a(47)(B)(v). These securities would not be swaps
or security-based swaps whether or not required to be registered
under the Securities Act. See SEC v. United Benefit Life Ins. Co.,
387 U.S. 202 (1967) (holding that the accumulation provisions of a
``flexible fund'' annuity contract were not entitled to exemption
under section 3(a)(8) of the Securities Act, 15 U.S.C. 77c(a)(8),
for insurance and annuities); SEC v. Variable Annuity Life Ins. Co.,
359 U.S. 65 (1959) (holding that a variable annuity was not entitled
to exemption under section 3(a)(8) of the Securities Act).
\43\ For the purpose of determining whether an agreement,
contract or transaction falls within the Insurance Safe Harbor,
Title VII provides the Commissions with flexibility to address the
facts and circumstances of new products that may be marketed or sold
as insurance, through joint interpretations pursuant to section
712(d)(4) of the Dodd-Frank Act.
---------------------------------------------------------------------------
[[Page 48214]]
Further, in response to commenters' concerns,\44\ the Commissions
are confirming that the Product Test, the Provider Test and the
Enumerated Products represent a non-exclusive safe harbor. None of the
Product Test, the Provider Test, or the Enumerated Products
(collectively, the ``Insurance Safe Harbor'') implies or presumes that
an agreement, contract, or transaction that does not meet any of their
respective requirements is a swap or security-based swap. Such an
agreement, contract, or transaction will require further analysis of
the applicable facts and circumstances, including the form and
substance of such agreement, contract, or transaction, to determine
whether it is insurance, and thus not a swap or security-based swap.
---------------------------------------------------------------------------
\44\ See infra notes 178 and 179 and accompanying text.
---------------------------------------------------------------------------
However, future market conditions or other developments may prompt
the Commissions to reconsider whether a particular product that
satisfies the requirements of the Insurance Safe Harbor should instead
fall within the swap or security-based swap definition. Because a
determination that such a product is a swap or security-based swap
could potentially have an unsettling effect on the domestic insurance
or financial markets, the Commissions would only consider making a
determination that such a product is a swap or security-based swap
through a rulemaking \45\ process that would provide market
participants with an opportunity to comment.\46\
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\45\ The Commissions can engage in rulemakings in a variety of
ways including an advanced notice of proposed rulemaking, a notice
of proposed rulemaking, or an interim final rule.
\46\ When determining whether a particular product is a swap or
security-based swap instead of insurance, if such product does not
meet the requirements set out in the Insurance Safe Harbor, the
Commissions will consider prior regulation as an insurance contract
as one factor in their respective facts and circumstances analysis.
---------------------------------------------------------------------------
(a) Types of Insurance Products
Final Rules
Product Test
The Commissions are adopting the Product Test as proposed, with
certain modifications to respond to commenters' concerns. The Product
Test sets forth four criteria for an agreement, contract, or
transaction to be considered insurance. First, the final rules require
that the beneficiary have an ``insurable interest'' underlying the
agreement, contract, or transaction and thereby carry the risk of loss
with respect to that interest continuously throughout the duration of
the agreement, contract, or transaction. The requirement that the
beneficiary be at risk of loss (which could be an adverse financial,
economic, or commercial consequence) with respect to the interest that
is the subject of the agreement, contract, or transaction continuously
throughout the duration of the agreement, contract, or transaction will
ensure that an insurance contract beneficiary has a stake in the
interest on which the agreement, contract, or transaction is
written.\47\ Similarly, the requirement that the beneficiary have the
insurable interest continuously throughout the duration of the
agreement, contract, or transaction is designed to ensure that payment
on the insurance product is inextricably connected to both the
beneficiary and the interest on which the insurance product is written.
In contrast to insurance, a credit default swap (``CDS'') (which may be
a swap or a security-based swap) does not require the purchaser of
protection to hold any underlying obligation issued by the reference
entity on which the CDS is written.\48\ One commenter identified the
existence of an insurable interest as a material element to the
existence of an insurance contract.\49\ Because neither swaps nor
security-based swaps require the presence of an insurable interest at
all (although an insurable interest may sometimes be present
coincidentally), the Commissions continue to believe that whether an
insurable interest is present continuously throughout the duration of
the agreement, contract, or transaction is a meaningful way to
distinguish insurance from swaps and security-based swaps.
---------------------------------------------------------------------------
\47\ Requiring that a beneficiary of an insurance policy have a
stake in the interest traditionally has been justified on public
policy grounds. For example, a beneficiary that does not have a
property right in a building might have an incentive to profit from
arson.
\48\ Standard CDS documentation stipulates that the incurrence
or demonstration of a loss may not be made a condition to the
payment on the CDS or the performance of any obligation pursuant to
the CDS. See, e.g., ISDA, 2003 ISDA Credit Derivatives Definitions,
art. 9.1(b)(i) (2003) (``2003 Definitions'') (stating that ``the
parties will be obligated to perform * * * irrespective of the
existence or amount of the parties' credit exposure to a Reference
Entity, and Buyer need not suffer any loss nor provide evidence of
any loss as a result of the occurrence of a Credit Event'').
\49\ See D&L Letter.
---------------------------------------------------------------------------
Second, the requirement that a loss occur and be proved similarly
ensures that the beneficiary has a stake in the insurable interest that
is the subject of the agreement, contract, or transaction. If the
beneficiary can demonstrate loss, that loss would ``trigger''
performance by the insurer on the agreement, contract, or transaction
such that, by making payment, the insurer is indemnifying the
beneficiary for such loss. In addition, limiting any payment or
indemnification to the value of the insurable interest aids in
distinguishing swaps and security-based swaps (where there is no such
limit) from insurance.\50\
---------------------------------------------------------------------------
\50\ To the extent an insurance product provides for such items
as, for example, a rental car for use while the car that is the
subject of an automobile insurance policy is being repaired, the
Commissions would consider such items as constituting part of the
value of the insurable interest.
---------------------------------------------------------------------------
Third, the final rules require that the insurance product not be
traded, separately from the insured interest, on an organized market or
over the counter. As the Commissions observed in the Proposing Release,
with limited exceptions,\51\ insurance products traditionally have not
been entered into on or subject to the rules of an organized exchange
nor traded in secondary market transactions (i.e., they are not traded
on an organized market or over the counter). While swaps and security-
based swaps also generally have not been tradable at will in secondary
market transactions (i.e., on an organized market or over the counter)
without counterparty consent, the Commissions understand that all or
part of swaps and security-based swaps are novated or assigned to third
parties, usually pursuant to industry standard terms and documents.\52\
In response to commenter concerns,\53\ the Commissions are clarifying
when assignments of insurance contracts and trading on ``insurances
exchanges'' do not constitute trading the contract separately from the
related insurable interest, and thus would not violate the Product
Test. The Commissions do not interpret the assignment of an insurance
contract as described by commenters \54\
[[Page 48215]]
to be ``trading'' as that term is used in the Product Test.\55\ Nor do
the Commissions find that the examples of exchanges offered by
commenters,\56\ such as Federal Patient Protection and Affordable Care
Act ``exchanges,'' \57\ are exchanges as that term is used in the
Product Test, e.g., a national securities exchange or designated
contract market. Mandated insurance exchanges are more like
marketplaces for the purchase of insurance, and there is no trading of
insurance policies separately from the insured interest on these
insurance exchanges. Thus, 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, contract, or transaction separately
from the insured interest and would not violate the trading restriction
in the Product Test. For the foregoing reasons as clarified, the
Commissions continue to believe that lack of trading separately from
the insured interest is a feature of insurance that is useful in
distinguishing insurance from swaps and security-based swaps.
---------------------------------------------------------------------------
\51\ See, e.g., ``Life Settlements Task Force, Staff Report to
the United States Securities and Exchange Commission'' (``In an
effort to help make the bidding process more efficient and to
facilitate trading of policies after the initial settlement occurs,
some intermediaries have considered or instituted a trading platform
for life settlements.''), available at http://www.sec.gov/news/studies/2010/lifesettlements-report.pdf (July 22, 2010).
\52\ See, e.g., ISDA, 2005 Novation Protocol, available at
http://www.isda.org/2005novationprot/docs/NovationProtocol.pdf
(2005); ISDA, ISDA Novation Protocol II, available at http://www.isda.org/isdanovationprotII/docs/NPII.pdf (2005); 2003
Definitions, Exhibits E (Novation Agreement) and F (Novation
Confirmation).
\53\ See infra notes 74 and 75 and accompanying text.
\54\ See, e.g., Letter from Kim O'Brien, President & CEO,
National Association for Fixed Annuities (``NAFA''), dated July 21,
2011 (``NAFA Letter''); Letter from Robert Pickel, Executive Vice
Chairman, ISDA, dated July 22, 2011 (``ISDA Letter''); ACLI Letter;
and Letter from Letter from Stephen E. Roth, Frederick R. Bellamy
and James M. Cain, Sutherland Asbill & Brennan LLP on behalf of the
Committee of Annuity Insurers (``CAI''), dated July 22, 2011 (``CAI
Letter'').
\55\ The assignment of the benefits or proceeds of an insurance
contract by an owner or beneficiary does not violate the trading
restriction in the Product Test. This interpretation does not extend
to ``stranger originated'' products. The transfer of obligations for
policyholder benefits between two insurance companies, such as would
occur in connection with an insurance company merger or acquisition,
also does not violate the trading restriction contained in the
Product Test.
\56\ See Letter from Susan E. Voss, Commissioner Iowa Insurance
Division & National Association of Insurance Commissioners
(``NAIC'') President, and Therese M. Vaughan, NAIC Chief Executive
Officer, dated July 22, 2011 (``NAIC Letter'').
\57\ See Patient Protection and Affordable Care Act;
Establishment of Exchanges and Qualified Health Plans, 76 FR 41866
(Jul. 15, 2011) (proposed).
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Fourth, the final rules provide that in the case of financial
guaranty insurance policies, also known as bond insurance or bond
wraps, any acceleration of payment under the policy must be at the sole
discretion of the provider of the financial guaranty insurance policy
in order to satisfy the Product Test.\58\ Although such products can be
economically similar to products such as CDS, they have certain key
characteristics that distinguish them from swaps and security-based
swaps.\59\ For example, under a financial guaranty policy, the insurer
typically is required to make timely payment of any shortfalls in the
payment of scheduled interest to the holders of the underlying
guaranteed obligation. Also, for particular bonds that are covered by a
financial guaranty policy, the indenture, related documentation, and/or
the financial guaranty policy will provide that a default in payment of
principal or interest on the underlying bond will not result in
acceleration of the obligation of the insurer to make payment of the
full amount of principal on the underlying guaranteed obligation unless
the insurer, in its sole discretion, opts to make payment of principal
prior to the final scheduled maturity date of the underlying guaranteed
obligation. Conversely, under a CDS, a protection seller frequently is
required to make payment of the relevant settlement amount to the
protection buyer upon demand by the protection buyer after any credit
event involving the issuer.\60\
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\58\ Financial guarantee policies are used by entities such as
municipalities to provide greater assurances to potential purchasers
of their bonds and thus reduce their interest costs. See ``Report by
the United States Securities and Exchange Commission on the
Financial Guarantee Market: The Use of the Exemption in section
3(a)(2) of the Securities Act for Securities Guaranteed by Banks and
the Use of Insurance Policies to Guarantee Debt Securities'' (Aug.
28, 1987).
\59\ See, e.g., Letter from Sean W. McCarthy, Chairman,
Association of Financial Guaranty Insurers on the ANPR, dated Sept.
20, 2010 (explaining the differences between financial guaranty
policies and CDS); Letter from James M. Michener, General Counsel,
Assured Guaranty on the ANPR, dated Dec. 14, 2010 (noting that the
Financial Accounting Standards Board has issued separate guidance on
accounting for financial guaranty insurance and CDS); Letter from
Ernest C. Goodrich, Jr., Managing Director--Legal Department,
Deutsche Bank AG on the ANPR, dated Sept. 20, 2010 (noting that
financial guaranty policies require the incurrence of loss for
payment, whereas CDS do not).
\60\ While a CDS requires payment in full on the occurrence of a
credit event, the Commissions recognize that there are other
financial instruments, such as corporate guarantees of commercial
loans and letters of credit supporting payments on loans or debt
securities, that allow for acceleration of payment obligations
without such guarantees or letters of credit being swaps or
security-based swaps.
---------------------------------------------------------------------------
As noted in the Proposing Release, the Commissions do not believe
that financial guaranty policies, in general, should be regulated as
swaps or security-based swaps. However, because of the close economic
similarity of financial guaranty insurance policies guaranteeing
payment on debt securities to CDS, in addition to the criteria noted
above with respect to insurance generally, the final rules require
that, in order to satisfy the Product Test, financial guaranty policies
also must satisfy the requirement that they not permit the beneficiary
of the policy to accelerate the payment of any principal due on the
debt securities. This requirement further distinguishes financial
guaranty policies from CDS because, as discussed above, the latter
generally requires payment of the relevant settlement amount on the CDS
after demand by the protection buyer.
Finally, in response to comments,\61\ the Commissions are
clarifying that reinsurance and retrocession transactions fall within
the scope of the Product Test. The Commissions find that these
transactions have insurable interests, as the Commissions interpret
such interests in this context, if they have issued insurance policies
covering the risks that they wish to insure (and reinsure). Moreover,
the Commissions find that retrocession transactions are encompassed
within the Product Test and the Provider Test because retrocession is
reinsurance of reinsurance (provided the retrocession satisfies the
other requirements of both tests). In addition, reinsurance (including
retrocession) of certain types of insurance products is included in the
list of Enumerated Products.\62\
---------------------------------------------------------------------------
\61\ See infra note 105 and accompanying text.
\62\ See supra note 41 and accompany text.
---------------------------------------------------------------------------
Requiring all of the criteria in the Product Test will help to
limit the application of the final rules to agreements, contracts, and
transactions that are appropriately regulated as insurance, and help to
assure that agreements, contracts, and transactions appropriately
subject to the regulatory regime under Title VII of the Dodd-Frank Act
are regulated as swaps or security-based swaps. As a result, the
Commissions believe that these requirements will help prevent the final
rules from being used to circumvent the applicability of the swap and
security-based swap regulatory regimes under Title VII.
Enumerated Products
In the Proposing Release, the Commissions proposed an
interpretation that certain enumerated types of insurance products
would be outside the scope of the statutory definitions of swap and
security-based swap under the Dodd-Frank Act if provided in accordance
with the Provider Test and regulated as insurance. Based on comments
received,\63\ the Commissions are adding three products to the list of
products as proposed (fidelity bonds, disability insurance and
insurance against default on individual residential mortgages), adding
reinsurance (including retrocession) of any of the traditional
insurance products included in the list, deleting a requirement
applicable to annuities, and codifying the Enumerated Products in the
final rules. The revised list of Enumerated Products is: Surety bonds,
fidelity bonds, life insurance, health insurance, long-term
[[Page 48216]]
care insurance, title insurance, property and casualty insurance,
annuities, disability insurance, insurance against default on
individual residential mortgages (commonly known as private mortgage
insurance, as distinguished from financial guaranty of mortgage pools),
and reinsurance (including retrocession) of any of the foregoing.\64\
The Commissions believe that the Enumerated Products, as traditional
insurance products, are not the types of agreements, contracts, or
transactions that Congress intended to subject to the regulatory regime
for swaps and security-based swaps under the Dodd-Frank Act. Codifying
the Enumerated Products in the final rules appropriately places
traditional insurance products outside the scope of the swap and
security-based swap definition so long as such Enumerated Products are
provided in accordance with the Provider Test, including a requirement
that an Enumerated Product that is provided in accordance with the
first prong of the Provider Test must be regulated as insurance under
applicable state law or the laws of the United States.
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\63\ See infra notes 93 and 94 and accompanying text.
\64\ See supra note 41 and accompanying text.
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Comments
Insurable Interest
Six commenters objected to the requirement in the Product Test that
the beneficiary have an insurable interest continuously throughout the
duration of the contract.\65\ These commenters noted that, under state
law, an insurable interest may not always be required to be present
continuously throughout the duration of the policy. For example,
commenters noted that life insurance may only require an insurable
interest at the time the policy is executed; \66\ and some property and
casualty or liability insurance may only require an insurable interest
at the time a loss occurs.\67\ Commenters also noted that annuities and
health insurance do not require the existence of an insurable interest
at all.\68\ Another commenter suggested that the Commissions modify the
Product Test to indicate that annuities would not need to satisfy the
``insurable interest'' component, or to use terminology other than
insurable interest to make clear that annuities are not swaps.\69\
---------------------------------------------------------------------------
\65\ See ACLI Letter; CAI Letter; ISDA Letter (objecting to the
requirement that the risk of loss be held continuously throughout
the contact); NAFA Letter; NAIC Letter; and Letter from Kenneth F.
Spence III, Executive Vice President & General Counsel, The
Travelers Companies, Inc. (``Travelers''), dated Nov. 14, 2011
(``Travelers Letter'').
\66\ See ACLI Letter; CAI Letter; ISDA Letter; NAIC Letter; and
Travelers Letter. The Commissions understand that some states may
define what constitutes an insurable interest with reference to
personal or emotional consequence in addition to the financial,
economic, or commercial consequence mentioned in the statutory swap
definition.
\67\ See NAIC Letter and Travelers Letter. However, one
commenter noted that the Product and Provider Tests, as proposed,
should be an effective means of helping to distinguish between those
contracts that qualify for exclusion from the definition of swap and
security-based swap from those contracts that will not. See Letter
from Michael A. Bell, Senior Counsel, Financial Policy, The Property
Casualty Insurers Association of America, dated July 22, 2011.
\68\ See CAI Letter; ISDA Letter; NAFA Letter; and NAIC Letter.
\69\ See Letter from Nicholas D. Latrenta, Executive Vice
President and General Counsel, Metropolitan Life Insurance Companies
and its insurance affiliates (``MetLife''), dated July 22, 2011
(``MetLife Letter'').
---------------------------------------------------------------------------
As discussed above, the Commissions are retaining the insurable
interest requirement of the Product Test. The Commissions continue to
believe that this requirement is a useful tool to distinguish insurance
from swaps and security-based swaps, because swaps and security-based
swaps do not require the presence of an insurable interest (or require
either counterparty to bear any risk of loss) at any time during the
term of the agreement, contract, or transaction. While the Commissions
acknowledge commenters who argued that products such as life insurance,
property and casualty insurance, and annuities may fail the Product
Test because of the insurable interest requirement, the Commissions do
not interpret any such failure to mean that life insurance, property
and casualty insurance, and annuities are not insurance products. To
the contrary, as discussed above, these products are included in the
list of Enumerated Products that are excluded from the swap and
security-based swap definitions so long as they are provided in
accordance with the Provider Test. If a life insurance, property and
casualty insurance, or annuity is provided in accordance with the
Provider Test, such product is not a swap or security-based swap,
whether or not an insurable interest is present at all times during the
term of the contract.
Indemnification for Loss
Five commenters objected to the requirement in the Product Test
that a loss occur and be proven, and that any payment be limited to the
value of the insurable interest, because payment under many insurance
products may not be directly based upon actual losses incurred.\70\ Two
commenters argued that annuities do not provide indemnification for
loss and that life insurance products are not constrained by the value
of the insurable interest.\71\ Another argued that many insurance
policies pay fixed amounts upon the occurrence of a loss without a
requirement that the loss be tied to the value of an insurable
interest.\72\ Disability insurance and long-term care insurance are
other products that commenters indicate would not be able to satisfy
this requirement of the Product Test.\73\
---------------------------------------------------------------------------
\70\ See ACLI Letter; CAI Letter; ISDA Letter; NAFA Letter; and
Travelers Letter.
\71\ See ACLI Letter and Travelers Letter.
\72\ See Travelers Letter.
\73\ See, e.g., ACLI Letter and CAI Letter.
---------------------------------------------------------------------------
As discussed above, the Commissions are retaining the requirement
in the Product Test that a loss occur and be proven and that any
payment for such loss be limited to the value of the insurable
interest. The Commissions continue to believe that this requirement is
a useful tool to distinguish insurance from swaps and security-based
swaps, because payments under swaps and security-based swaps may be
required when neither party incurs a loss, nor is the amount of payment
limited by any such loss. While the Commissions acknowledge commenters
who identified various products that may fail this part of the Product
Test, the Commissions do not interpret any such failure to mean that
products such as annuities, disability insurance, and long-term care
insurance are not insurance products. To the contrary, as discussed
above, these products are included in the list of Enumerated Products
that are excluded from the swap and security-based swap definitions so
long as they are provided in accordance with the Provider Test. If
long-term care insurance, disability insurance, or an annuity is
provided in accordance with the Provider Test, such product is not a
swap or a security-based swap, whether or not a loss occurs, is proven,
or indemnification for loss is limited to the value of the insurable
interest.
Not Traded Separately
Six commenters stated that the proposed requirement that the
agreement, contract, or transaction not be traded, separately from the
insured interest, on an organized market or over the counter, is not an
effective criterion in determining whether a product is insurance.\74\
According to commenters, this criterion is ineffective and should be
deleted from the Product Test because many conventional insurance
[[Page 48217]]
products, such as annuities, are assignable (and therefore tradable),
which may violate the trading restriction.\75\ Two commenters observed
that the trading of insurance policies has already occurred and is
expected to increase.\76\ One commenter stated that a number of states
have ``insurance exchanges'' that sell reinsurance and excess or
surplus lines, and that the Patient Protection and Affordable Care Act
requires states or the Federal government to establish health benefit
``insurance exchanges'' through which insurers will sell health
insurance to individuals and small groups.\77\ One commenter
recommended that the trading restriction apply only to trading by the
policyholder or beneficiary of an insurance policy.\78\
---------------------------------------------------------------------------
\74\ See ACLI Letter; Letter from Chris Barnard (``Barnard''),
dated June 28, 2011 (``Barnard Letter''); CAI Letter; NAFA Letter;
NAIC Letter; and ISDA Letter.
\75\ Id. ACLI stated that many conventional insurance products,
particularly annuities, can be assigned by the owner, and often
state insurance law requires such assignability as a condition for
approval of the product for sale under applicable insurance law.
ACLI also stated that insurance policies are frequently assigned
among family members, to third parties as collateral for loans, and
in a host of other situations, and does not believe that these
common kinds of assignment should cause an insurance product to be
characterized as a swap.
\76\ See Barnard Letter and NAIC Letter.
\77\ See NAIC Letter. The commenter explained that the
``insurance exchanges'' mandated by the Patient Protection and
Affordable Care Act would be marketplaces for insurance policies.
The commenter described them as ``cooperatives'' where people could
go to buy insurance policies with standardized terms/actuaries. The
commenter noted that the insurable interest would not ``trade''
separately from the insurance policy in these cooperatives.
\78\ See Travelers Letter.
---------------------------------------------------------------------------
The Commissions are retaining the requirement in the Product Test
that the agreement, contract, or transaction not be traded separately
from the insured interest, on an organized market or over the counter,
and as discussed above have provided a clarification regarding
assignments and trading on insurance exchanges. The Commissions
continue to believe that using this criterion is an effective way to
distinguish insurance from swaps and security-based swaps because swaps
and security-based swaps are traded on organized markets and over the
counter.
As stated above, the Commissions do not interpret the assignment of
an insurance contract as described by commenters to be ``trading'' as
that term is used in the Product Test.\79\ Nor do the Commissions find
that the examples of exchanges offered by commenters, such as Federal
Patient Protection and Affordable Care Act ``exchanges,'' are exchanges
as that term is used in the Product Test, e.g., a national securities
exchange or designated contract market.\80\ Mandated insurance
exchanges are more like marketplaces for the purchase of insurance, and
there is no trading of insurance policies separately from the insured
interest on these insurance exchanges. Thus, 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,
contract, or transaction separately from the insured interest and would
not violate the trading restriction in the Product Test.
---------------------------------------------------------------------------
\79\ See supra notes 54 and 55.
\80\ See supra notes 56 and 57.
---------------------------------------------------------------------------
Acceleration
Three commenters believed that the proposed requirement that, in
the event of payment default or insolvency of the obligor, any
acceleration of payments under a financial guaranty insurance policy be
at the sole discretion of the insurer, is not an effective criterion in
determining whether financial guaranty insurance falls outside the swap
and security-based swap definitions and should be deleted from the
Product Test.\81\ However, one commenter supported its inclusion,
observing that the proposed requirement is ``firmly based on
substantive business realities.'' \82\ Two commenters believed that the
acceleration of payments requirement is not useful in distinguishing
between financial guaranty insurance and swaps or security-based swaps
because it is designed to protect financial guaranty insurers from
insolvency.\83\ They noted that the criterion is a regulatory
requirement imposed by state insurance commissioners that is subject to
change, and that a state could not change this regulatory requirement
without converting the financial guaranty policy into a swap or
security-based swap.\84\ One commenter stated that the acceleration of
payments criterion has been the subject of significant analysis and
interpretation by state insurance regulators, and including the
requirement in the rules could result in conflicting interpretations
and additional legal uncertainty.\85\ This commenter also stated that
this uncertainty will impose significant burdens on financial guaranty
insurers that insure municipal bonds.\86\
---------------------------------------------------------------------------
\81\ See Letter from Bruce E. Stern, Chairman, Association of
Financial Guaranty Insurers (``AFGI''), dated July 20, 2011 (``AFGI
Letter''); ISDA Letter; and Letter from Kimberly M. Welsh, Vice
President and Assistant General Counsel, Reinsurance Association of
America (``RAA''), dated July 22, 2011 (``RAA Letter'').
\82\ See Letter from Dennis M. Kelleher, President & CEO, Better
Markets Inc., dated July 22, 2011 (``Better Markets Letter'').
\83\ See ISDA Letter and RAA Letter.
\84\ Id.
\85\ See AFGI Letter.
\86\ Id. The commenter argued that these burdens would (a)
increase instability in the currently fragile municipal bond market
and (b) decrease the availability or attractiveness of bond
insurance to municipal issuers that would otherwise save money by
employing bond insurance. The Commissions understand that only one
member of AFGI is currently active in the municipal bond insurance
market.
---------------------------------------------------------------------------
The Commissions are retaining the requirement that acceleration be
at the sole option of the provider of the financial guaranty insurance
policy in the Product Test. In response to commenter concerns, the
Commissions are clarifying that they plan to interpret the acceleration
limitation in accordance with applicable state law to the extent that
it does not contradict the Commissions' rules, interpretations and/or
guidance regarding what is a swap or security-based swap.\87\ The
Commissions continue to believe that, for purposes of further defining
swaps and security-based swaps, this criterion is useful to distinguish
between financial guaranty insurance on the one hand, and swaps and
security-based swaps, such as CDS, on the other because, as discussed
above, the latter generally requires payment of the relevant settlement
amount on the CDS after demand by the protection buyer.
---------------------------------------------------------------------------
\87\ One commenter noted that ``financial guarantors, for some
time and in full compliance with state insurance laws, have issued
insurance policies that contemplate acceleration upon events
unrelated to an issuer default, e.g., upon the downgrade of the
insurer.'' See AFGI Letter. In response to this comment, the
Commissions note that the acceleration requirement in the Product
Test refers only to ``payment default or insolvency of the obligor''
(emphasis added), without precluding other triggers.
---------------------------------------------------------------------------
Enumerated Products
The Commissions proposed an interpretation that certain enumerated
types of insurance products would be outside the scope of the statutory
definitions of swap and security-based swap. Several commenters stated
that the list of enumerated insurance products should be codified in
order to enhance legal certainty.\88\ In particular, one commenter
stated that it is important for the Commissions to codify the
interpretation because the traditional insurance products included in
the enumerated list may not satisfy the Product Test.\89\ The commenter
also expressed concern that insurance companies and state insurance
[[Page 48218]]
regulators would face the possibility that the Commissions could revise
or withdraw the interpretation in the future, with or without
undergoing a formal rulemaking process.\90\ As noted above, in response
to commenters' concerns, the Commissions are codifying the Enumerated
Products in the final rules.
---------------------------------------------------------------------------
\88\ See ACLI Letter; NAIC Letter; RAA Letter; AIA Letter; NAFA
Letter; and Letter from Mark R. Thresher, Executive Vice President,
Nationwide, dated July 19, 2011 (``Nationwide Letter'').
\89\ See Travelers Letter.
\90\ Id.
---------------------------------------------------------------------------
One commenter further argued that the enumerated types of insurance
products included in the list should not have to additionally satisfy
the requirements that the person offering such product be a U.S.
domiciled insurer and that the product be regulated in the U.S. as
insurance.\91\ The commenter argued that this additional requirement
would result in the Insurance Safe Harbor not applying to traditional
insurance products offered by insurers domiciled outside of the U.S. or
by insurers that are not organized as insurance companies. The
Commissions are retaining the requirement that the Enumerated Products
be provided in accordance with the Provider Test. The Commissions also
note that, in response to commenters' concerns, the Commissions have
revised the first prong of the Provider Test so that it is not limited
to insurance companies or to entities that are domiciled in the U.S. A
product that need not satisfy the Product Test must be provided in
accordance with the Provider Test, including a requirement that
products provided in accordance with the first prong of the Provider
Test must be regulated as insurance.\92\
---------------------------------------------------------------------------
\91\ See D&L Letter.
\92\ See infra notes 147 and 148 and accompanying text.
---------------------------------------------------------------------------
Five commenters addressed the treatment of annuities in the
proposed interpretive guidance, with all recommending that all
annuities be excluded from the swap and security-based definitions
regardless of their status under the tax laws.\93\ In response to the
comments, the Commissions are eliminating the proposed requirement that
annuities comply with section 72 of the Internal Revenue Code in order
to qualify as an Enumerated Product. The Commissions are persuaded that
the proposed reference to the Internal Revenue Code is unnecessarily
limiting and does not help to distinguish insurance from swaps and
security-based swaps.
---------------------------------------------------------------------------
\93\ See ACLI Letter; CAI Letter; MetLife Letter; Nationwide
Letter; and RAA Letter.
---------------------------------------------------------------------------
Other commenters suggested adding other products to the list of
enumerated types of insurance products,\94\ with one suggesting that
the Commissions' interpretation cover all transactions currently
reportable as insurance in the provider's regulatory and financial
reports under a state's or a foreign jurisdiction's insurance laws.\95\
One commenter noted that the list of enumerated types of insurance
products does not include other state-regulated products such as
service contracts, that may not satisfy the Product Test.\96\ In
response to requests to expand the list of enumerated products, the
Commissions are adding fidelity bonds,\97\ disability insurance, and
insurance against default on individual residential mortgages (commonly
known as private mortgage insurance, as distinguished from financial
guaranty of mortgage pools) to the list of Enumerated Products. The
Commissions agree that these are traditional insurance products, and
thus their inclusion in the list of Enumerated Products is appropriate.
The Commissions have also added reinsurance (including retrocession) of
any of the traditional insurance products to the list of Enumerated
Products.\98\ However, the Commissions decline at this time to expand
the list of Enumerated Products to include other types of contracts
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.\99\ These products do not receive the
benefit of state insurance guaranty funds; their providers are not
limited to insurance companies. The Commissions received little detail
on sales of these other products, and do not believe it is appropriate
to determine whether particular complex, novel or still evolving
products are swaps or security-based swaps in the context of a general
definitional rulemaking. Rather these products should be considered in
a facts and circumstances analysis. With respect to GICs, the
Commissions have published a request for comment regarding the study of
stable value contracts. \100\
---------------------------------------------------------------------------
\94\ See ACLI Letter; AIA Letter; CAI Letter; D&L Letter; NAIC
Letter; Letter from Michael A. Bell, Senior Counsel, Financial
Policy, RAA Letter; and Letter from Robert J. Duke, The Surety &
Fidelity Association of America (``SFAA''), dated July 13, 2011
(``SFAA Letter''). ACLI, CAI and RAA requested the addition of other
types of annuity and pension plan products, such as group annuity
contracts, guaranteed investment contracts, funding agreements,
structured settlements, deposit administration contracts, and
immediate participation guarantee contracts. D&L requested the
addition of reinsurance of any of the enumerated types of
traditional insurance products. NAIC requested the addition of
mortgage guaranty, accident, and disability insurance. SFAA request
the addition of surety and fidelity bonds.
\95\ See Letter from J. Stephen Zielezienski, Senior Vice
President & General Counsel, American Insurance Association
(``AIA''), dated July 22, 2011 (``AIA Letter'').
\96\ See NAIC Letter. The Commissions note that service
contracts, although regulated as insurance in some states, comprise
consumer warranties, extended service plans, and buyer protection
plans of the sort purchased with major appliances, electronics, and
the like. The Commissions are addressing these contracts in their
interpretation regarding consumer/commercial transactions. See infra
part II.B.3.
\97\ SFAA requested that the Commissions issue specific guidance
that surety and fidelity bonds are insurance products rather than
swaps, noting that all states include surety and fidelity bonds as
lines of insurance subject to state oversight. Surety bonds were
already included in the list of enumerated insurance products
contained in the Proposing Release.
\98\ See supra note 41 and accompanying text.
\99\ See, e.g., RAA Letter; CAI Letter; Letter from Ian K.
Shepherd, Managing Director, Alice Corp. Pty Ltd (``Alice Corp.''),
dated July 22, 2011. Alice Corp. stated that industry loss warrants
are a contingent instrument with a somewhat illiquid secondary
market but ``are currently treated as a reinsurance product and
require an insurable interest.'' Alice Corp. also stated that
``[c]atastrophe bonds may reference a specific insured portfolio or
a set of parameters and may be traded in a secondary market and
behave like a coupon bond if there is no triggering event but have a
contingent element since some or all of the principal may be lost if
the referenced event or loss occurs.'' Id. The Commissions note that
catastrophe bonds are ``securities'' under the Federal securities
laws and decline to provide an interpretation regarding industry
loss warrants because it is inappropriate to determine whether a
complex and novel product is a swap or a security-based swap in a
general definitional rulemaking.
\100\ See Acceptance of Public Submissions Regarding the Study
of Stable Value Contracts, 76 FR 53162 (Aug. 25, 2011).
---------------------------------------------------------------------------
Reliance on State Law Concepts
Two commenters noted that the Product Test relies on concepts
derived from state law, such as ``insurable interest'' and
``indemnification for loss,'' which do not have uniform
definitions.\101\ This would require the
[[Page 48219]]
Commissions to analyze state insurance law, as well as to determine
which state law should apply.\102\ One of these commenters also
requested that such concepts be applied consistently with the
historical interpretation by the applicable state.\103\
---------------------------------------------------------------------------
\101\ See ACLI Letter and AFGI Letter. Some states define
concepts such as ``insurable interest'' in statute; in other states
definitions have developed through common law. The Commissions
recognize that the terms denoting such concepts may vary from state
to state; for instance, what one state calls an ``insurable
interest'' may be referred to as a ``material interest'' in another.
See, e.g., New York Insurance Law Section 1101 (``material
interest''). The Commissions believe, however, that both the
concepts and their labels are well understood by insurance
professionals and that any such variations would not impede market
participants from interpreting or applying the final rules. Indeed,
one commenter acknowledged this and applied the concepts, labeled
differently, to particular products. ``The terms used in the rule's
criteria are different from the terms used with respect to a surety
bond. For example, the bond is generally not referred to as a
`policy.' In addition, the beneficiary of a bond typically is known
as the `obligee.' Further, the bond's limit is referred to as the
`penal sum.' Nevertheless, the criteria can be applied to surety
bonds and fidelity bonds, and such application would exclude bonds
from the statutory definition of swaps.'' See SFAA Letter.
\102\ See ACLI Letter and AFGI Letter.
\103\ See AFGI Letter.
---------------------------------------------------------------------------
State law differences regarding these concepts should not impede
the ability of market participants from interpreting or applying the
final rules to distinguishing between insurance and swaps or security-
based swaps, and thus the Commissions are retaining these concepts in
the Product Test. The Commissions intend to interpret these concepts
consistently with the existing and developing laws of the relevant
state(s) governing the agreement, contract, or transaction in question.
However, the Commissions note their authority to diverge from state law
if the Commissions become aware of evasive conduct.\104\
---------------------------------------------------------------------------
\104\ The Commissions may also diverge from interpretations or
determinations of state law based on an analysis of applicable facts
and circumstances when determining whether a particular product is a
swap or security-based swap.
---------------------------------------------------------------------------
Inclusion of Reinsurance and Retrocession Transactions
Several commenters suggested that the Commissions amend the Product
Test to explicitly address reinsurance and retrocession (i.e.,
reinsurance of reinsurance) transactions.\105\
---------------------------------------------------------------------------
\105\ See ACLI Letter; CAI Letter; D&L Letter; ISDA Letter; NAFA
Letter; Nationwide Letter; and RAA Letter. ACLI noted that the
Product Test does not include a reference to reinsurance and that
the ``insurable interest'' requirement under state insurance law
generally does not apply to reinsurance products which, therefore,
would not satisfy the Product Test. ACLI and CAI state that
reinsurance in a chain of reinsurance also should not be considered
a swap or security-based swap. In addition to expressly referencing
reinsurance and retrocession transactions, ACLI believes that the
Product Test should be expanded to include reinsurance and
retrocession of insurance risks ceded by non-U.S. insurance
companies to domestic insurance companies. RAA recommended adding a
new clause to the Product Test to provide that ``[a]ny agreement,
contract, or transaction which reinsures any agreement, contract, or
transaction meeting the criteria of paragraph (xxx)(4)(i)(A)-(C) of
this section is also an insurance product.''
---------------------------------------------------------------------------
In response to these comments, the Commissions are clarifying that
reinsurance and retrocession transactions may fall within the Insurance
Safe Harbor, thus, it is unnecessary for the Product Test to be
modified as suggested by these commenters. In addition, the Commissions
have modified the final rules to include reinsurance (including
retrocession) of certain types of insurance products in the list of
Enumerated Products. Reinsurance or retrocession of these Enumerated
Products will fall within the Insurance Safe Harbor so long as such
reinsurance or retrocession is provided in accordance with the Provider
Test.\106\
---------------------------------------------------------------------------
\106\ See supra note 41 and accompanying text.
---------------------------------------------------------------------------
Payment Based on the Price, Rate, or Level of a Financial Instrument
In the Proposing Release, the Commissions requested comment on
whether, in order for an agreement, contract, or transaction to be
considered insurance under the Product Test, the Commissions should
require that payment not be based on the price, rate, or level of a
financial instrument, asset, or interest or any commodity. The
Commissions also requested comment on whether variable annuity
contracts (where the income is subject to tax treatment under section
72 of the Internal Revenue Code) and variable life insurance should be
excepted from such a requirement, if adopted.\107\
---------------------------------------------------------------------------
\107\ See Proposing Release at 29824. See also id. at 29825,
Request for Comment 7.
---------------------------------------------------------------------------
Eight commenters stated that it is inappropriate to include such a
requirement in the final rules because a number of traditional
insurance products would not satisfy the requirement and suggested that
the Commissions should instead consider whether the agreement,
contract, or transaction transfers risk and argued that such a
requirement is not a useful marker for distinguishing insurance from
swaps and security-based swaps.\108\ Several commenters also believed
that the addition to the Product Test of the criterion that payment not
be based on the price, rate, or level of a financial instrument, asset,
or interest or any commodity would contribute to greater legal
uncertainty.\109\
---------------------------------------------------------------------------
\108\ See ACLI Letter; AIA Letter; AFGI Letter; CAI Letter; ISDA
Letter; NAFA Letter; NAIC Letter; and Nationwide Letter (concurring
with ACLI's comments).
Commenters cited several examples of products that would fail a
requirement that payment not be based on the price, rate, or level
of a financial instrument, asset, or interest or any commodity.
ACLI, CAI and NAFA cited registered and unregistered variable
annuities and variable life insurance, and certain fixed annuities
and equity indexed annuities, stating that these could be construed
as being based on, or related to, a price, rate or level of a
financial asset. ACLI also cited financial guaranty insurance, and
replacement value property and casualty insurance, where the
insurer's payment obligation may be based on the current price of
the insured property or adjusted to reflect inflation. ACLI and ISDA
cited crop insurance, because it could call for payment to be based
in some way on the market price of the covered crop on the date of
loss. ISDA and RAA cited ``dual trigger'' insurance (such as
replacement power insurance); property and casualty policies
purchased by some commodity producers (e.g., oil refineries, copper
mines) with deductibles that increase or decrease based on the price
of the commodity that the company produces; event cancellation
insurance that uses commodity indices to determine claims; and
weather insurance and malpractice insurance. NAIC cited guaranteed
investment contracts, financial guaranty insurance, and mortgage
guaranty insurance
\109\ See AIA Letter and AFGI Letter.
---------------------------------------------------------------------------
Two commenters agreed that such a requirement should be included in
the final rules.\110\ One commenter argued that any insurance
instrument that provides for payment based on the price, rate, or level
of a financial instrument, asset, or interest in any commodity is in
substance a swap or security-based, regardless of its label, and should
be regulated as such.\111\ One of these commenters further recommended
that the Commissions exclude annuity and variable universal life
insurance from this requirement because these products were investments
with some minimal level of life insurance cover or investment guarantee
rider on top.\112\
---------------------------------------------------------------------------
\110\ See Barnard Letter and Better Markets Letter.
\111\ See Better Markets Letter.
\112\ See Barnard Letter.
---------------------------------------------------------------------------
The Commissions are not adopting an additional requirement for the
Product Test that payment not be based on the price, rate, or level of
a financial instrument, asset, or interest or any commodity because the
Commissions find the requirement to be unsuitable for distinguishing
insurance from swaps and security-based swaps. While the provision
might work for property and casualty insurance, as many commenters
noted, it is not an effective distinction for a number of other
traditional insurance products.
Accounting Standards
In the Proposing Release, the Commissions requested comment on
whether the proposed rules relating to insurance should include a
provision related to whether a product is recognized at fair value on
an ongoing basis with changes in fair value reflected in earnings under
U.S. generally accepted accounting principles.\113\
---------------------------------------------------------------------------
\113\ See Proposing Release at 29827, Request for Comment 17.
---------------------------------------------------------------------------
Three commenters argued that the proposed rules should not include
a provision that an insurance product is recognized at fair value under
generally accepted accounting principles.\114\ One commenter argued
that the determinants of what is an insurance product should be the
existence of an insurable interest, transfer of risk, and
indemnification of covered loss.\115\ Another argued that factoring
accounting standards into the analysis of whether a product is a swap
[[Page 48220]]
or insurance will introduce unnecessary complexity in most cases but
that the examination of accounting standards would be useful in cases
where the classification of a product as insurance or swap is
unclear.\116\
---------------------------------------------------------------------------
\114\ See AFGI Letter; D&L Letter; and ISDA Letter.
\115\ See D&L Letter.
\116\ See ISDA Letter.
---------------------------------------------------------------------------
After considering these comments, the Commissions are not including
a reference to accounting standards in the Product Test.
(b) Providers of Insurance Products
Under the first prong of the Provider Test, the agreement,
contract, or transaction must be provided by a person that is subject
to supervision by the insurance commissioner (or similar official or
agency) of any state\117\ or by the United States.\118\ In addition,
such agreement, contract, or transaction also must be regulated as
insurance under applicable state law\119\ or the laws of the United
States.
---------------------------------------------------------------------------
\117\ See supra note 32, regarding the definition of ``State''
contained in the Proposing Release.
\118\ This requirement in the final rules is substantially
similar to the requirement included in section 3(a)(8) of the
Securities Act, 15 U.S.C. 77c(a)(8).
\119\ See supra note 34.
---------------------------------------------------------------------------
The Commissions have revised the first prong of the Provider Test
from the proposal. As proposed, the first prong of the Provider Test
could only be satisfied by a company that was organized as an insurance
company whose primary and predominant business activity was the writing
of insurance or the reinsuring of risks underwritten by insurance
companies.\120\ The Commissions have revised this prong of the Provider
Test to address commenters' concerns that the proposed rules would
exclude insurers that were not organized as ``insurance companies,'' as
well as insurers that were domiciled outside of the United States.\121\
As adopted, the first prong of the Provider Test can be satisfied by
any person that is subject to state or Federal insurance supervision,
regardless of that person's corporate structure or domicile. The
Commissions understand that, with the exception of non-admitted
insurers,\122\ foreign insurers are subject to supervision in the
states in which they offer insurance products. The treatment of non-
admitted insurers is addressed in the fourth prong of the Provider
Test.
---------------------------------------------------------------------------
\120\ See Proposing Release at 29824.
\121\ See infra notes 139, 140, and 141 and accompanying text.
\122\ The Commissions understand that the surplus lines brokers
who place insurance on behalf of non-admitted insurers are subject
to supervision in the states in which they offer non-admitted
insurance products.
---------------------------------------------------------------------------
The Commissions believe that the requirement that the agreement,
contract, or transaction be provided by a person that is subject to
state or Federal insurance supervision should help prevent regulatory
gaps that otherwise might exist between insurance regulation and the
regulation of swaps and security-based swaps by ensuring that products
provided by persons that are not subject to state or Federal insurance
supervision are not able to be offered by persons that avoid regulation
under Title VII of the Dodd-Frank Act as well.
The first prong of the Provider Test also requires that the
agreement, contract, or transaction being provided is ``regulated as
insurance'' under applicable state law or the laws of the United
States. As stated in the Proposing Release, the purpose of this
requirement is that an agreement, contract, or transaction that
satisfies the other conditions of the final rules must be subject to
regulatory oversight as an insurance product. The Commissions believe
that this condition will help prevent products that are not regulated
as insurance in the states in which they are offered, and that are
swaps or security-based swaps, from being characterized as insurance
products in order to evade the regulatory regime under Title VII of the
Dodd-Frank Act. As noted by commenters,\123\ the Commissions recognize
that the ``regulated as insurance'' limitation means that it is
possible that a particular product that may not be regulated as
insurance in a particular state may not qualify for the Insurance Safe
Harbor.\124\
---------------------------------------------------------------------------
\123\ See infra notes 145 and 146 and accompanying text.
\124\ See infra notes 147 and 148 and accompanying text.
---------------------------------------------------------------------------
As stated in the Proposing Release, the Commissions believe that it
is appropriate to exclude, from regulation under Title VII, insurance
that is issued by the United States or any of its agencies or
instrumentalities, or pursuant to a statutorily authorized program
thereof, from regulation as swaps or security-based swaps.\125\ Such
insurance includes, for example, Federal insurance of funds held in
banks, savings associations, and credit unions; catastrophic crop
insurance; flood insurance; Federal insurance of certain pension
obligations; and terrorism risk insurance. At the request of
commenters,\126\ the Commissions are persuaded that it is also
appropriate to provide a similar exclusion to insurance that is issued
by a state or any of its agencies or instrumentalities, or pursuant to
a statutorily authorized program thereof. Accordingly, the Commissions
have revised the second prong of the Provider Test to provide that
products meeting the Product Test are excluded from the swap and
security-based swap definitions if they are provided (i) directly or
indirectly by the Federal government or a state or (ii) pursuant to a
statutorily authorized program of either.\127\
---------------------------------------------------------------------------
\125\ See Proposing Release at 29824.
\126\ See Ex Parte Communication between NAIC and CFTC and SEC
Staff on October 5, 2011, at http://sec.gov/comments/s7-16-11/s71611-61.pdf.
\127\ The Commissions understand that certain types of Federal
and State insurance programs, including crop insurance, are
administered by third parties; as a result, the Commissions have
added ``directly or indirectly'' to the second prong of the Provider
Test to clarify that it can be satisfied even if the agreement,
contract, or transaction is not provided directly by the federal
government or a state. See Id.
---------------------------------------------------------------------------
As stated in the Proposing Release, the Commissions believe that
where an agreement, contract, or transaction qualifies for the safe
harbor and therefore is considered insurance excluded from the swap and
security-based swap definitions, the lawful reinsurance of that
agreement, contract, or transaction similarly should be excluded.\128\
Accordingly, the Commissions are adopting the third prong of the
Provider Test as proposed, with certain modifications, to provide that
an agreement, contract, or transaction of reinsurance will be excluded
from the swap and security-based swap definitions, provided that: (i)
The person offering such reinsurance is not prohibited by applicable
state law or the laws of the United States from offering such
reinsurance to a person that satisfies the Provider Test; (ii) the
agreement, contract, or transaction to be reinsured meets the
requirements under the Product Test or is one of the Enumerated
Products; and (iii) except as otherwise permitted under applicable
state law, the total amount reimbursable by all reinsurers for such
insurance product cannot exceed the claims or losses paid by the
cedant.
---------------------------------------------------------------------------
\128\ See Proposing Release at 29825.
---------------------------------------------------------------------------
In response to commenters' concerns,\129\ the Commissions have
revised the third prong of the Provider Test from that contained in the
Proposing Release. As adopted, the third prong of the Provider Test
encompasses all reinsurers wherever incorporated or organized, and not
just those based outside of the United States. The Commissions also
have revised the third prong of the Provider Test to clarify that the
total amount reimbursable by all reinsurers may not exceed the claims
or losses paid by the cedant, unless otherwise permitted by applicable
state law. It is not the Commissions' intent to
[[Page 48221]]
impose requirements that conflict with state law regarding the
calculation of amounts reimbursable under reinsurance contracts.
---------------------------------------------------------------------------
\129\ See infra notes 150, 151, 152, and 153 and accompanying
text.
---------------------------------------------------------------------------
The Commissions have added a fourth prong to the Provider Test to
address commenters' concerns that the proposed Provider Test excluded
entities issuing insurance products on a non-admitted basis through
surplus lines brokers.\130\ Non-admitted insurance is typically
property and casualty insurance that is permitted to be placed through
a surplus lines broker \131\ by an insurer that is not licensed to do
business in the state where the product is offered.\132\ In practice, a
provider of non-admitted insurance may not satisfy the first prong of
the Provider Test because it may not be subject to state or Federal
insurance supervision. The Commissions understand that non-admitted
insurance plays a very important role in the insurance marketplace. In
addition, Congress has explicitly recognized non-admitted insurance
products as insurance and specified that a state cannot prohibit
certain types of entities from offering non-admitted insurance
products.\133\ Because Congress recognized that certain persons qualify
as non-admitted insurers, the Commissions find that it is appropriate
to add the fourth prong to the Provider Test.
---------------------------------------------------------------------------
\130\ See infra note 146 and accompanying text.
\131\ For the purposes of this release, the term ``surplus lines
broker'' means an individual, firm, or corporation that is licensed
in a state to sell, solicit, or negotiate insurance on properties,
risks, or exposures located or to be performed in a state with non-
admitted insurers.
\132\ See supra note 39. With respect to domestic reinsurance,
state insurance regulators do retain the authority to prevent or
allow a non-admitted company from participating in a state market.
Some states compile a list of companies that may sell as non-
admitteds; other states list non-admitted companies that may not
sell.
\133\ See Subtitle B of Title V of the Dodd-Frank Act.
---------------------------------------------------------------------------
A person will qualify under the fourth prong of the Provider Test
if it satisfies any one of the following two requirements:
It is located outside of the United States and listed on
the Quarterly Listing of Alien Insurers that is compiled and maintained
by the International Insurers Department of the National Association of
Insurance Commissioners;\134\ or
---------------------------------------------------------------------------
\134\ Section 524 of the Nonadmitted and Reinsurance Reform Act
of 2010 (15 U.S.C. 8204) provides that a state cannot prohibit a
surplus lines broker from placing non-admitted insurance with a non-
admitted insurer that is listed on the Quarterly Listing of Alien
Insurers. According to the NAIC the non-admitted alien insurers
whose names appear in the Quarterly Listing of Alien Insurers have
filed financial statements, copies of auditors' reports, the names
of their U.S. attorneys or other representatives, and details of
U.S. trust accounts with the NAIC's International Insurers
Department and, based upon those documents and other information,
appear to fulfill the criteria set forth in the International
Insurers Department Plan of Operation for Listing of Alien
Nonadmitted Insurers.
---------------------------------------------------------------------------
It meets the eligibility criteria for non-admitted
insurers under applicable state law.
Comments
General
The Commissions received ten comment letters that addressed the
Provider Test.\135\ A few commenters recommended that the Commissions
retract the Provider Test.\136\ These commenters argued that if a
product is subject to regulation as insurance in the United States, the
regulated status of the insurer is irrelevant.\137\ The Commissions are
retaining the Provider Test with modifications as discussed above. The
Commissions believe that insurance products should fall outside the
swap or security-based swap definitions only if they are offered by
persons subject to state or Federal insurance supervision or by certain
reinsurers.\138\ The Provider Test will help to prevent products that
are swaps or security-based swaps from being characterized as insurance
in order to evade the regulatory regime under Title VII of the Dodd-
Frank Act. Other commenters suggested various modifications to the
Provider Test and those comments are discussed in more detail below.
---------------------------------------------------------------------------
\135\ See ACLI Letter; AIA Letter; CAI Letter; D&L Letter; ISDA
Letter; NAIC Letter; NAFA Letter; Nationwide Letter; RAA Letter; and
Travelers Letter.
\136\ See AIA Letter; D&L Letter; and ISDA Letter.
\137\ Id.
\138\ See infra notes 147 and 148 and accompanying text.
---------------------------------------------------------------------------
``Insurance Company'' Limitation
Several commenters recommended that the Commissions expand the
first prong of the Provider Test so that it is not limited to
``insurance companies,'' but to all insurers because not all insurers
are organized as ``insurance companies,''\139\ to accommodate insurers
and reinsurers that are domiciled outside of the United States,\140\
and to cover domestic and foreign insurance companies and other
entities that issue insurance products on a non-admitted basis through
surplus lines brokers.\141\
---------------------------------------------------------------------------
\139\ See AIA Letter; D&L Letter; ISDA Letter; RAA Letter; NAIC
Letter; and Travelers Letter.
\140\ See AIA Letter; D&L Letter; RAA Letter; and Travelers
Letter.
\141\ See RAA Letter and Travelers Letter.
---------------------------------------------------------------------------
The Commissions have revised the first prong of the Provider Test
to remove the ``insurance company'' limitation and to clarify that any
person that is subject to state or Federal insurance supervision will
qualify under the first prong of the Provider Test. As noted above, the
Commissions also believe that this revision should address commenters'
concerns that the proposed rules could have excluded some foreign
insurers since the revised test does not require that a person be
domiciled in the United States; it only requires that the person be
subject to state or Federal insurance supervision.
Several commenters suggested that the proposed Provider Test would
permit an insurer that is not organized as an insurance company to
evade state insurance oversight by deliberately failing the exemption
for insurance products (that is, by issuing a contract that would fail
the proposed rules because it would not be issued by an insurance
company).\142\ These commenters were concerned that if a product were
to be considered a swap merely because it was not issued by an
insurance company, this would render the regulation of such products
outside of the scope of state insurance laws due to the Federal
preemption of swaps regulation.\143\ Commenters noted that a likely
consequence of this preemption would be that the same product would be
subject to substantially different regulation within a state's
jurisdiction based solely on the nature of the issuing person.\144\
---------------------------------------------------------------------------
\142\ See ACLI Letter; CAI Letter; NAFA Letter; Nationwide
Letter; RAA Letter; and Travelers Letter.
\143\ Id.
\144\ Id.
---------------------------------------------------------------------------
The Commissions have revised the first prong of Provider Test to
address commenters' concerns that providers of insurance products could
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. As adopted, any
person that provides insurance products (and therefore should be
subject to state or Federal insurance supervision) must, in fact, be
subject to state or Federal insurance supervision in order to satisfy
the first prong of the Provider Test. Persons that are organized as
insurance companies or whose business activity is predominantly
insurance or reinsurance, but who are not in fact subject to state or
Federal insurance supervision, would not satisfy the first prong of the
Provider Test.
Finally, as discussed below, the Commissions have added a fourth
prong
[[Page 48222]]
to the Provider Test to provide relief for persons that provide
insurance products on a non-admitted basis through surplus lines
brokers.
``Regulated as Insurance'' Limitation
Two commenters recommended that the Commissions remove the
provision in the first prong of the Provider Test that states ``and
such agreement, contract, or transaction is regulated as insurance
under the laws of such state or of the United States.''\145\ These
commenters argued that the provision should be deleted because it was
redundant with the Product Test and may exclude certain reinsurers and
non-admitted insurers, as well as products that may not be specifically
``regulated as insurance'' in all states.\146\
---------------------------------------------------------------------------
\145\ See RAA Letter and Travelers Letter.
\146\ Id. These commenters also recommended the addition of a
new prong to the Provider Test to cover domestic or foreign entities
that issue insurance products on a non-admitted basis through
surplus lines brokers. See discussion below. The Commissions note
that the first prong of the Provider Test does not apply to
reinsurance contracts and the third prong of the Provider Test,
which does apply to reinsurance contracts, does not contain the
``regulated as insurance'' limitation.
---------------------------------------------------------------------------
The Commissions have retained the requirement in the first prong of
the Provider Test that an insurance product must be regulated as
insurance, but have revised the provision to clarify that an insurance
product must be regulated as insurance under applicable state law or
the laws of the United States. As discussed above, the Commissions
believe that this condition will help prevent products that are not
regulated as insurance and are swaps or security-based swaps from being
characterized as insurance products in order to evade the regulatory
regime under the Dodd-Frank Act.
The Commissions have received conflicting comments regarding
whether surety bonds are currently offered by persons who do not
satisfy the Provider Test, in particular the ``regulated as insurance''
requirement.\147\ If a person who does not satisfy the Provider Test
sells a surety bond incidental to other business activity and is not
subject to state or Federal insurance supervision, it does not mean
that such surety bond is a swap or security-based swap. The surety bond
may not satisfy the Insurance Safe Harbor, but it would be subject to a
facts and circumstances analysis. Similarly, one commenter indicated
that title insurance is not always subject to state insurance
regulation.\148\ Title insurance sold in a state that does not regulate
title insurance as insurance would be in the list of Enumerated
Products but would not satisfy the Provider Test and, thus would not
qualify for the Insurance Safe Harbor. However, this does not mean that
title insurance sold in a state that does not regulate title insurance
as insurance is a swap or security-based swap. The title insurance may
not satisfy the Insurance Safe Harbor, but it would be subject to a
facts and circumstances analysis. The Commissions anticipate that many
factors would militate against a determination that such a surety bond
or title insurance that fails the Provider Test, because it cannot meet
the ``regulated as insurance'' requirement, is a swap or security-based
swap rather than insurance.
---------------------------------------------------------------------------
\147\ See SFAA Letter. SFAA stated that all states include
surety and fidelity bonds as lines of insurance subject to state
oversight. However, Travelers stated that surety bonds may not be
``specifically'' regulated as insurance. See Travelers Letter.
\148\ See ACLI Letter.
---------------------------------------------------------------------------
The Commissions agree that the inclusion of the ``regulated as
insurance'' requirement in the first prong of the Provider Test will
have the effect of causing non-admitted insurance products to fall
within the swap and security-based swap definitions. In response to
commenters' concerns about the ability of non-admitted insurers to
qualify under the Provider Test, the Commissions have added a fourth
prong to the Provider Test to address providers of non-admitted
insurance products.\149\
---------------------------------------------------------------------------
\149\ See supra notes 130, 131, and 132 and accompanying text.
---------------------------------------------------------------------------
Providers of Reinsurance
Several commenters recommended that the Commissions expand the
third prong of the Provider Test to include domestic reinsurers.\150\
One commenter requested that the Commissions remove the third prong of
the Provider Test from the final rules because it appears to prohibit a
reinsurer from offering a product in a state where it is permitted if
any other state prohibits that product.\151\ Two commenters requested
revisions to the portion of the third prong of the Provider Test that
addresses a cedant's reimbursable losses.\152\ One commenter argued
this portion of the third prong of the Provider Test may conflict with
the state-based insurance receivership law.\153\
---------------------------------------------------------------------------
\150\ See ACLI Letter; CAI Letter; NAIC Letter; and RAA Letter.
\151\ See RAA Letter. The commenter argued that one state's
prohibition on a reinsurance product should not affect the ability
of the reinsurer to offer the product in a state where it is
permitted.
\152\ See RAA Letter and Travelers Letter. Both commenters
suggested specific edits to the proposed rules.
\153\ See RAA Letter. RAA stated that in an insurance
receivership reinsurers are required to comply with the reinsurance
contract and pay all amounts due and owing to the estate of the
insolvent cedant even if the estate of the cedant may not
necessarily pay the full amount of the underlying claims to the
applicable policyholders.
---------------------------------------------------------------------------
As noted above, the Commissions have revised the third prong of the
Provider Test to remove the limitation that a reinsurance provider has
to be located outside of the United States, and thereby address
commenters' concerns that domestic reinsurers would not qualify under
the reinsurance prong. In addition, in response to commenters'
concerns, the Commissions have clarified the third prong of the
Provider Test so that it does not prohibit a reinsurer from offering a
product in a state where it is permitted, even if that product is
prohibited in another state, and have revised the portion of the third
prong of the Provider Test that addresses a cedant's reimbursable
losses to make it subject to applicable state law so that it does not
conflict with state-based insurance receivership law.
(c) Grandfather Provision for Existing Insurance Transactions
In the Proposing Release, the Commissions asked whether the
proposed rules should include a provision similar to section 302(c)(1)
of the Gramm-Leach-Bliley Act that any product regulated as insurance
before the date the Dodd-Frank Act was signed into law and provided in
accordance with the Provider Test would be considered insurance and not
fall within the swap or security-based swap definitions.
In response to comments,\154\ the Commissions are adding a new
paragraph (ii) to rule 1.3(xxx)(4) under the CEA and new paragraph (b)
to rule 3a69-1 under the Exchange Act that provides that an agreement,
contract, or transaction entered into on or before the effective date
of the Product Definitions will be considered insurance and not fall
within the swap and security-based swap definitions, provided that, at
such time it was entered into, such agreement, contract, or transaction
was provided in accordance with the Provider Test (the ``Insurance
Grandfather'').
---------------------------------------------------------------------------
\154\ See infra notes 157, 158, 159, and 160 and accompanying
text.
---------------------------------------------------------------------------
As stated in the Proposing Release, the 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.\155\ The
[[Page 48223]]
Commissions have designed the Insurance Safe Harbor to provide greater
assurance to market participants that traditional insurance products
that were regulated as insurance prior to the Dodd-Frank Act will fall
outside the swap and security-based swap definitions. Nevertheless,
after considering comments received, the Commissions believe that it is
appropriate to adopt the Insurance Grandfather in order to assure
market participants that those agreements, contracts, or transactions
that meet the conditions set out in the Insurance Grandfather will not
fall within the swap or security-based swap definitions.
---------------------------------------------------------------------------
\155\ See Proposing Release at 29821.
---------------------------------------------------------------------------
In order to qualify for the Insurance Grandfather an agreement,
contract, or transaction must meet two requirements. First, it must be
entered into on or before the effective date of the Product
Definitions. The Commissions are linking the Insurance Grandfather to
the effective date of the Product Definitions, rather than the date
that the Dodd-Frank Act was signed into law, in order to avoid
unnecessary market disruption.\156\ Second, such agreement, contract,
or transaction must be provided in accordance with the Provider Test.
In other words, the provider must be subject to state or Federal
insurance supervision or be a non-admitted insurer or a reinsurer that
satisfies the conditions for non-admitted insurers and reinsurers that
are set out in the Provider Test. The Commissions note that an
agreement, contract or transaction that is provided in accordance with
the first prong of the Provider Test must also be regulated as
insurance under applicable state law or the laws of the United States.
---------------------------------------------------------------------------
\156\ The Commissions believe that 60 days after publication of
this release should be sufficient time for market participants to
enter into pending agreements, contracts, or transactions for which
the Insurance Grandfather may provide relief.
---------------------------------------------------------------------------
By adopting the Insurance Grandfather and the Insurance Safe
Harbor, the Commissions are excluding agreements, contracts, and
transactions for which the Commissions have found no evidence that
Congress intended them to be regulated as swaps or security-based
swaps, and are providing greater certainty regarding the treatment of
agreements, contracts, and transactions currently regulated as
insurance.
Comments
Four commenters addressed whether the final rules should include a
grandfather provision that would exclude certain insurance products
from the swap or security-based swap definitions.\157\ Two commenters
suggested that a grandfather provision for all products that were
regulated as insurance before the Dodd-Frank Act was signed into law
would be appropriate, stating that it would reduce confusion and
uncertainty in applying the swap and security-based swap definitions to
products that are traditionally regulated as insurance while addressing
the Commissions' stated concern that products might be structured as
insurance products to evade Dodd-Frank Act requirements.\158\ These
commenters also stated that it is necessary to add an effective date-
based grandfather provision to the final rule providing that any
contract or transaction subject to state insurance regulation and
entered into prior to any final rules necessary to implement Title VII,
including the Product Definitions, are not swaps or security-based
swaps.\159\ These commenters noted that a grandfather provision based
on effective date of all the Title VII rules was needed to address
product development and variation that occurred between the date the
Dodd-Frank Act was enacted and the effective date of the rules mandated
under that statute.\160\
---------------------------------------------------------------------------
\157\ See ACLI Letter; AFGI Letter; CAI Letter; and D&L Letter.
\158\ See ACLI Letter and CAI Letter. ACLI and CAI argued that
products that were regulated as insurance prior to the effective
date of the Dodd-Frank Act clearly were not characterized as
insurance to avoid the Title VII regulatory regime. See also AFGI
Letter; AFGI argued that all insurance contracts issued by state-
regulated insurance companies should be excluded from the swap
definition but in the alternative, all insurance products regulated
as insurance before July 21, 2010 should be grandfathered. See also
D&L Letter. D&L stated that prior regulation of insurance products
before July 21, 2010 could be a consideration, but not an absolute
determinant for exclusion from the swap or security-based swap
definitions.
\159\ See ACLI Letter and CAI Letter.
\160\ Id.
---------------------------------------------------------------------------
The Commissions believe that the combination of the Insurance
Grandfather along with the Insurance Safe Harbor provides market
participants with increased legal certainty with respect to existing
agreements, contracts, transactions, and products. In addition, the
fact that the Commissions are linking the Insurance Grandfather to the
effective date of the Product Definitions, rather than the date that
the Dodd-Frank Act was signed into law, takes into account product
development and innovation that may have occurred between the date the
Dodd-Frank Act was signed into law at the effective date of the Product
Definitions. Further, the Commissions believe that a grandfather
provision that would exclude all products regulated as insurance before
the Dodd-Frank Act was signed into law, as recommended by some
commenters,\161\ is unnecessary because non-grandfathered regulated
insurance transactions generally should fall within the Insurance Safe
Harbor. The Commissions believe that market participants could be
incentivized to use such a broader grandfather provision to create new
swap or security-based swap products with characteristics similar to
those of existing categories of regulated insurance contracts for the
purpose of evading the Dodd-Frank Act regulatory regime. The
Commissions also believe that a broader grandfather provision would be
contrary to the explicit direction of sections 722(b) and 767 of the
Dodd-Frank Act which provide that swaps and security-based swaps may
not be regulated as insurance contracts by any state.\162\
---------------------------------------------------------------------------
\161\ See ACLI Letter; AGFI Letter; and CAI Letter.
\162\ Section 722(b) of the Dodd-Frank Act provides, (B)
Regulation of Swaps Under Federal and State Law.--Section 12 of the
Commodity Exchange Act (7 U.S.C. 16) is amended by adding at the end
the following: ``(h) Regulation of Swaps as Insurance Under Federal
and State Law.--A swap--(1) Shall not be considered to be insurance;
and (2) may not be regulated as an insurance contract under the law
of any State.'' Section 767 of the Dodd-Frank Act amended section
28(a) of the Exchange Act, 15 U.S.C. 78bb(a), to provide, ``A
security-based swap may not be regulated as an insurance contract
under any provision of State law.''
---------------------------------------------------------------------------
One commenter argued that the Provider Test should not apply to
grandfathered contracts. The commenter stated that it should be enough
that the product is regulated as insurance.\163\ As described above,
the grandfather provision will apply only to agreements, contracts, and
transactions that are entered into prior to the effective date of the
Product Definitions if they were provided in accordance with the
Provider Test, including a requirement that an agreement, contract or
transaction that is provided in accordance with the first prong of the
Provider Test must be regulated as insurance under applicable State law
or the laws of the United States. As the Commissions discussed in the
Proposing Release, and above in describing the Provider Test, the
Commissions believe the requirement that the agreement, contract, or
transaction be provided in accordance with the Provider Test should
help ensure that persons who are not subject to state or Federal
insurance supervision are not able to avoid the oversight
[[Page 48224]]
provided for under Title VII of the Dodd-Frank Act.
---------------------------------------------------------------------------
\163\ See CAI Letter. CAI suggested that for a product to be
regulated as insurance it means that it was provided by an insurance
company. See supra part II.B.1.b) for a discussion of the need for
the Provider Test portion of the Insurance Safe Harbor.
---------------------------------------------------------------------------
(d) Alternative Tests
A number of commenters proposed that the Commissions adopt
alternative tests to distinguish insurance from swaps and security-
based swaps.\164\ After considering each of these alternatives, the
Commissions are not adopting them.
---------------------------------------------------------------------------
\164\ See ACLI Letter; AIA Letter; AFGI Letter; CAI Letter;
MetLife Letter; NAFA Letter; NAIC Letter; Nationwide Letter; and
Travelers Letter.
---------------------------------------------------------------------------
Several commenters suggested that the sole test for determining
whether an agreement, contract, or transaction is insurance should be
whether it is subject to regulation as insurance by the insurance
commissioner of the applicable state(s).\165\ The Commissions find this
alternative to be unworkable because it does not provide a sufficient
means to distinguish agreements, contracts and transactions that are
insurance from those that are swaps or security-based swaps. Section
712(d) of the Dodd-Frank Act directs the Commissions to ``further
define'' the terms swap and security-based swap. Neither swaps nor
security-based swaps may be regulated as insurance contracts under the
laws of any state.\166\ While insurance contracts have long been
subject to state regulation, swaps and security-based swaps were
largely unregulated. Since the Dodd-Frank Act created a new regulatory
regime for swaps and specifically provides that ``swaps may not be
regulated as an insurance contract under the law of any state,\167\ the
Commissions believe that it is important to have a test that
distinguishes insurance from swaps and security-based swaps without
relying entirely on the regulatory environment prior to the enactment
of the Dodd-Frank Act. The Product Test is an important element of the
Insurance Safe Harbor.
---------------------------------------------------------------------------
\165\ See ACLI Letter; AIA Letter; AFGI Letter; MetLife Letter;
and Travelers Letter.
\166\ See section 12(h) of the CEA, 7 U.S.C. 16(h) (regarding
swaps) and section 28(a)(4) of the Exchange Act, 15 U.S.C.
78bb(a)(4) (regarding security-based swaps).
\167\ See section 12(h)(2) of the CEA, 7 U.S.C. 16(h)(2).
---------------------------------------------------------------------------
Several commenters suggested an approach in which insurance
products that qualify for the exclusion contained in section 3(a)(8) of
the Securities Act\168\ would be excluded from the swap
definition.\169\ One commenter argued that ``Section 3(a)(8) has long
been recognized as the definitive provision as to where Congress
intends to separate securities products that are subject to SEC
regulation from `insurance' and `annuity' products that are to be left
to state insurance regulation'' and that the section 3(a)(8) criteria
are well understood and have a long history of interpretation by the
SEC and the courts.\170\ Other commenters suggest that because section
3(a)(8) includes both a product and a provider requirement, if the
Commissions include it in their final rules, it should be a requirement
separate from the Product Test and the Provider Test, and should extend
to insurance products that are securities.\171\
---------------------------------------------------------------------------
\168\ Section 3(a)(8) of the Securities Act excludes the
following from all provisions of the Securities Act: Any insurance
or endowment policy or annuity contract or optional annuity
contract, issued by a corporation subject to the supervision of the
insurance commissioner, bank commissioner, or any agency or officer
performing like functions, of any State or Territory of the United
States or the District of Columbia.
See infra note 1283 and accompanying text.
\169\ See ACLI Letter; CAI Letter; NAFA Letter; and Nationwide
Letter.
\170\ See NAFA Letter.
\171\ See ACLI Letter and CAI Letter.
---------------------------------------------------------------------------
While the Commissions agree that the section 3(a)(8) criteria have
a long history of interpretations by the SEC and the courts, the
Commissions find that it is inappropriate to apply the section 3(a)(8)
criteria in this context. Although section 3(a)(8) contains some
conditions applicable to insurance providers that are similar to the
prongs of the Provider Test, it does not contain any conditions that
are similar to the prongs of the Product Test. Moreover, section
3(a)(8) provides an exclusion from the Securities Act and the CFTC has
no jurisdiction under the Federal securities laws. Congress directed
both agencies to further define the terms ``swap'' and ``security-based
swap.'' As such, the Commissions find that it is more appropriate to
have a standalone rule that incorporates features that distinguish
insurance products from swaps and security-based swaps and over which
both Commissions will have joint interpretative authority.
One commenter suggested yet another approach, recommending that
insurance be defined as an agreement, contract, or transaction that by
its terms:
Exists for a specified period of time;
Where the party (the ``insured'') to the contract promises
to make one or more payments such as money, goods or services;
In exchange for another party's promise to provide a
benefit of pecuniary value for the loss, damage, injury, or impairment
of an identified interest of the insured as a result of the occurrence
of a specified event or contingency outside of the parties' control;
and
Where such payment is related to a loss occurring as a
result of a contingency or specified event.\172\
---------------------------------------------------------------------------
\172\ See NAIC Letter.
---------------------------------------------------------------------------
The Commissions do not find this alternative preferable to the
Commissions' proposal for two reasons. First, the requirements of a
specified term and the promise to make payments are present in both
insurance products and in agreements, contracts, or transactions that
are swaps or security-based swaps and therefore do not help to
distinguish between them. A test based solely on these requirements,
then, could be over-inclusive and exclude from the Dodd-Frank Act
regulatory regime agreements, contracts, and transactions that have not
traditionally been considered insurance. Further, the third and fourth
requirements of this alternative test collapse into the Product Test's
requirement that the loss must occur and be proved, and any payment or
indemnification therefor must be limited to the value of the insurable
interest.
One commenter suggested a three-part test in lieu of the Product
and Provider Tests. Under this test, the terms ``swap'' and ``security-
based swap'' would exclude any agreement, contract, or transaction
that:
Is issued by a person who is or is required to be
organized as an insurance company and subject to state insurance
regulation;
Is the type of contract issued by insurance companies; and
Is not of the type that the Commissions determine to
regulate. \173\
---------------------------------------------------------------------------
\173\ See ACLI Letter (Appendix 1). See also CAI Letter. CAI
stated that it believes that the approach and test recommended by
ACLI is a fundamentally sound method for determining those insurance
products that are not swaps or security-based swaps and that should
remain subject to state regulation, and is more appropriate than the
Commissions' proposals. Nationwide suggested a three-part test to
differentiate insurance products from swaps and security-based swaps
similar to the test proposed by ACLI. See also Nationwide Letter.
---------------------------------------------------------------------------
This commenter stated that its approach does not contain a
definition of insurance, and believes that is preferable to the
Commissions' approach, which it believes creates legal uncertainty
because any attempted definition of insurance has the potential to be
over- or under- inclusive.\174\ As discussed above, the Commissions'
rules and interpretations are not intended to define insurance. Rather,
they provide a safe harbor for certain types of traditional insurance
products by reference to factors that may be used to distinguish
insurance from swaps and security-based swaps, and a list of
[[Page 48225]]
products that do not have to satisfy a portion of the safe harbor
factors. Agreements, contracts, and transactions that do not qualify
for the Insurance Safe Harbor may or may not be insurance, depending
upon the facts and circumstances regarding such agreements, contracts
and transactions. The Commissions find the first two requirements of
the commenter's three-part test to be tautologous, and the third
provides no greater certainty than the Commissions' facts and
circumstances approach. In addition, the Commissions find that this
alternative test could exclude from the Dodd-Frank Act regulatory
regime agreements, contracts, and transactions that have not
traditionally been considered insurance.
---------------------------------------------------------------------------
\174\ See ACLI Letter.
---------------------------------------------------------------------------
Another commenter proposed different approaches for existing
products and new products.\175\ Specifically, if an existing type of
agreement, contract or transaction is currently reportable as insurance
in the provider's regulatory and financial reports under a state or
foreign jurisdiction's insurance laws, then that agreement, contract,
or transaction would be insurance rather than a swap or security-based
swap. On the other hand, for new products, if this approach were
inconclusive, this commenter recommended that the Commissions use the
Product Test of the Commissions' rules only.\176\ As discussed above,
rather than treating existing products and new products differently,
the Commissions are providing ``grandfather'' protection for
agreements, contracts, and transactions entered into prior to the
effective date of the Products Definitions.\177\ Moreover, this
commenter's test would eliminate the Provider Test for new products,
which the Commissions believe is important to help prevent products
that are swaps or security-based swaps from being characterized as
insurance.
---------------------------------------------------------------------------
\175\ See AIA Letter.
\176\ Id.
\177\ See supra part II.B.1.c)
---------------------------------------------------------------------------
In sum, the Commissions find that each of the alternatives proposed
by commenters could exclude from the Dodd-Frank Act regulatory regime
agreements, contracts, and transactions that have not historically been
considered insurance, and that should, in appropriate circumstances, be
regulated as swaps or security-based swaps. Accordingly, the
Commissions do not find these alternatives to be appropriate for
delineating the scope of the Insurance Safe Harbor from the swap and
security-based swap definitions.
(e) ``Safe Harbor''
Five commenters recommended that the Product Test, the Provider
Test, and related interpretations should be structured as a ``safe
harbor'' so that they do not raise any presumption or inference that
products that do not meet the Product Test, Provider Test and related
interpretations are necessarily swaps or security-based swaps.\178\ One
commenter suggested that this safe harbor approach could be modeled
after Rule 151 under the Securities Act.\179\
---------------------------------------------------------------------------
\178\ See ACLI Letter; CAI Letter; NAFA Letter (concurring with
ACLI and CAI); Nationwide Letter; and Travelers Letter.
\179\ See ACLI Letter.
---------------------------------------------------------------------------
As discussed above, the Commissions do not intend to create a
presumption that agreements, contracts, or transactions that do not
fall within the Insurance Safe Harbor are necessarily swaps or
security-based swaps. As stated above, the Commissions are instead
adopting final rules that clarify that certain agreements, contracts,
or transactions meeting the requirements of a non-exclusive ``safe
harbor'' established by such rules will not be considered to be swaps
or security-based swaps. An agreement, contract, or transaction that
does not fall within the Insurance Safe Harbor will require further
analysis of the applicable facts and circumstances to determine whether
it is insurance, and thus not a swap or security-based swap.
(f) Applicability of Insurance Exclusion to Security-Based Swaps
Four commenters expressed concerns that the proposed rules were
unclear in their application to both swaps and security-based
swaps.\180\ These commenters argued that the proposed rules do not
directly exclude insurance products from the term ``security-based
swap'' because the rules explicitly state that ``[t]he term `swap' does
not include'' the products that meet the Product and Provider Tests,
but do not make the same statement as to the term ``security-based
swap.'' \181\
---------------------------------------------------------------------------
\180\ See ACLI Letter; CAI Letter; NAFA Letter (concurring with
ACLI and CAI); and Nationwide Letter (concurring the ACLI and CAI).
\181\ Id. The commenters suggested that this ambiguity could be
resolved by making it clear in the final rules that an excluded
product is neither a swap nor a security-based swap.
---------------------------------------------------------------------------
The Commissions have revised rule 1.3(xxx)(4) under the CEA and
rule 3a69-1 under the Exchange Act to clarify that the exclusion
contained therein applies to both swaps and security-based swaps.
(g) Guarantees
In the Proposing Release, the Commissions requested comment on
whether insurance of an agreement, contract, or transaction that falls
within the swap or security-based swap definitions should itself be
included in the swap or security-based swap definition. The Commissions
also requested comment on whether the Commissions should provide
guidance as to whether swap or security-based swap guarantees offered
by non-insurance companies should be considered swaps or security-based
swaps.\182\
---------------------------------------------------------------------------
\182\ See Proposing Release at 29827.
---------------------------------------------------------------------------
Guarantees of Swaps.\183\
---------------------------------------------------------------------------
\183\ The discussion in this subsection relates only to swaps
that are not security-based swaps or mixed swaps and has no effect
on the laws or regulations applicable to security-based swaps or
mixed swaps.
---------------------------------------------------------------------------
No commenter identified any product that insures swaps (that are
not security-based swaps or mixed swaps) other than financial guaranty
insurance. The CFTC finds that insurance of an agreement, contract, or
transaction that falls within the swap definition (and is not a
security-based swap or mixed swap) is functionally or economically
similar to a guarantee of a swap (that is not a security-based swap or
mixed swap) offered by a non-insurance company.\184\ Therefore, the
CFTC is treating financial guaranty insurance of swaps (that are not
security-based swaps or mixed swaps) the same way it is treating all
other guarantees of swaps (that are not security-based swaps or mixed
swaps), as discussed below.\185\
---------------------------------------------------------------------------
\184\ The Commissions did not express a view regarding whether
financial guaranty insurance is a swap or security-based swap in the
Entities Release. See Entities Release at 30689, n.1132.
\185\ Subsequent references to ``guarantees'' in this discussion
shall thus be deemed to include ``financial guaranty insurance
policies.''
---------------------------------------------------------------------------
The CFTC is persuaded that when a swap has the benefit of a
guarantee,\186\ the guarantee is an integral part of that swap. The
CFTC finds that a guarantee of a swap (that is not a security-based
swap or mixed swap) is a term of that swap that affects the price or
pricing attributes of that swap.\187\ When a swap
[[Page 48226]]
counterparty typically provides a guarantee as credit support for its
swap obligations, the market will not trade with that counterparty at
the same price, on the same terms, or at all without the guarantee. The
guarantor's resources are added to the analysis of the swap; if the
guarantor is financially more capable than the swap counterparty, the
analysis of the swap becomes more dependent on the creditworthiness of
the guarantor. Therefore, the CFTC is interpreting the term ``swap''
(that is not a security-based swap or mixed swap) to include a
guarantee of such swap, to the extent that a counterparty to a swap
position would have recourse to the guarantor in connection with the
position.\188\ The CFTC anticipates that a ``full recourse'' guarantee
would have a greater effect on the price of a swap than a ``limited''
or ``partial recourse'' guarantee; nevertheless, the CFTC is
determining that the presence of any guarantee with recourse, no matter
how robust, is price forming and an integral part of a guaranteed swap.
---------------------------------------------------------------------------
\186\ For purposes of this release, the CFTC views a guarantee
of a swap to be a collateral promise by a guarantor to answer for
the debt or obligation of a counterparty obligor under a swap. A
guarantee of a swap does not include for purposes of this release:
(i) A ``guarantee agreement'' as defined in CFTC regulation Sec.
1.3(nn), 17 CFR 1.3(nn); (ii) any assumption by a clearing member of
financial or performance responsibility to a derivatives clearing
organization (``DCO'') for swaps cleared by a DCO; or (iii) any
guarantee by a DCO with respect to a swap that it clears.
\187\ E.g., a swap counterparty may specify that a guarantee is
a Credit Support Document under an ISDA Master Agreement. If the
guarantor fails to comply with or perform under such guarantee, such
guarantee expires or terminates, or if such guarantee ceases to be
in full force and effect, the ``Credit Support Default'' Event of
Default under the ISDA Master Agreement would generally be
triggered, potentially bringing down the entire swap trading
relationship between the parties to the ISDA Master Agreement. See
generally the standard 1992 ISDA Master Agreement and 2002 ISDA
Master Agreement. However, the CFTC finds the presence of a
guarantee to be an integral part of a swap and that affects the
price or pricing attributes of a swap whether or not such guarantee
is a Credit Support Document under an ISDA Master Agreement.
\188\ This interpretation is consistent with the interpretations
of the Commissions in the Entity Definitions Release. See, e.g.,
Entity Definitions Release at 30689 (``[A]n entity's swap or
security-based swap positions in general would be attributed to a
parent, other affiliate or guarantor for purposes of major
participant analysis to the extent that counterparties to those
positions would have recourse to that other entity in connection
with the position. Positions would not be attributed in the absence
of recourse.''). A swap backed by a partial or limited recourse
guarantee will include the guarantee to the extent of such partial
or limited recourse; a blanket guarantee that supports both swap and
non-swap obligations will be treated as part of the guaranteed swap
only to the extent that such guarantee backstops obligations under a
swap or swaps.
In the Entity Definitions Release, the Commissions stated, ``we
do not believe that it is necessary to attribute a person's swap or
security-based swap positions to a parent or other guarantor if the
person is already subject to capital regulation by the CFTC or SEC
(i.e., swap dealers, security-based swap dealers, major swap
participants, major security-based swap participants, FCMs and
broker-dealers) or if the person is a U.S. entity regulated as a
bank in the United States. Positions of those regulated entities
already will be subject to capital and other requirements, making it
unnecessary to separately address, via major participant
regulations, the risks associated with guarantees of those
positions.'' Id. In a footnote, the Commissions continued, ``As a
result of this interpretation, holding companies will not be deemed
to be major swap participants as a result of guarantees to certain
U.S. entities that are already subject to capital regulation.'' Id.
As a result of interpreting the term ``swap'' (that is not a
security-based swap or mixed swap) to include a guarantee of such
swap, to the extent that a counterparty to a swap position would
have recourse to the guarantor in connection with the position, and
based on the reasoning set forth above from the Entity Definitions
Release in connection with major swap participants, the CFTC will
not deem holding companies to be swap dealers as a result of
guarantees to certain U.S. entities that are already subject to
capital regulation. It may, however, be appropriate to regulate as a
swap dealer a parent or other guarantor who guarantees swap
positions of persons who are not already subject to capital
regulation by the CFTC (i.e., who are not swap dealers, major swap
participants or FCMs). The CFTC is addressing guarantees provided to
non-U.S. entities, and guarantees by non-U.S. holding companies, in
its proposed interpretive guidance and policy statement regarding
the cross-border application of the swaps provisions of the CEA, 77
FR 41214 (Jul. 12, 2012).
---------------------------------------------------------------------------
The CFTC's interpretation of the term ``swap'' to include
guarantees of swaps does not limit or otherwise affect in any way the
relief provided by the Insurance Grandfather. In a separate release,
the CFTC will address the practical implications of interpreting the
term ``swap'' to include guarantees of swaps (the ``separate CFTC
release'').\189\
---------------------------------------------------------------------------
\189\ Briefly, in the separate CFTC release the CFTC anticipates
proposing reporting requirements with respect to guarantees of swaps
under Parts 43 and 45 of the CFTC's regulations and explaining the
extent to which the duties and obligations of swap dealers and major
swap participants pertaining to guarantees of swaps, as an integral
part of swaps, are already satisfied to the extent such obligations
are satisfied with respect to the related guaranteed swaps. The CFTC
also anticipates addressing in the separate CFTC release the effect,
if any, of the interpretation regarding guarantees of swaps on
position limits and large trader reporting requirements.
---------------------------------------------------------------------------
Comments
Three commenters provided comments regarding the treatment of
guarantees. Two commenters \190\ opposed treating insurance or
guarantees of swaps as swaps. Suggesting that the products are not
economically similar, one commented that insurance wraps of swaps do
not ``necessarily replicate the economics of the underlying swap, and
only following default could the wrap provider end up with the same
payment obligations as a wrapped defaulting swap counterparty.'' \191\
This commenter also stated that the non-insurance guarantees are not
swaps because the result of most guarantees is that the guarantor is
responsible for monetary claims against the defaulting party, which in
this commenter's view is a different obligation than the arrangement
provided by the underlying swap itself.\192\
---------------------------------------------------------------------------
\190\ See AFGI Letter and ISDA Letter.
\191\ ISDA Letter.
\192\ Id.
---------------------------------------------------------------------------
One commenter supported treating financial guaranty insurance of a
swap or security-based swap as itself a swap or a security-based swap.
This commenter argued that financial guaranty insurance of a swap or
security-based swap transfers the risk of counterparty non-performance
to the guarantor, making it an embedded and essential feature of the
insured swap or security-based swap. This commenter further argued that
the value of such swap or security-based swap is largely determined by
the likelihood that the proceeds from the financial guaranty insurance
policy will be available if the counterparty does not meet its
obligations.\193\ This commenter maintained that financial guaranty
insurance of swaps and security-based swaps serves a very similar
function to credit default swaps in hedging counterparty default
risk.\194\
---------------------------------------------------------------------------
\193\ See Better Markets Letter.
\194\ See Better Markets Letter.
---------------------------------------------------------------------------
The CFTC is persuaded that when a swap (that is not a security-
based swap or mixed swap) has the benefit of a guarantee, the guarantee
and related guaranteed swap must be analyzed together. The events
surrounding the failure of AIG Financial Products (``AIGFP'') highlight
how guarantees can cause major risks to flow to the guarantor.\195\ The
CFTC finds that the regulation of swaps and the risk exposures
associated with them, which is an essential concern of the Dodd-Frank
Act, would be less effective if the CFTC did not interpret the term
``swap'' to include a guarantee of a swap.
---------------------------------------------------------------------------
\195\ ``AIGFP's obligations were guaranteed by its highly rated
parent company * * * an arrangement that facilitated easy money via
much lower interest rates from the public markets, but ultimately
made it difficult to isolate AIGFP from its parent, with disastrous
consequences.'' Congressional Oversight Panel, The AIG Rescue, Its
Impact on Markets, and the Government's Exit Strategy 20 (2010).
---------------------------------------------------------------------------
Two commenters cautioned against unnecessary and duplicative
regulation. One commented that, because the underlying swap, and the
parties to it, will be regulated and reported to the extent required by
Title VII, there is no need for regulation of non-insurance
guarantees.\196\ The other commented that an insurance policy on a swap
would be subject to state regulation; without addressing non-insurance
guarantees, this commenter stated that additional Federal regulation
would be duplicative.\197\ The CFTC disagrees with these arguments. As
stated above, the CFTC is treating financial guaranty insurance of
swaps and all other guarantees of swaps in a similar manner because
they are functionally or
[[Page 48227]]
economically similar products. If a guarantee of a swap is not treated
as an integral part of the underlying swap, price forming terms of
swaps and the risk exposures associated with the guarantees may remain
hidden from regulators and may not be regulated appropriately.
Moreover, treating guarantees of swaps as part of the underlying swaps
ensures that the CFTC will be able to take appropriate action if, after
evaluating information collected with respect to the guarantees and the
underlying swaps, such guarantees of swaps are revealed to pose
particular problems in connection with the swaps markets. In the
separate CFTC release, the CFTC will clarify the limited practical
effects of the CFTC's interpretation, which should address concerns
regarding duplicative regulation.
---------------------------------------------------------------------------
\196\ See ISDA Letter.
\197\ See AFGI Letter.
---------------------------------------------------------------------------
One commenter also argued that regulating financial guaranty of
swaps as swaps would cause monoline insurers to withdraw from the
market, which could adversely affect the U.S. and international public
finance, infrastructure and structured finance markets, given that
insuring a related swap often is integral to the insurance of municipal
bonds and other securities.\198\ The CFTC finds this argument
unpersuasive. The CFTC understands that the 2008 global financial
crisis severely affected most monolines and only one remains active in
U.S. municipal markets. Thus, it appears that the monolines have, for
the most part, already exited these markets. In addition, as stated
above, the CFTC will clarify in the separate CFTC release the limited
practical effects of the CFTC's interpretation, which should address
these concerns.
---------------------------------------------------------------------------
\198\ See AFGI Letter. Of the members of AFGI, only Assured
Guaranty (or its affiliates) is currently writing financial guaranty
insurance policies on U.S. municipal obligations.
---------------------------------------------------------------------------
Guarantees of Security-Based Swaps
The SEC believes that a guarantee of an obligation under a
security-based swap, including financial guaranty insurance of a
security-based swap, is not a separate security-based swap. Further,
the SEC is not adopting an interpretation that a guarantee of a
security-based swap is part of the security-based swap. Instead, the
SEC will consider requiring, as part of its rulemaking relating to the
reporting of security-based swaps,\199\ the reporting of information
about any guarantees and the guarantors of obligations under security-
based swaps in connection with the reporting of the security-based swap
transaction itself. In addition, the SEC will consider issues involving
cross-border guarantees of security-based swaps in a separate release
addressing the cross-border application of Title VII. The SEC notes
that security-based swaps are included in the definition of
``security'' contained in the Securities Act and the Exchange Act.\200\
Under the Securities Act, a guarantee of a security also is a
``security.'' \201\ Therefore, a guarantee of a security-based swap is
a security subject to Federal securities law regulation.\202\
---------------------------------------------------------------------------
\199\ See Regulation SBSR Proposing Release infra note 1231.
\200\ See sections 768(a)(1) and 761(a)(2) of the Dodd-Frank Act
(amending sections 2(a)(1) of the Securities Act, 15 U.S.C.
77b(a)(1), and 3(a)(10) of the Exchange Act, 15 U.S.C. 78c(a)(10),
respectively).
\201\ See section 2(a)(1) of the Securities Act, 15 U.S.C.
77b(a)(1).
\202\ The SEC has previously addressed the treatment of
financial guaranty insurance under the Federal securities laws. See
supra note 58.
---------------------------------------------------------------------------
2. The Forward Contract Exclusion
As the Commissions explained in the Proposing Release, the
definitions of the terms ``swap'' and ``security-based swap'' do not
include forward contracts.\203\ These definitions 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.''
\204\ The Commissions provided an interpretation in the Proposing
Release regarding the applicability of the exclusion from the swap and
security-based swap definition for forward contracts with respect to
nonfinancial commodities \205\ and securities. The Commissions are
restating this interpretation as set forth in the Proposing Release
with certain modifications in response to commenters.
(a) Forward Contracts in Nonfinancial Commodities
---------------------------------------------------------------------------
\203\ See Proposing Release at 29827.
\204\ CEA section 1a(47)(B)(ii), 7 U.S.C. 1a(47)(B)(ii).
\205\ The discussion in subsections (a) and (b) of this section
applies solely to the exclusion of nonfinancial commodity forwards
from the swap definition in the CEA.
---------------------------------------------------------------------------
The CFTC provided an interpretation in the Proposing Release
regarding the forward contract exclusion for nonfinancial commodities
and is restating this interpretation with certain modifications in
response to commenters. These clarifications include that the CFTC will
interpret the forward contract exclusion consistent with the entire
body of CFTC precedent.\206\ The CFTC is also clarifying what
``commercial participant'' means under the ``Brent Interpretation.''
\207\ In addition, while the CFTC is withdrawing its 1993 ``Energy
Exemption'' \208\ as proposed, it is clarifying that certain
alternative delivery procedures will not disqualify a transaction from
the forward contract exclusion. In response to comments, the CFTC is
providing a new interpretation regarding book-out documentation, as
well as additional factors that may be considered in its ``facts and
circumstances'' analysis of whether a particular contract is a forward.
---------------------------------------------------------------------------
\206\ See infra part II.B.2(a)(i)(F).
\207\ Statutory Interpretation Concerning Forward Transactions,
55 FR 39188 (Sep. 25, 1990) (``Brent Interpretation'').
\208\ Exemption for Certain Contracts Involving Energy Products,
58 FR 21286-02 (Apr. 20, 1993) (``Energy Exemption'').
---------------------------------------------------------------------------
(i) Forward Exclusion From the Swap and Future Delivery Definitions
(A) Consistent Interpretation
The wording of the forward contract exclusion from the swap
definition with respect to nonfinancial commodities is similar, but not
identical, to the forward exclusion from the definition of the term
``future delivery'' that applies to futures contracts, which excludes
``any sale of any cash commodity for deferred shipment or delivery.''
\209\
---------------------------------------------------------------------------
\209\ CEA section 1a(27), 7 U.S.C. 1a(27).
---------------------------------------------------------------------------
In the Proposing Release, the CFTC proposed an interpretation
clarifying the scope of the exclusion of forward contracts for
nonfinancial commodities from the swap definition and from the ``future
delivery'' definition in a number of respects. After considering the
comments received, the CFTC is restating substantially all of its
interpretation regarding these forward exclusions set forth in the
Proposing Release, but with several clarifications in response to
commenters.
The CFTC is restating from the Proposing Release that the forward
exclusion for nonfinancial commodities in the swap definition will be
interpreted in a manner consistent with the CFTC's historical
interpretation of the existing forward exclusion with respect to
futures contracts, consistent with the Dodd-Frank Act's legislative
history.\210\ In addition, in response to a
[[Page 48228]]
commenter, the CFTC is clarifying that the entire body of CFTC
precedent regarding forwards should apply to the forward exclusions
from the swap and future delivery definitions.\211\
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\210\ See 156 Cong. Rec. H5248-49 (June 30, 2010) (introducing
into the record a letter authored by Senator Blanche Lincoln,
Chairman of the U. S. Senate Committee on Agriculture, Nutrition and
Forestry, and Christopher Dodd, Chairman U. S. Senate Committee on
Banking, Housing, and Urban Affairs, stating that the CFTC is
encouraged ``to clarify through rulemaking that the exclusion from
the definition of swap for `any sale of a nonfinancial commodity or
security for deferred shipment or delivery, so long as the
transaction is intended to be physically settled' is intended to be
consistent with the forward contract exclusion that is currently in
the [CEA] and the CFTC's established policy and orders on this
subject, including situations where commercial parties agree to
`book-out' their physical delivery obligations under a forward
contract.''). See also 156 Cong. Rec. H5247 (June 30, 2010)
(colloquy between U. S. House Committee on Agriculture Chairman
Collin Peterson and Representative Leonard Boswell during the debate
on the Conference Report for the Dodd-Frank Act, in which Chairman
Peterson stated: ``Excluding physical forward contracts, including
book-outs, is consistent with the CFTC's longstanding view that
physical forward contracts in which the parties later agree to book-
out their delivery obligations for commercial convenience are
excluded from its jurisdiction. Nothing in this legislation changes
that result with respect to commercial forward contracts.'').
\211\ See Letter from Craig Donahue, Chief Executive Officer,
CME Group Inc. (``CME''), dated July 22, 2011 (``CME Letter'')
(requesting this clarification). But see below regarding the CFTC's
response to CME's comment concerning the Brent Interpretation that
it may be inconsistent, in CME's view, with more recent CFTC
adjudicatory decisions.
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The CFTC's historical interpretation has been that forward
contracts with respect to nonfinancial commodities are ``commercial
merchandising transactions.'' \212\ The primary purpose of a forward
contract is to transfer ownership of the commodity and not to transfer
solely its price risk. As the CFTC has noted and reaffirms today:
\212\ See, e.g., Brent Interpretation, supra note 207.
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The 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.\213\
\213\ See Brent Interpretation, supra note 207. The CFTC has
reiterated this view in more recent adjudicative orders. See, e.g.,
In re Grain Land Coop., [2003-2004 Transfer Binder] Comm. Fut. L.
Rep. (CCH) ] 29,636 (CFTC Nov. 25, 2003); In re Competitive
Strategies for Agric., Ltd., [2003-2004 Transfer Binder] Comm. Fut.
L. Rep. (CCH) ] 29,635 (CFTC Nov. 25, 2003). Courts have expressed
this view as well. See, e.g., Salomon Forex, Inc. v. Tauber, 8 F.3d
966, 971 (4th Cir. 1993) (``[C]ash forwards are generally
individually negotiated sales * * * in which actual delivery of the
commodity is anticipated, but is deferred for reasons of commercial
convenience or necessity.''); CFTC v. Int'l Fin. Serv. (N.Y.), 323
F. Supp. 2d 482, 495 (S.D.N.Y. 2004). See also CFTC v. Co Petro
Mktg. Grp., Inc., 680 F.2d 573, 579-580 (9th Cir. 1982); CFTC v.
Noble Metals Int'l, Inc., 67 F.3d 766, 772-773 (9th Cir. 1995; CFTC
v. Am. Metal Exch. Corp., 693 F. Supp. 168, 192 (D.N.J. 1988); CFTC
v. Morgan, Harris & Scott, Ltd., 484 F. Supp. 669, 675 (S.D.N.Y.
1979) (forward contract exclusion does not apply to speculative
transactions in which delivery obligations can be extinguished under
the terms of the contract or avoided for reasons other than
commercial convenience or necessity).
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As noted in the Proposing Release, because a forward contract is a
commercial merchandising transaction, intent to deliver historically
has been an element of the CFTC's analysis of whether a particular
contract is a forward contract.\214\ In assessing the parties'
expectations or intent regarding delivery, the CFTC consistently has
applied a ``facts and circumstances'' test.\215\ Therefore, the CFTC
reads the ``intended to be physically settled'' language in the swap
definition with respect to nonfinancial commodities to reflect a
directive that intent to deliver a physical commodity be a part of the
analysis of whether a given contract is a forward contract or a swap,
just as it is a part of the CFTC's analysis of whether a given contract
is a forward contract or a futures contract.
---------------------------------------------------------------------------
\214\ The CFTC observed in its decision in In re Wright that
``it is well-established that the intent to make or take delivery is
the critical factor in determining whether a contract qualifies as a
forward.'' In re Wright, CFTC Docket No. 97-02, 2010 WL 4388247 at
*3 (CFTC Oct. 25, 2010) (citing In re Stovall, et al., [1977-1980
Transfer Binder] Comm. Fut. L. Rep. (CCH) 20,941 (CFTC Dec. 6,
1979); Brent Interpretation, supra note 207). In Wright, the CFTC
noted that ``[i]n distinguishing futures from forwards, the [CFTC]
and the courts have assessed the transaction as a whole with a
critical eye toward its underlying purpose. Such an assessment
entails a review of the overall effect of the transaction as well as
a determination as to what the parties intended.'' Id. at *3
(quoting Policy Statement Concerning Swap Transactions, 54 FR 30694
(Jul. 21, 1989) (``Swap Policy Statement'') (citations and internal
quotations omitted)).
\215\ In Wright, the CFTC applied its facts and circumstances
test in an administrative enforcement action involving hedge-to-
arrive contracts for corn, and observed that ``[o]ur views of the
appropriateness of a multi-factor analysis remain unchanged.''
Wright, note 214, supra, n.13. The CFTC let stand the administrative
law judge's conclusion that the hedge-to-arrive contracts at issue
in the case were forward contracts. Id. at **5-6. See also Grain
Land, supra note 213; Competitive Strategies for Agric., supra note
213.
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(B) Brent Interpretation
In this interpretation, the CFTC is restating, with certain
clarifications in response to commenters, its interpretation from the
Proposing Release that the principles underlying the CFTC's ``Brent
Interpretation'' regarding book-outs developed in connection with the
forward exclusion from futures apply to the forward exclusion from the
swap definition as well. Book-out transactions meeting the requirements
specified in the Brent Interpretation that are effectuated through a
subsequent, separately negotiated agreement qualify for the safe harbor
under the forward exclusions.
As was noted in the Proposing Release, the issue of book-outs first
arose in 1990 in the Brent Interpretation \216\ because the parties to
the crude oil contracts in that case could individually negotiate
cancellation agreements, or ``book-outs,'' with other parties.\217\ In
describing these transactions, the CFTC stated:
---------------------------------------------------------------------------
\216\ See Brent Interpretation, supra note 207. The CFTC issued
the Brent Interpretation in response to a Federal court decision
that held that certain 15-day Brent system crude oil contracts were
illegal off-exchange futures contracts. See Transnor (Bermuda) Ltd.
v. BP N. Am. Petroleum, 738 F. Supp. 1472 (S.D.N.Y. 1990). The Brent
Interpretation provided clarification that the 15-day Brent system
crude oil contracts were forward contracts that were excluded from
the CEA definition of ``future delivery,'' and thus were not futures
contracts. See Brent Interpretation, supra note 207.
\217\ The Brent Interpretation described these ``book-outs'' as
follows: ``In the course of entering into 15-day contracts for
delivery of a cargo during a particular month, situations often
arise in which two counterparties have multiple, offsetting
positions with each other. These situations arise as a result of the
effectuation of multiple, independent commercial transactions. In
such circumstances, rather than requiring the effectuation of
redundant deliveries and the assumption of the credit, delivery and
related risks attendant thereto, the parties may, but are not
obligated to and may elect not to, terminate their contracts and
forego such deliveries and instead negotiate payment-of-differences
pursuant to a separate, individually-negotiated cancellation
agreement referred to as a `book-out.' Similarly, situations
regularly arise when participants find themselves selling and
purchasing oil more than once in the delivery chain for a particular
cargo. The participants comprising these `circles' or `loops' will
frequently attempt to negotiate separate cancellation agreements
among themselves for the same reasons and with the same effect
described above.'' Brent Interpretation, supra note 207, at 39190.
It is noteworthy that while such [book-out] agreements may
extinguish a party's delivery obligation, they are separate,
individually negotiated, new agreements, there is no obligation or
arrangement to enter into such agreements, they are not provided for
by the terms of the contracts as initially entered into, and any
party that is in a position in a distribution chain that provides
for the opportunity to book-out with another party or parties in the
chain is nevertheless entitled to require delivery of the commodity
to be made through it, as required under the contracts.\218\
---------------------------------------------------------------------------
\218\ Id. at 39192.
Thus, in the scenario at issue in the Brent Interpretation, the
contracts created a binding obligation to make or take delivery without
providing any right to offset, cancel, or settle on a payment-of-
differences basis. The ``parties enter[ed] into such contracts with the
recognition that they may be required to make or take delivery.'' \219\
---------------------------------------------------------------------------
\219\ Id. at 39189.
---------------------------------------------------------------------------
On these facts, the Brent Interpretation concluded that the
contracts were forward contracts, not futures contracts:
Under these circumstances, the [CFTC] is of the view that
transactions of this type which are entered into between commercial
participants in connection with their business, which create
specific delivery obligations that impose substantial economic risks
of a commercial nature to these participants, but which may involve,
in
[[Page 48229]]
certain circumstances, string or chain deliveries of the type
described * * * are within the scope of the [forward contract]
exclusion from the [CFTC's] regulatory jurisdiction.\220\
---------------------------------------------------------------------------
\220\ Id. at 39192.
Although the CFTC did not expressly discuss intent to deliver, the
Brent Interpretation concluded that transactions retained their
character as commercial merchandising transactions, notwithstanding the
practice of terminating commercial parties' delivery obligations
through ``book-outs'' as described. At any point in the chain, one of
the parties could refuse to enter into a new contract to book-out the
transaction and, instead, insist upon delivery pursuant to the parties'
obligations under their contract.
The CFTC also is clarifying that commercial market participants
that regularly make or take delivery of the referenced commodity in the
ordinary course of their business meet the commercial participant
standard of the Brent Interpretation.\221\ The CFTC notes that the
Brent Interpretation applies to ``commercial participants in connection
with their business.'' \222\ The CFTC intends that the interpretation
in this release be consistent with the Brent Interpretation, and
accordingly is adding ``commercial'' before ``market participants'' in
this final interpretation. Such entities qualify for the forward
exclusion from both the future delivery and swap definitions for their
forward transactions in nonfinancial commodities under the Brent
Interpretation even if they enter into a subsequent transaction to
``book out'' the contract rather than make or take delivery. 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 referenced commodity in the ordinary course of their
business.
---------------------------------------------------------------------------
\221\ See CME Letter (noting that, although the Brent
Interpretation applies to ``commercial market participants,'' the
proposed guidance in the Proposing Release was described as applying
to ``market participants'' (omitting the word ``commercial'') who
``regularly make or take delivery of the referenced commodities * *
* in the ordinary course of business.'' See also Proposing Release
at 29829.
\222\ Brent Interpretation, supra note 207, at 39192.
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Further, in this final interpretation, the CFTC clarifies, in
response to a comment received, that an investment vehicle taking
delivery of gold as part of its investment strategy would not be
engaging in a commercial activity within the meaning of the Brent
Interpretation.\223\ By contrast, were the investment vehicle, for
example, to own a gold mine and sell the output of the gold mine for
forward delivery, or own a chain of jewelry stores that produces its
own jewelry from raw materials and purchase a supply of gold from
another entity's gold mine in order to provide raw materials for its
jewelry stores, such contracts could qualify as forward contracts under
the Brent Interpretation--provided that such contracts otherwise
satisfy the terms thereof.
---------------------------------------------------------------------------
\223\ See CME Letter. In connection with its comment regarding
``market participants'' described above, see supra note 221, the CME
further requests confirmation that the CFTC intends to apply the
Brent Interpretation to market participants who can demonstrate that
they meet the standard in the guidance as proposed, but are not
themselves commercial actors:
Because the Commission`s interpretation does not explicitly
refer to commercial market participants, it would seem to cover
financial players as long as those entities regularly make or take
delivery of the underlying commodity in connection with their
business. Examples of such entities would be hedge funds or other
investment vehicles that regularly make or take delivery of
commodities (e.g. gold) in conjunction with their line of business--
that is, as part of their investment strategies. [CME] asks that the
[CFTC] confirm that the Brent safe harbor would be available to
these types of market participants that technically are not
``commercial'' actors.
See CME Letter.
---------------------------------------------------------------------------
In sum, the CFTC is interpreting the term ``commercial'' in the
context of the Brent Interpretation in the same way it has done since
1990: ``related to the business of a producer, processor, fabricator,
refiner or merchandiser.'' \224\ While a market participant need not be
solely engaged in ``commercial'' activity to be a ``commercial market
participant'' within the meaning of the Brent Interpretation under this
interpretation, the business activity in which it makes or takes
delivery must be commercial activity for it to be a commercial market
participant. A hedge fund's investment activity is not commercial
activity within the CFTC's longstanding view of the Brent
Interpretation.
---------------------------------------------------------------------------
\224\ Brent Interpretation, supra note 207, at 39191. See also
dissent of Commissioner Fowler West (stating that commercial means
``in the traditional sense of those who produce, process, use or * *
* handle the underlying commodity.''). Note that being a commercial
market participant with respect to an agreement, contract or
transaction in one commodity, or grade of a commodity, neither makes
an entity, nor precludes an entity from being, a commercial market
participant with respect to an agreement, contract or transaction in
a different grade of the commodity or a different commodity. For
example, a West Texas Intermediate oil producer may or may not also
be a commercial with respect to Brent. Similarly, that same West
Texas Intermediate oil producer may or may not have commercial corn
operations. In determining whether an entity is a commercial market
participant with respect to an agreement, contract or transaction in
a commodity, the CFTC will consider the facts and circumstances,
though it is not unlikely that an entity that is a commercial market
participant with respect to one commodity may also be a commercial
market participant with respect to either a different grade of the
commodity or a closely related commodity.
---------------------------------------------------------------------------
In addition, the CFTC is expanding the Brent Interpretation, which
applied only to oil, to all nonfinancial commodities, as proposed.\225\
As a result, book-outs are permissible (where the conditions of the
Brent Interpretation are satisfied) for all nonfinancial commodities
with respect to the exclusions from the definition of the term ``swap''
and the definition of the term ``future delivery'' under the CEA.\226\
---------------------------------------------------------------------------
\225\ See infra part II.B.2(a)(ii), with respect to the CFTC's
interpretation concerning nonfinancial commodities.
\226\ The CFTC reminds market participants that this does not
mean, as was noted in the Brent Interpretation, that these
transactions or persons who engage in them are wholly outside the
reach of the CEA for all purposes. See, e.g., CEA section 8(d), 7
U.S.C. 12(d), which directs the CFTC to investigate the marketing
conditions of commodities and commodity products and byproducts,
including supply and demand for these commodities, cost to the
consumer, and handling and transportation charges; CEA sections
6(c), 6(d), and 9(a)(2), 7 U.S.C. 9, 13b, and 13(a)(2), which
proscribe any manipulation or attempt to manipulate the price of any
commodity in interstate commerce; and CEA section 6(c) as amended by
section 753 of the Dodd-Frank Act, which contains prohibitions
regarding manipulation and false reporting with respect to any
commodity in interstate commerce, including prohibiting any person
to (i) ``use or employ, or attempt to use or employ * * * any
manipulative or deceptive device or contrivance'' (section 6(c)(1));
(ii) ``to make any false or misleading statement of material fact''
to the CFTC or ``omit to state in any such statement any material
fact that is necessary to make any statement of material fact made
not misleading in any material respect'' (section 6(c)(2)); and
(iii) ``manipulate or attempt to manipulate the price of any swap,
or of any commodity in interstate commerce * * * (section 6(c)(3)).
See also Rule 180.1(a) under the CEA, 17 CFR 180.1(a) (broadly
prohibiting in connection with a commodity in interstate commerce
manipulation, false or misleading statements or omissions of
material fact to the Commission, fraud or deceptive practices or
courses of business, and false reporting).
---------------------------------------------------------------------------
(C) Withdrawal of the Energy Exemption
Because the CFTC has expanded the Brent Interpretation to
nonfinancial commodities in this final interpretation, the CFTC also
has determined to withdraw the Energy Exemption as proposed. In
response to comments received, the CFTC is clarifying that certain
alternative delivery procedures discussed in the Energy Exemption \227\
will not disqualify a transaction from the Brent Interpretation safe
harbor.
---------------------------------------------------------------------------
\227\ These include pre-transaction netting agreements that
result in offsetting physical delivery obligations, ``bona fide
termination rights,'' and certain other methods by which parties may
settle their delivery obligations. See Energy Exemption, supra note
208, at 21293.
---------------------------------------------------------------------------
In the Proposing Release, the CFTC proposed to withdraw the Energy
Exemption, which, among other things,
[[Page 48230]]
expanded the Brent Interpretation to energy commodities other than oil,
on the basis that the exemption was no longer necessary in light of the
extension of the Brent Interpretation to nonfinancial commodities.\228\
The Energy Exemption, like the Brent Interpretation, requires binding
delivery obligations at the outset, with no right to cash settle or
offset transactions.\229\ Each requires that book-outs be undertaken
pursuant to a subsequent, separately negotiated agreement.
---------------------------------------------------------------------------
\228\ See Proposing Release at 29829. The CFTC also noted that,
to avoid any uncertainty, the Dodd-Frank Act supersedes the Swap
Policy Statement. Id. at 29829 n. 74. The CFTC reaffirms that such
is the case.
\229\ Compare Energy Exemption, supra note 208, at 21293 with
Brent Interpretation, supra note 207, at 39192.
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As discussed above, the CFTC is extending the Brent Interpretation
to the swap definition and applying it to all nonfinancial commodities
for both the swap and future delivery definitions, but is withdrawing
the Energy Exemption. With regard to netting agreements that were
expressly permitted by the Energy Exemption,\230\ the CFTC clarifies
that a physical netting agreement (such as, for example, the Edison
Electric Institute Master Power Purchase and Sale Agreement) that
contains a provision contemplating the reduction to a net delivery
amount of future, unintentionally offsetting delivery obligations, is
consistent with the intent of the book out provision in the Brent
Interpretation--provided that the parties had a bona fide intent, when
entering into the transactions, to make or take delivery (as
applicable) of the commodity covered by those transactions.
---------------------------------------------------------------------------
\230\ See Energy Exemption, supra note 208, at 21293.
---------------------------------------------------------------------------
The CFTC also has determined that, notwithstanding the withdrawal
of the Energy Exemption, a failure to deliver as a result of the
exercise by a party of a ``bona fide termination right'' does not
render an otherwise binding delivery obligation as non-binding.\231\ In
the Energy Exemption, the CFTC provided the following examples of bona
fide termination rights: force majeure provisions and termination
rights triggered by events of default, such as counterparty insolvency,
default or other inability to perform.\232\ The CFTC confirms that
market participants who otherwise qualify for the forward exclusion may
continue to rely on the bona fide termination right concept as set
forth in this interpretation, although, as was stated in the Energy
Exemption, such right must be bona fide and not for the purpose of
evasion. In this regard, the CFTC further clarifies, consistent with
the Energy Exemption, that a bona fide termination right must be
triggered by something not expected by the parties at the time the
contract is entered into.\233\
---------------------------------------------------------------------------
\231\ See also infra part II.B.2(b)(v) for a discussion of
liquidated damages.
\232\ Energy Exemption, supra note 208, at 21293.
\233\ Id.
---------------------------------------------------------------------------
The Energy Exemption also discussed a number of methods by which
parties to energy contracts settle their obligations, including: 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; and physically exchanging (i.e., delivering) one
quality, grade or type of physical commodity for another quality, grade
or type of physical commodity.\234\ The CFTC clarifies that these
settlement methods generally \235\ are not inconsistent with the Brent
Interpretation.\236\
---------------------------------------------------------------------------
\234\ Id.
\235\ The CFTC will carefully scrutinize whether market
participants are legitimately relying on the Brent Interpretation
safe harbor. For example, if non-commercial market participants are
intermediate purchasers in a delivery chain, then the transaction is
not actually a commercial merchandising transaction, and the parties
cannot rely on the Brent Interpretation safe harbor.
\236\ By definition, if two parties exchange (i.e., physically
deliver) one physical commodity for another physical commodity in
settlement of the parties' delivery obligations, each seller has
delivered the commodity that is the subject of its delivery
obligation under the relevant agreement, contract or transaction.
Depending on the settlement timing, such transactions, which
resemble barter transactions, would be spot transactions or forward
transactions. While the most common forward transaction involves an
exchange of a physical commodity for cash, neither the Brent
Interpretation nor any other CFTC authority requires payment for a
forward delivery to be made in cash. Thus, a physical exchange of
one quality, grade or type of physical commodity for another
quality, grade, or type of physical commodity does not affect the
characterization of the transaction as a spot or forward
transaction. As for the sellers passing title and buyers, instead of
taking delivery of the commodity, passing title to another
intermediate purchaser in a chain, this is consistent with the
description of Brent transactions in the Brent Interpretation,
provided that, as set forth therein, delivery is required and ``the
delivery obligations create substantial economic risk of a
commercial nature to the parties required to make or take delivery *
* * includ[ing, without limitation,] demurrage, damage, theft or
deterioration.'' That description was based on the industry delivery
structure as it existed prior to the Brent Interpretation. To the
extent other industries are similarly structured for commercial
reasons, the delivery-by-title-and-related-bill-of-lading-transfer
delivery method would be able to rely on the Brent Interpretation if
it otherwise satisfied the terms thereof. However, to the extent
persons seek to establish such a delivery structure for new products
and markets (e.g., not actually delivering the commodity to most of
the participants in a chain), that could, depending on the
applicable facts and circumstances, be viewed as outside the Brent
Interpretation safe harbor or evasion. The CFTC expects that the
limitation of counterparties eligible to rely on the Brent
Interpretation to those with a commercial purpose for entering into
the transaction should limit the development of such markets to
those with commercial reasons for such a delivery structure.
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(D) Book-Out Documentation
The CFTC has taken into consideration comments regarding the
documentation of book-outs.\237\ Under the Brent Interpretation, what
is relevant is that the book out occur through a subsequent, separately
negotiated agreement. While the CFTC is sensitive to existing
recordkeeping practices for book-outs, in order to prevent abuse of the
safe harbor, the CFTC clarifies that in the event of an oral agreement,
such agreement must be followed in a commercially reasonable timeframe
by a confirmation in some type of written or electronic form.
---------------------------------------------------------------------------
\237\ See Letter from R. Michael Sweeney, Jr., Hunton & Williams
LLP, on behalf of the Working Group of Commercial Energy Firms
(``WGCEF''), dated July 22, 2011 (``WGCEF Letter'').
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(E) Minimum Contract Size and Other Contextual Factors
In the Proposing Release, the CFTC requested comment about
potentially imposing additional conditions (such as, for example, a
minimum contract size) in order for a transaction to qualify as a
forward contract under the Brent Interpretation with respect to the
future delivery and swap definitions.\238\ The CFTC has determined that
a minimum contract size should not be required in order for a contract
to qualify as a forward contract under the Brent Interpretation.\239\
However, as suggested
[[Page 48231]]
by a commenter, the CFTC may consider contract size as a contextual
factor in determining whether a particular contract is a forward.\240\
Moreover, the CFTC may consider other contextual factors when
determining whether a contract qualifies as a forward, such as a
demonstrable commercial need for the product, the underlying purpose of
the contract (e.g. whether the purpose of the claimed forward was 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, or whether the absence of physical settlement is based on
a change in commercial circumstances. These contextual factors are
consistent with the CFTC's historical facts-and-circumstances approach
to the forward contract exclusion outside of the Brent Interpretation
safe harbor.
---------------------------------------------------------------------------
\238\ See Proposing Release at 29831, Request for Comment 27.
\239\ Most commenters opposed adding a minimum contract size or
other conditions to the CFTC's interpretation of the forward
exclusion. One commenter argued that such an approach would be
inconsistent with CFTC precedent, citing the fact that neither the
Brent Interpretation nor subsequent CFTC precedent interpreting the
forward exclusion mention contract size. See CME Letter. Another
commenter pointed out that Congress did not impose such a
requirement, and thus believes that the CFTC should not do so. See
Letter from David M. Perlman, Partner, Bracewell & Giuliani LLP,
Counsel to the Coalition of Physical Energy Companies (``COPE''),
dated July 22, 2011 (``COPE Letter''). Similarly, a third commenter
argued that the only condition Congress placed on the forward
exclusion is intent to physically settle, and contract size is not
relevant to such intent. See Letter from Natural Gas Supply
Association/National Corn Growers Association (``NGSA/NCGA''), dated
July 22, 2011 (``NGSA/NCGA Letter'').
Two commenters questioned the reasonableness in instituting a
minimum contract size below which a transaction would become
regulated, but otherwise would not. See Letter from Craig G.
Goodman, Esq., President, The National Energy Marketers Association
(``NEMA''), dated July 21, 2011, (``NEMA Letter'') and Letter from
Phillip G. Lookadoo on behalf of the International Energy Credit
Association (``IECA''), dated July 28, 2011 (``IECA Letter''). Two
commenters believed that such an approach would be contrary to the
purposes of Dodd-Frank in regulating transactions that would affect
systemic risk. See NEMA Letter and Letter from Dan Gilligan and
Michael Trunzo, Petroleum Marketers Association of America and New
England Fuel Institute (``PMAA/NEFI''), dated July 22, 2011 (``PMAA/
NEFI Letter''). One commenter urged that the Brent Interpretation be
applied with minimal restrictive overlay. It believed that contract
size is a ``contextual factor'' that may be considered in evaluating
the existence of intent to deliver, but should not be viewed as an
independent determinant. See ISDA Letter.
One commenter argued that the forward exclusion should be
strengthened with additional conditions to preclude evasion. Its
suggested conditions include defining the required regularity of
delivery (such as a predominance, or ``more often than not''
standard); providing a quantitative test of bona fide intent to
deliver (such as a demonstrable commercial need for the product and
justifying non-physical settlement based on a change in commercial
circumstances); and re-evaluating the book-outs aspect of the Brent
Interpretation. See Better Markets Letter.
\240\ See ISDA Letter.
---------------------------------------------------------------------------
Comments
Several commenters believed that the CFTC should codify its
proposed interpretation regarding the Brent Interpretation in rule text
to provide greater legal certainty.\241\ One commenter further
commented that the Dodd-Frank Act's legislative history expressly
directed the CFTC to clarify through rulemaking that the nonfinancial
commodity forward contract exclusion from the swap definition is
intended to be consistent with the forward contract exclusion from the
term ``future delivery.''\242\ The commenter also stated its view that
the interpretation as proposed does not provide notice to the
electricity industry as to how to determine whether a nonfinancial
commodity agreement is a swap or a nonfinancial commodity forward
contract, nor as to which factors the CFTC would consider in
distinguishing between swaps and nonfinancial forward contracts.\243\
Moreover, another commenter suggested that the CFTC should include in
regulatory text a representative, non-exhaustive list of the kinds of
contracts that are excluded from the swap definition.\244\
---------------------------------------------------------------------------
\241\ See Letter from Lisa Yoho, Director, Regulatory Affairs,
BGA, dated July 22, 2011) (``BGA Letter''); COPE Letter; Letter from
Michael Bardee, General Counsel, Federal Energy Regulatory
Commission (``FERC''), dated July 22, 2011 (``FERC Staff Letter'');
Letter from Stephanie Bird, Chief Financial Officer, Just Energy,
dated July 22, 2011 (``Just Energy Letter''); Letter from the
Electric Trade Associations (the Electric Power Supply Association,
National Rural Electric Cooperative Association, Large Public Power
Council, Edison Electric Institute and American Power Association)
(``ETA Letter''), dated July 22, 2011.
\242\ See ETA Letter (citing the ``Lincoln-Dodd Letter'' printed
at 156 Cong. Rec. H5248-249).
\243\ See ETA Letter. The commenter requests that the CFTC
``further define the statutory term `swap' by defining relevant
terms in the Dodd-Frank Act, reconciling the wording used in the
various provisions in the CEA as amended by the Dodd-Frank Act, and
setting forth in the [CFTC's] rules the factors that are
determinative in drawing the distinction between a `swap' and a
`nonfinancial commodity forward contract.''' The commenter suggests
rule text to codify the CFTC's interpretation regarding the
exclusion of nonfinancial commodity forward contracts. Id.
\244\ See FERC Staff Letter.
---------------------------------------------------------------------------
The CFTC has determined not to codify its interpretation in rule
text. The CFTC has never codified its prior interpretations of the
forward contract exclusion with respect to the future delivery
definition as a rule or regulation;\245\ thus, providing an
interpretation is consistent with the manner in which the CFTC has
interpreted the forward exclusion in the past, which in turn is
consistent with the Dodd-Frank Act legislative history.\246\ Moreover,
Congress did not direct the CFTC to write rules regarding the forward
exclusion. The Dodd-Lincoln letter, cited by a commenter in support of
its argument, ``encourages'' the CFTC to clarify the forward exclusion
``through rulemaking'' in the generic sense of that term (i.e., through
the rulemaking process of notice and comment), not specifically through
rule text.\247\ Similarly, the CFTC is not providing in rule text a
representative list of contracts in nonfinancial commodities that are
excluded from the swap definition as forwards.
---------------------------------------------------------------------------
\245\ See, e.g. Brent Interpretation, supra note 207; Energy
Exemption, supra note 208; Characteristics Distinguishing Cash and
Forward Contracts and ``Trade'' Options, 50 FR 39656 (Sep. 30, 1985)
(``1985 CFTC OGC Interpretation'').
\246\ See supra note 210 and accompanying text.
\247\ See 156 Cong. Rec. H5248-49 (June 30, 2010).
---------------------------------------------------------------------------
The CFTC believes that its interpretation provides sufficient
clarity with respect to the forward contract exclusion from the swap
and future delivery definitions.\248\ The CFTC also believes that the
interpretation provides sufficient notice to the public regarding how
the forward exclusions from the swap and future delivery definitions
will be interpreted. As noted above, the CFTC's historical approach to
the forward contract exclusion from the future delivery definition
developed on a case-by-case basis, not by rule.
---------------------------------------------------------------------------
\248\ This is particularly true given that the CFTC intends to
interpret the forward exclusion from the swap definition
consistently with its interpretation of the forward exclusion from
the term ``future delivery,'' with which market participants have
had decades of experience.
---------------------------------------------------------------------------
Commenters generally supported applying the Brent Interpretation to
the forward exclusion from the swap definition and expanding it to all
nonfinancial commodities for purposes of the forward exclusion from
both the definitions of the terms ``future delivery'' and ``swap.''
\249\ However, in addition to the requests for clarification to which
the CFTC has responded in its final interpretation provided above,
commenters raise other requests for clarification. One commenter,\250\
for example, believed that the CFTC's adjudicatory decisions in Grain
Land \251\ and Wright \252\ should be construed to have expanded the
Brent Interpretation's safe harbor. This commenter stated its view that
in Grain Land, the CFTC recognized that cancellation provisions or an
option to roll the delivery date within flexible hedge-to-arrive
contracts did not render the transactions futures contracts, as opposed
to forwards. As such, this commenter believed this case may be at odds
with the literal terms of the Brent Interpretation regarding book-outs,
which required that, to be a forward contract, any cancellation of
delivery must be effected through a subsequent, separately negotiated
agreement. The commenter argued that cases subsequent to the Brent
Interpretation, such as Grain Land and Wright, recognized the need for
flexibility and innovation in the commercial merchandising transactions
that are eligible for the forward exclusion. Therefore, this commenter
requested that the CFTC consider the body of
[[Page 48232]]
forward contract precedent as a whole and extend the Brent
Interpretation's safe harbor to situations like those presented in
Grain Land, notwithstanding the absence of a subsequent, separately-
negotiated agreement.\253\
---------------------------------------------------------------------------
\249\ See BGA Letter; COPE Letter; ISDA Letter; IECA Letter;
Letter from Stuart J. Kaswell, Executive Vice President & Managing
Director, Managed Funds Association (``MFA''), dated July 22, 2011
(``MFA Letter''); NGSA/NCGA Letter; Letter from Charles F. Conner,
President and CEO, National Council of Farmer Cooperatives
(``NCFC''), dated July 22, 2011 (``NCFC Letter''); NEMA Letter;
PMAA/NEFI Letter; WGCEF Letter.
\250\ See CME Letter.
\251\ Grain Land, supra note 213.
\252\ Wright, supra note 214.
\253\ See CME Letter.
---------------------------------------------------------------------------
While, as noted above, the CFTC has clarified that the entire body
of its precedent applies to its interpretation of the forward exclusion
for nonfinancial commodities in the swap definition, the CFTC does not
believe that there is a conflict between the Brent Interpretation and
the Grain Land or Wright cases. In Grain Land, the CFTC concluded that
the fact that a contract includes a termination right, standing alone,
is not determinative of whether the contract is a forward. Rather, as
the CFTC has always interpreted the forward exclusion, it looks to the
facts and circumstances of the transaction. Similarly in Wright, which
cited Grain Land with approval, the CFTC stated that ``[i]n assessing
the parties' expectations or intent regarding delivery, the Commission
applies a `facts and circumstances' test rather than a bright-line test
focused on the contract's terms * * * .'' In contrast, the Brent
Interpretation is a safe harbor that assures commercial parties that
book-out their contracts through a subsequent, separately negotiated
agreement that their contracts will not fall out of the forward
exclusion. The CFTC's conclusion that application of its facts-and-
circumstances approach demonstrated that the particular contracts at
issue in Grain Land and Wright were forwards did not expand the scope
of the safe harbor afforded by the Brent Interpretation.\254\
---------------------------------------------------------------------------
\254\ As described above in the interpretation, the CFTC has
addressed CME's other comments on the forward exclusion, including
the interpretation's applicability to commercial market participants
and CME's hedge fund example.
---------------------------------------------------------------------------
Several commenters suggested that the Energy Exemption should not
be withdrawn. One commenter noted that the Energy Exemption, along with
the Brent Interpretation, should inform the CFTC's interpretation of
the forward exclusion.\255\ Another commenter believed that the Energy
Exemption appears entirely consistent with the Dodd-Frank Act and
should be included in the rules as a non-exclusive exemption to ensure
continued clarity.\256\ A third commenter requested clarification that
revoking the Energy Exemption will not harm market participants,
stating that the Proposing Release did not sufficiently explain the
rationale for withdrawing the Energy Exemption or the possible
consequences for energy market participants. This commenter sought
confirmation that, despite the withdrawal of the Energy Exemption,
market participants will be permitted to rely on the Brent
Interpretation, as expanded by the Energy Exemption, particularly as it
relates to alternative delivery procedures.\257\ This commenter
expressed concern that by withdrawing the Energy Exemption, the CFTC
would be revoking the ability of market participants to rely on pre-
transaction netting agreements to offset physical delivery obligations
as an alternative to separately negotiating book-outs after entering
into the transactions.\258\ As discussed above, the CFTC has determined
to withdraw the Energy Exemption as proposed, but has provided certain
clarifications to address commenters' concerns.
---------------------------------------------------------------------------
\255\ See COPE Letter Appendix.
\256\ See IECA Letter.
\257\ See MFA Letter.
\258\ Ex Parte Communication between MFA and CFTC Staff on
September 15, 2011, at http://comments.cftc.gov/PublicComments/ViewExParte.aspx?id=387&SearchText= .
---------------------------------------------------------------------------
One commenter suggested the deletion of ``commercial merchandising
transaction'' as a descriptive term in the interpretation. Although
recognizing its provenance from the Brent Interpretation, this
commenter believed that the phrase was anachronistic at that time, and
that it is misleading and narrow in the current evolving commercial
environment.\259\ Contrary to this commenter's suggestion, the CFTC has
determined to retain the phrase ``commercial merchandising
transaction'' in its final interpretation regarding forward contracts.
The CFTC characterized forward transactions in this manner in the Brent
Interpretation, as well as in its subsequent adjudications. Courts also
have characterized forwards as commercial merchandising transactions or
cited the CFTC's characterization with approval.\260\ Accordingly, the
CFTC believes that ``commercial merchandising transaction'' continues
to be an accurate descriptive term for characterizing forward
transactions.
---------------------------------------------------------------------------
\259\ See ISDA Letter.
\260\ See, e.g., In re Bybee, 945 F.2d 309, 315 (9th Cir. 1991).
---------------------------------------------------------------------------
Another commenter requested that the CFTC clarify that a
subsequent, separately-negotiated agreement to effectuate a book-out
under the Brent Interpretation may be oral or written. This commenter
noted that the pace at which certain energy markets transact and the
frequency with which book-outs may sometimes occur, makes formal
written documentation of all book-outs impracticable.\261\ The CFTC has
provided an interpretation above regarding the documentation of book-
outs in response to this commenter's concerns.
(ii) Nonfinancial Commodities
---------------------------------------------------------------------------
\261\ See WGCEF Letter.
---------------------------------------------------------------------------
In response to commenters,\262\ the CFTC is providing an
interpretation regarding the scope of the term ``nonfinancial
commodity'' in the forward exclusion from the swap definition.\263\
---------------------------------------------------------------------------
\262\ The Commissions requested comment in the Proposing Release
on whether they should provide guidance regarding the scope of the
term ``nonfinancial commodity'' and, if so, how and where the line
should be drawn between financial and nonfinancial commodities. See
Proposing Release at 29832.
\263\ As noted above, the CEA definition of the term ``swap''
excludes ``any sale of a nonfinancial commodity or security for
deferred shipment or delivery, so long as the transaction is
intended to be physically settled.'' CEA section 1a(47)(B)(ii), 7
U.S.C. 1a(47)(B)(ii). Thus, the forward exclusion from the swap
definition is limited to transactions in nonfinancial commodities.
To the extent the CFTC uses the term ``nonfinancial commodity'' in
other contexts in this release, such as in connection with the Brent
Interpretation (including as it applies with respect to the ``future
delivery'' definition), the term will have the same meaning as
discussed in this section in those contexts.
---------------------------------------------------------------------------
The CFTC interprets the term ``nonfinancial commodity'' to mean a
commodity that can be physically delivered and that is an exempt
commodity \264\ or an agricultural commodity.\265\ Unlike excluded
commodities, which generally are financial,\266\ exempt and
agricultural commodities by their nature generally are nonfinancial.
The requirement that the commodity be able to be physically delivered
is designed to prevent market participants from relying on the forward
exclusion to enter into swaps based on indexes of exempt or
agricultural commodities outside of the Dodd-Frank Act and settling
them in cash, which would be inconsistent with the historical
limitation of the forward exclusion to commercial merchandising
transactions. However, to the extent that a transaction is intended to
be physically settled, otherwise meets the terms of the forward
contract exclusion and uses an index merely to determine the price to
be paid for the nonfinancial commodity intended to be delivered,
[[Page 48233]]
the transaction may qualify for the forward exclusion from the swap
definition.
---------------------------------------------------------------------------
\264\ The CEA defines an ``exempt commodity'' as ``a commodity
that is not an excluded commodity or an agricultural commodity.''
CEA section 1a(20), 7 U.S.C. 1a(20). A security is an excluded
commodity as discussed below, and therefore is not an exempt
commodity.
\265\ The CFTC has defined the term ``agricultural commodity''
in its regulations at Rule 1.3(zz) under the CEA, 17 CFR 1.3(zz).
See Agricultural Commodity Definition, 76 FR 41048 (Jul. 13, 2011).
\266\ The CEA defines an ``excluded commodity'' at CEA section
1a(19), 7 U.S.C. 1a(19).
---------------------------------------------------------------------------
In addition, the CFTC is providing an interpretation that an
intangible commodity (that is not an excluded commodity) which can be
physically delivered qualifies as a nonfinancial commodity if ownership
of the commodity can be conveyed in some manner and the commodity can
be consumed. One example of an intangible nonfinancial commodity that
qualifies under this interpretation, as discussed in greater detail
below, is an environmental commodity, such as an emission allowance,
that can be physically delivered and consumed (e.g., by emitting the
amount of pollutant specified in the allowance).\267\ The
interpretation provided herein recognizes that transactions in
intangible commodities can, in appropriate circumstances, qualify as
forwards, while setting forth certain conditions to assure that the
forward exclusion may not be abused with respect to intangible
commodities.
---------------------------------------------------------------------------
\267\ See supra part II.B.2.a)iii), regarding environmental
commodities. An emission allowance buyer also can consume the
allowance by retiring it without emitting the permitted amount of
pollutant.
---------------------------------------------------------------------------
Comments
Several commenters believed that the CFTC should provide an
interpretation regarding the meaning of the term ``nonfinancial
commodity'' to provide clarity to market participants on the
applicability of the forward exclusion.\268\ The CFTC is providing the
interpretation discussed above to address these commenters' concerns
but, contrary to one commenter's request, declines to adopt a
regulation.\269\
(iii) Environmental Commodities
---------------------------------------------------------------------------
\268\ See Letter from Steven J. Mickelsen, Counsel, 3Degrees
Group, Inc., dated July 22, 2011 (``3Degrees Letter''); ETA Letter;
and Letter from Kari S. Larsen, General Counsel, Chief Regulatory
Officer, Green Exchange LLC, dated July 22, 2011 (``GreenX
Letter''). Each of these commenters proposed its own definition of
``nonfinancial commodity.'' The interpretation above incorporates
many of their suggestions.
\269\ See ETA Letter. This is consistent with CFTC practice in
providing an interpretation rather than regulations where warranted.
In this context, the CFTC is providing an interpretation rather than
rule text because the CFTC is not limiting the definition of
``nonfinancial commodity'' to exempt and agricultural commodities
(the latter category includes agricultural commodity indexes (see 17
CFR 1.3(zz)(4))). The definition also requires physical
deliverability and, with respect to intangible commodities,
ownership transferability and consumability. Whether a commodity has
these features may require interpretation. In any case, courts can
rely on agency interpretations.
---------------------------------------------------------------------------
The Commissions requested comment on whether environmental
commodities should fall within the forward exclusion from the swap
definition and, if so, subject to what parameters.\270\ In response to
commenters, the CFTC is providing an interpretation regarding the
circumstances under which agreements, contracts or transactions in
environmental commodities will satisfy the forward exclusion from the
swap definition.\271\ The CFTC did not propose a definition of the term
``environmental commodity'' in the Proposing Release and is not doing
so in this release.\272\ The CFTC believes it is not necessary to
define the term ``environmental commodity'' because any intangible
commodity--environmental or otherwise--that satisfies the terms of the
interpretation provided herein is a nonfinancial commodity, and thus an
agreement, contract or transaction in such a commodity is eligible for
the forward exclusion from the swap definition.\273\ The forward
exclusion from the swap definition does not apply to commodities
themselves, but to certain types of agreements, contracts or
transactions in a specified type of commodity (i.e., a ``nonfinancial''
commodity).\274\ Environmental commodities that meet the interpretation
regarding nonfinancial commodities discussed in subsection (ii) above
are nonfinancial commodities and, therefore, a sale for deferred
shipment or delivery in such a commodity, so long as the transaction is
intended to be physically settled, may qualify for the forward
exclusion from the swap definition.
---------------------------------------------------------------------------
\270\ See Proposing Release at 29832, Request for Comment 32,
asked: Should the forward contract exclusion from the swap
definition apply to environmental commodities such as emissions
allowances, carbon offsets/credits, or renewable energy
certificates? If so, please describe these commodities, and explain
how transactions can be physically settled where the commodity lacks
a physical existence (or lacks a physical existence other than on
paper)? Would application of the forward contract exclusion to such
environmental commodities permit transactions that should be subject
to the swap regulatory regime to fall outside the Dodd-Frank Act?
\271\ Because the CFTC has determined, as discussed elsewhere in
this release, to interpret the forward exclusion from the swap
definition consistently with the forward exclusion from the ``future
delivery'' definition, the discussion in this section applies
equally to the forward exclusion from future delivery.
\272\ See also Letter from Gene Grace, Senior Counsel, American
Wind Energy Association (``AWEA''), dated July 22, 2011 (``AWEA
Letter'') (providing a general description of renewable energy
credits (``RECs''), emission allowances, and offsets, which the
commenter collectively termed ``environmental commodities'' for
purposes of its letter).
\273\ Thus, market participants should apply the interpretation
to their facts to determine whether their specific circumstances
support reliance on the forward exclusion from the swap definition.
\274\ Several commenters appear to have confused these concepts.
The term ``commodity'' is defined in CEA section 1a(9), 7 U.S.C.
1a(9). The forward exclusion in CEA section 1a(47)(B)(ii), 7 U.S.C.
1a(47)(B)(ii), excludes from the swap definition ``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 intangible nature of environmental, or other, commodities does
not disqualify contracts based on such commodities from the forward
exclusion from the swap definition, notwithstanding that the core of
the forward exclusion is intent to deliver the underlying
commodity.\275\ As commenters noted, securities are intangible (with
the exception of the rare certificated security) and yet they are
expressly permitted by CEA section 1a(47)(B)(ii) \276\ to be the
subject of the forward exclusion; this reflects recognition by Congress
that the forward exclusion can apply to intangible commodities.\277\
---------------------------------------------------------------------------
\275\ See supra part II.B.2.a)i)(A).
\276\ 7 U.S.C. 1a(47)(B)(ii).
\277\ As commenters also note, each Commission or its staff has
previously indicated that environmental commodities, in the CFTC's
case, and securities, in the SEC's case, can be physically settled.
See Letter from Kyle Danish, Van Ness Feldman, P.C., on behalf of
Coalition for Emission Reduction Policy (``CERP''), dated July 18,
2011 (``CERP Letter'') and 3Degrees Letter. Also, the recent Carbon
Report suggested that the forward exclusion could apply to
agreements, contracts or transactions in environmental commodities.
See Interagency Working Group for the Study on Oversight of Carbon
Markets (``Interagency Working Group''), Report on the Oversight of
Existing and Prospective Carbon Markets (January 2011) (``Carbon
Report''). The Carbon Report specifically stated that--[n]o set of
laws currently exist that apply a comprehensive regulatory regime--
such as that which exists for derivatives--specifically to secondary
market trading of carbon allowances and offsets. Thus, for the most
part, absent specific action by Congress, a secondary market for
carbon allowances and offsets may operate outside the routine
oversight of any market regulator.
---------------------------------------------------------------------------
The CFTC understands that market participants often engage in
environmental commodity transactions in order to transfer ownership
\278\ of the environmental commodity (and not solely price risk),\279\
so that the buyer
[[Page 48234]]
can consume the commodity in order to comply with the terms of
mandatory or voluntary environmental programs.\280\ Those two
features--ownership transfer and consumption--distinguish such
environmental commodity transactions from other types of intangible
commodity transactions that cannot be delivered, such as temperatures
and interest rates. The ownership transfer and consumption features
render such environmental commodity transactions similar to tangible
commodity transactions that clearly can be delivered, such as wheat and
gold.\281\
---------------------------------------------------------------------------
\278\ One commenter maintains that a transaction in an
environmental allowance represents a physically-settled transaction
because its primary purpose is to transfer ownership of the right to
emit a specified unit of pollution. See Letter from Andrew K. Soto,
American Gas Association (``AGA''), dated July 22, 2011 (``AGA
Letter''). Compare to Proposing Release at 29828 (stating that
``[t]he primary purpose of the contract is to transfer ownership of
the commodity'').
\279\ Another commenter states that, from a practical
standpoint, the buyer must take delivery to satisfy a compliance
obligation, which typically requires surrender of allowances and
offset credits, and likens such transactions to forward sales of
more tangible commodities, noting they are not devices for
transferring price risk. See CERP Letter. Compare to Proposing
Release at 29828 (stating that ``[t]he primary purpose of the
contract is * * * not to transfer solely * * * price risk''). This
commenter also advises that delivery of RECs and offsets is
typically deferred for commercial convenience, consistent with the
Brent Interpretation, because ``not all of the purchased RECs and
offsets are generated at the time of the transaction'' and ``long-
term contracts with deferred delivery are important for renewable
energy projects to ensure a consistent revenue stream over a long
period of time.'' See CERP Letter.
\280\ Consumption also can be part of a commercial merchandising
transaction in the chain of commerce. See, e.g., Brent
Interpretation, supra note 207 (dissent of Commissioner Fowler West)
(citing the 1985 CFTC OGC Interpretation and cases cited therein for
the proposition that ``parties to forward contracts * * * seek to
profit in their businesses from producing, processing, distributing,
storing, or consuming the commodity'').
\281\ Similarly, the settlement method for the types of
environmental commodity transactions described by commenters such as
RECs, emission allowances, and offsets are equivalent to that of
physical commodities where ownership is transferred by delivering a
warehouse receipt from the seller to the buyer, thereby indicating
the presence in the warehouse of the contracted for commodity
volume. See GreenXLetter. See also REMA letter (averring that ``[i]n
effect, the REC is an intangible contract right or interest in that
specific quantity of energy; thus, it is quite analogous to a
warehouse receipt that represents title to a physical commodity'').
Another similarity between these environmental commodity
transactions and tangible commodities is that it is possible to
manipulate the deliverable supply of an environmental commodity just
as it is for a tangible commodity. The CFTC reminds market
participants of its continuing authority over forwards under the
CEA's anti-manipulation provisions prohibiting manipulation, making
false and misleading statements and omissions of material fact to
the CFTC, fraud and deceptive practices, and false reporting. See
supra note 226.
---------------------------------------------------------------------------
For such transactions, in addition to the factors discussed above,
intent to deliver is readily determinable,\282\ delivery failures
generally result from frustration of the parties' intentions,\283\ and
cash-settlement is insufficient because delivery of the commodity is
necessary for compliance purposes.\284\ For the foregoing reasons,
environmental commodities can be nonfinancial commodities that can be
delivered through electronic settlement or contractual attestation.
Therefore, an agreement, contract or transaction in an environmental
commodity may qualify for the forward exclusion from the swap
definition if the transaction is intended to be physically settled.
---------------------------------------------------------------------------
\282\ See Letter from Jennifer Martin, Executive Director,
Center for Research Solutions (``CRS''), dated July 22, 2011 (``CRS
Letter'').
\283\ See 3Degrees Letter.
\284\ See GreenX Letter.
---------------------------------------------------------------------------
Comments
Several commenters responded to the Commission's request for
comment regarding the applicability of the forward exclusion from the
swap definition for agreements, contracts and transactions in
environmental commodities.\285\
---------------------------------------------------------------------------
\285\ One commenter provided a general description of renewable
energy credits (``RECs''), emission allowances, offsets, (which the
commenter collectively termed ``environmental commodities'' for
purposes of its letter), and related transactions. See AWEA Letter.
According to the commenter, RECs are created by state regulatory
bodies in conjunction with the production of electricity from a
qualifying renewable energy facility. The forward sale of a REC
transfers ownership of the REC from the producing entity to another
entity that can use the REC for compliance with an obligation to
sell a certain percentage of renewable energy. Many times, this
forward sale takes place prior to the construction of a project to
enable developers to secure related project financing. See AWEA
Letter. See also Letter from Mary Anne Mason, HoganLovells LLP on
behalf of Southern California Edison Company, Pacific Gas and
Electric Company and San Diego Gas and Electric Company
(``California Utilities''), dated July 22, 2011 (``California
Utilities Letter'') (stating that the California Utilities transact
in allowances, under the EPA's and anticipated California cap-and-
trade programs, as well as in RECs, in order to comply with or
participate in various regulatory and voluntary programs).
The CFTC understands that, in the United States, emission
allowances and offsets are issued by the U.S. Environmental
Protection Agency (``EPA''), state government entities and private
entities. Emission allowances and offsets are transferred between
counterparties, often through forward contracts, with the purchasing
party obtaining the ability to use the allowances or offsets for
compliance with clean air or greenhouse gas regulations. The forward
sale of allowances and offsets allows market participants to hedge
the compliance obligations associated with expected emissions, or to
meet a voluntary emissions reduction commitment or make an
environmental claim. See, e.g., AWEA Letter; Letter from Henry
Derwent, President and CEO, International Emissions Trading
Association, dated July 22, 2011 (defining a carbon offset as a
``credit[] granted by a state or regional governmental body or an
independent standards organization in an amount equal to the
generation of electricity from a qualifying renewable energy
facility.'').
---------------------------------------------------------------------------
Most commenters responding to the Commissions' request for comment
concerning the appropriate treatment of agreements, contracts or
transactions in environmental commodities asserted that emission
allowances, carbon offsets/credits, or RECs should be able to qualify
for the forward exclusion from the swap definition. In support of this
view, several commenters explained that the settlement process for
environmental commodity transactions generally involves ``the transfer
of title via a tracking system, registry or contractual attestation, in
exchange for a cash payment.'' \286\ One commenter stated that this
form of settlement demonstrates that the lack of physical existence of
a commodity is not relevant to whether a transaction in the commodity
physically settles for purposes of the forward exclusion.\287\ Another
commenter contended that title transfer constitutes physical delivery
because the settlement results in the environmental commodity being
consumed to meet an environmental obligation or goal, which occurs
through ``retirement'' of the environmental commodity.\288\ Other
commenters compared the settlement of a transaction in an environmental
commodity through an electronic registry system to a warehouse receipt
that represents title to a physical commodity.\289\
---------------------------------------------------------------------------
\286\ See 3Degrees Letter. See also WGCEF Letter (advising that
``physical delivery takes place the moment that title and ownership
in the environmental commodity itself is transferred from the seller
to the buyer[,] whether through the execution of a legally binding
contract or attestation, or submission of records to a centralized
data base, such as a registry''); Letter from the Hons. Jeffrey A.
Merkley, Sherrod Brown and Jeanne Shaheen, U.S. Senators, dated
January 13, 2012 (``Senators Letter'') (relaying that ``[t]he
purchase or sale of a REC is settled through the transfer of title
to the REC, either electronically over a tracking system or via a
paper attestation''); Letter from Harold Buchanan, Chief Executive
Officer, CE2 Carbon Capital, LLC (``CE2''), dated July 22, 2011
(``CE2 Letter''); Letter from Jason M. Rosenstock, ML Strategies LLC
on behalf of The Business Council for Sustainable Energy (``BCSE''),
dated January 24, 2012 (``BCSE Letter''); NEMA Letter (stating that
RECs must be physically settled through a REC registry, which
``ensures that there is a physical megawatt hour from a green
generator behind the REC'').
\287\ See 3Degrees Letter. See also GreenX Letter (stating that
environmental commodities share the same characteristics as tangible
physical commodities ``in all key respects,'' including that they
are in limited supply).
\288\ See CRS Letter. CRS explains that retirement occurs
through a registry or electronic tracking system by transfer into a
retirement account (or, alternatively, an exchange of paperwork) and
that, once retired, an environmental commodity cannot be resold. The
CRS also argues that such environmental commodity transactions are
commercial merchandising transactions, and thus may be forward
contracts, because the primary purpose of the transactions is to
transfer ownership so that the purchaser may comply with an
applicable environmental program. See also 3Degrees Letter and AWEA
Letter.
\289\ See Letter from Josh Lieberman, General Manager, Renewable
Energy Markets Association (``REMA''), dated July 22, 2011 (``REMA
Letter'') (distinguishing RECs, which allow the buyer to own
environmental attributes, from a pure financial swap, where only
price risk is transferred); See also GreenX Letter (likening the
settlement of an environmental commodity transaction (where delivery
typically would take place by electronic delivery from the registry
account of the seller to the registry account of the buyer) to that
of transactions in many tangible physical commodities, such as
agricultural commodities and metals, where settlement is evidenced
by an electronic transfer of a warehouse receipt in the records of
the warehouse and the underlying commodity does not move--it remains
in the warehouse or vault--but its ownership changes)).
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[[Page 48235]]
A few commenters also analogized environmental commodities to
securities, which (with the exception of certificated securities) are
intangible. Some commenters, for example, asserted that the language of
the forward exclusion from the swap definition means that non-physical
items can be physically settled because the exclusion, which references
securities, ``implies that securities--which lack a strict physical
existence--may be physically settled.'' \290\
---------------------------------------------------------------------------
\290\ See CRS Letter. See also CERP Letter (claiming that
Congress did not intend for the phrase ``physically settled'' in the
forward exclusion to be limited to tangible commodities because,
like environmental commodities, securities only exist ``on
paper.''). See also AWEA Letter.
---------------------------------------------------------------------------
Some commenters assured the Commissions that applying the forward
exclusion to transactions in environmental commodities would not permit
transactions that should be subject to the swap regulatory regime to
fall outside it. One commenter submitted that intent to deliver with
respect to environmental commodities will be readily determinable.\291\
Another commenter contended that: environmental commodity contracts
almost universally require delivery and that failure to do so is an
event of default; to the best of its knowledge, it is rare for such a
contract to include the right to unilaterally terminate an agreement
under a pre-arranged contractual provision permitting financial
settlement; \292\ and defaults generally are the result of something
frustrating parties' intentions.\293\ Still other commenters
distinguished environmental commodities from other intangible
commodities, such as the nonfinancial commodities (such as interest
rates and temperatures) that the CFTC referred to in its Adaptation
Notice of Proposed Rulemaking,\294\ because RECs and emissions
allowances or offsets can be physically transferred from one account to
another, whereas ``it is not possible to move and physically transfer
an interest rate or a temperature reading.'' \295\
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\291\ See CRS Letter (``unlike a stock or a bond, which can be
resold for its cash value, purchasers of environmental commodities
intend to take delivery of RECs or carbon offsets for either
compliance purposes or in order to make an environmental claim
regarding their renewable energy use or carbon footprint.''). See
also GreenX Letter.
\292\ Such a provision would preclude reliance on the forward
exclusion.
\293\ See 3Degrees Letter.
\294\ See Adaptation of Regulations to Incorporate Swaps, 76 FR
33066, June 7, 2011.
\295\ See California Utilities Letter.
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As discussed above, the CFTC has addressed the foregoing concerns
of commenters by providing an interpretation that agreements, contracts
and transactions in environmental commodities may qualify for the
forward exclusion from the swap definition.
One commenter stated its view that the forward exclusion from the
swap definition should not be available for carbon transactions because
they should be standardized and conducted on open, transparent and
regulated exchanges.\296\ This commenter acknowledged the possibility
that carbon transactions can be physically settled (as the statute
requires of excluded forward contracts) but argued that, in light of
the fact that there is no cost associated with making or taking
delivery of carbon, there is no cost to store it, and there is no delay
in delivering it, a forward exclusion for carbon transactions may allow
financial speculators to escape regulation otherwise required by the
Dodd-Frank Act. The CFTC believes that if a transaction satisfies the
terms of the statutory exclusion, the CFTC lacks the authority to
deprive the transaction of the exclusion, absent evasion.\297\
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\296\ See Letter from Michelle Chan, Director, Economic Policy
Programs, Friends of the Earth, dated July 22, 2011.
\297\ While the commenter contended that ``the intangible nature
of carbon makes it much easier for speculators or those simply
seeking to hedge carbon price risk to take delivery of the carbon
itself rather than enter into a derivatives transaction,'' as the
CFTC states in section VII.A.2.c), infra, deciding to enter into a
forward transaction rather than a swap does not constitute evasion.
Thus, if the transaction in question is a forward contract, that is
the end of the analysis, absent the presence of other factors that
may indicate evasion. See AWEA Letter.
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One commenter stated that ``[i]n the solar industry, RECs are often
traded by an individual consumer as an assignment of a right owned by
that consumer.'' \298\ This commenter also advised that many individual
consumers transact forward contracts through solar REC (``SREC'')
aggregators at a fixed price. The CFTC notes \299\ that a transaction
entered into by a consumer cannot be a forward transaction, and
accordingly should not be the subject of an interpretation of the
forward exclusion.\300\
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\298\ See Letter from Katherine Gensler, Director, Regulatory
Affairs, SEIA, dated August 5, 2011 (``SEIA Letter'').
\299\ See Proposing Release at 29832 n.104.
\300\ However, in section II.B.3., infra, the Commissions
provide an interpretation regarding the applicability of the swap
definition to consumer transactions.
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One commenter takes the position that, because EPA emission
allowances are issued in transactions with the EPA, only resales of
such allowances (secondary market transactions) could be swaps because
the EPA's initial issuance of allowances would be excluded from the
swap definition under CEA section 1a(47)(B)(ix).\301\ The CFTC declines
to address the commenter's legal conclusion regarding the application
of CEA section 1a(47)(B)(ix), but agrees that an emission allowance
created by the EPA is a nonfinancial commodity and that agreements,
contracts and transactions in such allowances may fall within the
forward exclusion from the swap definition.
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\301\ See Letter from Lauren Newberry, Jeffrey C. Fort, Jeremy
D. Weinstein, and Christopher B. Berendt, Environmental Markets
Association, dated July 21, 2011.
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(iv) Physical Exchange Transactions
The Commissions received a comment letter seeking clarification
that physical exchange transactions are forward contracts excluded from
the swap definition.\302\ As described by the commenter, physical
exchange transactions involve ``a gas utility entering into a
transaction with another gas utility or other market participant to
take delivery of natural gas at one delivery point in exchange for the
same quantity of gas to be delivered at an alternative delivery point *
* * for the primary purpose of transferring ownership of the physical
commodity in order to rationalize the delivery of physical supplies to
where they are needed'' at a price ``generally reflecting the
difference in value at the delivery points.'' \303\ This commenter
stated that ``exchange transactions create binding obligations on each
party to make and take delivery of physical commodities [, i]n essence
constituting paired forward contracts that are intended to go to
physical delivery.'' \304\ The commenter added that, to the extent an
exchange transaction payment is based on an index price, such pricing
is not severable from the physical exchange.\305\
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\302\ See AGA Letter.
\303\ Id. This commenter noted that gas utilities often can
receive gas at more than one interconnection or delivery point on a
pipeline.
\304\ Id.
\305\ Id.
---------------------------------------------------------------------------
The CFTC interprets the exchange transactions described by the
commenter, to the extent they are for deferred delivery, as examples of
transactions in nonfinancial commodities that are within the forward
exclusion from the definition of the terms ``swap'' and ``future
delivery.'' Based on the information supplied by the commenter, they
are commercial merchandising transactions, the primary purpose of which
is to transfer
[[Page 48236]]
ownership of natural gas between two parties who intend to physically
settle such transactions. That exchange transactions may involve, in
addition to gas deliveries at two separate delivery points, a cash
payment by one party to the other reflecting the difference in value of
the gas at different delivery points, or that such payment may be based
on an index, does not necessarily affect the nature of the transactions
as forward transactions.\306\ For an exchange transaction to fall
within the forward exclusion, though, the parties to the transaction
must intend for the transaction to be physically settled, and the
exchange transaction must satisfy all applicable interpretations set
forth herein, including that relating to book-outs.\307\
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\306\ However, if such payment stems from an embedded option,
the interpretation set forth in the embedded option section of this
release, see infra part II.B.2(b)(v), also would be relevant to
determining whether an exchange transaction were covered by the
forward exclusion from the swap definition.
\307\ While the commenter also states that ``[g]as utilities
contract with interstate pipelines for capacity rights to have their
gas supplies delivered to specific delivery points,'' its discussion
of exchange transactions appears unrelated to such capacity rights.
Therefore, the CFTC's guidance on exchange transactions does not
address exchange transactions with capacity elements, which,
depending on their structures, may be covered by the guidance set
forth in the embedded option section of this release or by the
CFTC's recent Commodity Options release. See infra note 317.
Conversely, that parties to an exchange transaction separately enter
into a capacity transaction with a pipeline operator to transport
natural gas delivered via an exchange transaction is not relevant to
today's guidance regarding exchange transactions.
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(v) Fuel Delivery Agreements
The CFTC understands that fuel delivery agreements can generally be
described as agreements whereby two or more parties agree to divide the
cost of acquiring fuel for generation facilities based on some formula
or factors, which can include, for example, their respective financial
contributions to developing the source of the fuel (e.g., a natural gas
field). One example of a fuel delivery agreement could involve a joint
power agency providing to a municipal utility a long-term supply of
natural gas from a natural gas project developed by the joint power
agency and other entities to provide fuel for, among others, the joint
power agency's and the municipal utility's natural gas-fired electric
generating facilities. The municipal utility would pay the joint power
agency through direct capital contributions to the entity formed to
develop the natural gas project for the cost of developing it. In
addition, the municipal utility would pay the joint power agency a
monthly fee for the natural gas supplied from the natural gas project.
The monthly fee would be composed of an operating cost fee component,
an interstate pipeline transportation cost fee component and an
operating reserve cost fee component. The municipal utility's natural
gas-fired electric generating facility would be used to supply a
portion of its expected retail electric load.
Such agreements are forward transactions if they otherwise meet the
interpretation set forth in this release regarding the forward
exclusions (e.g., no optionality other than as permitted by the
interpretation). Monthly or other fees that are not in the nature of
option premiums do not convert the transactions from forwards to
options. Because the transactions as described above do not appear to
exhibit optionality as to delivery, and no other aspect of the
transactions as described above seem to exhibit optionality, the fees
would not seem to resemble option premiums.\308\
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\308\ This interpretation is limited to the facts and
circumstances described herein; the CFTC is not opining on different
facts or circumstances, which could change the CFTC's
interpretation.
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(vi) Cleared/Exchange-Traded Forwards
In the Proposing Release, the Commissions requested comment
regarding whether forwards executed on trading platforms should fall
within the forward exclusion from the swap definition and, if so,
subject to what parameters.\309\ One commenter requested that the CFTC
adopt a non-exclusive safe harbor providing that exchange-traded
contracts with respect to which more than 50 percent of contracts, on
average on a rolling three-month basis, go to delivery and where 100
percent of the counterparties are commercial counterparties, are
neither futures nor swaps (``50/100 Forward Safe Harbor'').\310\ This
commenter further requested that the CFTC provide an appropriate
transition period once those thresholds are breached. This commenter
contended that two hallmarks of the exchange-traded forward markets,
which it characterized as ``a relatively new development,'' are that
the participants generally are commercials and a high percentage of
contracts go to delivery, notwithstanding netting of delivery
obligations.\311\ This commenter added that, while parties to such
contracts intend to go to delivery when they enter into them, their
delivery needs may change as time passes.
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\309\ See Proposing Release at 29831-29832, Request for Comment
30.
\310\ See Letter from Peter Krenkel, President and CEO, NGX,
dated Nov. 4, 2010, resubmitted by email to CFTC staff on Sept. 14,
2011 (``NGX Letter''). One other commenter addressed a related
issue, asserting that the Commissions should clarify that cleared
forwards between commercial participants should be permitted under
the forward contract exclusion. See Ex Parte Communication among
Evolution Markets Inc. (``Evolution''), Ogilvy Government Relations
(``Ogilvy'') and CFTC staff on May 18, 2011 at http://comments.cftc.gov/PublicComments/ViewExParte.aspx?id=197&SearchText=.
\311\ Id.
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The CFTC declines to address this request for the 50/100 Forward
Safe Harbor, which raises policy issues that are beyond the scope of
this rulemaking. Should the CFTC consider the implications of the
requested 50/100 Forward Safe Harbor, including possible additional
conditions for relief, it would be appropriate for the CFTC to obtain
further comment from the public on this discrete proposal. For the same
reasons, the CFTC declines to address at this time the comment
requesting that the CFTC take the view that cleared forwards between
commercial participants fall within the scope of the forward contract
exclusion.
(b) Commodity Options and Commodity Options Embedded in Forward
Contracts
(i) Commodity Options \312\
---------------------------------------------------------------------------
\312\ As used in this release, the term ``commodity option''
refers to an option that is subject to the CEA.
---------------------------------------------------------------------------
The CFTC noted in the Proposing Release \313\ that the statutory
swap definition explicitly provides that commodity options are swaps,
that it had proposed revisions to its existing options rules in parts
32 and 33 of its regulations \314\ with respect to the treatment of
commodity options under the Dodd-Frank Act, and that it had requested
comment on those proposed revisions in that rulemaking proceeding.\315\
Accordingly, the CFTC did not propose an additional interpretation in
the Proposing Release with respect to commodity options.
---------------------------------------------------------------------------
\313\ See Proposing Release at 29829-30.
\314\ 17 CFR Parts 32 and 33.
\315\ See Commodity Options and Agricultural Swaps, 76 FR 6095
(Feb. 3, 2011) (proposed).
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The CFTC reaffirms that commodity options are swaps under the
statutory swap definition, and is not providing an additional
interpretation regarding commodity options in this release. The CFTC
recently addressed commodity options in the context of a separate final
rulemaking and interim final rulemaking, under its plenary options
authority in CEA section 4c(b).\316\ There, the CFTC adopted a modified
trade option exemption, and has invited
[[Page 48237]]
public comment on the interim final rules.\317\
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\316\ 7 U.S.C. 6c(b).
\317\ See Commodity Options, 77 FR 25320 (Apr. 27, 2012).
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Comments
Several commenters in response to the Proposing Release argued that
commodity options should not be regulated as swaps.\318\ In general,
these commenters believed that commodity options should qualify for the
forward exclusion from the swap definition, emphasizing similarities
between commodity options and forward contracts on nonfinancial
commodities.\319\
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\318\ See Letter from Brian Knapp, Policy Advisor, American
Petroleum Institute (``API''), dated January 31, 2012 (``API
Letter''); BGA Letter; COPE Letter; ETA Letter; Just Energy Letter;
NGSA/NCGA Letter; and WGCEF Letter.
\319\ For example, one commenter asserted that, similar to a
forward contract on a nonfinancial commodity, a commodity option
conveys no ability for a party to unilaterally require a financial
settlement. Reasoning that both commodity options and forward
contracts on nonfinancial commodities are intended to settle by
physical delivery, this commenter contended that they should have
the same regulatory treatment. See COPE Letter. Similarly, another
commenter argued that the forward exclusion ``plainly covers''
commodity options because they are: (i) Contracts for the sale of
physical, nonfinancial commodities, (ii) for deferred delivery, and
(iii) intended to be physically settled, given that purchasers have
an absolute right to physical delivery and sellers have an absolute
obligation to physically deliver the amounts called for by the
purchasers if the option is exercised. See NGSA/NCGA Letter. A third
commenter recommended that the CFTC interpret the forward exclusion
``broadly'' to include options that, if exercised, become forwards
in nonfinancial commodities in light of the particular circumstances
of the electricity industry, where electric companies use commodity
options to efficiently meet the demands of electric customers by
hedging or mitigating commercial risks due to seasonal and
geographically unique weather and load patterns and fluctuations.
See ETA letter. In the alternative, a fourth commenter requested
that the CFTC exercise its plenary options authority under CEA
section 4c(b), 7 U.S.C. 6c(b), to establish a separate regulatory
regime for commodity options analogous to the trade option exemption
under former CFTC Rule 32.4. See WGCEF Letter. See 17 CFR 32.4
(2011).
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The CFTC is not providing an interpretation that commodity options
qualify as forward contracts in nonfinancial commodities. Such an
approach would be contrary to the plain language of the statutory swap
definition, which explicitly provides that commodity options are
swaps.\320\ This approach also would be a departure from the CFTC's and
its staff's longstanding interpretation of the forward exclusion with
respect to the term ``future delivery,'' \321\ which the CFTC has
determined above to apply to the forward exclusion from the swap
definition as well.\322\ Further, the CFTC notes that it has recently
issued final and interim final rules adopting a modified version of the
CFTC's existing trade option exemption.\323\
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\320\ See CEA section 1a(47)(A)(i), 7 U.S.C. 1a(47)(A)(i)
(defining a swap as, among other things, ``a put, call * * * or
option of any kind * * * for the purchase or sale * * * of * * *
commodities'') and CEA section 1a(47)(B), 7 U.S.C. 1a(47)(B) (not
excluding commodity options from the swap definition).
\321\ See 1985 CFTC OGC Interpretation, supra note 245. In this
regard, an option cannot be a forward under the CFTC's 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.
\322\ See supra part II.B.2(a)(i)(A).
\323\ See supra note 317.
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(ii) Commodity Options Embedded in Forward Contracts
The CFTC is restating the interpretation regarding forwards with
embedded options from the Proposing Release, but with certain
modifications based on comments received. The CFTC is providing
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.
As was noted in the Proposing Release, the question of the
application of the forward exclusion from the swap definition with
respect to nonfinancial commodities, where commodity options are
embedded in forward contracts (including embedded options to cash
settle such contracts), is similar to that arising under the CEA's
existing forward contract exclusion from the definition of the term
``future delivery.'' \324\ The CFTC's Office of General Counsel
addressed forward contracts that contained embedded options in the 1985
CFTC OGC Interpretation,\325\ which recently was adhered to by the CFTC
in its adjudicatory Order in the Wright case.\326\ While both were
issued prior to the effective date of the Dodd-Frank Act, the CFTC
believes that, as was stated in the Proposing Release, it is
appropriate to apply this interpretation to the treatment of forward
contracts in nonfinancial commodities that contain embedded options
under the Dodd-Frank Act.\327\
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\324\ See Proposing Release at 29830.
\325\ See 1985 CFTC OGC Interpretation, supra note 245.
\326\ Wright, supra note 214.
\327\ See Proposing Release at 29830.
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In Wright, the CFTC stated that it traditionally has engaged in a
two-step analysis of ``embedded options'' in which the first step
focuses on whether the option operates on the price or the delivery
term of the forward contract and the second step focuses on secondary
trading.\328\ As was stated in the Proposing Release, these same
principles can be applied with respect to the forward contract
exclusion from the swap definition for nonfinancial commodities in the
Dodd-Frank Act, too.\329\ Utilizing these principles, the CFTC is
providing a final interpretation that a forward contract that contains
an embedded commodity option or options \330\ will be considered an
excluded nonfinancial commodity forward contract (and not a swap) if
the embedded option(s):
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\328\ Wright, supra note 214, at n.5. In Wright, the CFTC
affirmed the Administrative Law Judge's holding that an option
embedded in a hedge-to-arrive contract did not violate CFTC rules
regarding the sale of agricultural trade options. The CFTC first
concluded that the puts at issue operated to adjust the forward
price and did not render the farmer's overall obligation to make
delivery optional. Then, turning to the next step of the analysis,
the CFTC explained that ``the put and [hedge-to-arrive contract]
operated as a single contract, and in most cases were issued
simultaneously * * *. We do not find that any put was severed from
its forward or that either of [the put or the hedge-to-arrive
contract] was traded separately from the other. We hold that in
these circumstances, no freestanding option came into being * * *.''
Id. at *7.
\329\ See Proposing Release at 29830.
\330\ Options in the plural would include, for example, a
situation in which the embedded optionality involves option
combinations, such as costless collars, that operate on the price
term of the agreement, contract, or transaction.
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1. May be used to adjust the forward contract price,\331\ but do
not undermine the overall nature of the contract as a forward contract;
---------------------------------------------------------------------------
\331\ For example, a forward with an embedded option with a
formulaic strike price based on an index value that may not be known
until after exercise would be a forward if it meets the rest of the
3 components of this interpretation. Triggering an option to buy or
sell one commodity based on the price of a different commodity
reaching a specified level, such as in a cross-commodity
transaction, does not constitute an adjustment to the forward
contract price within the meaning of this 3-part interpretation.
---------------------------------------------------------------------------
2. Do not target the delivery term, so that the predominant feature
of the contract is actual delivery; and
3. Cannot be severed and marketed separately from the overall
forward contract in which they are embedded.\332\
---------------------------------------------------------------------------
\332\ See Wright, supra note 214, at **6-7.
In evaluating whether an agreement, contract, or transaction qualifies
for the forward contract exclusions from the swap definition for
nonfinancial commodities, the CFTC will look to the specific facts and
circumstances of the transaction as a whole to evaluate whether any
embedded 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.\333\ Such an approach
will help
[[Page 48238]]
assure that commodity options that should be regulated as swaps do not
circumvent the protections established in the Dodd-Frank Act through
the forward contract exclusion for nonfinancial commodities instead.
---------------------------------------------------------------------------
\333\ This facts and circumstances approach to determining
whether a particular embedded option takes a transaction out of the
forward contract exclusion for nonfinancial commodities is
consistent with the CFTC's historical approach to determining
whether a particular embedded option takes a transaction out of the
forward contract exclusion from the definition of the term ``future
delivery'' in the CEA. See id. at *5 (``As we have held since
Stovall, the nature of a contract involves a multi-factor analysis *
* *.'').
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The CFTC also is providing an interpretation, in response to
commenters,\334\ with respect to forwards with embedded volumetric
optionality.\335\ Several commenters asserted that agreements,
contracts, and transactions that contain embedded ``volumetric
options,'' and that otherwise satisfy the terms of the forward
exclusions, should qualify as excluded forwards, notwithstanding their
embedded optionality.\336\ The CFTC believes that agreements,
contracts, and transactions with embedded volumetric optionality may
satisfy the forward exclusions from the swap and future delivery
definitions under certain circumstances. Accordingly, the CFTC is
providing an interpretation that an agreement, contract, or transaction
falls within the forward exclusion from the swap and future delivery
definitions, notwithstanding that it contains embedded volumetric
optionality, when:
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\334\ The CFTC requested comment on, among other things: whether
there are other factors that should be considered in determining how
to characterize forward contracts with embedded options with respect
to nonfinancial commodities; and whether there are provisions in
forward contracts with respect to nonfinancial commodities, other
than delivery and price, containing embedded optionality. See
Proposing Release at 29832.
\335\ One commenter characterized ``volumetric optionality'' as
the optionality in a contract settling by physical delivery and used
to meet varying customer demand for a commodity.'' See WGCEF Letter.
See also BGA Letter (stating that ``it is commonplace for energy
suppliers to enter into commercial transactions with customers
(local distribution companies, electric utility companies,
industrial, commercial and residential customers, power plants,
etc.), which provide volumetric, price and delivery-related
flexibility and variability''). BGA claims that commercial
transactions containing embedded volumetric optionality ``include,
but are not limited to, full requirements contracts, interruptible
load agreements, capacity contracts, tolling agreements, energy
management agreements, natural gas transportation contracts and
natural gas storage contracts.'' Id.
\336\ See, e.g., WGCEF Letter (submitting that ```volumetric
optionality' is [a] separate and distinct concept from
`deliverability optionality'''); BGA Letter; AGA Letter; Letter from
Jeffrey Perryman, Director, Contracts and Compliance, Atmos Energy
Holdings, Inc. (``Atmos''), dated July 22, 2011 (``Atmos Letter'');
NGSA/NCGA Letter; Letter from Paul M. Architzel, Wilmer Hale LLP on
behalf of ONEOK, Inc. (``ONEOK''), dated July 22, 2011 (``ONEOK
Letter''); COPE Letter.
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1. The embedded optionality does not undermine the overall nature
of the agreement, contract, or transaction as a forward contract;
2. The predominant feature of the agreement, contract, or
transaction is actual delivery;
3. The embedded optionality cannot be severed and marketed
separately from the overall agreement, contract, or transaction in
which it is embedded; \337\
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\337\ When a forward contract includes an embedded option that
is severable from the forward contract, the forward can remain
subject to the forward contract exclusion, if the parties document
the severance of the embedded option component and the resulting
transactions, i.e. a forward and an option. Such an option would be
subject to the CFTC's regulations applicable to commodity options.
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4. The seller of a nonfinancial commodity underlying the agreement,
contract, or transaction with embedded volumetric optionality intends,
at the time it enters into the agreement, contract, or transaction to
deliver the underlying nonfinancial commodity if the optionality is
exercised;
5. The buyer of a nonfinancial commodity underlying the agreement,
contract or transaction with embedded volumetric optionality intends,
at the time it enters into the agreement, contract, or transaction, to
take delivery of the underlying nonfinancial commodity if it exercises
the embedded volumetric optionality;
6. Both parties are commercial parties; \338\ and
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\338\ See discussion in section II.B.2.(a)(i)(B), supra.
---------------------------------------------------------------------------
7. The exercise or non-exercise of the embedded volumetric
optionality is based primarily on physical factors,\339\ or regulatory
requirements,\340\ that are outside the control of the parties and are
influencing demand for, or supply of, the nonfinancial commodity.\341\
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\339\ See, e.g., BGA Letter (advising that ``[v]ariability
associated with an energy customer's physical demand is influenced
by factors outside the control of * * * energy suppliers (and
sometimes * * * consumers) * * * including, but not limited to, load
growth, weather and certain operational considerations (e.g.,
available transportation capacity to deliver physical natural gas
purchased on the spot market)'').
\340\ Volumetric optionality in this category would include, for
example, a supply contract entered into to satisfy a regulatory
requirement that a supplier procure, or be able to provide upon
demand, a specified volume of commodity (e.g., electricity). To the
extent the optionality covers an amount of the commodity in excess
of the regulatory requirement, such optionality would not
necessarily be covered by this aspect of the guidance, though it may
nevertheless be covered by the guidance if such excess volumetric
optionality is based on physical factors within the meaning of the
guidance. For example, the California Utilities explained that the
California Public Utilities Commission (``CPUC'') requires them to
file a supply plan with the CPUC demonstrating that they have
procured sufficient capacity resources (including reserves) needed
to serve their aggregate system load on a monthly and yearly basis.
See California Utilities Letter. Each utility's system requirement
is 100 percent of its peak-hourly forecast load plus a 15-17 percent
reserve margin. The California Utilities enter into resource
adequacy agreements to procure electric power generating capacity to
meet these requirements. The ability to call on the additional 15 to
17% reserve reflected in such an agreement is covered by the
regulatory requirements part of this element. To the extent the
California Utilities may have a business need to procure additional
capacity resources beyond the foregoing regulatory requirement
(e.g., because they wish to maintain a slightly larger reserve
margin than required due to a recent upswing in unscheduled plant
outages due to aging plants), that may be covered under the
interpretation if the additional capacity is required due to
physical factors beyond the control of the parties (i.e., the
unscheduled outage, in the foregoing example).
\341\ In other words, the predominant basis for failing to
exercise the option would be that the demand or supply (as
applicable) that the optionality was intended to satisfy, if needed,
never materialized, materialized at a level below that for which the
parties contracted or changed due to physical factors or regulatory
requirements outside the parties' control. Such failure to exercise,
or an exercise for a reduced amount of the underlying commodity,
could, for example, be due to colder than expected weather during
the summer decreasing demand for air conditioning, in turn
decreasing demand for power to run the air conditioning. The
Commission does not interpret this to mean that absolutely all
factors involved in the decision to exercise an option must be
beyond the parties' control, but rather the decision must be
predominantly driven by factors affecting supply and demand that are
beyond a parties control. This also means that the forward contract
with embedded volumetric optionality needs to be a commercially
appropriate method for securing the purchase or sale of the
nonfinancial commodity for deferred shipment at the time it is
entered into. The CFTC cautions market participants that, to the
extent a party relies on the forward exclusion from the swap or
future delivery definitions, notwithstanding that there is
volumetric optionality, if that volumetric optionality is
inconsistent with the seventh element of the interpretation, the
agreement, contract or transaction may be an option.
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The first two elements of the interpretation for embedded
volumetric optionality, which mirror the CFTC's historical embedded
option interpretation discussed above, have been modified to reflect
that embedded volumetric optionality relates to delivery rather than
price. As noted above, the predominant feature of a forward contract is
a binding, albeit deferred, delivery obligation. It is essential that
any embedded option in a forward contract as to volume must not
undermine a forward contract's overall purpose.\342\ The CFTC
recognizes that the nature of commercial operations are such that
supply and demand requirements cannot always be accurately predicted
and that forward contracts that allow for some optionality as to the
amount of a nonfinancial commodity actually delivered offer a great
deal of value to commercial
[[Page 48239]]
participants. Where an agreement, contract, or transaction requires
delivery of a non-nominal volume of a nonfinancial commodity, even if
an embedded volumetric option is exercised, the CFTC believes that the
predominant feature of the contract, notwithstanding the embedded
volumetric optionality, is actual delivery. This is the case in many
forward contracts that have an embedded option that allows a party to
buy or sell an additional amount of a commodity beyond the fixed amount
called for in the underlying forward contract. For instance, a forward
contract could call for the delivery of 10,000 bushels of wheat and
include an option for an additional 5,000 bushels of wheat.\343\
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\342\ See discussion in part II.B.2.(a)(i)(B), supra. See also
supra note 321.
\343\ In evaluating whether the predominant feature of a
transaction is actual delivery, the CFTC will look at the contract
as a whole. Thus, with respect to this contract, the CFTC would
consider the intent element of the forward exclusions to be
satisfied because the contract requires the seller to deliver a non-
nominal volume of a commodity (i.e., 10,000 bushels of wheat),
viewing the contract as a whole. As a result, if the other elements
of the guidance above are satisfied, this contract would be a
forward contract, even if the party did not exercise the option for
the additional 5,000 bushels.
---------------------------------------------------------------------------
The third element is substantially the same as the third element of
the interpretation above with respect to commodity options embedded in
forward contracts generally.
The fourth and fifth elements are designed to ensure that both
parties intend to make or take delivery (as applicable), subject to the
relevant physical factors or regulatory requirements, which may lead
the parties to deliver more or less than originally intended. This
distinguishes a forward contract from a commodity option, where only
the option seller must at all times be prepared to deliver during the
term of the option. The sixth element is intended to ensure that the
interpretation is not abused by market participants not engaged in a
commercial business involving the nonfinancial commodity underlying the
embedded volumetric optionality.\344\
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\344\ The fact that the CFTC is expressly including the fourth
through sixth elements in the embedded optionality guidance for
volumetric options but not elsewhere does not mean that intent to
deliver and the ability to make or take delivery expressed in these
elements are not part of the facts and circumstances the CFTC will
consider in the context of determining whether other agreements,
contracts, and transactions qualify for the forward exclusions.
Intent to deliver and the ability to make or take delivery have long
been a part of the CFTC's facts-and-circumstances approach to making
that determination, and they remain so. The CFTC is emphasizing
these elements in this guidance because the CFTC has not previously
expressed the view that an agreement, contract, or transaction with
embedded volumetric optionality which affects the delivery term may
qualify as a forward if these facts and circumstances are present.
---------------------------------------------------------------------------
The seventh element is based on comments stating that parties to
agreements, contracts, and transactions with embedded volumetric
optionality intend to make or take delivery (as applicable) of a
commodity, and that it is merely the volume of a commodity that would
be required to be delivered if the option is exercised, that varies. It
is designed to ensure that the volumetric optionality is primarily
driven by physical factors or regulatory requirements that influence
supply and demand and that are outside the parties' control, and that
the optionality is a commercially reasonable way to address uncertainty
associated with those factors.\345\ Element seven must be interpreted
with the other elements set forth here. For instance, even if the
optionality is consistent with element seven, such optionality cannot
undermine the overall nature of the contract as a forward contract as
discussed above.
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\345\ See, e.g., AGA Letter (advising that ``[i]n general,
retail demand for natural gas is weather driven * * * as a result
[of which], a gas utility's peaking supplies must have significant
flexibility * * * [and g]as utilities * * * use a variety of
contracts with gas suppliers to physically deal with peak periods of
demand''); BGA Letter (citing gas supply curtailment due to a
pipeline outage and power generation curtailment by an Independent
System Operator for operational reasons as factors outside the
control of energy suppliers and which could impact the amount of a
commodity delivered). The CFTC understands BGA's comment to address
involuntary curtailments, but also recognizes that power buyers may
agree in advance that the relevant Regional Transmission
Organization or Independent System Operator may, in order to
maintain system reliability, curtail power deliveries to the buyers.
While voluntary curtailments are within the control of the power
buyer, the potential system reliability issue is not. Therefore,
such voluntary curtailments would be within the guidance because, if
triggered, they would be based on a physical factor (e.g., supply
constraints).
---------------------------------------------------------------------------
As discussed in the interpretation regarding forwards with embedded
optionality discussed above, in evaluating whether an agreement,
contract or transaction with embedded volumetric optionality qualifies
for the forward exclusions, the CFTC will look to the relevant facts
and circumstances of the transaction as a whole to evaluate whether the
transaction qualifies for the forward exclusions from the definitions
of the terms ``swap'' and ``future delivery.''
The CFTC is providing further interpretations to explain how it
would treat some of the specific contracts described in the comment
letters. According to one commenter, a ``full requirements contract''
can be described as a ``contract where the seller agrees to provide all
requirements for a specific customer's location or delivery point.''
\346\ According to another commenter, ``[a] full requirements contract
* * * is a well-established concept in contract law'' and ``[i]n a
requirements contract, the purchaser * * * deals exclusively with one
supplier.'' \347\ This commenter added that, while the amount of
commodity delivered can vary, it is based on an objective need and that
the Uniform Commercial Code imposes on the buyer ``an obligation to act
in good faith with respect to the varying amount that is called for
delivery.'' \348\ Based upon this description, the CFTC believes that a
going commercial concern with an exclusive supply contract has no
option but to get its supply requirements met through that exclusive
supplier consistent with the terms of the contract. Any instance where
nominal or zero delivery occurred would have to be because the
commercial requirements changed or did not materialize. Furthermore,
any variability in delivery amounts under the contract appears to be
driven directly by the buyer's commercial requirements and is not
dependent upon the exercise of any commodity option by the contracting
parties.
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\346\ See Letter from Keith M. Sappenfield, II, Director, US
Regulatory Affairs, Encana Marketing (USA) Inc. (``Encana''), dated
July 22, 2011 (``Encana Letter'').
\347\ See ONEOK Letter. The CFTC notes that this commenter
discussed full requirements contracts in the context of supply
agreements between one of its affiliates and retail customers. If
such customers are non-commercial customers, such contracts are not
forwards, but nevertheless they may not be swaps under the
Commissions' guidance regarding the non-exhaustive list of consumer
transactions, or otherwise if they have characteristics or factors
described under the consumer transaction interpretation, see infra
part II.B.3.
\348\ See, e.g., NY UCC Sec. 2-306(1) (stating that ``[a] term
which measures the quantity by the output of the seller or the
requirements of the buyer means such actual output or requirements
as may occur in good faith.* * *''). This commenter cited Corbin on
Contracts for the proposition that the mere fact that the quantity
term of the contract is ``the buyer's needs or requirements'' does
not render the requirements contract ``a mere options contract''
because ``the buyer's promise is not illusory * * * [but] is
conditional upon the existence of an objective need for the
commodity.'' See ONEOK Letter (citing Corbin on Contracts Sec. 6.5
at 240-53 (1995)).
---------------------------------------------------------------------------
Accordingly, full requirements contracts, as described above,
appear not to contain embedded volumetric options. Therefore, a full
requirements contract may qualify for the forward exclusion under the
same facts and circumstances analysis applicable to all other
agreements, contracts, and transactions that might be forwards. The
same analysis would apply to an output
[[Page 48240]]
contract satisfying the terms of this interpretation.\349\
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\349\ See Letter from Phillip g. Lookadoo, Esq., Reed Smith LLP
and Jeremy D. Weinstein, Esq. on behalf of IECA dated May 23, 2012
(suggesting that output contracts, in addition to full requirements
contracts, should be within the forward exclusion). An output
contract has been defined as ``a contract pursuant to which the
obligor's duty to supply the promised commodity is quantified (and
therefore limited) by reference to its production thereof.'' See
Boyd v. Kmart Corp., 110 F.3d 73 (10th Cir. 1997).
---------------------------------------------------------------------------
With respect to capacity contracts, transmission (or
transportation) services agreements, and tolling agreements, the CFTC
understands that: (i) Capacity contracts are generally products
designed to ensure that sufficient physical generation capacity is
available to meet the needs of an electrical system;\350\ (ii)
transmission (or transportation) services agreements are generally
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;\351\ and (iii)
tolling agreements, as described by commenters, 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.\352\
---------------------------------------------------------------------------
\350\ See California Utilities Letter.
\351\ See NEMA Letter.
\352\ See California Utilities Letter.
---------------------------------------------------------------------------
Such agreements, contracts and transactions, may have features that
will satisfy the ``forwards with embedded volumetric optionality''
interpretation discussed above, or, like full requirements contracts,
may not contain embedded volumetric options and may satisfy other
portions of the forward interpretations herein. For example, according
to one commenter, the delivery obligations in some tolling agreements
are not optional which is indicative that the predominant feature of
such tolling agreements is actual delivery.\353\ It is also possible,
based on descriptions provided to the CFTC, that tolling agreements
could fit within the interpretation concerning certain physical
agreements, contracts, or transactions,\354\ or other interpretations
herein.
---------------------------------------------------------------------------
\353\ Id.
\354\ See infra part II.B.2.(b)(iii).
---------------------------------------------------------------------------
Some commenters focused on forwards with embedded volumetric
optionality in the natural gas industry. For example, one commenter
stated that ``peaking supply'' natural gas contracts do not render
delivery optional. Although the purchaser has the option to specify
when and if the quantity of gas will be delivered on any given day,
this commenter asserted that there is no cash settlement alternative.
If the purchaser does not exercise the right to purchase, then the
right is terminated. The seller under the transaction must deliver the
entire quantity of gas that the purchaser specifies, or pay liquidated
damages. Moreover, the option is not severable and cannot be marketed
separately from the supply agreement itself.\355\ Similarly, another
commenter said that there is no ability to sever an embedded option
from a natural gas forward contract. Moreover, it stated that the
ability for a gas purchaser to specify a quantity of gas for a certain
day is not to encourage speculative activity; rather, it is because the
exact quantity of gas to be needed on that future day is unknown, and
many gas purchasers have weather-dependent needs that cannot accurately
be predicted in advance.\356\
---------------------------------------------------------------------------
\355\ See AGA Letter.
\356\ See Atmos Letter.
---------------------------------------------------------------------------
Depending on the relevant facts and circumstances, these types of
agreements, contracts, and transactions--capacity contracts,
transmission (or transportation) services agreements, tolling
agreements, and peaking supply contracts--may satisfy the elements of
the ``forwards with embedded volumetric options'' interpretation set
forth above, or may satisfy other portions of this interpretation. If
they do, they would fall within the forward exclusions from the swap
and future delivery definitions.
In addition, the CFTC is providing an interpretation in response to
a comment that contracts with evergreen or extension terms should be
considered forwards.\357\ The CFTC is clarifying that an extension term
in a commercial contract, such as a renewal term in a five year power
purchase agreement (which, due to the renewal, would require additional
deliveries), is not an option on the delivery term within the meaning
of the CFTC's interpretation, and consequently would not render such a
contract ineligible for the forward exclusions from the definitions of
the terms ``swap'' and ``future delivery.'' Similarly, an evergreen
provision, which automatically renews a contract (and, as such, would
require additional deliveries)\358\ absent the parties affirmatively
terminating it, would not render such a contract ineligible for the
forward exclusions from the swap or future delivery definitions.\359\
When the Proposing Release stated that a forward contract containing an
embedded option that does not ``target the delivery term'' is an
excluded forward contract,\360\ it meant that the embedded option does
not affect the delivery amount.\361\
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\357\ See IECA Letter.
\358\ The CFTC refers in this and the prior sentence to
``additional deliveries'' because the IECA's example involves an
agreement calling for delivery of a physical nonfinancial commodity.
\359\ Using extension or evergreen provisions to avoid delivery,
however, as was the case with the ``rolling spot'' contracts at
issue in CFTC v. Zelener, 373 F.3d 861 (7th Cir. 2004), could
constitute evasion or violate other provisions of the CEA (e.g., CEA
section 4(a), 7 U.S.C. 6(a)). This interpretation does not limit the
CFTC's other interpretations in this release regarding when delivery
does not occur (e.g., the Brent Interpretation).
\360\ See NGSA/NCGA Letter (requesting clarification of the
phrase ``target the delivery term.'').
\361\ See Proposing Release at 29830, n.81.
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Also, in response to a commenter,\362\ the CFTC clarifies that
embedded optionality as to delivery points and delivery dates will not
cause a transaction that otherwise qualifies as a forward contract to
be considered a swap. The CFTC emphasizes, however, that delivery must
occur at some delivery point and on some date, or the lack of delivery
must be due to the transaction being booked out or otherwise be
consistent with the CFTC's interpretation regarding the forward
exclusions from the swap and future delivery definitions.
---------------------------------------------------------------------------
\362\ See COPE Letter.
---------------------------------------------------------------------------
Comments
Commenters generally supported the CFTC's proposed interpretation
regarding forwards with embedded options, but many believed that it
should be modified or expanded. As noted above, several commenters
believed that forward contracts with embedded options that contain
optionality as to the quantity/volume of the nonfinancial commodity to
be delivered should qualify as forwards, and that the CFTC's proposed
interpretation (which only mentions price optionality) should be
modified accordingly.\363\ In this regard, several commenters focused
on forwards with embedded volumetric options in the natural gas
industry.\364\ One commenter noted that, although the 1985 CFTC OGC
Interpretation distinguishes forward contracts from trade options, it
is based on a limited number of agricultural contract examples, so
additional guidance is needed, particularly in light of the wide range
of cash market and commercial merchandising contracting practices in
[[Page 48241]]
which delivery terms and amounts vary.\365\
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\363\ See AGA Letter; API Letter; Atmos Letter; ONEOK Letter;
NGSA/NCGA Letter; WGCEF Letter.
\364\ See AGA Letter; Atmos Letter.
\365\ See ONEOK Letter. This commenter noted that it offers its
customers a number of types of contracts for delivery of natural gas
under which the amount called for delivery may vary. In each of
these types of contracts, this commenter stated that both parties
intend the contracts to result in delivery of the commodity, as
needed. The purpose of these contracts is to ensure that customers,
most of which are gas or electric utilities, have an adequate supply
of natural gas regardless of day-to-day changes in demand that may
be caused by variation in weather, operational considerations, or
other factors. They are not designed for one-way price protection as
would be the case with an option. See ONEOK Letter.
---------------------------------------------------------------------------
In addition, another commenter requested more generally that any
embedded option (for example, price, quantity, delivery point, delivery
date, contract term) that does not permit a unilateral election of
financial settlement based upon the value change in an underlying cash
market should not render the contract a swap.\366\
---------------------------------------------------------------------------
\366\ See COPE Letter, Appendix.
---------------------------------------------------------------------------
As discussed above, the CFTC has provided an additional
interpretation with respect to forwards with embedded volumetric
options to address commenters' concerns. The CFTC also has provided an
interpretation above, regarding price optionality, optionality with
respect to delivery points and delivery dates specifically in response
to this commenter, and optionality as to certain contract terms (such
as evergreen and renewal provisions) to address particular concerns
raised by commenters. The CFTC declines to adopt a more expansive
approach with respect to ``any'' embedded option.
One commenter requested that an option to purchase or sell a
physical commodity, whether embedded in a forward contract or stand
alone, should either (i) fall within the statutory forward exclusion
from the swap definition, or (ii) alternatively, if deemed by the CFTC
to be a swap, should be exempt from the swap definition pursuant to a
modified trade option exemption pursuant to CEA section 4c(b).\367\ The
CFTC has modified its proposed interpretation regarding forwards with
embedded options as discussed above; contracts with embedded options
that are swaps under this final interpretation may nevertheless qualify
for the modified trade option exemption recently adopted by the CFTC
and discussed above.\368\
---------------------------------------------------------------------------
\367\ See WGCEF Letter; 7 U.S.C. 6c(b).
\368\ 77 FR 25320 (Aug. 27, 2012). Encana believed that the
guidance on forwards with embedded options should include embedded
physical delivery options because it asserted that many of the
contracts currently used by participants in the wholesale natural
gas market contain an option for the physical delivery of natural
gas. See Encana Letter. To the extent that Encana's comment goes
beyond volumetric optionality, commodity options are discussed supra
in section II.B.2(b).
---------------------------------------------------------------------------
Another commenter urged the CFTC to broadly exempt commercial
forward contracting from swap regulation by generally excluding from
the swap definition any forward contract with embedded optionality
between end users ``whose primary purpose is consistent with that of an
`end user', and in which any embedded option is directly related to
`end use.' '' \369\ The CFTC believes that this interpretation is vague
and overbroad, and declines to adopt it.
---------------------------------------------------------------------------
\369\ See Letter from Roger Cryan, Vice President for Milk
Marketing and Economics, National Milk Producers Federation
(``NMPF''), dated July 22, 2011 (``NMPF Letter'').
---------------------------------------------------------------------------
Another commenter believed that the CFTC's ``facts and
circumstances'' approach to forwards with embedded options does not
provide the legal certainty required by nonfinancial entities engaging
in commercial contracts in the normal course of business.\370\ This
commenter further argued that many option-like contract terms could be
determined to ``target the delivery term'' under a facts and
circumstances analysis.\371\
---------------------------------------------------------------------------
\370\ See ETA Letter. Similarly, COPE comments that a
nonfinancial commodity forward contract that, ``by its terms,'' is
intended to settle physically should be permitted to contain
optionality without being transformed into a swap unless such
optionality negates the physical settlement element of the contract.
That is, if one party can exercise an option to settle the contract
financially based upon the value change in an underlying cash
market, then the intent for physical settlement is not contained in
``the four corners of the contract'' and may render the contract a
swap. See COPE Letter. As discussed elsewhere in this release, the
CFTC historically has eschewed approaches to the forward exclusion
that rely on the ``four corners of the contract,'' which can provide
a roadmap to evasion of statutory requirements.
\371\ Accordingly, this commenter believed that the CFTC should
provide in its rules that an embedded option or embedded optionality
will not result in a nonfinancial forward being a swap unless: (i)
Delivery is optional; (ii) financial settlement is allowed; and
(iii) transfer and trading of the option separately from the forward
is permitted. See ETA Letter.
---------------------------------------------------------------------------
The CFTC has long applied a facts-and-circumstances approach to the
forward exclusion, including with respect to forwards with embedded
options, and thus it is an approach with which market participants are
familiar. That approach balances the need for legal certainty against
the risk of providing opportunities for evasion.\372\ The CFTC's
additional interpretation noted above, including clarification about
the meaning of the phrase ``target the delivery term,'' and forwards
with embedded volumetric optionality, provides enhanced legal certainty
in response to the commenter's concerns. \373\
---------------------------------------------------------------------------
\372\ See also NCFC Letter (supporting the CFTC's guidance
because it provides legal certainty).
\373\ See also Commodity Options, 77 FR 25320, 25324 n. 25 (Apr.
27, 2012) (discussing the CFTC's conclusion that an ``option[] to
redeem'' under the USDA Commodity Credit Corporation's marketing
loan program constitutes a cotton producer's contractual right to
repay its marketing loan and ``redeem'' the collateral (cotton) to
sell in the open market).
---------------------------------------------------------------------------
Request for Comment
The CFTC's interpretation regarding forwards with volumetric
options is an interpretation of the CFTC and may be relied upon by
market participants. However, the CFTC believes that it would benefit
from public comment about its interpretation, and therefore requests
public comment on all aspects of its interpretation regarding forwards
with embedded volumetric options,\374\ and on the following questions:
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\374\ Separately, it is expected that CFTC staff will be issuing
no-action relief with respect to the conditions of the modified
trade option exemption (except the enforcement provisions retained
in Sec. 32.3(d)) until December 31, 2012. This extension will
afford the CFTC an opportunity to review and evaluate the comments
received on both the interpretation above regarding embedded
volumetric optionality, and the modified trade option exemption, in
order to determine whether any changes thereto are appropriate.
---------------------------------------------------------------------------
1. Are the elements set forth in the interpretation to distinguish
forwards with embedded volumetric optionality from commodity options
appropriate? Why or why not?
2. Are there additional elements that would be appropriate? Please
describe and provide support for why such elements would serve to
distinguish forwards with embedded volumetric optionality from
commodity options.
3. Is the seventh element that, to ensure that an agreement,
contract, or transaction with embedded volumetric optionality is a
forward and not an option, the 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, necessary and appropriate? Why
or why not? Is the statement of this element sufficiently clear and
unambiguous? If not, what adjustments would be appropriate?
4. Are there circumstances where volumetric optionality is based on
other factors? Please describe. Would such factors, if made a part of
the interpretation, serve to distinguish forwards with embedded
volumetric optionality from commodity options? If so, how?
5. Does the interpretation provide sufficient guidance as to
whether agreements, contracts, or transactions
[[Page 48242]]
with embedded volumetric optionality permitting a nominal amount, or no
amount, of a nonfinancial commodity to be delivered are forwards or
options, viewing the agreements, contracts, or transactions as a whole,
if they satisfy the seven elements of the interpretation? Why or why
not? Does this interpretation encourage evasion, or do the seven
elements sufficiently distinguish forwards from agreements, contracts,
and transactions that may evade commodity options regulation?
6. Is the interpretation sufficiently clear with respect to
capacity contracts, transmission (or transportation) services
agreements, peaking supply contracts, or tolling agreements? Why or why
not? Do capacity contracts, transmission (or transportation) services
agreements, peaking supply contracts, or tolling agreements generally
have features that satisfy the forwards with volumetric options
interpretation included in this release? If so, which ones? If not, why
not? Could these types of agreements, contracts, and transactions
qualify for the forward exclusions under other parts of the
interpretation set forth above? Are there material differences in the
structure, operation, or economic effect of these types of agreements,
contracts, and transactions as compared to full requirements contracts
that are relevant to whether such agreements, contracts, and
transactions are options under the CEA? Please explain. If so, what are
the material differences?
7. Do the agreements, contracts, and transactions listed in
question No. 6 above have embedded optionality in the first instance?
Based on descriptions by commenters, it appears that they may have a
binding obligation for delivery, but have no set amount specified for
delivery. Instead, delivery (including the possibility of nominal or
zero delivery) is determined by the terms and conditions contained
within the agreement, contract, or transaction (including, for example,
the satisfaction of a condition precedent to delivery, such as a
commodity price or temperature reaching a level specified in the
agreement, contract, or transaction). That is, the variation in
delivery is not driven by the exercise of embedded optionality by the
parties. Do the agreements, contracts, and transactions listed in
question No. 6 exhibit these kinds of characteristics? If so, should
the CFTC consider them in some manner other than its forward
interpretation? Why or why not?
(iii) Certain Physical Commercial Agreements, Contracts or Transactions
The CFTC is providing an interpretation in response to comments
regarding certain physical commercial agreements for the supply and
consumption of energy that provide flexibility, such as tolls on power
plants, transportation agreements on natural gas pipelines, and natural
gas storage agreements.\375\ Commenters recognized that these types of
agreements, contracts or transactions may have option-like features,
but analogized them to leases and concluded that they were forwards
rather than swaps. One commenter, for example, characterized taking
power produced pursuant to a physical tolling agreement--which can
involve one party thereto providing fuel for a generation plant and
having the exclusive right to take the power produced by that plant
from the fuel provided--thus, in effect, ``renting'' the plant to the
extent the plant is used to produce power from the fuel provided--as
more akin to a lease than to an option.\376\
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\375\ See BGA Letter and California Utilities Letter. This
interpretation also may apply to firm transmission agreements
pursuant to which transmission service may not be interrupted for
any reason except during an emergency when continued delivery of
power is not possible. See http://www.interwest.org/wiki/index.php?title=Firm_transmission_service.
\376\ See California Utilities Letter.
---------------------------------------------------------------------------
The CFTC will interpret an agreement, contract or transaction not
to be an option if the following three elements are satisfied: (1) The
subject of the agreement, contract or 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; (2) the agreement, contract or
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; \377\ and
(3) 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
such agreements, contracts and transactions, while there is optionality
as to whether the person uses the specified facility, the person's
right to do so is legally established, does not depend upon any further
exercise of an option and merely represents a decision to use that for
which the lessor already has paid. 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 of the interpretation above are satisfied.
As with the interpretation regarding forwards with embedded options
generally, discussed above, in evaluating whether flexible physical
commercial agreements that meet the 3-part test qualify for the forward
exclusions, the CFTC will look to the specific facts and circumstances
of the agreement, contract or transaction as a whole to evaluate
whether the agreement, contract or transaction qualifies for the
forward exclusions from the definitions of ``swap'' and ``future
delivery.''
---------------------------------------------------------------------------
\377\ In this regard, the usage rights offered for sale should
be limited to the capacity of the specified facility. While
overselling such capacity would not per se be inconsistent with
satisfying the terms of this interpretation, the CFTC cautions
market participants that overselling not based on reasonable
commercial expectations of the use of the specified facility could
lead the contract to be deemed evasion and lead to an agreement,
contract or transaction being considered a swap, as it would
undermine the ``right'' being offered. For example, given physical
constraints of the power grid and gas pipelines, overselling
transmission or transportation capacity would be per se inconsistent
with satisfying the terms of this interpretation.
---------------------------------------------------------------------------
However, in the alternative, 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 agreement,
contract or transaction is a commodity option subject to the swap
definition.
Comments
Two commenters addressed ``lease-like'' physical agreements,
contracts or transactions.\378\ One of these commenters asserted that
there are many physical commercial agreements for the supply and
consumption of energy that effectively provide leases on flexible
energy assets, such as tolls on power plants, transportation agreements
on natural gas pipelines and natural gas storage agreements.\379\
According to this commenter, these assets have the capability to be
turned on and off to meet fluctuating demand due to weather and other
factors; physical contracts around these assets transfer that delivery
flexibility to the contract holder. The commenter believed that these
types of commercial arrangements should not be considered commodity
options, but rather should be excluded forwards. The other commenter
described tolling agreements as having the characteristics of a lease,
in that the
[[Page 48243]]
purchasing entity obtains the exclusive right to the use of the power
plant during the term of the agreement.\380\ This commenter asserted
that such agreements should not be considered commodity options, but
rather forwards because the obligations are not contingent. The CFTC is
providing the above interpretation that these types of agreements,
contracts and transactions are not commodity options if the above
conditions are satisfied, but may qualify for the forward exclusions
under the facts and circumstances, in response to these commenters'
concerns.
---------------------------------------------------------------------------
\378\ See BGA Letter and California Utilities Letter.
\379\ See BGA Letter.
\380\ See California Utilities Letter.
---------------------------------------------------------------------------
(iv) Effect of Interpretation on Certain Agreements, Contracts and
Transactions
In the Proposing Release,\381\ the CFTC requested comment regarding
how its proposed interpretation concerning the forward contract
exclusion would affect full requirements contracts, reserve sharing
agreements, tolling agreements, energy management agreements and
ancillary services. The CFTC asked whether such agreements, contracts
or transactions have optionality as to delivery and, if so, whether
they, or any other agreement, contract or transaction in a nonfinancial
commodity, should be excluded from the swap definition.\382\
---------------------------------------------------------------------------
\381\ See Request for Comment 35, which stated: How would the
proposed interpretive guidance set forth in this section affect full
requirements contracts, capacity contracts, reserve sharing
agreements, tolling agreements, energy management agreements, and
ancillary services? Do these agreements, contracts, or transactions
have optionality as to delivery? If so, should they--or any other
agreement, contract, or transaction in a nonfinancial commodity that
has optionality as to delivery--be excluded from the swap
definition? If so, please provide a detailed analysis of such
agreements, contracts, or transactions and how they can be
distinguished from options that are to be regulated as swaps
pursuant to the Dodd-Frank Act. To what extent are any such
agreements, contracts, or transactions in the electric industry
regulated by the Federal Energy Regulatory Commission (``FERC''),
State regulatory authorities, regional transmission organizations
(``RTOs''), independent system operators (``ISOs'') or market
monitoring units associated with RTOs or ISOs?
See Proposing Release at 29832.
\382\ Id.
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Commenters generally believed that such types of agreements,
contracts and transactions, although they may contain delivery
optionality, should be considered forwards rather than swaps or
commodity options.\383\ By contrast, one commenter believed that traded
power markets involve many types of contracts that are actually
exchanges of cash flows based on referenced values and that have no
relevant characteristics of physical delivery.\384\
---------------------------------------------------------------------------
\383\ See Atmos Letter; BGA Letter; California Utilities Letter;
COPE Letter; ETA Letter; Encana Letter; FERC Staff Letter; IECA
Letter; NEMA Letter; ONEOK Letter; and Letter from Kenneth R.
Carretta, General Regulatory Counsel--Markets, PSEG Services Corp.,
on behalf of the Public Service Electric and Gas Company, PSEG Power
LLC, and PSEG Energy Resources & Trade LLC (``PSEG Companies''),
dated July 22, 2011 (``PSEG Letter'').
\384\ See Better Markets Letter. This commenter stated that
ancillary services are in substance swaps based on congestion costs
between two transmission points, measured by the difference between
actual prices assigned at those points by the grid operator.
Capacity contracts are often documented using trading agreements for
transactions in physicals, but this commenter believed that they
constitute swaps that are used to hedge the price risk associated
with periodic auctions of the contracts to provide reliable capacity
to the grid operator. This commenter asserted that such contracts do
not meet the CFTC's appropriate tests to exclude them, which should
be made explicit in the guidance. This commenter stated that basic
power contracts often do not meet the intent to deliver test because
power buyers and sellers each schedule delivery to/from the grid,
and such transactions can be settled based on readily available
price differentials rather than scheduling capacity and load as a
pair. At a minimum, this commenter believed that guidance should be
provided to require that, in order to demonstrate intent to deliver,
secondary delivery-related costs (e.g., congestion charges and
penalties to which those scheduling capacity and load on the grid
are subject) must be allocated by contract. Id.
---------------------------------------------------------------------------
With the exception of energy management agreements, which are
discussed below, the interpretations that the CFTC has already provided
above may apply to such types of agreements, contracts and
transactions. Specifically, to the extent that such types of
agreements, contracts and transactions are forwards with embedded
volumetric options, the CFTC has provided an additional interpretation
in section II.B.2.b(iii) above. To the extent such types of agreements,
contracts or transactions are physical commercial agreements, contracts
or transactions discussed in section II.B.2.b(iii), supra, the CFTC has
provided an interpretation in that section. To the extent such types of
agreements, contracts and transactions are considered commodity
options, the CFTC has addressed commodity options under the separate
rulemaking establishing a modified trade option exemption.\385\ And to
the extent that such types of agreements, contracts, and transactions,
such as ancillary services, occur in Regional Transmission
Organizations or Independent System Operators, or entered into between
entities described in section 201(f) of the Federal Power Act,\386\
they may be addressed through the public interest waiver process in CEA
section 4(c)(6).\387\
---------------------------------------------------------------------------
\385\ See supra note 317.
\386\ 16 U.S.C. 824(f).
\387\ 7 U.S.C. 6(c)(6).
---------------------------------------------------------------------------
With regard to Energy Management Agreements (``EMAs''), in general,
commenters expressed the view that EMAs are forwards, and not swaps,
although they did not provide analysis to support that conclusion.\388\
They also did not provide a working definition of EMAs. The CFTC
understands that EMAs can cover a number of services and transactions,
which can include spot, forward and swap transactions. EMAs can include
services such as: (i) Acting as a financial intermediary by
substituting one party's credit and liquidity for those of a less
credit worthy owner of illiquid energy producing assets (i.e. the other
party to the EMA) to facilitate the owner's purchase of fuel and sale
of power; \389\ (ii) providing market information to assist the owner
in developing and refining a risk-management plan for the plant; \390\
and (iii) procuring fuel, arranging delivery and storage, selling
excess power not needed to serve load for another party.\391\ The
entity carrying out these activities may receive a portion of the
revenue generated from such activities as compensation for its efforts.
Because commenters did not provide a working definition of EMAs, the
CFTC cannot state categorically that EMAs are or are not swaps.
However, if the fuel acquisition, sales of excess generation and any
other transactions executed under the auspices of an EMA are not swaps,
nothing about the fact that the transactions are executed as a result
of or pursuant to an EMA transforms the transactions into swaps. For
example, if one party hires another party to enter into spot or forward
transactions on its behalf, the fact that their relationship is
governed by an EMA does not render those transactions swaps.\392\
Conversely, were swaps to be executed by one party on behalf of another
party as a result of, or pursuant to, an EMA, the parties thereto would
need to consider their respective roles thereunder (e.g. principal
versus agent) and whether commodity trading advisor, introducing
broker, futures commission merchant, or other registration or other
elements of the Dodd-Frank Act regime were implicated. At a minimum,
the fact that a swap was executed would implicate
[[Page 48244]]
reporting and recordkeeping requirements.\393\
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\388\ See, e.g., Encana Letter and BGA Letter.
\389\ See, e.g., The Royal Bank of Scotland Group plc, Order
Approving Notice To Engage in Activities Complementary to a
Financial Activity, 2008 Federal Reserve Bulletin volume 94.
\390\ Id.
\391\ See, e.g., Energy Management Agreement between Long Island
Lighting Company and Long Island Power Authority, available at
http://www.lipower.org/pdfs/company/papers/contract/energy.pdf.
\392\ Similarly, using an EMA would not render swaps entered as
a result of or pursuant to an EMA spot or forward transactions.
\393\ This interpretation is limited to the facts and
circumstances described herein; the CFTC is not opining on different
facts or circumstances, which could change the CFTC's
interpretation.
---------------------------------------------------------------------------
(v) Liquidated Damages Provisions
The Commissions also received several comments discussing
contractual liquidated damages provisions. The CFTC is clarifying that
the presence, in an agreement, contract, or transaction involving
physical settlement of a nonfinancial commodity, of a liquidated
damages provision (which may be referred to by another name, such as a
``cover costs'' or ``cover damages'' provision) does not necessarily
render such an agreement, contract, or transaction ineligible for the
forward exclusion.\394\ Such a provision in an agreement, contract, or
transaction is consistent with the use of the forward exclusion,
provided that the parties intend the transaction to be physically
settled.\395\ However, liquidated damages provisions can be used to
mask a lack of intent to deliver.\396\ In light of the possibility for
evasion of the Dodd-Frank Act, the CFTC will continue to utilize its
historical facts-and-circumstances approach in determining whether the
parties to a particular agreement, contract, or transaction with a
liquidated damage provision have the requisite intent to deliver.
---------------------------------------------------------------------------
\394\ With respect to performance guarantees, the fact that a
failure to deliver a nonfinancial commodity triggers a payment under
a performance guaranty does not excuse the performance, nor render
delivery optional. Accordingly, such a payment trigger would not
itself preclude an agreement, contract, or transaction from being
covered by the forward exclusion from the swap or future delivery
definitions. But see supra part II.B.1.g, which provides that the
CFTC is interpreting the term ``swap'' (that is not a security-based
swap or mixed swap) to include a guarantee of such swap, to the
extent that a counterparty to a swap position would have recourse to
the guarantor in connection with the position.
\395\ See 1985 CFTC OGC Interpretation, supra note 245 (stating
generally that while ``[s]ome contracts provide for a liquidated
damages of penalty clause if the producer fails to deliver, the
presence of such clauses in a contract does not change the analysis
of the nature of the contract [if] * * * it is intended that
delivery of the physical crop occur, absent destruction of all or a
portion of the crop by forces which neither party can control'').
See generally Corbin on Contracts Sec. 58.1 (characterizing
liquidated damages provisions as designed to ``[d]etermin[e] the
amount of damages that are recoverable for a breach of contract'').
\396\ In that regard, see 1985 CFTC OGC Interpretation, supra
note 245 (stating that ``a contract provision which permitted a
producer to avoid delivery for a reason other than for an
intervening condition not in the control of either party could
change any conclusion about the nature of the contract'').
---------------------------------------------------------------------------
Comments
One commenter notes that a commercial merchandising arrangement
involving a nonfinancial commodity may provide that the remedy for a
failure to make or take delivery is the payment of a market-rate
replacement price, a payment on a performance guaranty, or ``cover
damages'' to compensate the non-breaching party for the failure of the
other party to fulfill its contractual obligations.\397\ Such a
contractual damages or remedy provision, this commenter contended, is
not analogous to a financial settlement option in a trading
instrument.\398\ This commenter further asserted that one party or the
other may be unable to perform, or excused or prevented for commercial
reasons from performing, its contractual obligations to make or take
delivery of a nonfinancial commodity, and therefore may be liable to
the other party for a monetary payment, calculated in accordance with
the contract.\399\
---------------------------------------------------------------------------
\397\ See ETA Letter.
\398\ Id. This commenter cited FERC Order No. 890, which
recognizes that ``[w]hile any party to any contract can choose to
fail to perform, that does not convey a contractual right to fail to
perform'' and that the Edison Electric Institute Master Power
Purchase and Sale Agreement (``EEI MPPSA'') clearly obligates the
supplier to provide power, except in cases of force majeure. As the
ETA explains, ``[t]he EEI MPPSA is a master agreement frequently
used to document transactions for deferred delivery and receipt of
nonfinancial electric energy, and the terms of the ISDA North
American Power Annex contain substantially identical master
agreement provisions * * *.'' Id.
\399\ According to this commenter, parties typically include
liquidated damages provisions in their agreements, contracts and
transactions to address situations in which ``one party or the other
may be unable, excused or prevented for commercial reasons from
performing its contractual obligations to deliver or receive [the
relevant commodity],'' not to serve as ``a financial settlement
`option' analogous to a financial settlement option in a trading
instrument.'' Id.
---------------------------------------------------------------------------
Another commenter noted that physically settled gas contracts,
including peaking contracts (both for daily and monthly supply), bullet
day contracts and weather contracts, use the NAESB Base Contract, which
does not provide for financial settlement other than a liquidated
damages provision, which would compensate a utility for its cost of
obtaining alternative supply at the prevailing market price if the
seller fails to deliver.\400\ This commenter stated its view that the
seller has no real opportunity to arbitrage its obligation to deliver
based on changes in price, and the purchaser has no incentive to fail
to take delivery of its specified quantities of gas, because they are
needed for the physical operations of its system.\401\
---------------------------------------------------------------------------
\400\ See AGA Letter.
\401\ Id. See also Atmos Letter (stating that there is no
financial incentive for a seller to fail to deliver natural gas
under contracts used in the natural gas industry, as the standard
remedy for such a failure to deliver is to pay liquidated damages
sufficient to compensate the purchaser for having to obtain its
required natural gas).
---------------------------------------------------------------------------
The CFTC generally agrees with these comments regarding liquidated
damages provisions, and has provided the final interpretation described
above to address them.
(c) Security Forwards \402\
---------------------------------------------------------------------------
\402\ The discussion above regarding the exclusion from the swap
definition for forward contracts on nonfinancial commodities does
not apply to the exclusion from the swap and security-based swap
definitions for security forwards or to the distinction between
security forwards and security futures products.
---------------------------------------------------------------------------
As the Commissions stated in the Proposing Release, the Commissions
believe it is appropriate to address how the exclusions from the swap
and security-based swap definitions apply to security forwards and
other purchases and sales of securities.\403\ The Commissions are
restating the interpretation set out in the Proposing Release without
modification.
---------------------------------------------------------------------------
\403\ See Proposing Release at 29830.
---------------------------------------------------------------------------
The Dodd-Frank Act excludes purchases and sales of securities from
the swap and security-based swap definitions in a number of different
clauses.\404\ Under these exclusions, purchases and sales of securities
on a fixed or contingent basis \405\ and sales of securities for
deferred shipment or delivery that are intended to be physically
delivered \406\ are explicitly excluded from the swap and security-
based swap definitions.\407\ The exclusion from the swap and security-
based swap definitions of a sale of a security for deferred shipment or
delivery involves an agreement to purchase one or more securities, or
groups or indexes of securities, at a future date at a certain price.
---------------------------------------------------------------------------
\404\ See sections 1a(47)(B)(ii), (v), and (vi) of the CEA, 7
U.S.C. 1a(47)(B)(ii), (v), and (vi).
\405\ See section 1a(47)(B)(v) of the CEA, 7 U.S.C. 1a(47)(B)(v)
(excluding from the swap and security-based swap definitions ``any
agreement, contract, or transaction providing for the purchase or
sale of 1 or more securities on a fixed basis that is subject to
[the Securities Act and Exchange Act]''); and section 1a(47)(B)(vi)
of the CEA, 7 U.S.C. 1a(47)(B)(vi) (excluding from the swap and
security-based swap definitions ``any agreement, contract, or
transaction providing for the purchase or sale of 1 or more
securities on a contingent basis that is subject to [the Securities
Act and Exchange Act], unless the agreement, contract, or
transaction predicates the purchase or sale on the occurrence of a
bona fide contingency that might reasonably be expected to affect or
be affected by the creditworthiness of a party other than a party to
the agreement, contract, or transaction'').
\406\ See section 1a(47)(B)(ii) of the CEA, 7 U.S.C.
1a(47)(B)(ii).
\407\ The Commissions note that calling an agreement, contract,
or transaction a swap or security-based swap does not determine its
status. See supra part II.D.1.
---------------------------------------------------------------------------
As with other purchases and sales of securities, security forwards
are
[[Page 48245]]
excluded from the swap and security-based swap definitions. The sale of
the security in this case occurs at the time the forward contract is
entered into with the performance of the contract deferred or
delayed.\408\ If such agreement, contract, or 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.\409\ Moreover, as a purchase or sale
of a security, the Commissions believe it also would be within the
exclusions for the purchase or sale of one or more securities on a
fixed basis (or, depending on its terms, a contingent basis) and,
therefore, outside the swap and security-based swap definitions.\410\
---------------------------------------------------------------------------
\408\ A purchase or sale of a security occurs at the time the
parties become contractually bound, not at the time of settlement
(regardless of whether cash or physically settled). See Securities
Offering Reform, 70 FR 44722 (Aug. 3, 2005).
\409\ See section 1a(47)(B)(ii) of the CEA, 7 U.S.C.
1a(47)(B)(ii).
\410\ See sections 1a(47)(B)(v) and (vi) of the CEA, 7 U.S.C.
1a(47)(B)(v) and (vi).
---------------------------------------------------------------------------
In the Proposing Release, the Commissions provided the following
specific interpretation in the context of forward sales of mortgage-
backed securities (``MBS'') guaranteed or sold by the Federal National
Mortgage Association (``Fannie Mae''), the Federal Home Loan Mortgage
Corporation (``Freddie Mac''), and the Government National Mortgage
Association (``Ginnie Mae'').\411\ The Commissions are restating their
interpretation regarding such forward sales.
---------------------------------------------------------------------------
\411\ The Commissions provided the interpretation in the
Proposing Release in response to commenters on the ANPR. See
Proposing Release at 29830. These commenters requested clarification
that forward sales of MBS guaranteed or sold by Fannie Mae, Freddie
Mac and Ginnie Mae would not be included in the swap and security-
based swap definitions in order to provide the certainty needed to
avoid unnecessary disruption of this market. Id.
---------------------------------------------------------------------------
MBS guaranteed or sold by Fannie Mae, Freddie Mac and Ginnie Mae
are eligible to be sold in the ``To-Be-Announced'' (``TBA'') market,
which is essentially a forward or delayed delivery market.\412\ The TBA
market has been described as one that ``allows mortgage lenders
essentially to sell the loans they intend to fund even before the loans
are closed.'' \413\ In the TBA market, the lender enters into a forward
contract to sell MBS and agrees to deliver MBS on the settlement date
in the future. The specific MBS that will be delivered in the future
may not yet be created at the time the forward contract is entered
into.\414\ In a TBA transaction, the seller and the buyer agree to five
terms before entering into the transaction: (i) The type of security,
which will usually be a certain type of MBS guaranteed or sold by
Fannie Mae, Freddie Mac or Ginnie Mae and the type of mortgage
underlying the MBS; (ii) the coupon or interest rate; (iii) the face
value (the total dollar amount of MBS the purchaser wishes to
purchase); (iv) the price; and (v) the settlement date.\415\ The
purchaser will contract to acquire a specified dollar amount of MBS,
which may be satisfied when the seller delivers one or more MBS pools
at settlement.\416\
---------------------------------------------------------------------------
\412\ Task Force on Mortgage-Backed Securities Disclosure,
``Staff Report: Enhancing Disclosure in the Mortgage-Backed
Securities Markets,'' part II.E.2 (Jan. 2003), which is available at
http://www.sec.gov/news/studies/mortgagebacked.htm (``MBS Staff
Report'').
\413\ Id.
\414\ Id.
\415\ Id.
\416\ Id. The good delivery guidelines, titled ``Uniform
Practices for the Clearance and Settlement of Mortgage-Backed
Securities and Other Related Securities,'' which govern the
mechanics of trading and settling MBS, contain specific guidelines
for trading and settling MBS guaranteed or sold by Fannie Mae,
Freddie Mac and Ginnie Mae in the TBA market. The good delivery
guidelines outline the basic terms and conditions for trading,
confirming, delivering and settling MBS. The good delivery
guidelines set forth the basic characteristics that MBS guaranteed
or sold by Fannie Mae, Freddie Mac and Ginnie Mae must have to be
able to be delivered to settle an open TBA transaction. Id. The
Securities Industry and Financial Markets Association (``SIFMA'') is
the successor to the Bond Market Association and publishes the good
delivery guidelines, which are available at http://www.sifma.org/services/standard-forms-and-documentation/securitized-products/.
---------------------------------------------------------------------------
The Commissions are confirming that such forward sales of MBS in
the TBA market would fall within the exclusion for sales of securities
on a deferred settlement or delivery basis even though the precise MBS
are not in existence at the time the forward MBS sale is entered
into.\417\ Moreover, as the purchase or sale of a security, the
Commissions also are confirming that such forward sales of MBS in the
TBA market would fall within the exclusions for the purchase or sale of
one or more securities on a fixed basis (or, depending on its terms, a
contingent basis) and therefore would fall outside the swap and
security-based swap definitions.\418\
---------------------------------------------------------------------------
\417\ See section 1a(47)(B)(ii) of the CEA, 7 U.S.C.
1a(47)(B)(ii).
\418\ See sections 1a(47)(B)(v) and (vi) of the CEA, 7 U.S.C.
1a(47)(B)(v) and (vi).
---------------------------------------------------------------------------
Comments
The Commissions received two comments on the interpretation
regarding security forwards. One commenter recommended that the
Commissions codify in the text of the final rules the interpretation
regarding forward sales of MBS in the TBA market.\419\ The Commissions
are not codifying the interpretation because codification will create a
bright-line test. The Commissions note that the analysis as to whether
any product falls within the exclusion for sales of securities on a
deferred settlement or delivery basis requires flexibility, including
the consideration of applicable facts and circumstances. Because the
interpretation regarding forward sales of MBS in the TBA market is
based on particular facts and circumstances, the Commissions do not
believe that a bright-line test is appropriate.
---------------------------------------------------------------------------
\419\ See Letter from Lisa M. Ledbetter, Vice President and
General Counsel, Legislative & Regulatory Affairs, Freddie Mac, Jul.
21, 2011.
---------------------------------------------------------------------------
Another commenter suggested that the Commissions narrow the
exclusion for contracts for the purchase and sale of securities for
subsequent delivery as applied to security-based swaps because parties
can use the formal characterization of a delivery contract for
securities to disguise a transaction that is substantively a security-
based swap.\420\ This commenter was concerned because this commenter
believes that the securities subject to such a delivery obligation are
often easily convertible into cash, which facilitates cash settlement
without actual delivery.\421\ As such, this commenter suggested that
the Commissions should provide a test for determining whether parties
have a bona fide intent to deliver.\422\ This commenter recommended
that such test should prohibit cash settlement options in contracts for
subsequent delivery and should not consider a party that frequently
unwinds physical positions with cash settlements using side agreements
as having the requisite intent to deliver.\423\ The Commissions are not
providing a test at this time for determining whether parties have a
bona fide intent to deliver because the analysis as to whether sales of
securities for deferred shipment or delivery are intended to be
physically delivered is a facts and circumstances determination and a
bright-line test will not allow for the flexibility needed in such
analysis. Further, the Commissions note that the purchase and sale of a
security occurs at the time the forward contract is entered into.\424\
---------------------------------------------------------------------------
\420\ See Better Markets Letter.
\421\ Id.
\422\ Id.
\423\ Id.
\424\ See supra note 408.
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[[Page 48246]]
3. Consumer and Commercial Agreements, Contracts, and Transactions
The Commissions noted in the Proposing Release that ``[c]onsumers
enter into various types of agreements, contracts, and transactions as
part of their household and personal lives that may have attributes
that could be viewed as falling within the swap or security-based swap
definition.\425\ Similarly, businesses and other entities, whether or
not for profit, also enter into agreements, contracts, and transactions
as part of their operations relating to, among other things,
acquisitions or sales of property (tangible and intangible), provisions
of services, employment of individuals, and other matters that could be
viewed as falling within the definitions.'' \426\
---------------------------------------------------------------------------
\425\ See Proposing Release at 29832.
\426\ Id.
---------------------------------------------------------------------------
Commenters on the ANPR pointed out a number of areas in which a
broad reading of the swap and security-based swap definitions could
cover certain consumer and commercial arrangements that historically
have not been considered swaps or security-based swaps.\427\ Examples
of such instruments cited by those commenters included evidences of
indebtedness with a variable rate of interest; commercial contracts
containing acceleration, escalation, or indexation clauses; agreements
to acquire personal property or real property, or to obtain mortgages;
employment, lease, and service agreements, including those that contain
contingent payment arrangements; and consumer mortgage and utility rate
caps.\428\
---------------------------------------------------------------------------
\427\ Id.
\428\ Id.
---------------------------------------------------------------------------
The Commissions also stated in the Proposing Release that they ``do
not believe that Congress intended to include these types of customary
consumer and commercial agreements, contracts, or transactions in the
swap or security-based swap definition, to limit the types of persons
that can enter into or engage in them, or to otherwise to subject these
agreements, contracts, or transactions to the regulatory scheme for
swaps and security-based swaps.'' \429\
---------------------------------------------------------------------------
\429\ Id. If these types of arrangements were subject to Title
VII, the persons that could enter into or engage in them could be
restricted because Title VII imposes restrictions on entering into
swaps and security-based swaps with persons who are not eligible
contract participants (``ECPs''). See sections 723(1), 763(e), and
768(b) of the Dodd-Frank Act. The Dodd-Frank Act amended the
Securities Act and the Exchange Act to require that security-based
swap transactions involving a person that is not an ECP must be
registered under the Securities Act and effected on a national
securities exchange, and also amended the CEA to require that swap
transactions involving a person that is not an ECP must be entered
into on, or subject to the rules of, a board of trade designated as
a contract market. Id. The Commissions note that many consumers and
commercial and non-profit entities may not be ECPs. See section
1a(18) of the CEA, 7 U.S.C. 1a(18). Further, if these types of
arrangements were subject to Title VII, they would be subject to the
full regulatory scheme for swaps and security-based swaps created by
Title VII. These requirements could increase costs for consumers and
commercial and non-profit entities and potentially disrupt their
ability to enter into these arrangements.
---------------------------------------------------------------------------
Accordingly, the Commissions proposed an interpretation in the
Proposing Release to assist consumers and commercial and non-profit
entities in understanding whether certain agreements, contracts, or
transactions that they enter into would be regulated as swaps or
security-based swaps.\430\ The Commissions are adopting the
interpretation set out in the Proposing Release with certain
modifications in response to commenters.\431\
---------------------------------------------------------------------------
\430\ See Proposing Release at 29832-33.
\431\ See infra note 447 and accompanying text.
---------------------------------------------------------------------------
With respect to consumers, the Commissions have determined that the
types of agreements, contracts, or transactions that will not be
considered swaps or security-based swaps when entered into by consumers
(natural persons) as principals (or by their agents)\432\ primarily for
personal, family, or household purposes, include:\433\
---------------------------------------------------------------------------
\432\ For example, a mortgage broker may arrange a rate lock on
behalf of a consumer borrower.
\433\ The Commissions are not addressing here the applicability
of any other provisions of the CEA, the Federal securities laws or
the Commissions' regulations to such agreements, contracts or
transactions.
---------------------------------------------------------------------------
Agreements, contracts, or transactions 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, contracts, or transactions to purchase
products or services for personal, family or household purposes 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);\434\
---------------------------------------------------------------------------
\434\ These agreements, contracts, or transactions require the
parties respectively to make and take delivery of the underlying
commodity to each other directly; delivery may be deferred for
convenience or necessity. But see section 2(c)(2)(D) of the CEA, 7
U.S.C. 2(c)(2)(D), generally prohibiting certain leveraged, margined
or financed agreements, contracts and transactions with non-ECPs
when actual delivery does not occur within 28 days). The Commissions
view consumer agreements, contracts, and transactions involving
periodic or future purchases of consumer products and services as
transactions that are not swaps. This interpretation does not extend
to consumer agreements, contracts or transactions containing
embedded optionality or embedded derivatives other than those
discussed in the text associated with this footnote. This analysis
of consumer contracts is separate from the forward contract analysis
for commercial merchandising transactions discussed in supra part
II.B.2. The CFTC continues to view the forward contract exclusion
for nonfinancial commodities as limited to commercial merchandising
transactions.
---------------------------------------------------------------------------
Agreements, contracts, or transactions 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; \435\
---------------------------------------------------------------------------
\435\ An example of a consumer loan with a variable rate of
interest is credit card debt that includes a ``teaser'' rate. The
teaser rate is a low, adjustable introductory interest rate that is
temporary.
---------------------------------------------------------------------------
Service agreements, contracts, or transactions that are
consumer product warranties, extended service plans, or buyer
protection plans, such as those purchased with major appliances and
electronics; \436\
---------------------------------------------------------------------------
\436\ One commenter indicated that such service agreements,
contracts, or transactions may be regulated as insurance in some but
not all states. However, the Commissions believe that it is
appropriate to address these agreements, contracts, or transactions
in the context of their guidance regarding consumer and commercial
arrangements. See NAIC Letter.
---------------------------------------------------------------------------
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; \437\
---------------------------------------------------------------------------
\437\ The Commissions believe that options entered into by
consumers that result in physical delivery of the commodity, if
exercised, are not the type of agreements, contracts or transactions
that Congress intended to regulate as swaps or security-based swaps.
Conversely, options entered into by consumers that cash settle based
on the difference between the market price and the contract price of
a commodity are not within the scope of this interpretation.
---------------------------------------------------------------------------
Consumer agreements, contracts, or transactions where, by
law or regulation, the consumer may cancel the transaction without
legal cause; \438\ and
---------------------------------------------------------------------------
\438\ Examples of these types of transactions include consumer
transactions that may be cancelled pursuant to the Federal Reserve
Board's Regulation Z, 12 CFR Part 226 (i.e. certain consumer credit
transactions that involve a lien on the consumer's principal
dwelling), consumer mail/telephone orders that may be cancelled when
orders have not been filled under 16 CFR Part 435, and other
consumer transactions that have cancellations rights conferred by
statute or regulation.
---------------------------------------------------------------------------
[[Page 48247]]
Consumer guarantees of credit card debt, automobile loans,
---------------------------------------------------------------------------
and mortgages of a friend or relative.
The Commissions have included in the interpretation above several
additional examples of consumer arrangements that the Commissions do
not consider to be swaps or security-based swaps. These additional
examples have been included in response to commenters \439\ and the
Commissions' determination that such additional examples would assist
consumers in identifying other agreements, contracts, or transactions
that they enter into that would not be regulated as swaps or security-
based swaps.\440\
---------------------------------------------------------------------------
\439\ See supra note 96 and accompanying text. See also infra
notes 436, 454 and 455 and accompanying text.
\440\ The additional example regarding consumer options to
acquire, lease, or sell real or personal property was added in
response to a commenter on the ANPR. See Letter from White & Case
LLP, dated September 20, 2010. The Commissions also are providing as
additional examples consumer agreements, contracts, or 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.
---------------------------------------------------------------------------
The types of commercial agreements, contracts, or transactions that
involve customary business arrangements (whether or not involving a
for-profit entity) and will not be considered swaps or security-based
swaps under this interpretation include:
Employment contracts and retirement benefit arrangements;
Sales, servicing, or distribution arrangements;
Agreements, contracts, or transactions for the purpose of
effecting a business combination transaction; \441\
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\441\ These business combination transactions include, for
example, a reclassification, merger, consolidation, or transfer of
assets as defined under the Federal securities laws or any tender
offer subject to section 13(e) and/or section 14(d) or (e) of the
Exchange Act, 15 U.S.C. 78m(e) and/or 78n(d) or (e). These business
combination agreements, contracts, or transactions can be contingent
on the continued validity of representations and warranties and can
contain earn-out provisions and contingent value rights.
---------------------------------------------------------------------------
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); \442\
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\442\ The Commissions believe that such lending arrangements
included in this category are traditional borrower/lender
arrangements documented using, for example, a loan agreement or
indenture, as opposed to a synthetic lending arrangement documented
in the form of, for example, a total return swap. The Commissions
also note that securitization transaction agreements also may
contain contingent obligations if the representations and warranties
about the underlying assets are not satisfied.
---------------------------------------------------------------------------
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 \443\ and non-banks, including the
following:
---------------------------------------------------------------------------
\443\ While the Commissions have included fixed or variable
interest rate commercial loans entered into by banks, the
Commissions understand that the CEA does not apply to, and the CFTC
may not exercise regulatory authority over, identified banking
products, and that the definitions of the terms ``security-based
swap'' and ``security-based swap agreement'' do not include
identified banking products. See infra note 488, regarding
identified banking products. However, such loans and mortgages
provided by certain banks may not qualify as identified banking
products because those banks may not satisfy the definition of
``bank'' for purposes of the ``identified banking products''
definition. See 7 U.S.C. 27(a).
---------------------------------------------------------------------------
Fixed or variable interest rate commercial loans or
mortgages entered into by the Farm Credit System institutions and
Federal Home Loan Banks;
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, contracts, and transactions
(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.
In response to commenters,\444\ the Commissions have included in the
interpretation above several additional examples of commercial
arrangements that the Commissions do not consider to be swaps or
security-based swaps.
---------------------------------------------------------------------------
\444\ See infra notes 456 and 461 and accompanying text.
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The Commissions intend for this interpretation to enable consumers
to engage in transactions relating to their households and personal or
family activities without concern that such arrangements would be
considered swaps or security-based swaps. Similarly, with respect to
commercial business arrangements, this interpretation should allow
commercial and non-profit entities to continue to operate their
businesses and operations without significant disruption and provide
that the swap and security-based swap definitions are not read to
include commercial and non-profit operations that historically have not
been considered to involve swaps or security-based swaps.
The types of agreements, contracts, and transactions discussed
above are not intended to be exhaustive of the customary consumer or
commercial arrangements that should not be considered to be swaps or
security-based swaps. There may be other, similar types of agreements,
contracts, and transactions that also should not be considered to be
swaps or security-based swaps. In determining whether similar types of
agreements, contracts, and transactions entered into by consumers or
commercial entities are swaps or security-based swaps, the Commissions
intend to consider the characteristics and factors that are common to
the consumer and commercial transactions listed above:
They do not contain payment obligations, whether or not
contingent, that are severable from the agreement, contract, or
transaction;
They are not traded on an organized market or over-the-
counter; and
In the case of consumer arrangements, they:
--Involve an asset of which the consumer is the owner or beneficiary,
or that the consumer is purchasing, or they involve a service provided,
or to be provided, by or to the consumer, or
In the case of commercial arrangements, they are 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
--Other than for speculative, hedging, or investment purposes.
Two of the key components reflected in these characteristics that
distinguish these agreements, contracts, and transactions from swaps
and security-based swaps are that: (i) The payment provisions of the
agreement, contract, or transaction are not severable; and (ii)
[[Page 48248]]
the agreement, contract, or transaction is not traded on an organized
market or over-the-counter, and therefore such agreement, contract, or
transaction does not involve risk-shifting arrangements with financial
entities, as would be the case for swaps and security-based swaps.\445\
In response to commenters,\446\ the Commissions clarify that merely
because an agreement, contract, or transaction is assignable does not
mean that it is ``traded'' or that the agreement, contract, or
transaction is a swap or security-based swap. An assignment of a
contractual obligation must be analyzed to assure that the result is
not to sever the payment obligations.
---------------------------------------------------------------------------
\445\ There also are alternative regulatory regimes that have
been enacted as part of the Dodd-Frank Act specifically to provide
enhanced protections to consumers relating to various consumer
transactions. See, e.g., the Consumer Financial Protection Act of
2010, Public Law 111-203, tit. X, 124 Stat. 1376 (Jul. 21, 2010)
(establishing the Bureau of Consumer Financial Protection to
regulate a broad category of consumer products and amending certain
laws under the jurisdiction of the Federal Trade Commission); the
Mortgage Reform and Anti-Predatory Lending Act, Public Law 111-203,
tit. XIV, 124 Stat. 1376 (Jul. 21, 2010) (amending existing laws,
and adding new provisions, related to certain mortgages). Some of
these agreements, contracts, or transactions are subject to
regulation by the Federal Trade Commission and other Federal
financial regulators and state regulators.
\446\ See infra note 470.
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This interpretation is not intended to be the exclusive means for
consumers and commercial or non-profit entities to determine whether
their agreements, contracts, or transactions fall within the swap or
security-based swap definition. If there is a type of agreement,
contract, or transaction that is not enumerated above, or does not have
all the characteristics and factors that are listed above (including
new types of agreements, contracts, or transactions that may be
developed in the future), the agreement, contract, or transaction will
be evaluated based on its particular facts and circumstances. Parties
to such an agreement, contract or transaction may also seek an
interpretation from the Commissions as to whether the agreement,
contract or transaction is a swap or security-based swap.
Comments
Eleven commenters provided comments on the proposed interpretation
set forth in the Proposing Release regarding consumer and commercial
arrangements.\447\ While most commenters supported the proposed
interpretation, these commenters suggested certain changes.
---------------------------------------------------------------------------
\447\ See BGA Letter; Letter from The Coalition for Derivatives
End-Users, Jul. 22, 2011, (``CDEU Letter''); ETA Letter; Letter from
Robbie Boone, Vice President, Government Affairs, Farm Credit
Council, Jul. 22, 2011 (``FCC Letter''); FERC Staff Letter; Letter
from Warren N. Davis, Of Counsel, Sutherland Asbill & Brennan LLP,
on behalf of the Federal Home Loan Banks, Jul. 22, 2011 (``FHLB
Letter''); IECA Letter; ISDA Letter; Just Energy Letter; PMAA/NEFI
Letter; and SEIA Letter.
---------------------------------------------------------------------------
Four commenters recommended that the Commissions codify the
proposed interpretation regarding consumer and commercial
arrangements.\448\ The Commissions are not codifying the
interpretation. The interpretation is intended to provide guidance to
assist consumers and commercial and non-profit entities in evaluating
whether certain arrangements that they enter into will be regulated as
swaps or security-based swaps. The interpretation is intended to allow
the flexibility necessary, including the consideration of the
applicable facts and circumstances by the Commissions, in evaluating
consumer and commercial arrangements to ascertain whether they may be
swaps or security-based swaps. The representative characteristics and
factors taken together are indicators that a consumer or commercial
arrangement is not a swap or security-based swap and the Commissions
have provided specific examples demonstrating how these characteristics
and factors apply to some common types of consumer and commercial
arrangements. However, as the interpretation is not intended to be a
bright-line test for determining whether a particular consumer or
commercial arrangement is a swap or security-based swap, if the
particular arrangement does not meet all of the identified
characteristics and factors, the arrangement will be evaluated based on
its particular facts and circumstances.
---------------------------------------------------------------------------
\448\ See ETA Letter; FERC Letter; IECA Letter; and Just Energy
Letter.
---------------------------------------------------------------------------
One commenter was concerned that the interpretation itself
implicitly suggests that many types of consumer and commercial
arrangements could be swaps, although none of these arrangements
historically has been considered a swap.\449\ The Commissions do not
intend to suggest that many types of consumer and commercial
arrangements that historically have not been considered swaps are
within the swap or security-based swap definitions. The Commissions
provided the interpretation in response to comments received on the
ANPR. Commenters on the ANPR identified areas in which a broad reading
of the swap and security-based swap definitions could cover certain
consumer and commercial arrangements that historically have not been
considered swaps or security-based swaps.\450\ The Commissions believe
it is appropriate to provide the interpretation to allow consumers and
commercial and non-profit entities to engage in such transactions
without concern that such arrangements would be considered swaps or
security-based swaps.
---------------------------------------------------------------------------
\449\ See IECA Letter.
\450\ See Proposing Release at 29832.
---------------------------------------------------------------------------
One commenter requested that the Commissions remove the term
``customary'' from the description of consumer and commercial
arrangements in the interpretation.\451\ The Commissions note that the
use of the term ``customary'' was not intended to limit the
interpretation, but rather was used to describe certain types of
arrangements that consumers and businesses may normally or generally
enter into. The Commissions also note that the term ``customary'' is
itself not a separate representative characteristic or factor for
purposes of the interpretation.
---------------------------------------------------------------------------
\451\ See ISDA Letter.
---------------------------------------------------------------------------
This commenter also requested that specific examples of consumer
and commercial arrangements that are not swaps or security-based swaps
include ``any other similar agreements, contracts, or transactions.''
\452\ The specific examples are not intended to be an exhaustive list
and the Commissions do not believe that it is necessary to include a
general catchall provision. The interpretation also includes a list of
representative characteristics and factors to be used to analyze other
consumer and commercial arrangements.
---------------------------------------------------------------------------
\452\ Id.
---------------------------------------------------------------------------
Several commenters suggested additional examples of consumer and
commercial arrangements that the Commissions should not consider to be
swaps or security-based swaps.\453\ One commenter suggested that the
Commissions should expand the example of ``consumer agreements,
contracts, or transactions 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 home heating fuel)'' to
include all nonfinancial energy commodities in the parenthetical
example.\454\ The Commissions have modified the identified consumer
example to include all nonfinancial energy commodities. The
parenthetical example was not intended to be limited to agreements to
purchase home heating fuel.
---------------------------------------------------------------------------
\453\ See CDEU Letter; FCC Letter; FERC Letter; FHLB Letter;
ISDA Letter; Just Energy Letter; PMAA/NEFI Letter; and SEIA Letter.
\454\ See Just Energy Letter.
---------------------------------------------------------------------------
One commenter suggested that the Commissions should include as an
[[Page 48249]]
additional example residential fuel storage contracts.\455\ The
Commissions agree that these arrangements should not be considered
swaps or security-based swaps, provided that they are residential fuel
storage contracts where the consumer takes delivery of and consumes the
fuel, and the counterparty is a merchant (or agent of a merchant) that
delivers in the service area where the consumer's residence is located.
Although the consumer may not immediately consume the fuel contracted
for, because it will ultimately consume the fuel for personal, family,
or household purposes, such a transaction is a type of customary
consumer transaction excluded from the swap and security-based swap
definitions.
---------------------------------------------------------------------------
\455\ See PMAA/NEFI Letter.
---------------------------------------------------------------------------
Three commenters requested clarification that commercial loans and
mortgages would fall within the interpretation regardless of whether
entered into by a bank or non-bank.\456\ Two of these commenters were
concerned that the specific example was limited to commercial loans and
mortgages entered into by non-banks and did not address commercial
loans and mortgages entered into by financial institutions that are
banks but whose loans and mortgages do not qualify as identified
banking products.\457\ The Commissions are revising the example to
clarify that it includes fixed or variable interest rate commercial
loans or mortgages entered into by both banks and non-banks, including
such loans and mortgages entered into by the Farm Credit System
institutions and Federal Home Loan Banks. The Commissions understand
that the CEA does not apply to, and the CFTC may not exercise
regulatory authority over, and the definitions of the terms ``security-
based swap'' and ``security-based swap agreement'' do not include, any
fixed or variable interest rate commercial loan or mortgage entered
into by a bank that is an identified banking product.\458\ However,
loans and mortgages provided by certain banks may not qualify as
identified banking products because those banks do not satisfy the
definition of ``bank'' for purposes of the ``identified banking
products'' definition.\459\ According to commenters,\460\ while this
definition of ``bank'' includes insured depository institutions,
certain foreign banks, credit unions, institutions regulated by the
Federal Reserve and trust companies, it does not include certain other
financial institutions that provide commercial loans or mortgages, such
as government-sponsored enterprises (including the Federal Home Loan
Banks) and certain cooperatives (including the Farm Credit System
institutions).
---------------------------------------------------------------------------
\456\ See CDEU Letter; FCC Letter; and FHLB Letter.
\457\ See FCC Letter and FHLB Letter.
\458\ See infra note 488, regarding identified banking products.
\459\ See 7 U.S.C. 27(a). See also FCC Letter and FHLB Letter.
\460\ See supra note 457.
---------------------------------------------------------------------------
Three commenters suggested that the Commissions should include as
additional examples commercial rate lock agreements and commercial
loans with interest rate caps, floors, or options.\461\ The Commissions
agree that these arrangements should not be considered swaps or
security-based swaps, provided that the interest rate locks, caps, or
floors, or interest rate options are embedded in the commercial loans
or mortgages and not entered into separately from the commercial loans
and mortgages, and are including these arrangements as examples in the
interpretation. However, the Commissions are limiting the
interpretation to embedded interest rate locks, caps, or floors, and
interest rate options because interest rate locks, caps, or floors, or
interest rate options that are entered into separately from the
commercial loans and mortgages fall within the swap definition.\462\ In
order to further distinguish these arrangements from swaps and
security-based swaps, the interpretation provides the following: (i)
The embedded interest rate lock, cap, or floor must be included for the
sole purpose of providing a lock, cap, or floor on the interest rate on
such loan or mortgage and may not include additional provisions that
would provide exposure to enhanced or inverse performance, or other
risks unrelated to the interest rate risk being addressed, and (ii) the
embedded interest rate option may not include additional provisions
that would provide exposure to leverage, inverse performance, or other
risks unrelated to the primary reason the embedded interest rate option
is included in the commercial loan or mortgage.
---------------------------------------------------------------------------
\461\ See CDEU Letter; FCC Letter; and FHLB Letter. These
commenters indicated that such arrangements are similar to the
arrangements included in the list of examples of consumer
arrangements that the Commissions would not consider to be swaps or
security-based swaps.
\462\ See section 1a(47)(A)(i) of the CEA, 7 U.S.C.
1a(47)(A)(i). Similarly, with respect to consumer agreements,
contracts and transactions providing for an interest rate cap or an
interest rate lock on a consumer loan or mortgage, the Commissions
are limiting this example to interest rate caps and interest rate
locks entered into in connection with the consumer loan or mortgage
and prior to closing on the loan or mortgage. For this purpose, both
because obtaining a consumer loan or mortgage can involve a great
deal of documentation, which can be entered into at different times
during the process, and because consumers may have some flexibility
as to their deadline for deciding when to include or exclude an
interest rate cap or lock in their consumer loans or mortgages, the
Commissions will consider an interest rate cap or lock to be entered
into in connection with a consumer loan or mortgage if it is
included in the final terms of the loan at closing.
---------------------------------------------------------------------------
Four commenters suggested additional examples of commercial
arrangements that relate to nonfinancial energy commodities.\463\ These
arrangements are more appropriately addressed in the context of the
forward contract exclusion for nonfinancial commodities \464\ or the
trade option exemption.\465\
---------------------------------------------------------------------------
\463\ See BGA Letter (commercial physical transactions in the
natural gas and electric power markets should also fall under the
category of exemptions from the swap definition); FERC Letter
(commercial transactions executed or traded on RTOs/ISOs should be
included in the interpretation); Just Energy Letter (commercial
arrangements 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); and PMAA/NEFI Letter (petroleum fuel and gas storage
contracts between bona fide commercial market participants or
entities other than financial entities).
\464\ See supra part II.B.2. The Commissions note that they
provided the interpretation regarding consumer arrangements because
the CFTC in the past has not interpreted the forward contract
exclusion for nonfinancial commodities to apply to consumer
arrangements. See supra note 434.
\465\ See supra note 317 and accompanying text.
---------------------------------------------------------------------------
One commenter supported the representative characteristics and
factors the Commissions set forth to distinguish consumer and
commercial arrangements from swaps and security-based swaps.\466\ Two
commenters were concerned with certain of these characteristics and
factors because these commenters believed that such characteristics and
factors are common in a wide variety of consumer and commercial
arrangements.\467\ Both commenters suggested that the Commissions
remove ``for other than speculative, hedging or investment purposes''
from the interpretation because many of the types of transactions
listed as examples may be undertaken for speculative, hedging or
investment purposes and because all commercial merchandising
transactions are ``risk-shifting'' of commercial obligations and risks,
and ``hedge'' the enterprise's commercial risks.\468\ The Commissions
are not revising the interpretation to remove or otherwise modify this
representative characteristic and factor. The Commissions believe that
commercial arrangements undertaken for speculative, hedging or
investment purposes may be a swap or a security-based swap depending on
the particular facts and circumstances of the arrangement.
---------------------------------------------------------------------------
\466\ See FCC Letter.
\467\ See ETA Letter and ISDA Letter.
\468\ Id.
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[[Page 48250]]
One of these commenters also suggested the Commissions remove ``do
not contain payment obligations that are severable'' from the
interpretation because assignment of rights and delegation of
obligations are common in a wide variety of consumer and commercial
transactions.\469\ The Commissions are not revising the interpretation
to remove or otherwise modify this representative characteristic and
factor. The Commissions believe that the severability of payment
obligations could be indicative of a consumer or commercial arrangement
that may be a swap or a security-based swap depending on the particular
facts and circumstances of the arrangement because the severability of
payment obligations could be indicative of an instrument that is merely
an exchange of payments, such as is the case with swaps and security-
based swaps.
---------------------------------------------------------------------------
\469\ See ISDA Letter.
---------------------------------------------------------------------------
One of these commenters also suggested that the Commissions remove
``not traded on an organized market or over the counter'' from the
interpretation because many of the types of contracts listed as
examples are assignable and frequently assigned or traded.\470\ The
other commenter did not suggest removing this factor, but requested
that the factor be modified to provide that the arrangement is not
traded on a ``registered entity'' in order not to include transactions
on organized wholesale electricity markets.\471\ The Commissions are
not revising the interpretation to remove or otherwise modify this
representative characteristic and factor. The Commissions believe that
the trading of an instrument on an organized market or over the counter
could be indicative of a consumer or commercial arrangement that may be
a swap or a security-based swap depending on the particular facts and
circumstances of the arrangement. However, as noted above, the
Commissions are clarifying that merely because an arrangement is
assignable does not mean that it is ``traded'' or that the arrangement
is a swap or security-based swap. An assignment of a contractual
obligation must be analyzed to assure that the result is not to sever
the payment obligations.
---------------------------------------------------------------------------
\470\ Id.
\471\ See ETA Letter.
---------------------------------------------------------------------------
Further, as noted above, the representative characteristics and
factors are not intended to be a bright-line test for determining
whether a particular consumer or commercial arrangement is a swap or
security-based swap. These representative characteristics and factors
taken together are indicators that a consumer or commercial arrangement
is not a swap or security-based swap. These representative
characteristics and factors also do not imply or presume that a
consumer or commercial arrangement that does not meet all of these
characteristics and factors is a swap or security-based swap. As noted
above, if a particular arrangement does not meet all of these
characteristics and factors, the parties will need to evaluate the
arrangement based on the particular facts and circumstances. Moreover,
as noted above, if there is a type of consumer or commercial
arrangement that does not meet all of these characteristics and
factors, a party to the arrangement can seek an interpretation from the
Commissions as to whether the arrangement is outside the scope of the
swap and security-based swap definitions.
Residential Exchange Program
One commenter requested that the CFTC further define the term
``swap'' to exclude consumer benefits under the Pacific Northwest
Electric Power Planning and Conservation Act of 1980 (``Northwest Power
Act'') \472\ and transactions under the ``Residential Exchange
Program'' (``REP'').\473\ According to this commenter, the REP was
established by Congress ``[t]o extend the benefits of low cost Federal
System hydro power to residential and small farm electric power
consumers throughout the Pacific Northwest Region.'' \474\ Based on the
commenter's description, REP transactions do not appear to be among the
types of transactions historically considered swaps or security-based
swaps. Although the REP transactions described by the commenter share
some features with spread options (e.g., they settle in cash based on
the difference between two price sources),\475\ in both swaps and
security-based swaps, each party assumes market risk.\476\ By contrast,
neither party assumes or hedges risk in an REP transaction.\477\
Instead, the Commissions view an REP transaction essentially as a
subsidy provided to residential and small farm utility customers.\478\
Accordingly, the Commissions do not consider the REP transactions
described by the commenter to be swaps or security-based swaps.
---------------------------------------------------------------------------
\472\ 16 U.S.C. Chapter 12H.
\473\ Letter from Virginia K. Schaeffer, Attorney, Office of
General Counsel, Bonneville Power Administration, Jul. 22, 2011
(``BPA Letter''). This commenter refers to the implementation of
Section 5(c) of the Northwest Power Act, 16 U.S.C. 839c(c), as the
``Residential Exchange Program.'' See Id.
\474\ See BPA Letter. This commenter explained that, under the
REP: ``A Pacific Northwest electric utility has a right to * * *
sell power to Bonneville at the utility's average system cost (ASC)
of providing that power * * * Bonneville[] is required to purchase
that power at the utility's ASC, and then sell an equivalent amount
of power back to the utility at Bonneville's rates[,] which are
based in substantial part on low cost Federal hydro power. As
required by the Residential Exchange Statute, the amount of such
power ``exchanged'' is based on the related utility's residential
and small farm customer's power needs (also known as ``loads'') in
the Pacific Northwest Region. Under this ``exchange,'' no actual
power is transferred to or from Bonneville. Instead, consistent with
Congressional intent, the exchange transaction is implemented as an
accounting device that avoids the costs and burdens associated with
a physical exchange of power and that results in the payment of
funds by Bonneville to the REP exchanging utilities. Reduced to the
essentials, the Residential Exchange Statute as implemented in * * *
REP contracts results in Bonneville making cash payments for the
positive difference between the utility's ASC and Bonneville's lower
rate multiplied by the qualifying residential and small farm loads.
And, as required under the Residential Exchange Statute, the entire
monetary benefit Bonneville provides to the REP exchanging utilities
is in turn passed through to the residential and small farm power
consumers of that utility.'' Id.
\475\ A spread option is ``an option in which the payout is
based on the difference in performance between two assets.''
Superderivatives, ``Spread option in EQ'' definition, available at
http://www.sdgm.com/Support/Glossary.aspx?letter=S. See also S.J.
Denga and S.S. Oren, Electricity derivatives and risk management,
Science Direct at 945 (2006), available at http://
www.ieor.berkeley.edu/~oren/pubs/Deng%20and%20Oren-86.pdf (defining
a spark spread options as ``cross-commodity options paying out the
difference between the price of electricity sold by generators and
the price of the fuels used to generate it''); Chicago Mercantile
Exchange, Soybean-Corn Price Ratio Options Fact Card (describing its
soybean-corn price ratio option contract as ``an option on the ratio
between the price of the referencing Soybean futures contract and
the price of the referencing Corn futures contract * * *''),
available at http://www.cmegroup.com/trading/agricultural/files/AC-440-Soybean-CornRatioOptionsFC.pdf.
\476\ Even a hedging party assumes the risk that the market can
move against its hedging position, causing the hedge to reduce the
profit it otherwise would have made on an unhedged position.
\477\ The fact that the Commissions are relying in part on this
aspect of REP transactions to interpret such transactions to be
neither swaps nor security-based swaps does not mean that market
participants should conclude, in other contexts, that a lack of
market risk removes an agreement, contract, or transaction from the
swap and security-based swap definitions. The Commissions'
conclusion as to REP transactions is based on the unique facts and
circumstances presented by the commenter.
\478\ See, e.g., Paul M. Murphy, Northwest Public Power
Association, Background and Summary of the Residential Exchange
Program Settlement Agreement, March 16, 2011, available at http://www.nwppa.org/cwt/external/wcpages/wcmedia/documents/background_and_summary_of_rep_settlement_agreement.pdf (characterizing the
REP as ``require[ing] BPA to subsidize the residential and small
farm consumers of the higher cost utilities in the Pacific
Northwest'').
---------------------------------------------------------------------------
Loan Participations
The Commissions provided an interpretation in the Proposing Release
regarding the treatment of loan participations.\479\ The Commissions
are
[[Page 48251]]
restating the interpretation set out in the Proposing Release with
certain modifications in response to commenters.\480\
---------------------------------------------------------------------------
\479\ See Proposing Release at 29834.
\480\ See infra note 504 and accompanying text.
---------------------------------------------------------------------------
Loan participations arise when a lender transfers or offers a
participation in the economic risks and benefits of all or a portion of
a loan or commitment it has entered into with a borrower to another
party as an alternative or precursor to assigning to such person the
loan or commitment or an interest in the loan or commitment.\481\ The
Commissions understand that two types of loan participations exist in
the market today,\482\ LSTA-style participations\483\ and LMA-style
participations.\484\ LSTA-style participations transfer a beneficial
ownership interest in the underlying loan or commitment to the
participant.\485\ LMA-style participations do not transfer a beneficial
ownership interest in the underlying loan or commitment to the
participant, but rather create a debtor-creditor relationship between
the grantor and the participant under which a future beneficial
ownership interest is conveyed.\486\
---------------------------------------------------------------------------
\481\ See Loan Market Association, ``Guide to Syndicated
Loans,'' section 6.2.4 (``A [loan] participation * * * is made
between the existing lender and the participant. This creates new
contractual rights between the existing lender and the participant
which mirror existing contractual rights between the existing lender
and the borrower. However this is not an assignment of those
existing rights and the existing lender remains in a direct
contractual relationship with the borrower.''), available at http://www.lma.eu.com/uploads/files/Introductory_Guides/Guide_to_Par_Syndicated_Loans.pdf.
\482\ See Letter from R. Bram Smith, Executive Director, The
Loan Syndications and Trading Association, Jan. 25, 2011 (``January
LSTA Letter''); Letter from Elliot Ganz, General Counsel, The Loan
Syndications and Trading Association, Mar. 1, 2011 (``March LSTA
Letter''); and Letter from Clare Dawson, Managing Director, The Loan
Market Association, Feb. 23, 2011. The Commissions understand that
neither type of loan participation is a ``synthetic'' transaction.
See March LSTA Letter. Both types of loan participations are merely
transfers of cash loan positions and the ratio of underlying loan to
participation is always one to one. Id.
\483\ The LSTA is The Loan Syndications and Trading Association.
\484\ The LMA is The Loan Market Association.
\485\ See Letter from Clare Dawson, Managing Director, The LMA,
Jul. 22, 2011 (``July LMA Letter'').
\486\ See Id. The participant may exercise an ``elevation''
right and request that the grantor use commercially reasonable
efforts to cause the participant to become the legal owner, by
assignment, of the underlying loan or commitment. Id.
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Depending on the facts and circumstances, a loan participation may
be a security under the Federal securities laws and, as such, the loan
participation would be excluded from the swap definition as the
purchase and sale of a security on a fixed or contingent basis.\487\ In
addition, depending on the facts and circumstances, a loan
participation may be an identified banking product and, as such, would
be excluded from CFTC jurisdiction and from the security-based swap and
security-based swap agreement definitions.\488\
---------------------------------------------------------------------------
\487\ See sections 1a(47)(B)(v) and (vi) of the CEA, 7 U.S.C.
1a(47)(b)(v) and (vi), as amended by section 721(a)(21) of the Dodd-
Frank Act (excluding purchases and sales of a security on a fixed or
contingent basis, respectively from the swap definition).
\488\ See section 403(a) of the Legal Certainty for Bank
Products Act of 2000, 7 U.S.C. 27a(a), as amended by section
725(g)(2) of the Dodd-Frank Act (providing that, under certain
circumstances, the CEA shall not apply to, and the CFTC shall not
exercise regulatory authority over, identified banking products, and
the definitions of the terms ``security-based swap'' and ``security-
based swap agreement'' shall not include identified banking
products).
---------------------------------------------------------------------------
The Commissions believe it is important to provide further guidance
as to the other circumstances in which certain loan participations
would not fall within the swap and security-based swap definitions.
Consistent with the proposal, the Commissions do not interpret the swap
and security-based swap definitions to include loan participations that
reflect an ownership interest in the underlying loan or commitment. The
Commissions believe that 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 Commissions believe 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 levers its purchase, including by posting collateral to
secure a future payment obligation.
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.
These characteristics, which were identified by commenters,\489\
are intended to distinguish loan participations from swaps and
security-based swaps based on loans. The first characteristic above
addresses the ownership of the underlying loan or commitment. Swaps and
security-based swaps may be created using a synthetic or derivative
structure that does not require ownership of the underlying loan.\490\
The second characteristic above addresses the ratio of the
participation to the underlying loan or commitment. Swaps and security-
based swaps based on loans may involve synthetic exposure to a loan
that is a multiple of the principal amount.\491\ The third
characteristic above addresses leverage in the financing of a loan
participation. Leverage could be indicative of an instrument that is
merely an exchange of payments and not a transfer of the ownership of
the underlying loan or commitment, such as may be the case with a swap
or security-based swap.\492\ The fourth characteristic above addresses
the level of participation in the economic benefits and risks of the
underlying loan or commitment. This characteristic is indicative of
ownership when analyzed with the other characteristics and, as noted
above, swaps and security-based swaps may be created using a synthetic
or derivative structure that does not require ownership of the
underlying loan.
---------------------------------------------------------------------------
\489\ See infra note 504 and accompanying text. See also infra
notes 490, 491, and 492 and accompanying text.
\490\ See July LMA Letter.
\491\ Id.
\492\ Id.
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The Commissions agree with commenters that the loan participation
does not have to be a ``true participation,'' as the Commissions had
stated in their interpretation in the Proposing Release,\493\ in order
for the loan participation to fall outside the swap and security-based
swap definitions.\494\ The Commissions note 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
[[Page 48252]]
purposes.\495\ This analysis is unrelated to and does not inform
whether a loan participation is a swap or security-based swap. This
analysis also may be subject to varying interpretations.\496\ Further,
the Commissions understand that this analysis could result in certain
loan participations that reflect an ownership interest in the
underlying loan or commitment being included in the swap and security-
based swap definitions, which the Commissions do not intend.\497\
---------------------------------------------------------------------------
\493\ Proposing Release at 29834.
\494\ See infra note 503 and accompanying text.
\495\ Id.
\496\ Id.
\497\ Id.
---------------------------------------------------------------------------
Rather, as noted above, the Commissions believe that the analysis
as to whether a loan participation is outside the swap and security-
based swap definitions should be based on whether the loan
participation reflects an ownership interest in the underlying loan or
commitment. The Commissions understand that the characteristics noted
above are indicative, based on comments received,\498\ of whether a
loan participation represents such an ownership interest. Further, in
response to commenters,\499\ the Commissions are clarifying 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).
---------------------------------------------------------------------------
\498\ See supra note 482. See infra note 501.
\499\ See infra note 506 and accompanying text.
---------------------------------------------------------------------------
The Commissions believe that the interpretation will prevent
disruption in the syndicated loan market for loan participations. Loan
participations facilitate a lender's diversification of its portfolio
holdings, provide a key component of the efficient settlement process,
and enhance liquidity in the global syndicated loan market.\500\ The
interpretation will enable this market to continue operating as it did
prior to the enactment of Title VII.
---------------------------------------------------------------------------
\500\ See January LSTA Letter.
---------------------------------------------------------------------------
Comments
Commenters supported the interpretation that certain loan
participations should not be included in the swap and security-based
swaps definitions.\501\ Commenters agreed with the proposal that a loan
participation should represent a current and future direct or indirect
ownership interest in the loan or commitment that is the subject of the
loan participation.\502\ However, commenters disagreed with the
proposal that a loan participation should be required to be a ``true
participation'' in order for the loan participation to fall outside the
swap and security-based swap definitions because LMA-style
participations do not represent a beneficial ownership in the
underlying loan or commitment such that they would be considered a true
participation.\503\ Commenters requested that the Commissions remove
this factor and instead recognize additional factors.\504\ The
Commissions agree 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 and are revising the
interpretation as noted above.
---------------------------------------------------------------------------
\501\ See FCC Letter; Letter from Richard M. Whiting, Executive
Director and General Counsel, Financial Services Roundtable, Jul.
22, 2011 (``FSR Letter''); July LMA Letter; Letter from R. Bram
Smith, Executive Director, The LSTA, Jul. 22, 2011 (``July LSTA
Letter''); MFA Letter; and Letter from Kenneth E. Bentsen, Jr.,
Executive Vice President, Public Policy and Advocacy, SIFMA, Jul.
22, 2011 (``SIFMA Letter'').
\502\ See FSR Letter; July LMA Letter; July LSTA Letter; MFA
Letter; and SIFMA Letter. Commenters indicated that both LSTA-style
participations and LMA-style participations represent a current or
future direct or indirect ownership interest in the related loan or
commitment. Id.
\503\ See July LMA Letter; July LSTA Letter; MFA Letter; and
SIFMA Letter. These commenters indicated that neither LMA-style
participations nor certain LSTA-style participations are true
participations. See July LMA Letter; July LSTA Letter; and SIFMA
Letter. Further, according to the July LSTA Letter, ``[l]oan market
participants in the United States will likely interpret the `true
participation' requirement as a requirement that loan participations
must qualify for `true sale' treatment in order to avoid
classification as a `swap.' A `true sale' or `true participation'
analysis is a test aimed at determining whether a transaction has
resulted in the underlying assets being legally isolated from the
transferor's creditors for U.S. bankruptcy law purposes. Its
underlying purpose is to distinguish between a sale and a financing,
not between a sale and a swap.'' If this is the case, certain LSTA-
style participations, which typically are offered in the United
States, could be determined under a ``true sale'' analysis to be a
financing and not a true participation. See July LSTA Letter.
\504\ See July LMA Letter; July LSTA Letter; MFA Letter; and
SIFMA Letter. Commenters recommended that the Commissions revise the
interpretation by providing that the Commissions do not interpret
the swap and security-based swap definitions to include loan
participations in which (1) the participant is acquiring a current
or future direct or indirect ownership interest in the related loan
or commitment, and (2) the agreement pursuant to which the
participant is acquiring such an interest (i) is a participation
agreement that is, or any similar agreement of a type that has been,
is presently, or in the future becomes, customarily entered into in
the primary or secondary loan markets, (ii) requires the grantor to
represent that it is a lender under, or a participant or sub-
participant in, the loan or commitment, (iii) provides that the
participant is entitled to receive from the grantor all of the
economic benefit of the whole or part of a loan or commitment to the
extent of payments received by the grantor in respect of such loan
or commitment, and (iv) requires that 100% of the purchase price
calculated with respect to the loan or commitment is paid on the
settlement date. See id. The characteristics identified by these
commenters are reflected in the Commission's revised interpretation.
---------------------------------------------------------------------------
One commenter also indicated that loan participations 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).\505\ This commenter requested that the
Commissions revise the proposed interpretation to reflect both
outstanding loans and a lender's commitments.\506\ The Commissions
agree and are revising the interpretation to reflect both outstanding
loans and loan commitments as noted above.
---------------------------------------------------------------------------
\505\ See July LMA Letter.
\506\ Id.
---------------------------------------------------------------------------
C. Final Rules and Interpretations Regarding Certain Transactions
Within the Scope of the Definitions of the Terms ``Swap'' and
``Security-Based Swap''
1. In General
In light of provisions in the Dodd-Frank Act that specifically
address certain foreign exchange products, the Commissions in the
Proposing Release proposed rules to clarify the status of products such
as foreign exchange forwards, foreign exchange swaps, foreign exchange
options, non-deliverable forwards involving foreign exchange
(``NDFs''), and cross-currency swaps. The Commissions also proposed a
rule to clarify the status of forward rate agreements and provided
interpretations regarding: (i) Combinations and permutations of, or
options on, swaps or security-based swaps; and (ii) contracts for
differences (``CFDs'').
The Commissions are adopting the rules as proposed without
modification and are restating the interpretations provided in the
Proposing Release without modification. In addition, the Commissions
are providing additional interpretations regarding foreign exchange
spot transactions and retail foreign currency options.
As adopted, rule 1.3(xxx)(2) under the CEA and rule 3a69-2 under
the Exchange Act explicitly define the term ``swap'' to include certain
foreign exchange-related products and forward rate agreements unless
such products are excluded by the statutory exclusions in subparagraph
(B) of the swap definition.\507\ In adopting these rules, the
Commissions do not mean to suggest that the list of agreements,
contracts, and transactions set forth in rule 1.3(xxx)(2) under the CEA
and rule
[[Page 48253]]
3a69-2(b) under the Exchange Act is an exclusive list.
---------------------------------------------------------------------------
\507\ See section 1a(47)(B) of the CEA, 7 U.S.C. 1a(47)(B).
---------------------------------------------------------------------------
2. Foreign Exchange Products
(a) Foreign Exchange Products Subject to the Secretary's Swap
Determination: Foreign Exchange Forwards and Foreign Exchange Swaps
The CEA, as amended by the Dodd-Frank Act, provides that ``foreign
exchange forwards'' and ``foreign exchange swaps'' shall be considered
swaps under the swap definition unless the Secretary of the Treasury
(``Secretary'') issues a written determination that either foreign
exchange swaps, foreign exchange forwards, or both: (i) Should not be
regulated as swaps; and (ii) are not structured to evade the Dodd-Frank
Act in violation of any rule promulgated by the CFTC pursuant to
section 721(c) of the Dodd-Frank Act.\508\ A foreign exchange forward
is defined in the CEA as ``a transaction that solely involves the
exchange of two different currencies on a specific future date at a
fixed rate agreed upon on the inception of the contract covering the
exchange.'' \509\ A foreign exchange swap, in turn, is defined as ``a
transaction that solely involves an exchange of 2 different currencies
on a specific date at a fixed rate that is agreed upon on the inception
of the contract covering the exchange; and a reverse exchange of the 2
currencies described in subparagraph (A) at a later date and at a fixed
rate that is agreed upon on the inception of the contract covering the
exchange.'' \510\
---------------------------------------------------------------------------
\508\ See section 1a(47)(E)(i) of the CEA, 7 U.S.C.
1a(47)(E)(i). The Secretary published in the Federal Register a
request for comment as to whether an exemption from the swap
definition for foreign exchange swaps, foreign exchange forwards, or
both, is warranted, and on the application of the statutory factors
that the Secretary must consider in making a determination regarding
whether to exempt these products. See Determinations of Foreign
Exchange Swaps and Forwards, 75 FR 66829 (Oct. 28, 2010).
Subsequently, the Secretary published in the Federal Register a
proposed determination to exempt both foreign exchange swaps and
foreign exchange forwards from the definition of the term ``swap''
in the CEA. See Determination of Foreign Exchange Swaps and Foreign
Exchange Forwards Under the Commodity Exchange Act, Notice of
Proposed Determination, 76 FR 25774 (May 5, 2011) (``Notice of
Proposed Determination''). The comment period on the Secretary's
proposed determination closed on June 6, 2011. A final determination
has not yet been issued.
\509\ See section 1a(24) of the CEA, 7 U.S.C. 1a(24).
\510\ See section 1a(25) of the CEA, 7 U.S.C. 1a(25).
---------------------------------------------------------------------------
Under the Dodd-Frank Act, if foreign exchange forwards or foreign
exchange swaps are no longer considered swaps due to a determination by
the Secretary, nevertheless, certain provisions of the CEA added by the
Dodd-Frank Act would continue to apply to such transactions.\511\
Specifically, those transactions still would be subject to certain
requirements for reporting swaps, and swap dealers and major swap
participants engaging in such transactions still would be subject to
certain business conduct standards.\512\
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\511\ The Secretary's determination also does not affect the
CFTC's jurisdiction over retail foreign currency agreements,
contracts, or transactions pursuant to section 2(c)(2) of the CEA, 7
U.S.C. 2(c)(2). See section 1a(47)(F)(ii) of the CEA, 7 U.S.C.
1a(47)(F)(ii).
\512\ See, e.g., sections 1a(47)(E)(iii) and (iv) of the CEA, 7
U.S.C. 1a(47)(E)(iii) and (iv) (reporting and business conduct
standards, respectively). In addition, a determination by the
Secretary does not exempt any foreign exchange forward or foreign
exchange swap traded on a designated contract market or a swap
execution facility, or cleared by a derivatives clearing
organization, from any applicable antifraud or anti-manipulation
provision under the CEA. See sections 1a(47)(F)(i) and 1b(c) of the
CEA, 7 U.S.C. 1a(47)(F)(i) and 1b(c).
---------------------------------------------------------------------------
The Commissions are adopting the rules as proposed to explicitly
define by rule the term ``swap'' to include foreign exchange forwards
and foreign exchange swaps (as those terms are defined in the
CEA),\513\ in order to include in one rule the definitions of those
terms and the related regulatory authority with respect to foreign
exchange forwards and foreign exchange swaps.\514\ The final rules
incorporate the provision of the Dodd-Frank Act that foreign exchange
forwards and foreign exchange swaps will no longer be considered swaps
if the Secretary issues the written determination described above to
exempt such products from the swap definition.\515\ The final rules
also reflect the continuing applicability of certain reporting
requirements and business conduct standards in the event that the
Secretary makes such a determination.\516\
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\513\ See rules 1.3(xxx)(3)(iii) and (iv) under the CEA and rule
3a69-2(c)(3) and (4) under the Exchange Act.
\514\ See rules 1.3(xxx)(2)(i)(C) and (D) under the CEA and
rules 3a69-2(b)(1)(iii) and (iv) under the Exchange Act. The rules
further provide that foreign exchange forwards and forward exchange
swaps are not swaps if they fall within one of the exclusions set
forth in subparagraph (B) of the statutory swap definition. See rule
1.3(xxx)(2)(ii) under the CEA and rule 3a69-2(b)(2) under the
Exchange Act.
\515\ See rule 1.3(xxx)(3) under the CEA and rule 3a69-2(c)
under the Exchange Act.
\516\ See rule 1.3(xxx)(3)(ii) under the CEA and rule 3a69-
2(c)(2) under the Exchange Act. The exclusion of foreign exchange
forwards and foreign exchange swaps would become effective upon the
Secretary's submission of the determination to exempt to the
appropriate Congressional Committees. See sections 1a(47)(E)(ii) and
1b of the CEA, 7 U.S.C. 1a(46)(E)(ii) and 1b.
---------------------------------------------------------------------------
Comments
Two commenters recommended that the Commissions defer action on
defining foreign exchange swaps and foreign exchange forwards in their
regulations until the Secretary has made his final determination about
whether to exempt them.\517\ One commenter believed that finalizing the
Commissions' proposal prior to the Secretary's final determination
would be ``premature.'' \518\ The other commenter believed that the
industry will be ``better positioned'' to assess the need to clarify
the scope of the swap definition with respect to foreign exchange
derivatives after the Secretary has made his determination.\519\ The
Commissions understand that, if the final rules are effective before
the Secretary issues a written determination, market participants
entering into foreign exchange forwards and foreign exchange swaps
might incur costs in order to comply with the requirements of the CEA
(as amended by the Dodd-Frank Act) that could be rendered unnecessary
if the Secretary subsequently were to issue a written determination to
exempt.\520\ The Commissions, however, believe the final rules are
necessary because in the event the Secretary issues a written
determination to exempt, certain reporting requirements and business
conduct standards will continue to apply to the exempted instruments,
and the final rules set forth those requirements that will continue to
apply.
---------------------------------------------------------------------------
\517\ See CME Letter and SIFMA Letter.
\518\ See CME Letter. This commenter also believes that if the
Secretary exempts foreign exchange swaps and foreign exchange
forwards from the swap definition, it would create an ``awkward''
situation both for the CFTC and market participants, given that
options on such products would be swaps but the products into which
they exercise would not be swaps, and would result in a lack of
clarity and consistency for market participants. Id.
\519\ See SIFMA Letter.
\520\ These costs market participants may incur relate to the
upfront and ongoing costs associated with the regulation of Title
VII instruments generally. See infra parts X and XI, for a
discussion of these costs. The Commissions also note that the final
rules will reduce (and may eliminate), the costs of determining
whether foreign exchange swaps and foreign exchange forwards are
subject to Title VII, as well as the costs associated with
determining which provisions of the new Title VII regulatory regime
will apply to these instruments. Id.
---------------------------------------------------------------------------
Further, the Commissions do not believe that adopting the rules is
premature, as the Secretary may issue a determination at any time, and
the Secretary's authority to do so is independent of the Commissions'
authority to issue these rules to further define the term ``swap.''
\521\ The
[[Page 48254]]
Commissions' final rules are consistent with this statutory framework
by specifically providing that, in the event a determination to exempt
is issued, foreign exchange swaps and foreign exchange forwards will
not be considered swaps, and will be subject only to those CEA
requirements that are specified in the statute.\522\ As such, the final
rules accommodate the possibility of (rather than the certainty of) an
exemptive determination made by the Secretary.
---------------------------------------------------------------------------
\521\ Compare section 712(d)(1) of the CEA (Commissions' joint
rulemaking authority to further define the term ``swap''), with
section 1a(47)(E) and 1b of the CEA (Secretary's authority to
determine to exempt foreign exchange swaps and foreign exchange
forwards from the definition of ``swap.'').
\522\ See rule 1.3(xxx)(3)(ii) under the CEA and rule 3a69-
2(c)(2) under the Exchange Act. The statutory requirements that
remain applicable, notwithstanding a written determination by the
Secretary to exempt, are that foreign exchange swaps and foreign
exchange forwards shall be reported to either a swap data
repository, or, if there is no swap data repository that would
accept such swaps or forwards, to the CFTC pursuant to section 4r of
the CEA, 7 U.S.C. 6r, within such time period as the CFTC may by
rule or regulation prescribe, and any party to a foreign exchange
swap or forward that is a swap dealer or major swap participant
shall conform to the business conduct standards contained in section
4s(h) of the CEA, 7 U.S.C. 6s(h). Section 1a(47)(E)(iii) and (iv) of
the CEA, 7 U.S.C. 1a(47)(E)(iii) and (iv).
---------------------------------------------------------------------------
Moreover, commenters provided no support for the assertion that the
situation would be awkward for market participants because options on
foreign exchange forwards and foreign exchange swaps will be swaps,
regardless of whether the Secretary determines to exempt the underlying
transactions from the swap definition. The Commissions note that
Congress drew the distinction in the statute between foreign currency
options and foreign exchange forwards and foreign exchange swaps. The
Commissions conclude that adopting these final rules would not
contribute to a lack of clarity or consistency for market participants,
regardless of any determination the Secretary makes.
(b) Foreign Exchange Products Not Subject to the Secretary's Swap
Determination
The Commissions are adopting rules as proposed stating that a
determination by the Secretary that foreign exchange forwards or
foreign exchange swaps, or both, should not be regulated as swaps would
not affect certain other products involving foreign currency, such as
foreign currency options, NDFs, currency swaps and cross-currency
swaps.\523\ The rules explicitly define the term ``swap'' to include
such products, irrespective of whether the Secretary makes a
determination to exempt foreign exchange forwards or foreign exchange
swaps from the swap definition.\524\
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\523\ See rule 1.3(xxx)(3)(v) under the CEA and rule 3a69-
2(c)(5) under the Exchange Act.
\524\ See rule 1.3(xxx)(2)(i) under the CEA and rule 3a69-
2(b)(1) under the Exchange Act. The final rules provide, however,
that none of these products are swaps if they fall within one of the
exclusions set forth in subparagraph (B) of the statutory swap
definition. See rule 1.3(xxx)(2)(ii) under the CEA and rule 3a69-
2(b)(2) under the Exchange Act. Also, the rules do not define the
term ``swap'' to include currency swaps because they are already
included in the statutory definition, but the rules clarify that
currency swaps are not subject to the Secretary's determination. See
section 1a(47)(A)(iii)(VII) of the CEA, 7 U.S.C.
1a(47)(A)(iii)(VII); rule 1.3(xxx)(3)(v)(A) under the CEA; and rule
3a69-2(c)(5)(i) under the Exchange Act.
---------------------------------------------------------------------------
(i) Foreign Currency Options \525\
---------------------------------------------------------------------------
\525\ This discussion is not intended to address, and has no
bearing on, the CFTC's jurisdiction over foreign currency options in
other contexts. See, e.g., CEA sections 2(c)(2)(A)(iii) and
2(c)(2)(B)-(C), 7 U.S.C. 2(c)(2)(A)(iii) and 2(c)(2)(B)-(C) (off-
exchange options in foreign currency offered or entered into with
retail customers).
---------------------------------------------------------------------------
As discussed above, the statutory swap definition includes options,
and it expressly enumerates foreign currency options. It encompasses
any agreement, contract, or transaction that is a put, call, cap,
floor, collar, or similar option of any kind that is for the purchase
or sale, or based on the value, of 1 or more interest or other rates,
currencies, commodities, securities, instruments of indebtedness,
indices, quantitative measures, or other financial or economic
interests or property of any kind.\526\ Foreign exchange options traded
on a national securities exchange (``NSE''), however, are securities
under the Federal securities laws and not swaps or security-based
swaps.\527\
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\526\ See section 1a(47)(A)(i) of the CEA, 7 U.S.C.
1a(47)(A)(i).
\527\ See section 1a(47)(B)(iv) of the CEA, 7 U.S.C.
1a(47)(B)(iv).
---------------------------------------------------------------------------
Any determination by the Secretary, discussed above, that foreign
exchange forwards or foreign exchange swaps should not be regulated as
swaps would not impact foreign currency options because a foreign
currency option is neither a foreign exchange swap nor a foreign
exchange forward, as those terms are defined in the CEA. The
Commissions did not receive any comments either on the proposed rule
further defining the term ``swap'' to include foreign currency options
or the proposed rule clarifying that foreign currency options are not
subject to the Secretary's determination to exempt foreign exchange
swaps and foreign exchange forwards.\528\ Consequently, the Commissions
are adopting rules to explicitly define the term ``swap'' to include
foreign currency options (other than foreign currency options traded on
an NSE).\529\ The rules also state that foreign currency options are
not foreign exchange forwards or foreign exchange swaps under the
CEA.\530\
---------------------------------------------------------------------------
\528\ A comment regarding the CFTC's jurisdiction over retail
foreign currency options is discussed below.
\529\ See rule 1.3(xxx)(2)(ii) under the CEA and rule 3a69-
2(b)(1) under the Exchange Act. The final rules treat the terms
foreign currency options, currency options, foreign exchange
options, and foreign exchange rate options as synonymous. Moreover,
for purposes of the final rules, foreign currency options include
options to enter into or terminate, or that otherwise operate on, a
foreign exchange swap or foreign exchange forward, or on the terms
thereof. As discussed above, foreign exchange options traded on an
NSE are securities and therefore are excluded from the swap
definition. See supra note 527 and accompanying text.
\530\ See rule 1.3(xxx)(3)(v) under the CEA and rule 3a69-
2(c)(5) under the Exchange Act.
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(ii) Non-Deliverable Forward Contracts Involving Foreign Exchange
As explained by the Commissions in the Proposing Release,\531\ an
NDF generally is similar to a forward foreign exchange contract,\532\
except that at maturity the NDF does not require physical delivery of
currencies; rather, the contract typically is settled in a reserve
currency, such as U.S. dollars. One of the currencies involved in the
transaction, usually an emerging market currency, may be subject to
capital controls or similar restrictions, and is therefore said to be
``nondeliverable.'' \533\ If the spot market exchange rate on the
settlement date is greater (in foreign currency per dollar terms) than
the previously agreed forward exchange rate, the party to the contract
that is long the nondeliverable (e.g. emerging market) currency must
pay its counterparty the difference between the contracted forward
price and the spot market rate, multiplied by the notional amount.\534\
---------------------------------------------------------------------------
\531\ See Proposing Release at 29836.
\532\ A deliverable forward foreign exchange contract is an
obligation to buy or sell a specific currency on a future settlement
date at a fixed price set on the trade date. See Laura Lipscomb,
Federal Reserve Bank of New York, ``An Overview of Non-Deliverable
Foreign Exchange Forward Markets,'' 1 (May 2005) (citation omitted)
(``Fed NDF Overview'').
\533\ See id. at 1-2 (citation omitted).
\534\ See id. at 2. Being long the emerging market currency
means that the holder of the NDF contract is the ``buyer'' of the
emerging market currency and the ``seller'' of dollars. Conversely,
if the emerging market currency appreciates relative to the
previously agreed forward rate, the holder of the contract that is
short the emerging market currency must pay its counterparty the
difference between the spot market rate and the contracted forward
price, multiplied by the notional amount. See id. at 2, n.4.
---------------------------------------------------------------------------
NDFs are not expressly enumerated in the swap definition, but as
was stated in the Proposing Release,\535\ they satisfy clause (A)(iii)
of the swap definition because they provide for a future
[[Page 48255]]
(executory) payment based on an exchange rate, which is an ``interest
or other rate[ ]'' within the meaning of clause (A)(iii).\536\ Each
party to an NDF transfers to its counterparty the risk of the exchange
rate moving against the counterparty, thus satisfying the requirement
that there be a transfer of financial risk associated with a future
change in rate. This financial risk transfer in the context of an NDF
is not accompanied by a transfer of an ownership interest in any asset
or liability. Thus, an NDF is a swap under clause (A)(iii) of the swap
definition.\537\
---------------------------------------------------------------------------
\535\ See Proposing Release at 29836.
\536\ See section 1a(47)(A)(iii) of the CEA, 7 U.S.C.
1a(47)(A)(iii) (providing that a swap is an agreement, contract, or
transaction ``that provides on an executory basis for the exchange,
on a fixed or contingent basis, of 1 or more payments based on the
value or level of 1 or more interest or other rates, currencies,
commodities, securities, instruments of indebtedness, indices,
quantitative measures, or other financial or economic interests or
property of any kind, or any interest therein or based on the value
thereof, and that transfers, as between the parties to the
transaction, in whole or in part, the financial risk associated with
a future change in any such value or level without also conveying a
current or future direct or indirect ownership interest in an asset
(including any enterprise or investment pool) or liability that
incorporates the financial risk so transferred * * * .'').
\537\ In addition, as was noted in the Proposing Release, at
least some market participants view NDFs as swaps today, and thus
NDFs also may fall within clause (A)(iv) of the swap definition as
``an agreement, contract, or transaction that is, or in the future
becomes, commonly known to the trade as a swap.'' See Proposing
Release at 29836. See also section 1a(47)(A)(iv) of the CEA, 7
U.S.C. 1a(47)(A)(iv). Cf. rule 35.1(b)(1)(i) under the CEA, 17 CFR
35.1(b)(1)(i) (providing that the definition of ``swap agreement''
includes a ``forward foreign exchange agreement,'' without reference
to convertibility or delivery).
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Moreover, the Commissions have determined that NDFs do not meet the
definitions of ``foreign exchange forward'' or ``foreign exchange
swap'' set forth in the CEA.\538\ NDFs do not involve an ``exchange''
of two different currencies (an element of the definition of both a
foreign exchange forward and a foreign exchange swap); instead, they
are settled by payment in one currency (usually U.S. dollars).\539\
---------------------------------------------------------------------------
\538\ In the Notice of Proposed Determination, the Secretary
stated that his authority to issue a determination ``is limited to
foreign exchange swaps and forwards and does not extend to other
foreign exchange derivatives'' and noted that ``NDFs may not be
exempted from the CEA's definition of ``swap'' because they do not
satisfy the statutory definitions of a foreign exchange swap or
forward.'' See Notice of Proposed Determination.
\539\ Likewise, the Commissions have determined that a foreign
exchange transaction, which initially is styled as or intended to be
a ``foreign exchange forward,'' and which is modified so that the
parties settle in a reference currency (rather than settle through
the exchange of the 2 specified currencies), does not conform with
the definition of ``foreign exchange forward'' in the CEA. See infra
note 626.
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Notwithstanding their ``forward'' label, NDFs also do not fall
within the forward contract exclusion of the swap definition because
currency is outside the scope of the forward contract exclusion for
nonfinancial commodities.\540\ Nor have NDFs traditionally been
considered commercial merchandising transactions. Rather, as the
Commissions observed in the Proposing Release,\541\ NDF markets appear
to be driven in large part by speculation \542\ and hedging,\543\ which
features are more characteristic of swap markets than forward markets.
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\540\ Currency is an excluded commodity under the CEA. See
section 1a(19)(i) of the CEA, 7 U.S.C. 1a(19)(i). In accordance with
the interpretation regarding nonfinancial commodities, which as
discussed above, see supra part II.B.2(a), are exempt and
agricultural commodities that can be physically delivered, currency
does not qualify as a nonfinancial commodity for purposes of the
forward exclusion from the swap definition.
\541\ See Proposing Release at 29836.
\542\ See Fed NDF Overview at 5 (``[E]stimates vary but many
major market participants estimate as much as 60 to 80 percent of
NDF volume is generated by speculative interest, noting growing
participation from international hedge funds.'') and 4 (``[D]ealers
note that much of the volume in Chinese yuan NDFs is generated by
speculative positioning based on expectations for an alteration in
China's current, basically fixed exchange rate.'') (italics in
original).
\543\ See id. at 4 (noting that ``[much of the] Korean won NDF
volume[,] * * * estimated to be the largest of any currency, * * *
is estimated to originate with international investment portfolio
managers hedging the currency risk associated with their onshore
investments'').
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Comments
Commenters who addressed the nature of NDFs believed that NDFs
should not be considered swaps, but rather should be categorized as
foreign exchange forwards. In general, commenters maintained that NDFs
are functionally and economically equivalent to foreign exchange
forwards, and therefore should be treated in the same manner for
regulatory purposes.\544\ In support of this view, commenters made
several arguments, including that both NDFs and foreign exchange
forwards require the same net value to be transferred between
counterparties; the purpose for using them is the same--to cover
foreign currency exchange risk; both are typically short term
transactions; and both may be cleared by CLS Bank.\545\
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\544\ See CDEU Letter; Letter from The Committee on Investment
of Employee Benefit Assets, dated Jul. 22, 2011 (``CIEBA Letter'');
Letter from Bruce C. Bennett, Covington & Burling LLP, dated Jul.
22, 2011 (``Covington Letter''); and Letter from Karrie McMillan and
Cecelia Calaby, the Investment Company Institute/American Bar
Association Securities Association, dated Jul. 22, 2011 (``ICI/ABASA
Letter'').
\545\ See Covington Letter and ICI/ABASA Letter. CLS Bank
operates the largest multi-currency cash settlement system to
eliminate settlement risk in the foreign exchange market.
---------------------------------------------------------------------------
In addition, commenters believed that not treating NDFs as foreign
exchange forwards or foreign exchange swaps would be contrary to both
domestic and international market practices. As specific examples,
commenters noted that NDFs typically are traded as part of a bank's or
broker's foreign exchange desk; the Federal Reserve Bank of New York
has described an NDF in a 1998 publication as an instrument ``similar
to an outright forward,'' except that there is no physical delivery or
transfer of the local currency; the Bank for International Settlements
(``BIS'') categorizes NDFs in its ``outright forward'' category;
various European regulations do not distinguish between the two
transaction types; standard foreign exchange trading documentation
includes both net- and physically-settled foreign exchange transactions
in general definitions of foreign exchange transactions; and special
rules under the U.S. tax code apply equally to physically settled and
cash settled foreign exchange forwards.\546\
---------------------------------------------------------------------------
\546\ See Covington Letter and ICI/ABASA Letter.
---------------------------------------------------------------------------
Commenters also raised potential negative consequences to certain
U.S. market participants if NDFs are not considered to be foreign
exchange forwards. For example, one commenter argued that treating NDFs
as swaps will put U.S. corporations doing business in emerging markets
at a disadvantage relative to U.S. corporations doing business solely
in developed markets.\547\ This commenter stated that NDFs are widely
used by U.S. corporations that do business in emerging markets to hedge
their exposure to the currencies of those markets, and that regulating
NDFs as swaps would significantly increase the cost of hedging those
exposures.\548\
---------------------------------------------------------------------------
\547\ See Covington Letter.
\548\ See supra note 520.
---------------------------------------------------------------------------
With respect to the Commissions' legal conclusion that NDFs are not
foreign exchange forwards, and thus are not subject to the Secretary's
determination, one commenter stated that the Commissions' reading of
the definition of the term ``foreign exchange forward'' as not
including NDFs is ``too restrictive.'' \549\ In this regard, this
commenter believed that the term ``exchange'' should be read to include
``the economic exchange that occurs in net settlement rather than being
narrowly read as the physical `exchange' of two different currencies.''
---------------------------------------------------------------------------
\549\ See ICI/ABASA Letter.
---------------------------------------------------------------------------
One commenter, in contrast, agreed with the Commissions'
interpretation that NDFs are not encompassed within the definition of
the term ``foreign
[[Page 48256]]
exchange forward.'' \550\ This commenter requested, though, that the
CFTC exempt NDFs from the swap definition, using its exemptive
authority under section 4(c) of the CEA.\551\
---------------------------------------------------------------------------
\550\ See CIEBA Letter.
\551\ 7 U.S.C. 6(c).
---------------------------------------------------------------------------
While commenters raised a number of objections to the Commissions'
proposal to define NDFs as swaps, these objections primarily raise
policy arguments. No commenter has provided a persuasive, alternative
interpretation of the statute's plain language in the definition of the
term ``foreign exchange forward'' to overcome the Commissions'
conclusion that, under the CEA, NDFs are swaps, not foreign exchange
forwards.
One commenter believed that the Commissions' interpretation of
``exchange of 2 different currencies'' as used in the foreign exchange
forward definition is too restrictive, and that the phrase should be
read broadly to mean an economic exchange of value in addition to
physical exchange; the Commissions believe that this contention is
misplaced.\552\ This commenter essentially asks the Commissions to
interpret the statutory language to mean an exchange of foreign
currencies themselves, as well as an exchange based on the value of
such currencies. However, only the word ``exchange'' appears in the
relevant definitions, reinforcing the conclusion that Congress intended
the definition of ``foreign exchange forward'' to be distinct from
other types of transactions covered by the definition of ``swap'' in
the CEA. Moreover, the language of each definition emphasizes that
these transactions may ``solely'' involve an exchange. The ordinary
meaning of the verb ``exchange'' is to ``barter'' \553\ or ``part with,
give or transfer for an equivalent,'' \554\ i.e., each party is both
giving to and receiving from the other party. This does not occur under
an NDF, in which only a single party makes a payment.
---------------------------------------------------------------------------
\552\ See ICI/ABASA Letter.
\553\ See Webster's New World Dictionary (3d College Ed. 1988).
\554\ See Black's Law Dictionary.
---------------------------------------------------------------------------
Elsewhere in the CEA, Congress used explicit language that
potentially could provide support for a broader interpretation of the
type advocated by this commenter, but such language is absent from the
definition of the term ``foreign exchange forward.'' For example,
section 2(a)(1)(C)(ii) confers exclusive jurisdiction on the CFTC over
``contracts of sale for future delivery of a group or index of
securities (or any interest therein or based upon the value thereof)
[that meet certain requirements]''. If the phrase ``exchange of 2
different currencies'' had been intended to include economic exchanges
of value, as suggested by this commenter, that phrase would have
included language similar to ``based on the value thereof'' to indicate
that other mechanisms of transferring value may occur in these
particular types of transactions. Instead, as noted above, Congress
limited the scope of each of these particular transactions by using the
words ``solely involves the exchange of 2 different currencies''. The
Commissions conclude that the use of the word ``solely'' provides
further support for the Commissions' interpretation that exchange means
an actual interchange of the 2 different currencies involved in the
transaction.\555\
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\555\ This commenter's request that the CFTC exempt NDFs from
the swap definition using its exemptive authority under section 4(c)
of the CEA, 7 U.S.C. 6(c), and that the SEC exercise its exemptive
authority under section 36 of the Exchange Act, 78 U.S.C. 78mm, with
respect to NDFs, is beyond the scope of this rulemaking.
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(iii) Currency Swaps and Cross-Currency Swaps
A currency swap \556\ and a cross-currency swap \557\ each
generally can be described as a swap in which the fixed legs or
floating legs based on various interest rates are exchanged in
different currencies. Such swaps can be used to reduce borrowing costs,
to hedge currency exposure, and to create synthetic assets \558\ and
are viewed as an important tool, given that they can be used to hedge
currency and interest rate risk in a single transaction.
---------------------------------------------------------------------------
\556\ A swap that exchanges a fixed rate against a fixed rate is
known as a currency swap. See Federal Reserve System, ``Trading and
Capital-Markets Activities Manual,'' section 4335.1 (Jan. 2009).
\557\ Cross-currency swaps with a fixed leg based on one rate
and a floating leg based on another rate, where the two rates are
denominated in different currencies, are generally referred to as
cross-currency coupon swaps, while those with a floating leg based
on one rate and another floating leg based on a different rate are
known as cross-currency basis swaps. Id. Cross-currency swaps also
include annuity swaps and amortizing swaps. In cross-currency
annuity swaps, level cash flows in different currencies are
exchanged with no exchange of principal; annuity swaps are priced
such that the level payment cash flows in each currency have the
same net present value at the inception of the transaction. An
amortizing cross-currency swap is structured with a declining
principal schedule, usually designed to match that of an amortizing
asset or liability. Id.
See also Derivatives ONE, ``Cross Currency Swap Valuation'' (``A
cross currency swap is swap of an interest rate in one currency for
an interest rate payment in another currency * * * This could be
considered an interest rate swap with a currency component.''),
available at http://www.derivativesone.com/cross-currency-swap-valuation/; Financial Accounting Standards Board, ``Examples
Illustrating Application of FASB Statement No. 138,'' Accounting for
Certain Derivative Instruments and Certain Hedging Activities,
section 2, Example 1, at 3 (``The company designates the cross-
currency swap as a fair value hedge of the changes in the fair value
of the loan due to both interest and exchange rates.''), available
at http://www.fasb.org/derivatives/examples.pdf.
\558\ BMO Capital Markets, ``Cross Currency Swaps,'' available
at http://www.bmocm.com/products/marketrisk/intrderiv/cross/default.aspx.
---------------------------------------------------------------------------
Currency swaps and cross-currency swaps are not foreign exchange
swaps as defined in the CEA because, although they may involve an
exchange of foreign currencies, they also require contingent or
variable payments in different currencies. Because the CEA defines a
foreign exchange swap as a swap that ``solely'' involves an initial
exchange of currencies and a reversal thereof at a later date, subject
to certain parameters, currency swaps and cross-currency swaps would
not be foreign exchange swaps. Similarly, currency swaps and cross-
currency swaps are not foreign exchange forwards because foreign
exchange forwards ``solely'' involve an initial exchange of currencies,
subject to certain parameters, while currency swaps and cross-currency
swaps contain additional elements, as discussed above.
Currency swaps are expressly enumerated in the statutory definition
of the term ``swap.'' \559\ Cross-currency swaps, however, are
not.\560\ Accordingly, based on the foregoing considerations, the
Commissions are adopting rules explicitly defining the term ``swap'' to
include cross-currency swaps.\561\ The rules also state that neither
currency swaps nor cross-currency swaps are foreign exchange forwards
or foreign exchange swaps as those terms are defined in the CEA. The
Commissions did not receive any comments either on the rule further
defining the term ``swap'' to include cross-currency swaps or the rule
clarifying that cross-currency swaps and currency swaps are not subject
to the Secretary's determination to exempt foreign exchange swaps and
foreign exchange forwards.
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\559\ See section 1a(47)(A)(iii)(VII) of the CEA, 7 U.S.C.
1a(47)(A)(iii)(VII).
\560\ Clause (A)(iii) of the swap definition expressly refers to
a cross-currency rate swap. See section 1a(47)(A)(iii)(V) of the
CEA, 7 U.S.C. 1a(47)(A)(iii)(V). Although the swap industry appears
to use the term ``cross-currency swap,'' rather than ``cross-
currency rate swap'' (the term used in section 1a(47)(A)(iii)(V) of
the CEA), the Commissions interpret these terms as synonymous.
\561\ See rule 1.3(xxx)(2)(i)(A) under the CEA and rule 3a69-
2(b)(1)(i) under the Exchange Act.
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(c) Interpretation Regarding Foreign Exchange Spot Transactions
The CEA generally does not confer regulatory jurisdiction on the
CFTC with respect to spot transactions.\562\ In
[[Page 48257]]
the context of foreign currency, spot transactions typically settle
within two business days after the trade date (``T+2'').\563\ The
accepted market practice of a two-day settlement for spot foreign
currency transactions has been recognized by the CFTC \564\ and the
courts.\565\
---------------------------------------------------------------------------
\562\ But see supra note 227.
\563\ Bank for International Settlements, Triennial Central Bank
Survey, Report on Global Foreign Exchange Market Activity in 2010 at
32 (Dec. 2010) (defining a foreign exchange spot transaction to
provide for cash settlement within 2 business days); Sam Y. Cross,
Federal Reserve Bank of New York, ``All About * * *. The Foreign
Exchange Market in the United States'' at 31-32 (1998).
\564\ See CFTC Division of Trading and Markets, Report on
Exchange of Futures for Physicals at 124-127 (1987) (noting that
foreign currency spot transactions settle in 2 days).
\565\ See CFTC v. Frankwell Bullion, Ltd., 99 F.3d 299, 300 (9th
Cir. 1996) (``Spot transactions in foreign currencies call for
settlement within two days.''); CFTC v. Int'l Fin. Servs. (NewYork),
Inc., 323 F. Supp. 2d 482, 495 (S.D.N.Y. 2004) (noting that spot
transactions ordinarily call for settlement within two days); Bank
Brussels Lambert, S.A. v. Intermetals Corp., 779 F.Supp. 741, 742
(S.D.N.Y. 1991) (same). But the Commissions understand that the
settlement cycle for spot transactions exchanging Canadian dollars
for U.S. dollars (or vice versa) is T+1. See Cross, supra 563, at
31.
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The Commissions recognize that the new foreign exchange forward
definition in the CEA, which was added by the Dodd-Frank Act and which
applies to an exchange of two different currencies ``on a specific
future date,'' could be read to apply to any foreign exchange
transaction that does not settle on the same day. Such a reading could
render most foreign exchange spot transactions foreign exchange
forwards under the CEA; as a result, such transactions would be subject
to the CEA reporting and business conduct standards requirements
applicable to foreign exchange forwards even if the Secretary
determines to exempt foreign exchange forwards from the definition of
``swap.'' The Commissions do not believe that Congress intended, solely
with respect to foreign exchange transactions, to extend the reach of
the CEA to transactions that historically have been considered spot
transactions. At the same time, however, the Commissions do not want to
enable market participants simply to label as ``spot'' foreign exchange
transactions that regularly settle after the relevant foreign exchange
spot market settlement deadline, or with respect to which the parties
intentionally delay settlement, both of which would be properly
categorized as foreign exchange forwards, or CEA section 2(c)(2)
transactions (discussed separately below), in order to avoid applicable
foreign exchange regulatory requirements.
Accordingly, the Commissions are providing an interpretation that a
bona fide foreign exchange spot transaction, i.e., 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.'' In
general, a foreign exchange transaction will be considered a bona fide
spot transaction if it settles via an actual delivery of the relevant
currencies within two business days. In certain circumstances, 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.\566\ In particular, as discussed
below, the Commissions will consider a foreign exchange transaction
that is entered into solely to effect the purchase or sale of a foreign
security to be a bona fide spot transaction where certain conditions
are met.
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\566\ In this regard, while the Commissions will look at the
relevant facts and circumstances, they will not expect that an
unintentional settlement failure or delay for operational reasons or
due to a market disruption will undermine the character of a bona
fide spot foreign exchange transaction as such.
---------------------------------------------------------------------------
The CFTC will consider the following to be a bona fide spot foreign
exchange transaction: An agreement, contract or transaction for the
purchase or sale of an amount of foreign currency equal to the price of
a foreign security with respect to which (i) the security and related
foreign currency transactions are executed contemporaneously in order
to effect delivery by the relevant securities settlement deadline and
(ii) actual delivery of the foreign security and foreign currency
occurs by such deadline (such transaction, a ``Securities Conversion
Transaction'').\567\ For Securities Conversion Transactions, the CFTC
will consider the relevant foreign exchange spot market settlement
deadline to be the same as the securities settlement deadline. As noted
above, while the CFTC will look at the relevant facts and
circumstances, it does not expect that an unintentional settlement
failure or delay for operational reasons or due to a market disruption
will undermine the character of a bona fide spot foreign exchange
transaction as such.
---------------------------------------------------------------------------
\567\ The interpretation herein with respect to Security
Conversion Transactions is limited to such transactions.
---------------------------------------------------------------------------
The CFTC also will interpret a Securities Conversion Transaction as
not leveraged, margined or financed within the meaning of section
2(c)(2)(C) of the CEA.\568\ While it is possible to view the fact that
the buyer of a currency in such a transaction does not pay for the
currency until it is delivered as leverage (in that the buyer puts
nothing down until taking delivery, thus achieving 100% leverage) or a
financing arrangement, the CFTC does not interpret it as such for
purposes of CEA section 2(c)(2)(C).\569\ Congress recognized that
settlement of bona fide spot foreign exchange transactions typically
takes two days.\570\ The fact that Congress expressly excluded these
types of bona fide spot foreign exchange transactions does not mean
that Congress intended to subject Security Conversion Transactions to
regulation under the retail foreign exchange regime.\571\ For the
foregoing reasons, the CFTC will interpret a Securities Conversion
Transaction as not leveraged, margined or financed within the meaning
of section 2(c)(2)(C) of the CEA.\572\
---------------------------------------------------------------------------
\568\ 7 U.S.C. 2(c)(2)(C). Similarly, a Securities Conversion
Transaction is not an option, option on a futures contract or
futures contract and thus would not be subject to CEA section
2(c)(2)(B), 7 U.S.C. 2(c)(2)(B). Of course, optionality as to
settlement would render the transaction an option and is
inconsistent with a ``spot'' characterization.
\569\ Cf. 12 CFR 220.8(b)(1) under Regulation T (12 CFR Part
220) (generally permits a customer to purchase a security (including
a foreign security) in a cash account, rather than a margin account,
even if the customer has no collateral in the account, if payment
for the security is made within the appropriate payment period).
Similarly, if a foreign exchange buyer in a Securities Conversion
Transaction posts no margin or collateral on the trade date, the
CFTC does not consider that transaction to be ``margined'' within
the meaning of 7 U.S.C. 2(c)(2)(C)(i)(I)(bb).
\570\ See section 2(c)(2)(C)(i)(II) of the CEA, 7 U.S.C.
2(c)(2)(C) (``[s]ubclause (I) of this clause shall not apply to * *
* a contract of sale that * * * results in delivery within 2
days'').
\571\ The CFTC notes, for example, that Congress recognized that
settlement in various spot markets in commodities other than foreign
exchange can be longer than two days. See CEA section
2(c)(2)(D)(ii)(III)(aa) (disapplying the DCM-trading requirement for
certain commodity transactions with non-ECPs when the contract
``results in actual delivery within 28 days or such other longer
period as the [CFTC] may determine by rule or regulation based on
the typical commercial practice in cash or spot markets for the
commodity involved'').
\572\ This interpretation is not intended to address, and has no
bearing on, the CFTC's interpretation of the term ``actual
delivery'' as set forth in section 2(c)(2)(D)(ii)(III)(aa), 7 CFR
2(c)(2)(D)(ii)(III)(aa). See Retail Commodity Transactions under the
Commodity Exchange Act, 76 FR 77670, Dec. 14, 2011.
---------------------------------------------------------------------------
Comments
One commenter requested clarification regarding the status of
foreign exchange spot transactions.\573\ This commenter recommended
that the Commissions clarify that foreign exchange spot transactions,
which this commenter defined as ``transactions of
[[Page 48258]]
one currency into another that settle within a customary settlement
cycle,'' are neither foreign exchange forwards nor swaps.\574\ Another
commenter indicated that the customary settlement cycle for purchases
of most non-U.S. denominated securities is ``T+3'' (in some securities
markets, such as South Africa, the settlement cycle can take up to
seven days), and requires the buyer to pay for the foreign securities
in the relevant foreign currency.\575\ Typically, according to this
commenter, a broker-dealer or bank custodian acting on behalf of the
buyer or seller will enter into a foreign currency transaction to
settle on a T+3 basis (or the relevant settlement period) as well.
Timing the foreign exchange transaction to settle at the same time as
the securities transaction benefits the customer by reducing his or her
exposure to currency risk on the securities transaction between trade
date and settlement date. The Commissions have provided the
interpretation described above regarding the interplay between the
foreign exchange forward definition, the meaning of ``leveraged,
margined or financed'' under section 2(c)(2)(C) of the CEA, and bona
fide foreign exchange spot transactions to address these commenters'
concerns.
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\573\ See SIFMA Letter.
\574\ Id. In this commenter's view, such clarification is
necessary to avoid the statutory foreign exchange forward definition
``unwittingly captur[ing] many typical foreign exchange spot
transactions * * * settl[ing] within a customary settlement cycle,''
which this commenter stated is generally ``T+2'' in the United
States, but can be ``T+3'' in some other countries.
\575\ See Letter from Phoebe A. Papageorgiou, Senior Counsel,
American Bankers Ass'n and James Kemp, Managing Director, Global
Foreign Exchange Division, dated April 18, 2012 (``ABA/Global FX
Letter''). This commenter requested clarification that the purchase,
sale or exchange of a foreign currency by a bank on behalf of a
retail customer for the sole purpose of effecting a purchase or sale
of a foreign security or in order to clear or settle such purchase
or sale, when the settlement period for such FX transaction is
within the settlement cycle for such foreign security, is excluded
from the retail foreign exchange under the CEA. The CFTC has
provided the clarification regarding the meaning of ``leveraged,
margined or financed'' under section 2(c)(2)(C) of the CEA to
address this commenter's concern.
---------------------------------------------------------------------------
(d) Retail Foreign Currency Options
The CFTC is providing an interpretation regarding the status of
retail foreign currency options that are described in section
2(c)(2)(B) of the CEA.\576\ As noted above, the Commissions proposed to
include foreign currency options generally within the definition of the
term ``swap,'' subject to the statutory exclusions in subparagraph (B)
of the definition. The statutory exclusions from the swap definition
encompass transactions described in sections 2(c)(2)(C) and (D) of the
CEA, but not those in section 2(c)(2)(B) of the CEA.\577\ Section
2(c)(2)(B) of the CEA applies to futures, options on futures and
options on foreign currency (other than foreign currency options
executed or traded on a national securities exchange), and permits such
transactions to be entered into with counterparties who are not ECPs
\578\ on an off-exchange basis by certain enumerated regulated
entities.\579\ No issue arises with respect to futures or options on
futures in foreign currency that are covered by section 2(c)(2)(B) of
the CEA, because they are expressly excluded from the statutory swap
definition.\580\ Commodity options, including options on foreign
currency, however, are not excluded from the swap definition (other
than foreign currency options executed or traded on a national
securities exchange).
---------------------------------------------------------------------------
\576\ 7 U.S.C. 2(c)(2)(B).
\577\ See section 1a(47)(B)(i) of the CEA, 7 U.S.C.
1a(47)(B)(i). Sections 2(c)(2)(B), (C), and (D) of the CEA, 7 U.S.C.
2(c)(2)(B), (C), and (D), govern certain types of off-exchange
transactions in commodities, including foreign currency, in which
one of the parties to the transaction is not an ECP.
\578\ ECPs are defined in section 1a(18) of the CEA, 7 U.S.C.
1a(18).
\579\ Section 2(c)(2)(B)(i) of the CEA provides: (i) This Act
applies to, and the Commission shall have jurisdiction over, an
agreement, contract, or transaction in foreign currency that--(I) is
a contract of sale of a commodity for future delivery (or an option
on such a contract) or an option (other than an option executed or
traded on a national securities exchange registered pursuant to
section 6(a) of the Securities Exchange Act of 1934, 15 U.S.C.
78f(a)); and (II) is offered to, or entered into with, a person that
is not an eligible contract participant, unless the counterparty, or
the person offering to be the counterparty, of the person is
[certain regulated counterparties enumerated in the statute.] 7
U.S.C. 2(c)(2)(B)(i). Thus, under section 2(c)(2)(B)(i) of the CEA,
the CEA's exchange-trading requirement generally applies with
respect to futures, options on futures, and options on foreign
currency. See section 4(a) of the CEA, 7 U.S.C. 6(a) (generally
requiring futures contracts to be traded on or subject to the rules
of a DCM); section 4c(b) of the CEA, 7 U.S.C. 6c(b) (prohibiting
trading options subject to the CEA contrary to CFTC rules,
regulations or orders permitting such trading); Part 32 of the
CFTC's rules, 17 CFR Part 32 (generally prohibiting entering into
options subject to the CEA (other than options on futures) other
than on or subject to the rules of a DCM); and CFTC Rule 33.3(a), 17
CFR 33.3(a) (prohibiting entering into options on futures other than
on or subject to the rules of a DCM). However, if the counterparty
to the non-ECP is an enumerated regulated entity identified in
section 2(c)(2)(B)(i)(II) of the CEA, 7 U.S.C. 2(c)(2)(B)(i)(II),
the CEA's exchange-trading requirement does not apply. Accordingly,
an enumerated regulated entity--including a banking institution
regulated by the OCC--can, pursuant to section 2(c)(2)(B) of the
CEA, lawfully enter into a future, an option on a future, or an
option on foreign currency with a non-ECP counterparty on an off-
exchange basis.
\580\ See section 1a(47)(B)(i) of the CEA, 7 U.S.C.
1a(47)(B)(i).
---------------------------------------------------------------------------
The CFTC notes that, in further defining the term ``swap'' to
include foreign currency options, the Proposing Release stated that the
proposal was not intended to address, and had no bearing on, the CFTC's
jurisdiction over foreign currency options in other contexts,
specifically citing section 2(c)(2)(B) of the CEA.\581\ Nonetheless,
the CFTC acknowledges the ambiguity in the statute regarding the status
of off-exchange foreign currency options with non-ECPs that are subject
to section 2(c)(2)(B) of the CEA. While foreign currency options are
swaps, they also are subject to section 2(c)(2)(B) of the CEA when
entered into off-exchange with non-ECPs, and there is no statutory
exclusion from the swap definition for section 2(c)(2)(B) transactions.
If foreign currency options were deemed to be swaps, then, pursuant to
section 2(e) of the CEA, as added by the Dodd-Frank Act,\582\ they
could not be entered into by non-ECP counterparties, except on a DCM.
This would render the provisions of section 2(c)(2)(B) of the CEA,
permitting off-exchange foreign currency options with non-ECPs by
enumerated regulated entities, a nullity.
---------------------------------------------------------------------------
\581\ See Proposing Release at 29835 n.125.
\582\ 7 U.S.C. 2(e).
---------------------------------------------------------------------------
The CFTC believes that Congress did not intend the swap definition
to overrule and effectively repeal another provision of the CEA in such
an oblique fashion.\583\ Nor is there anything in the legislative
history of the Dodd-Frank Act to suggest a congressional intent to
prohibit only one type of off-exchange foreign currency transaction
with non-ECPs (out of the three types of off-exchange foreign currency
transactions with non-ECPs that are addressed in CEA section
2(c)(2)(B)). The omission of section 2(c)(2)(B) of the CEA from the
exclusions set forth in the statutory swap definition appears to be a
scrivener's error.\584\ Accordingly, the CFTC is applying the exclusion
from the swap definition to foreign currency options described in CEA
section 2(c)(2)(B).
---------------------------------------------------------------------------
\583\ The CFTC notes in this regard that repeals by implication
are strongly disfavored by the courts. See, e.g., Village of
Barrington, Ill. v. Surface Transp. Bd., 636 F.3d 650, 662 (D.C.
Cir. 2011) (``Repeals by implication, however, are strongly
disfavored `absent a clearly expressed congressional intention' '')
(quoting Branch v. Smith, 538 U.S. 254, 273, 123 S.Ct. 1429 (2003));
Agri Processor Co., Inc. v. N.L.R.B., 514 F.3d 1, 4 (D.C. Cir. 2008)
(``[a]mendments by implication, like repeals by implication, are not
favored'' and ``will not be found unless an intent to repeal [or
amend] is `clear and manifest.' '') (quoting United States v.
Welden, 377 U.S. 95, 102 n. 12, 84 S.Ct. 1082 (1964) and Rodriguez
v. United States, 480 U.S. 522, 524, 107 S.Ct. 1391 (1987)).
\584\ See, e.g., Singer and Singer, Sutherland Statutes and
Statutory Construction Sec. 47:38 (7th ed. 2011) (``Words may be
supplied in a statute * * * where omission is due to inadvertence,
mistake, accident, or clerical error'').
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[[Page 48259]]
3. Forward Rate Agreements
The Commissions are adopting rules as proposed to explicitly define
the term ``swap'' to include forward rate agreements (``FRAs'').\585\
The Commissions did not receive any comments on the proposed rules
regarding the inclusion of FRAs in the swap definition.
---------------------------------------------------------------------------
\585\ See rules 1.3(xxx)(2)(i)(E) under the CEA and rule 3a69-
2(b)(1)(v) under the Exchange Act.
---------------------------------------------------------------------------
In general, an FRA is an over-the-counter contract for a single
cash payment, due on the settlement date of a trade, based on a spot
rate (determined pursuant to a method agreed upon by the parties) and a
pre-specified forward rate. The single cash payment is equal to the
product of the present value (discounted from a specified future date
to the settlement date of the trade) of the difference between the
forward rate and the spot rate on the settlement date multiplied by the
notional amount. The notional amount itself is not exchanged.\586\
---------------------------------------------------------------------------
\586\ See generally ``Trading and Capital-Markets Activities
Manual,'' supra note 556, section 4315.1 (``For example, in a six-
against-nine-month (6x9) FRA, the parties agree to a three-month
rate that is to be netted in six months' time against the prevailing
three-month reference rate, typically LIBOR. At settlement (after
six months), the present value of the net interest rate (the
difference between the spot and the contracted rate) is multiplied
by the notional principal amount to determine the amount of the cash
exchanged between the parties * * * . If the spot rate is higher
than the contracted rate, the seller agrees to pay the buyer the
differences between the prespecified forward rate and the spot rate
prevailing at maturity, multiplied by a notional principal amount.
If the spot rate is lower than the forward rate, the buyer pays the
seller.'').
---------------------------------------------------------------------------
An FRA provides for the future (executory) payment based on the
transfer of interest rate risk between the parties as opposed to
transferring an ownership interest in any asset or liability.\587\
Thus, the Commissions believe that an FRA satisfies clause (A)(iii) of
the swap definition.\588\
---------------------------------------------------------------------------
\587\ It appears that at least some in the trade view FRAs as
swaps today. See, e.g., The Globecon Group, Ltd., ``Derivatives
Engineering: A Guide to Structuring, Pricing and Marketing
Derivatives,'' 45 (McGraw-Hill 1995) (``An FRA is simply a one-
period interest-rate swap.''); DerivActiv, Glossary of Financial
Derivatives Terms (``A swap is * * * a strip of FRAs.''), available
at http://www.derivactiv.com/definitions.aspx?search=
forward+rate+agreements. Cf. Don M. Chance, et al., ``Derivatives in
Portfolio Management,'' 29 (AIMR 1998) (``[An FRA] involves one
specific payment and is basically a one-date swap (in the sense that
a swap is a combination of FRAs[,] with some variations).''). Thus,
FRAs also may fall within clause (A)(iv) of the swap definition, as
``an agreement, contract, or transaction that is, or in the future
becomes, commonly known to the trade as a swap.'' See section
1a(47)(a)(iv) of the CEA, 7 U.S.C. 1a(47)(a)(iv).
\588\ See section 1a(47)(A)(iii) of the CEA, 7 U.S.C.
1a(47)(A)(iii). CFTC regulations have defined FRAs as swap
agreements. See rule 35.1(b)(1)(i) under the CEA, 17 CFR
35.1(b)(1)(i); Exemption for Certain Swap Agreements, 58 FR 5587
(Jan. 22, 1993). The CFTC recently repealed that rule and amended
Part 35 of its rules in light of the enactment of Title VII of the
Dodd-Frank Act. See Agricultural Swaps, 76 FR 49291 (Aug. 10, 2011).
---------------------------------------------------------------------------
Notwithstanding their ``forward'' label, FRAs do not fall within
the forward contract exclusion from the swap definition. FRAs do not
involve nonfinancial commodities and thus are outside the scope of the
forward contract exclusion. Nor is an FRA a commercial merchandising
transaction, as there is no physical product to be delivered in an
FRA.\589\ Accordingly, the Commissions believe that the forward
contract exclusion from the swap definition for nonfinancial
commodities does not apply to FRAs.\590\
---------------------------------------------------------------------------
\589\ See Regulation of Hybrid and Related Instruments, 52 FR
47022, 47028 (Dec. 11, 1987) (stating ``[FRAs] do not possess all of
the characteristics of forward contracts heretofore delineated by
the [CFTC]'').
\590\ The Commissions note that Current European Union law
includes FRAs in the definition of ``financial instruments.'' See
Markets in Financial Instruments Directive (MiFID), ``Directive
2004/39/EC of the European Parliament and of the Council,'' Annex
I(C), 4, 5, 10 (Apr. 21, 2004), available at http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CONSLEG:2004L0039:20070921:EN:PDF 20070921:EN:PDF. European Commission legislation on derivatives,
central clearing, and trade repositories applies to FRAs that are
traded over-the-counter and, thus, would subject such transactions
to mandatory clearing, reporting and other regulatory requirements.
See Regulation of the European Parliament and of the Council on OTC
derivatives, central counterparties and trade repositories, tit. I,
art. 2 (1(3b)), 7509/1/12 REV 1 (Mar. 19, 2012).
---------------------------------------------------------------------------
Based on the foregoing considerations, the Commissions are adopting
rules to provide greater clarity by explicitly defining the term
``swap'' to include 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 exclusions set forth in subparagraph (B) of
the swap definition.
4. Combinations and Permutations of, or Options on, Swaps and Security-
Based Swaps
Clause (A)(vi) of the swap definition provides that ``any
combination or permutation of, or option on, any agreement, contract,
or transaction described in any of clauses (i) through (v)'' of the
definition is a swap.\591\ The Commissions provided an interpretation
regarding clause (A)(vi) in the Proposing Release.\592\ The Commissions
received no comments on the interpretation provided in the Proposing
Release regarding combinations and permutations of, or options on,
swaps and security-based swaps and are restating their interpretation
of clause (A)(vi) of the swap definition with one technical correction
and one clarification.
---------------------------------------------------------------------------
\591\ See section 1a(47)(vi) of the CEA, 7 U.S.C. 1a(47)(vi).
Clause (A)(vi) of the swap definition refers specifically to other
types of swaps in the swap definition. However, because section
3(a)(68) of the Exchange Act defines a security-based swap as a swap
[with some connection to a security], clause (A)(vi) of the swap
definition is relevant to determining whether any combination or
permutation of, or option on, a security-based swap is a security-
based swap.
\592\ See Proposing Release at 29838.
---------------------------------------------------------------------------
Clause (A)(vi) means, for example, that an option on a swap or
security-based swap (commonly known as a ``swaption'') would itself be
a swap or security-based swap, respectively. The Commissions also
interpret clause (A)(vi) to mean that a ``forward swap'' would itself
be a swap or security-based swap, respectively.\593\ By listing
examples here, the Commissions do not intend to limit the broad
language of clause (A)(vi) of the swap definition, which is designed to
capture those agreements, contracts and transactions that are not
expressly enumerated in the CEA swap definition but that nevertheless
are swaps.\594\
---------------------------------------------------------------------------
\593\ Forward swaps are also commonly known as forward start
swaps, or deferred or delayed start swaps. A forward swap can
involve two offsetting swaps that both start immediately, but one of
which ends on the deferred start date of the forward swap itself.
For example, if a counterparty wants to hedge its risk for four
years, starting one year from today, it could enter into a one-year
swap and a five-year swap, which would partially offset to create a
four-year swap, starting one year forward. A forward swap also can
involve a contract to enter into a swap or security-based swap at a
future date or with a deferred start date. A forward swap is not a
nonfinancial commodity forward contract or security forward, both of
which are excluded from the swap definition and discussed elsewhere
in this release.
\594\ This category could include categories of agreements,
contracts or transactions that do not yet exist as well as more
esoteric swaps that exist but that Congress did not refer to by name
in the statutory swap definition.
---------------------------------------------------------------------------
5. Contracts for Differences
As the Proposing Release notes, the Commissions have received
inquiries over the years regarding the treatment of CFDs under the CEA
and the Federal securities laws.\595\ A CFD generally is an agreement
to exchange the difference in value of an underlying asset between the
time at which a CFD position is established and the time at which it is
terminated.\596\ If the value increases, the
[[Page 48260]]
seller pays the buyer the difference; if the value decreases, the buyer
pays the seller the difference. CFDs can be traded on a number of
products, including treasuries, foreign exchange rates, commodities,
equities, and stock indexes. Equity CFDs closely mimic the purchase of
actual shares. The buyer of an equity CFD receives cash dividends and
participates in stock splits.\597\ In the case of a long position, a
dividend adjustment is credited to the client's account. In the case of
a short position, a dividend adjustment is debited from the client's
account. CFDs generally are traded over-the-counter (though they also
are traded on the Australian Securities Exchange) in a number of
countries outside the United States.
---------------------------------------------------------------------------
\595\ See Proposing Release at 29838.
\596\ See Ontario Securities Commission, Staff Notice 91-702,
``Offerings of Contracts for Difference and Foreign Exchange
Contracts to Investors in Ontario,'' at part IV.1 (defining a CFD as
``a derivative product that allows an investor to obtain economic
exposure (for speculative, investment or hedging purposes) to an
underlying asset * * * such as a share, index, market sector,
currency or commodity, without acquiring ownership of the underlying
asset''), available at http://www.osc.gov.on.ca/documents/en/Securities-Category9/sn_20091030_91-702_cdf.pdf (Oct. 30, 2009);
Financial Services Authority, Consultation Paper 7/20, ``Disclosure
of Contracts for Difference--Consultation and draft Handbook text,''
at part 2.2 (defining a CFD on a share as ``a derivative product
that gives the holder an economic exposure, which can be long or
short, to the change in price of a specific share over the life of
the contract''), available at http://www.fsa.gov.uk/pubs/cp/cp07_20.pdf (Nov. 2007).
\597\ See, e.g., Int'l Swaps and Derivatives Ass'n, ``2002 ISDA
Equity Derivatives Definitions,'' art. 10 (Dividends) and 11
(Adjustments and Modifications Affecting Indices, Shares and
Transactions).
---------------------------------------------------------------------------
The Commissions provided an interpretation in the Proposing Release
regarding the treatment of CFDs. The Commissions are restating the
interpretation set out in the Proposing Release without modification.
CFDs, unless otherwise excluded, fall within the scope of the swap
or security-based swap definition, as applicable.\598\ Whether a CFD is
a swap or security-based swap will depend on the underlying product of
that particular CFD transaction. Because CFDs are highly variable and a
CFD can contain a variety of elements that would affect its
characterization, the Commissions believe that market participants will
need to analyze the features of the underlying product of any
particular CFD in order to determine whether it is a swap or a
security-based swap. The Commissions are not adopting rules or
additional interpretations at this time regarding CFDs.
---------------------------------------------------------------------------
\598\ In some cases, depending on the facts and circumstances,
the SEC may determine that a particular CFD on an equity security,
for example, should be characterized as constituting a purchase or
sale of the underlying equity security and, therefore, be subject to
the requirements of the Federal securities laws applicable to such
purchases or sales.
---------------------------------------------------------------------------
Comments
Two commenters requested that the Commissions clarify that non-
deliverable forward contracts are not CFDs.\599\ These commenters
requested that the Commissions determine that NDFs involving foreign
exchange are not swaps. Given that the Commissions are defining NDFs as
swaps and that CFDs involving foreign currency also would be swaps,
there is no need to distinguish NDFs involving foreign exchange from
CFDs involving foreign exchange.
---------------------------------------------------------------------------
\599\ See Covington Letter and ICI/ABASA Letter.
---------------------------------------------------------------------------
D. Certain Interpretive Issues
1. Agreements, Contracts, or Transactions That May Be Called, or
Documented Using Form Contracts Typically Used for, Swaps or Security-
Based Swaps
The Commissions are restating the interpretation provided in the
Proposing Release regarding agreements, contracts, or transactions that
may be called, or documented using form contracts typically used for,
swaps or security-based swaps with one modification in response to a
commenter.\600\
---------------------------------------------------------------------------
\600\ See infra note 606.
---------------------------------------------------------------------------
As was noted in the Proposing Release,\601\ individuals and
companies may generally use the term ``swap'' to refer to certain of
their agreements, contracts, or transactions. For example, they may use
the term ``swap'' to refer to an agreement to exchange real or personal
property between the parties or to refer to an agreement for two
companies that produce fungible products and with delivery obligations
in different locations to perform each other's delivery obligations
instead of their own.\602\ However, the name or label that the parties
use to refer to a particular agreement, contract, or transaction is not
determinative of whether it is a swap or security-based swap.\603\
---------------------------------------------------------------------------
\601\ See Proposing Release at 29839.
\602\ For example, a company obligated to deliver its product to
a customer in Los Angeles would instead deliver the product in
Albany to a different company's customer on behalf of that other
company. In return, the company with the obligation to deliver a
product to its customer in Albany would deliver the product instead
in Los Angeles to the customer of the company obligated to deliver
its product to that customer in Los Angeles.
\603\ See, e.g., Haekel v. Refco, 2000 WL 1460078, at *4 (CFTC
Sept. 29, 2000) (``[T]he labels that parties apply to their
transactions are not necessarily controlling''); Reves v. Ernst &
Young, 494 U.S. 56, 61 (1990) (stating that the purpose of the
securities laws is ``to regulate investments, in whatever form they
are made and by whatever name they are called'') (emphasis in
original).
---------------------------------------------------------------------------
It is not dispositive that the agreement, contract, or transaction
is documented using an industry standard form agreement that is
typically used for swaps and security-based swaps,\604\ but it may be a
relevant factor.\605\ The key question is whether the agreement,
contract, or transaction falls within the statutory definitions of the
term ``swap'' or ``security-based swap'' (as further defined and
interpreted pursuant to the final rules and interpretations herein)
based on its terms and other characteristics. Even if one effect of an
agreement is to reduce the risk faced by the parties (for example, the
``swap'' of physical delivery obligations described above may reduce
the risk of non-delivery), the agreement would not be a swap or
security-based swap unless it otherwise meets one of those statutory
definitions, as further defined by the Commissions. If the agreement,
contract, or transaction satisfies the swap or security-based swap
definitions, the fact that the parties refer to it by another name
would not take it outside the Dodd-Frank Act regulatory regime.
Conversely, if an agreement, contract, or transaction is not a swap or
security-based swap, as those terms are defined in the CEA and the
Exchange Act and the rules and regulations thereunder, the fact that
the parties refer to it, or document it, as a swap or security-based
swap will not subject that agreement, contract, or transaction to
regulation as a swap or a security-based swap.
---------------------------------------------------------------------------
\604\ As noted in the Proposing Release, the CFTC consistently
has found that the form of a transaction is not dispositive in
determining its nature, citing Grain Land, supra note 213, at *16
(CFTC Nov. 25, 2003) (holding that contract substance is entitled to
at least as much weight as form); In the Matter of First Nat'l
Monetary Corp., [1984-1986 Transfer Binder] Comm. Fut. L. Rep. (CCH)
] 22,698 at 30,974 (CFTC Aug. 7, 1985) (``When instruments have been
determined to constitute the functional equivalent of futures
contracts neither we nor the courts have hesitated to look behind
whatever self-serving labels the instruments might bear.'');
Stovall, supra note 63 (holding that the CFTC ``will not hesitate to
look behind whatever label the parties may give to the
instrument''). As also noted in the Proposing Release, the form of a
transaction is not dispositive in determining whether an agreement,
contract, or transaction falls within the regulatory regime for
securities. See SEC v. Merch. Capital, LLC, 483 F.3d 747, 755 (11th
Cir. 2007) (``The Supreme Court has repeatedly emphasized that
economic reality is to govern over form and that the definitions of
the various types of securities should not hinge on exact and
literal tests.'') (quoting Williamson v. Tucker, 645 F.2d 404, 418
(5th Cir. 1981)); Robinson v. Glynn, 349 F.3d 166, 170 (4th Cir.
2003) (``What matters more than the form of an investment scheme is
the `economic reality' that it represents. * * *'') (internal
citation omitted); Caiola v. Citibank, N.A., New York, 295 F.3d 312,
325 (2d Cir. 2002) (quoting United Housing Foundation v. Foreman,
421 U.S. 837, 848 (1975) (``In searching for the meaning and scope
of the word `security' * * * the emphasis should be on economic
reality'')). See Proposing Release at 29839 n. 152.
\605\ The Commissions note, though, that documentation is not
controlling in evaluating whether an agreement, contract or
transaction is a swap, security-based swap, or neither.
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[[Page 48261]]
Comments
The Commissions requested comment regarding what agreements,
contracts, or transactions that are not swaps or security-based swaps
are documented using industry standard form agreements that are
typically used for swaps and security-based swaps, and asked for
examples thereof and details regarding their documentation, including
why industry standard form agreements typically used for swaps and
security-based swaps are used. One commenter stated its view that
documentation can be a relevant factor in determining whether an
agreement, contract or transaction is a swap or security-based
swap.\606\ The Commissions are persuaded by the commenter and are
modifying the interpretation to clarify that in determining whether an
agreement, contract or transaction is a swap or security-based swap,
documentation may be a relevant (but not dispositive) factor.
---------------------------------------------------------------------------
\606\ See IECA Letter. This commenter noted that ``[e]ven though
swaps are commonly documented on the ISDA Master Agreements without
annexes, physical transactions under such agreements with power or
natural gas annexes are not swaps because they are physically
settled forward contracts that are exempt under 1a47(B)''). Id.
---------------------------------------------------------------------------
2. Transactions in Regional Transmission Organizations and Independent
System Operators
The CFTC declines to address the status of transactions in Regional
Transmission Organizations (``RTOs'') and Independent System Operators
(``ISOs''), including financial transmission rights (``FTRs'') and
ancillary services, within this joint definitional rulemaking. As was
noted in the Proposing Release, section 722 of the Dodd-Frank Act
specifically addresses certain instruments and transactions regulated
by FERC that also may be subject to CFTC jurisdiction. Section 722(f)
added CEA section 4(c)(6),\607\ which provides that, if the CFTC
determines that an exemption for FERC-regulated instruments or other
specified electricity transactions would be in accordance with the
public interest, then the CFTC shall exempt such instruments or
transactions from the requirements of the CEA. Given that specific
statutory directive, the treatment of these FERC-regulated instruments
and transactions should be considered under the standards and
procedures specified in section 722 of the Dodd-Frank Act for a public
interest waiver, rather than through this joint rulemaking to further
define the terms ``swap'' and ``security-based swap.'' \608\
---------------------------------------------------------------------------
\607\ 7 U.S.C. 6(c)(6).
\608\ The Commissions note that this approach should not be
taken to suggest any finding by the Commissions as to whether or not
FTRs or any other FERC-regulated instruments or transactions are
swaps (or futures contracts).
---------------------------------------------------------------------------
The CFTC notes that it has been engaged in discussions with a
number of RTOs and ISOs regarding the possibility of a petition seeking
an exemption pursuant to CEA section 4(c)(6) for certain RTO and ISO
transactions. The CFTC also notes that the status of some RTO and ISO
transactions may have been addressed in the interpretation above
regarding embedded options and the forward exclusion from the swap
definition,\609\ and/or indirectly through the CFTC's recent interim
final rulemaking relating to trade options.\610\
---------------------------------------------------------------------------
\609\ See supra part II.B.2(a).
\610\ See supra note 317.
---------------------------------------------------------------------------
Comments
The CFTC received a number of comments discussing transactions in
RTOs and ISOs.\611\ These commenters argued that the CFTC should
further define the term ``swap'' to exclude transactions executed or
traded on RTOs and ISOs.\612\ One commenter argued that the CEA section
4(c)(6) exemptive approach will leave regulatory ambiguity for market
participants, since the CFTC might not grant an exemption, later revoke
an existing exemption, grant a partial or conditional exemption, or
limit an exemption to existing products.\613\ This commenter also noted
that FERC has complete regulatory authority over RTOs and ISOs and
their transactions, and that Congress expected the CFTC and FERC to
avoid duplicative, unnecessary regulation.\614\ Another commenter
argued that the CFTC should exclude RTO and ISO transactions in the
same manner as insurance has been excluded.\615\ A third commenter
stated that RTO and ISO transactions are commercial merchandising
transactions and thus forwards or, alternatively, that defining them as
swaps is inconsistent with the text, goals, and purpose of the Dodd-
Frank Act.\616\
---------------------------------------------------------------------------
\611\ See COPE Letter; ETA Letter; and FERC Staff Letter.
\612\ Id.
\613\ See COPE Letter.
\614\ Id.
\615\ See ETA Letter.
\616\ See FERC Staff Letter.
---------------------------------------------------------------------------
By contrast, one commenter asserted that FTRs are in substance
swaps and should be regulated as such.\617\
---------------------------------------------------------------------------
\617\ See Better Markets Letter.
---------------------------------------------------------------------------
Two commenters supported the CFTC's use of its section 722(f)
authority to exempt FERC-regulated transactions and other transactions
in RTOs or ISOs.\618\ As discussed above, section 722(f) of the Dodd-
Frank Act added new section 4(c)(6) to the CEA specifically addressing
how the CFTC should approach certain instruments and transactions
regulated by FERC that also may be subject to CFTC jurisdiction. The
CFTC continues to believe, as was stated in the Proposing Release, that
such an approach is the more appropriate means of considering issues
relating to the instruments and transactions specified in CEA section
4(c)(6). One commenter's argument that the CEA section 4(c)(6)
exemptive approach will cause regulatory ambiguity is not a convincing
basis on which to forego a process specifically designated by Congress
for the issue at hand.\619\ The CFTC also believes that the ability to
tailor exemptive relief, after notice and public comment, to the
complex issues presented by transactions on RTOs and ISOs, is further
reason to favor such an approach over the more general directive to
further define the terms ``swap'' and ``security-based swap'' that is
the subject of this rulemaking.
---------------------------------------------------------------------------
\618\ See NEMA Letter and WGCEF Letter.
\619\ See COPE Letter.
---------------------------------------------------------------------------
In response to one commenter's contentions that FERC has complete
regulatory authority over RTOs and ISOs and their transactions, and
that Congress expected the CFTC and FERC to avoid duplicative,
unnecessary regulation, the CFTC notes that Congress addressed this
issue not by excluding RTO and ISO transactions from the comprehensive
regime for swap regulation, but rather by enacting the exemptive
process in CEA section 4(c)(6).
And in response to another commenter's contention that the CFTC
should exclude RTO and ISO transactions in the same manner as insurance
has been excluded, the CFTC notes that Congress provided neither an
exemptive process equivalent to CEA section 4(c)(6) for insurance, nor
an energy market-equivalent to the McCarran-Ferguson Act.\620\
---------------------------------------------------------------------------
\620\ 15 U.S.C. 1011-1015.
---------------------------------------------------------------------------
As noted above, FERC staff opines that defining RTO and ISO
transactions as swaps would be inconsistent with the text, goals, and
purpose of the Dodd-Frank Act. The CFTC can consider concerns of the
sort expressed by FERC staff in connection with any petition for a CEA
section 4(c)(6) exemption that
[[Page 48262]]
may be submitted to the CFTC.\621\ Interested parties on all sides of
the issue would receive an opportunity to comment on the scope and
other aspects of any proposed exemptive relief at that time.
---------------------------------------------------------------------------
\621\ CEA section 4(c)(6) requires the CFTC to determine that an
exemption pursuant to such section ``is consistent with the public
interest and the purposes of th[e CEA].'' 7 U.S.C. 6(c)(6).
---------------------------------------------------------------------------
III. The Relationship Between the Swap Definition and the Security-
Based Swap Definition
A. Introduction
Title VII of the Dodd-Frank Act defines the term ``swap'' under the
CEA,\622\ and also defines the term ``security-based swap'' under the
Exchange Act.\623\ Pursuant to the regulatory framework established in
Title VII, the CFTC has regulatory authority over swaps and the SEC has
regulatory authority over security-based swaps. The Commissions are
further defining the terms ``swap'' and ``security-based swap'' to
clarify whether particular agreements, contracts, or transactions are
swaps or security-based swaps based on characteristics including the
specific terms and conditions of the instrument and the nature of,
among other things, the prices, rates, securities, indexes, or
commodities upon which the instrument is based.
---------------------------------------------------------------------------
\622\ See section 1a(47) of the CEA, 7 U.S.C. 1a(47).
\623\ See section 3(a)(68) of the Exchange Act, 15 U.S.C.
78c(a)(68).
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Because the discussion below is focused on whether particular
agreements, contracts, or transactions are swaps or security-based
swaps, the Commissions use the term ``Title VII instrument'' in this
release to refer to any agreement, contract, or transaction that is
included in either the definition of the term ``swap'' or the
definition of the term ``security-based swap.'' Thus, the term ``Title
VII instrument'' is synonymous with ``swap or security-based swap.''
\624\
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\624\ In some cases, the Title VII instrument may be a mixed
swap. Mixed swaps are discussed further in section IV below.
---------------------------------------------------------------------------
The determination of whether a Title VII instrument is either a
swap or a security-based swap should be made based on the facts and
circumstances relating to the Title VII instrument prior to execution,
but no later than when the parties offer to enter into the Title VII
instrument.\625\ If the Title VII instrument itself is not amended,
modified, or otherwise adjusted during its term by the parties, its
characterization as a swap or security-based swap will not change
during its duration because of any changes that may occur to the
factors affecting its character as a swap or security-based swap.\626\
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\625\ The determination must be made no later than when the
parties offer to enter into the Title VII instrument because persons
are prohibited from offering to sell, offering to buy or purchase,
or selling a security-based swap to any person who is not an ECP
unless a registration statement is in effect as to the security-
based swap. See section 5(e) of the Securities Act. This analysis
also would apply with respect to mixed swaps and security-based swap
agreements. With respect to swaps, the determination also would need
to be made no later than the time that provisions of the CEA and the
regulations thereunder become applicable to a Title VII Instrument.
For instance, certain duties apply to swaps prior to execution. See
Daily Trading Records under Rule 23.202 under the CEA, 17 CFR
23.202, and Subpart H of Part 23 of the CFTC's regulations, 17 CFR
Part 23, Subpart H (Business Conduct Standards for Swap Dealers and
Major Swap Participants Dealing with Counterparties, Including
Special Entities).
\626\ See infra part III.G.5(a), for a discussion regarding the
evaluation of Title VII Instruments on security indexes that move
from broad-based to narrow-based or narrow-based to broad-based.
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Classifying a Title VII instrument as a swap or security-based swap
is straightforward for most instruments. However, the Commissions
provided an interpretation in the Proposing Release to clarify the
classification of swaps and security-based swaps in certain areas and
to provide an interpretation regarding the use of certain terms and
conditions in Title VII instruments. The Commissions are restating the
interpretation set out in the Proposing Release with certain
modifications to the interpretation regarding TRS.
B. Title VII Instruments Based on Interest Rates, Other Monetary Rates,
and Yields
Parties frequently use Title VII instruments to manage risks
related to, or to speculate on, changes in interest rates, other
monetary rates or amounts, or the return on various types of assets.
Broadly speaking, Title VII instruments based on interest or other
monetary rates would be swaps, whereas Title VII instruments based on
the yield or value of a single security, loan, or narrow-based security
index would be security-based swaps. However, market participants and
financial professionals sometimes use the terms ``rate'' and ``yield''
in different ways. The Commissions proposed an interpretation in the
Proposing Release regarding whether Title VII instruments that are
based on interest rates, other monetary rates, or yields would be swaps
or security-based swaps and are restating the interpretation, but with
a modification to the list of examples of reference rates to include
certain secured lending rates under money market rates.\627\ The
Commissions find that this interpretation is an appropriate way to
address Title VII instruments based on interest rates, other monetary
rates, or yields and is designed to reduce costs associated with
determining whether such instruments are swaps or security-based
swaps.\628\
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\627\ These secured lending rates are the Eurepo, The Depository
Trust & Clearing Corporation's General Collateral Finance Repo
Index, the Repurchase Overnight Index Average Rate and the Tokyo
Repo Rate.
\628\ See supra part I, under ``Overall Economic
Considerations''.
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1. Title VII Instruments Based on Interest Rates or Other Monetary
Rates That Are Swaps
The Commissions believe that when payments exchanged under a Title
VII instrument are based solely on the levels of certain interest rates
or other monetary rates that are not themselves based on one or more
securities, the instrument would be a swap and not a security-based
swap.\629\ Often swaps on interest rates or other monetary rates
require the parties to make payments based on the comparison of a
specified floating rate (such as the London Interbank Offered Rate
(``LIBOR'')) to a fixed rate of interest agreed upon by the parties. A
rate swap also may require payments based on the differences between
two floating rates, or it may require that the parties make such
payments when any agreed-upon events with respect to interest rates or
other monetary rates occur (such as when a specified interest rate
crosses a threshold, or when the spread between two such rates reaches
a certain point). The rates referenced for the parties' obligations are
varied, and examples of such rates include the following:
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\629\ See infra part III.F, regarding the use of certain terms
and conditions.
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Interbank Offered Rates: An average of rates charged by a group of
banks for lending money to each other or other banks over various
periods of time, and other similar interbank rates,\630\ including, but
not limited to, LIBOR (regardless of currency); \631\ the Euro
[[Page 48263]]
Interbank Offered Rate (``Euribor''); the Canadian Dealer Offered Rate
(``CDOR''); and the Tokyo Interbank Offered Rate (``TIBOR''); \632\
---------------------------------------------------------------------------
\630\ Interbank lending rates are measured by surveys of the
loan rates that banks offer other banks, or by other mechanisms. The
periods of time for such loans may range from overnight to 12 months
or longer.
The interbank offered rates listed here are frequently called
either a ``reference rate,'' the rate of ``reference banks,'' or by
a designation that is specific to the service that quotes the rate.
For some of the interbank offered rates listed here, there is a
similar rate that is stated as an interbank bid rate, which is the
average rate at which a group of banks bid to borrow money from
other banks. For example, the bid rate similar to LIBOR is called
LIBID.
\631\ Today, LIBOR is used as a rate of reference for the
following currencies: Australian Dollar, Canadian Dollar, Danish
Krone, Euro, Japanese Yen, New Zealand Dollar, Pound Sterling,
Swedish Krona, Swiss Franc, and U.S. Dollar.
\632\ Other interbank offered rates include the following (with
the country or city component of the acronym listed in parentheses):
AIDIBOR (Abu Dhabi); BAIBOR (Buenos Aires); BKIBOR (Bangkok);
BRAZIBOR (Brazil); BRIBOR/BRIBID (Btatislava); BUBOR (Budapest);
CHIBOR (China); CHILIBOR (Chile); CIBOR (Copenhagen); COLIBOR
(Columbia); HIBOR (Hong Kong); JIBAR (Johannesburg); JIBOR
(Jakarta); KAIBOR (Kazakhstan); KIBOR (Karachi); KLIBOR (Kuala
Lumpur); KORIBOR ((South) Korea); MEXIBOR (Mexico); MIBOR (Mumbai);
MOSIBOR (Moscow); NIBOR (Norway); PHIBOR (Philippines); PRIBOR
(Prague); REIBOR/REIBID (Reykjavik); RIGIBOR/RIGIBID (Riga); SHIBOR
(Shanghai); SIBOR (Singapore); SOFIBOR (Sofia); STIBOR (Stockholm);
TAIBOR (Taiwan); TELBOR (Tel Aviv); TRLIBOR and TURKIBOR (Turkey);
VILIBOR (Vilnius); VNIBOR (Vietnam); and WIBOR (Warsaw).
---------------------------------------------------------------------------
Money Market Rates: A rate established or determined based on
actual lending or money market transactions, including, but not limited
to, the Federal Funds Effective Rate; the Euro Overnight Index Average
(``EONIA'' or ``EURONIA'') (which is the weighted average of overnight
unsecured lending transactions in the Euro-area interbank market); the
EONIA Swap Index; the Eurepo (the rate at which, at 11.00 a.m. Brussels
time, one bank offers, in the euro-zone and worldwide, funds in euro to
another bank if in exchange the former receives from the latter the
best collateral within the most actively-traded European repo market);
the Australian dollar RBA 30 Interbank Overnight Cash Rate; the
Canadian Overnight Repo Rate Average (``CORRA''); The Depository Trust
& Clearing Corporation's General Collateral Finance (``GCF'') Repo
Index (an average of repo rates collateralized by U.S. Treasury and
certain other securities); the Mexican interbank equilibrium interest
rate (``TIIE''); the NZD Official Cash Rate; the Sterling Overnight
Interbank Average Rate (``SONIA'') (which is the weighted average of
unsecured overnight cash transactions brokered in London by the
Wholesale Markets Brokers' Association (``WMBA'')); the Repurchase
Overnight Index Average Rate (``RONIA'') (which is the weighted average
rate of all secured overnight cash transactions brokered in London by
WMBA); the Swiss Average Rate Overnight (``SARON''); the Tokyo
Overnight Average Rate (``TONAR'') (which is based on uncollateralized
overnight average call rates for interbank lending); and the Tokyo Repo
Rate (average repo rate of active Japanese repo market participants).
Government Target Rates: A rate established or determined based on
guidance established by a central bank including, but not limited to,
the Federal Reserve discount rate, the Bank of England base rate and
policy rate, the Canada Bank rate, and the Bank of Japan policy rate
(also known as the Mutan rate);
General Lending Rates: A general rate used for lending money,
including, but not limited to, a prime rate, rate in the commercial
paper market, or any similar rate provided that it is not based on any
security, loan, or group or index of securities;
Indexes: A rate derived from an index of any of the foregoing or
following rates, averages, or indexes, including but not limited to a
constant maturity rate (U.S. Treasury and certain other rates),\633\
the interest rate swap rates published by the Federal Reserve in its
``H.15 Selected Interest Rates'' publication, the ISDAFIX rates, the
ICAP Fixings, a constant maturity swap, or a rate generated as an
average (geometric, arithmetic, or otherwise) of any of the foregoing,
such as overnight index swaps (``OIS'')--provided that such rates are
not based on a specific security, loan, or narrow-based group or index
of securities;
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\633\ A Title VII instrument based solely on the level of a
constant maturity U.S. Treasury rate would be a swap because U.S.
Treasuries are exempted securities that are excluded from the
security-based swap definition. Conversely, a Title VII instrument
based solely on the level of a constant maturity rate on a narrow-
based index of non-exempted securities under the security-based swap
definition would be a security-based swap.
---------------------------------------------------------------------------
Other Monetary Rates: A monetary rate including, but not limited
to, the Consumer Price Index (``CPI''), the rate of change in the money
supply, or an economic rate such as a payroll index; and
Other: The volatility, variance, rate of change of (or the spread,
correlation or difference between), or index based on any of the
foregoing rates or averages of such rates, such as forward spread
agreements, references used to calculate the variable payments in index
amortizing swaps (whereby the notional principal amount of the
agreement is amortized according to the movement of an underlying
rate), or correlation swaps and basis swaps, including but not limited
to, the ``TED spread'' \634\ and the spread or correlation between
LIBOR and an OIS.
---------------------------------------------------------------------------
\634\ The TED spread is the difference between the interest
rates on interbank loans and short-term U.S. government debt
(Treasury bills or ``T-bills''). The latter are exempted securities
that are excluded from the statutory definition of the term
``security-based swap.'' Thus, neither any aspect of U.S. Treasuries
nor interest rates on interbank loans can form the basis of a
security-based swap. For this reason, a Title VII instrument on a
spread between interbank loan rates and T-bill rates also would be a
swap, not a security-based swap.
---------------------------------------------------------------------------
As discussed above, the Commissions believe that when payments
under a Title VII instrument are based solely on any of the foregoing,
such Title VII instrument would be a swap.
Comments
Two commenters believed that constant maturity swaps always should
be treated as swaps, rather than mixed swaps, because they generally
are viewed by market participants as rates trades instead of trades on
securities.\635\ According to the commenters, the ``bulk'' of constant
maturity swaps are based on exempted securities, but the commenters
noted that the constant maturity leg may be based on a number of
different rates or yields, including, among other things, U.S. Treasury
yields, Treasury auction rates, yields on debt of foreign governments,
and debt related to indices of mortgage-backed securities.\636\ As
discussed above, the Commissions are adopting the interpretation as
proposed. The statutory language of the swap and security-based swap
definitions explicitly states that a Title VII instrument that is based
on a non-exempted security should be a security-based swap and not a
swap.\637\
---------------------------------------------------------------------------
\635\ See CME Letter and SIFMA Letter.
\636\ Id.
\637\ See supra note 633.
---------------------------------------------------------------------------
2. Title VII Instruments Based on Yields
The Commissions proposed an interpretation in the Proposing Release
clarifying the status of Title VII instruments in which one of the
underlying references of the instrument is a ``yield.'' The Commissions
received no comments on the interpretation set out in the Proposing
Release regarding Title VII instruments based on yields and are
restating the interpretation without modification. In cases when a
``yield'' is calculated based on the price or changes in price of a
debt security, loan, or narrow-based security index, it is another way
of expressing the price or value of a debt security, loan, or narrow-
based security index. For example, debt securities often are quoted and
traded on a yield basis rather than on a dollar price, where the yield
relates to a specific date, such as the date of maturity of the debt
security (i.e., yield to maturity) or the date upon which the debt
security may be redeemed or called by the issuer (e.g., yield to first
whole issue call).\638\
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\638\ See, e.g., Securities Confirmations, 47 FR 37920 (Aug. 27,
1982).
---------------------------------------------------------------------------
Except in the case of certain exempted securities, when one of the
underlying
[[Page 48264]]
references of the Title VII instrument is the ``yield'' of a debt
security, loan, or narrow-based security index in the sense where the
term ``yield'' is used as a proxy for the price or value of the debt
security loan, or narrow-based security index, the Title VII instrument
would be a security-based swap. And, as a result, in cases where the
underlying reference is a point on a ``yield curve'' generated from the
different ``yields'' on debt securities in a narrow-based security
index (e.g., a constant maturity yield or rate), the Title VII
instrument would be a security-based swap. However, where certain
exempted securities, such as U.S. Treasury securities, are the only
underlying reference of a Title VII instrument involving securities,
the Title VII instrument would be a swap. Title VII instruments based
on exempted securities are discussed further below.
The above interpretation would not apply in cases where the
``yield'' referenced in a Title VII instrument is not based on a debt
security, loan, or narrow-based security index of debt securities but
rather is being used to reference an interest rate or monetary rate as
outlined above in subsection one of this section. In these cases, this
``yield'' reference would be considered equivalent to a reference to an
interest rate or monetary rate and the Title VII instrument would be,
under the interpretation in this section, a swap (or mixed swap
depending on other references in the instrument).
3. Title VII Instruments Based on Government Debt Obligations
The Commissions provided an interpretation in the Proposing Release
regarding instances in which the underlying reference of the Title VII
instrument is a government debt obligation. The Commissions received no
comments on the interpretation provided regarding instances in which
the underlying reference of the Title VII instrument is a government
debt obligation and are restating such interpretation without
modification.
The security-based swap definition specifically excludes any
agreement, contract, or transaction that meets the definition of a
security-based swap only because it ``references, is based upon, or
settles through the transfer, delivery, or receipt of an exempted
security under [section 3(a)(12) of the Exchange Act], as in effect on
the date of enactment of the Futures Trading Act of 1982 (other than
any municipal security as defined in [section 3(a)(29) of the Exchange
Act] * * *), unless such agreement, contract, or transaction is of the
character of, or is commonly known in the trade as, a put, call, or
other option.'' \639\
---------------------------------------------------------------------------
\639\ Section 3(a)(68)(C) of the Exchange Act, 15 U.S.C.
76c(a)(68)(C).
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As a result of this exclusion in the security-based swap definition
for ``exempted securities,''\640\ if the only underlying reference of a
Title VII instrument involving securities is, for example, the price of
a U.S. Treasury security and the instrument does not have any other
underlying reference involving securities, then the instrument would be
a swap. Similarly, if the Title VII instrument is based on the
``yield'' of a U.S. Treasury security and does not have any other
underlying reference involving securities, then the instrument also
would be a swap, regardless of whether the term ``yield'' is a proxy
for the price of the security.
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\640\ As of January 11, 1983, the date of enactment of the
Futures Trading Act of 1982, Public Law 97-444, 96 Stat. 2294,
section 3(a)(12) of the Exchange Act, 15 U.S.C. 78c(a)(12), provided
that, among other securities, ``exempted securities'' include: (i)
Securities which are direct obligations of, or obligations
guaranteed as to principal or interest by, the United States; (ii)
certain securities issued or guaranteed by corporations in which the
United States has a direct or indirect interest as designated by the
Secretary of the Treasury; and (iii) certain other securities as
designated by the SEC in rules and regulations.
---------------------------------------------------------------------------
Foreign government securities, by contrast, were not ``exempted
securities'' as of the date of enactment of the Futures Trading Act of
1982 \641\ and thus do not explicitly fall within this exclusion from
the security-based swap definition. Therefore, if the underlying
reference of the Title VII instrument is the price, value, or ``yield''
(where ``yield'' is a proxy for price or value) of a foreign government
security, or a point on a yield curve derived from a narrow-based
security index composed of foreign government securities, then the
instrument is a security-based swap.
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\641\ Public Law 97-444, 96 Stat. 2294 (1983).
---------------------------------------------------------------------------
C. Total Return Swaps
The Commissions are restating the interpretation regarding TRS set
out in the Proposing Release with certain changes with respect to
quanto and compo equity TRS and loan TRS based on two or more loans,
and to reflect that TRS can overlie reference items other than
securities, loans, and indexes of securities or loans.\642\ The
Commissions find that this interpretation is an appropriate way to
address TRS and is designed to reduce the cost associated with
determining whether a TRS is a swap or a security-based swap.\643\
---------------------------------------------------------------------------
\642\ While this guidance focuses on TRS overlying securities
and loans, TRS also may overlie other commodities. Such TRS may be
structured differently due to the nature of the underlying.
\643\ See supra part I, under ``Overall Economic
Considerations.''
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As was described in the Proposing Release,\644\ a TRS is 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.\645\ A TRS also can overlie a
single loan, two or more loans and other underliers. The other
counterparty, the buyer of the TRS, makes a financing payment that is
often based on a variable interest rate, such as LIBOR (or other
interbank offered rate or money market rate, as described above), as
well as a payment based on the price depreciation of the underlying
reference. The ``total return'' consists of the price appreciation or
depreciation, plus any interest or income payments.\646\ Accordingly,
where a TRS is based on a single security or loan, or a narrow-based
security index, the TRS would be a security-based swap.\647\
---------------------------------------------------------------------------
\644\ See Proposing Release at 29842.
\645\ Where the underlying security is an equity security, a TRS
is also known as an ``equity swap.'' A bond may also be the
underlying security of a TRS.
\646\ If the total return is negative, the seller receives this
amount from the buyer. TRS can be used to synthetically reproduce
the payoffs of a position. For example, two counterparties may enter
into a 3-year TRS where the buyer of the TRS receives the positive
total return on XYZ security, if any, and the seller of the TRS
receives LIBOR plus 30 basis points and the absolute value of the
negative total return on XYZ security, if any.
\647\ However, if the underlying reference of the TRS is a
broad-based security index, it is a swap (and an SBSA) and not a
security-based swap. In addition, a TRS on an exempted security,
such as a U.S. Treasury, under section 3(a)(12) of the Exchange Act,
15 U.S.C. 78c(a)(12), as in effect on the date of enactment of the
Futures Trading Act of 1982 (other than any municipal security as
defined in section 3(a)(29) of the Exchange Act, 15 U.S.C.
78c(a)(29), as in effect on the date of enactment of the Futures
Trading Act of 1982), is a swap (and an SBSA), and not a security-
based swap. Similarly, and as discussed in more detail below, an
LTRS based on two or more loans that are not securities (``non-
security loans'') are swaps, and not security-based swaps.
---------------------------------------------------------------------------
In addition, the Commissions are providing a final interpretation
providing that, generally, the use of a variable interest rate in the
TRS buyer's payment obligations to the seller is incidental to the
purpose of, and the risk that the counterparties assume in, entering
into the TRS, because such payments are a form of financing reflecting
the seller's (typically a security-based swap dealer) cost of financing
the position or a related hedge, allowing the TRS buyer to receive
payments based on the price appreciation and income of a security or
security index without purchasing the security or security index. As
stated in
[[Page 48265]]
the Proposing Release, the Commissions believe that when such interest
rate payments act merely as a financing component in a TRS, or in any
other security-based swap, the inclusion of such interest rate terms
would not cause the TRS to be characterized as a mixed swap.\648\
Financing terms may also involve adding or subtracting a spread to or
from the financing rate,\649\ or calculating the financing rate in a
currency other than that of the underlying reference security or
security index.\650\
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\648\ See infra part IV.
\649\ See, e.g., Moorad Chowdry, ``Total Return Swaps: Credit
Derivatives and Synthetic Funding Instruments,'' at 3-4 (noting that
the spread to the TRS financing rate is a function of: The credit
rating of the counterparty paying the financing rate; the amount,
value, and credit quality of the reference asset; the dealer's
funding costs; a profit margin; and the capital charge associated
with the TRS), available at http://www.yieldcurve.com/Mktresearch/LearningCurve/TRS.pdf.
\650\ For example, a security-based swap on an equity security
priced in U.S. dollars in which payments are made in Euros based on
the U.S. dollar/Euro spot rate at the time the payment is made would
not be a mixed swap. As the Commissions stated in the Proposing
Release, under these circumstances, the currency is merely
referenced in connection with the method of payment, and the
counterparties are not hedging the risk of changes in currency
exchange rates during the term of the security-based swap See
Proposing Release at 29842, n. 176.
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However, where such payments incorporate additional elements that
create additional interest rate or currency exposures that are
unrelated to the financing of the security-based swap, or otherwise
shift or limit risks that are related to the financing of the security-
based swap, those additional elements may cause the security-based swap
to be a mixed swap. For example, where the counterparties embed
interest-rate optionality (e.g., a cap, collar, call, or put) into the
terms of a security-based swap in a manner designed to shift or limit
interest rate exposure, the inclusion of these terms would cause the
TRS to be both a swap and a security-based swap (i.e., a mixed swap).
Similarly, if a TRS is also based on non-security-based components
(such as the price of oil, or a currency), the TRS would also be a
mixed swap.\651\
---------------------------------------------------------------------------
\651\ See Mixed Swaps, infra part IV.
---------------------------------------------------------------------------
The Commissions also are providing an additional interpretation
regarding a quanto equity swap, in response to comments raised by one
commenter,\652\ and for illustrative purposes, a similar but
contrasting product, a compo equity swap. A quanto equity swap, which
``can provide a U.S. investor with currency-protected exposure to a
non-U.S. equity index by translating the percentage equity return in
the currency of such non-U.S. equity index into U.S. dollars,'' \653\
can be described as:
---------------------------------------------------------------------------
\652\ See SIFMA Letter.
\653\ Id.
An equity swap in which [(1)] the underlying is denominated in a
currency (the foreign currency) other than that in which the equity
swap is denominated (the domestic currency) * * * [and (2) t]he
final value of the underlying is denominated in the foreign currency
and is converted into the domestic currency using the exchange rate
prevailing at inception[,] result[ing in] the investor * * * not
[being] exposed to currency risk.\654\
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\654\ Handbook of Corporate Equity Derivatives and Equity
Capital Markets (``Corporate Equity Derivatives Handbook''), Sec.
1.2.10, at 23, available at http://media.wiley.com/product_data/excerpt/05/11199759/1119975905-83.pdf last visited May 4, 2012.
While a quanto equity swap, therefore, effectively ``exposes the
dealer on the foreign leg of the correlation product to a variable
notional principal amount that changes whenever the exchange rate or
the foreign index fluctuates,'' \655\ such exposure results from the
choice of hedges for the quanto equity swap, not from the cash flows of
the quanto equity swap itself.\656\ Thus, that exposure could be viewed
as created in the seller by the act of entering into the quanto equity
swap, rather than as a transfer between the parties, as is required by
the third prong of the statutory swap definition. Consequently, the
dealer's exchange rate exposure could be seen as incidental to the
securities exposure desired by the party initiating the quanto equity
swap.
---------------------------------------------------------------------------
\655\ James M. Mahoney, Correlation Products and Risk Management
Issues, FRBNY Economic Policy Review/October 1995 at 2, available at
http://www.ny.frb.org/research/epr/95v01n3/9510maho.pdf last visited
May 4, 2012.
\656\ While applicable in general, this logic, which merely
expands upon the principle that the character of a Title VII
instrument as either a swap or a security-based swap should follow
the underlying factors which are incorporated into the cash flows of
the instrument--a security, yield, loan, or other trigger for SEC
jurisdiction or as a commodity triggering CFTC jurisdiction (or both
for joint jurisdiction), should not be extrapolated to other Title
VII instruments, for which other principles may override.
---------------------------------------------------------------------------
The Commissions view a quanto equity swap as a security-based swap,
and not a mixed swap, where (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.\657\
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\657\ Although the SIFMA Letter describes quanto equity swaps in
terms of equity indexes, if the underlying reference of a quanto
equity swap is a single security, the result would be the same. The
Commissions also note that if a security index underlying a quanto
equity swap is not narrow-based, the quanto equity swap is a swap.
In that event, it is not a mixed swap because no element of the
quanto equity swap is a security-based swap and, to be a mixed swap,
a Title VII instrument must have both swap and security-based swap
components.
---------------------------------------------------------------------------
By contrast, in a compo equity swap, 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.\658\ Because the counterparty initiating a transaction can choose
to avoid currency exposure by entering into a quanto equity swap, the
currency exposure obtained via a compo equity swap is not incidental to
the equity exposure for purposes of determining mixed swap status. In
fact, investors seeking synthetic exposure to foreign securities via a
TRS may also be seeking exposure to the exchange rate between the
currencies, as evidenced by the fact that a number of mutual funds
exist in both hedged and unhedged versions to provide investors
exposure to the same foreign securities with or without the attendant
currency
[[Page 48266]]
exposure.\659\ Consequently, a compo equity swap is a mixed swap.\660\
---------------------------------------------------------------------------
\658\ See generally Corporate Equity Derivatives Handbook, supra
note 654, Sec. 1.2.9, at 21-23.
\659\ See, e.g., Descriptive Brochure: The Tweedy, Browne Global
Value Fund II--Currency Unhedged at 1, available at http://www.tweedy.com/resources/gvf2/TBGVF-II_verJuly2011.pdf (last
visited May 4, 2012) (comparing the Tweedy, Browne Global Value Fund
II--Currency Unhedged and the Tweedy, Browne Global Value Fund
(which hedges its currency exposure) and stating that ``[t]he only
material difference [between the funds] is that the Unhedged Global
Value Fund generally does not hedge currency risk [and] is designed
for long-term value investors who wish to focus their investment
exposure on foreign stock markets, and their associated non-U.S.
currencies'' and ``[b]y establishing the Tweedy, Browne Global Value
Fund II--Currency Unhedged, we were acknowledging that many
investors may view exposure to foreign currency as another form of
diversification when investing outside the U.S., and/or may have
strong opinions regarding the future direction of the U.S.
dollar.''). See also the PIMCO Foreign Bond Fund (Unhedged) Fact
Sheet at 1 (stating that ``[t]he fund seeks to capture the returns
of non-U.S. bonds including potential returns due to changes in
exchange rates. In a declining dollar environment foreign currency
appreciation may augment the returns generated by investments in
foreign bonds.''), available at http://investments.pimco.com/ShareholderCommunications/External%20Documents/Foreign%20Bond%20Fund%20(Unhedged)%20Institutional.pdf last visited
May 4, 2012 and the PIMCO Foreign Bond Fund (U.S. Dollar-Hedged)
INSTL Fact Sheet at 1 (stating that ``[t]he fund seeks to capture
the returns of non-U.S. bonds but generally hedges out most currency
exposure in order to limit the volatility of returns.''), available
at http://investments.pimco.com/ShareholderCommunications/External%20Documents/Foreign%20Bond%20Fund%20(U.S.%20Dollar-
Hedged)%20Institutional.pdf (last visited May 4, 2012).
\660\ Such swaps are examples of swaps with payments that
``incorporate additional elements that create additional * * *
currency exposures * * * unrelated to the financing of the security-
based swap * * * that may cause the security-based swap to be a
mixed swap.'' See Proposing Release at 29842.
---------------------------------------------------------------------------
In response to comments,\661\ the Commissions also are providing an
interpretation with respect to the treatment of loan TRS (``LTRS'') on
two or more loans. As noted above, the second prong of the security-
based swap definition includes a swap that is based on ``a single
security or loan, including any interest therein or on the value
thereof.'' Thus, an LTRS based on a single loan, as mentioned above, is
a security-based swap. The Commissions believe, however, that an LTRS
based on two or more non-security loans are swaps, and not security-
based swaps.\662\ An LTRS on a group or index of such non-security
loans is not covered by the first prong of the security-based swap
definition--swaps based on a narrow-based security index--because the
definition of the term ``narrow-based security index'' in both the CEA
and the Exchange Act only applies to securities, and not to non-
security loans.\663\ An LTRS, moreover, is not covered by the third
prong of the security-based swap definition because it is based on the
total return of such loans, and not events related thereto.
Accordingly, an LTRS on two or more loans that are non-security loans
is a swap and not a security-based swap.\664\
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\661\ See infra note 667 and accompanying text.
\662\ Depending on the facts and circumstances loans may be
notes or evidences of indebtedness that are securities. See section
3(a)(10) of the Exchange Act. In this section, the Commissions
address only groups or indexes of loans that are not securities.
\663\ See CEA section 1a(35), 7 U.S.C. 1a(35), and section
3(a)(55) of the Exchange Act, 15 U.S.C. 78c(a)(55).
\664\ The same would be true with respect to swaps (e.g.,
options, CFDs, NDFs), other than LTRS or loan index credit default
swaps, on two or more loans that are not securities.
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Comments
The Commissions received three comments with respect to the
interpretation provided on TRS in the Proposing Release.\665\ One of
these commenters addressed the Commissions' interpretation on security-
based TRS.\666\ The other two commenters requested that the Commissions
clarify the treatment of LTRS on two or more loans.\667\
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\665\ See July LSTA Letter; Letter from David Lucking, Allen &
Overy LLP, dated May 26, 2011 (``Allen & Overy Letter''); and SIFMA
Letter.
\666\ See SIFMA Letter.
\667\ See Allen & Overy Letter and July LSTA Letter.
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One commenter asserted that the terms of a TRS that create interest
rate or currency exposures incidental to the primary purpose of the TRS
should not cause a transaction that otherwise would be deemed to be a
security-based swap to be characterized as a mixed swap.\668\ This
commenter agreed with the Commissions that the scope of the mixed swap
category of Title VII instruments is intended to be narrow and that,
when variable interest rates are used for financing purposes incidental
to counterparties' purposes, and risks assumed, in entering into a TRS,
the TRS is a security-based swap and not a mixed swap.\669\
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\668\ See SIFMA Letter.
\669\ Id.
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This commenter also opined that the Commissions' interpretation
that ``where such payments incorporate additional elements that create
additional interest rate or currency exposures * * * unrelated to the
financing of the [TRS], or otherwise shift or limit risks that are
related to the financing of the [TRS], those additional elements may
cause the [TRS] to be a mixed swap'' could be seen as requiring a
quantitative analysis to determine whether a reference to interest
rates or currencies in a TRS is solely for financing purposes or
creates additional exposure that might be construed as extending beyond
those purposes.\670\
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\670\ Id. SIFMA added that such a determination could require
market participants to determine whether a specific interest rate or
spread referenced in the TRS is sufficiently in line with market
rates to constitute a financing leg of a transaction under the
proposed test. SIFMA continues by noting that there are a number of
examples where a TRS can provide for some interest rate or currency
exposure incidental to the primary purpose of the TRS, describing a
quanto equity swap as an example.
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The Commissions are clarifying that a quantitative analysis is not
necessarily required in order to determine whether a TRS is a mixed
swap. Any analysis, quantitative or qualitative, clearly demonstrating
the nature of a payment (solely financing-related, unrelated to
financing or a combination of the two) can suffice.\671\
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\671\ To the extent a market participant is uncertain as to the
results of such an analysis, it may seek informal guidance from the
Commissions' staffs or use the process established in this release,
see infra part VI, for seeking formal guidance from the Commissions
as to the nature of a Title VII instrument as a swap, security-based
swap or mixed swap.
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The Commissions also are clarifying that market participants are
not necessarily required to compare their financing rates to market
financing rates in order to determine whether the financing leg of a
TRS is merely a financing leg or is sufficient to render the TRS a
mixed swap. Because a number of factors can influence how a particular
TRS is structured,\672\ the Commissions cannot provide an
interpretation applicable to all situations. If the financing leg of a
TRS reflects the dealer's financing costs on a one-to-one basis, the
Commissions would view such leg as a financing leg. Adding a spread
would not alter that conclusion if the spread is consistent with the
dealer's course of dealing generally, with respect to a particular type
of TRS or with respect to a particular counterparty. The Commissions
believe that this would be the case even if the spread is ``off-
market,'' if the deviance from a market spread is explained by factors
unique to the dealer (e.g., the dealer has high financing costs), to
the TRS (e.g., the underlying securities are highly illiquid, so
financing them is more costly than would be reflected in a ``typical''
market spread for other TRS) or to then-current market conditions
(e.g., a share repurchase might make shares harder
[[Page 48267]]
for a dealer to procure in order to hedge its obligations under a TRS
to pay its counterparty the capital appreciation of a security,
resulting in higher financing costs due to the decrease in shares
outstanding, assuming demand for the shares does not change). If the
spread is designed to provide exposure to an underlying reference other
than securities, however, rather than to reflect financing costs, such
a TRS is a mixed swap.
---------------------------------------------------------------------------
\672\ For example, the Commissions would expect a dealer
perceived by the market to constitute a higher counterparty risk to
have higher funding costs generally, which might affect its TRS
financing costs. To the extent such a dealer passed through its
higher TRS financing costs to its TRS counterparty, such a pass-
through simply would reflect the dealer's specific circumstances,
and would not transform the TRS from a security-based swap into a
mixed swap.
---------------------------------------------------------------------------
Market participants are better positioned than are the Commissions
to determine what analysis, and what supporting information and
materials, best establish whether the nature of a particular payment
reflects financing costs alone, or something more. Moreover, the
Commissions expect that a dealer would know if the purpose of the
payment(s) in question is to cover its cost of financing a position or
a related hedge.\673\ In such cases, a detailed analysis should not be
necessary.
---------------------------------------------------------------------------
\673\ The Commissions expect that dealers know their financing
costs and can readily explain the components of the financing leg
paid by their TRS counterparties.
---------------------------------------------------------------------------
One commenter noted the nature of quanto equity swaps as TRS and
maintained that such a transaction ``is equivalent to a financing of a
long position in the underlying non-U.S. equity index[]'' and that the
currency protection is incidental to the financing element, which is
the primary purpose of the TRS.\674\ As discussed above, the
Commissions have provided a final interpretation regarding the
appropriate classification of Title VII instruments that are quanto
equity swaps and compo equity swaps.
---------------------------------------------------------------------------
\674\ Id. SIFMA distinguished quanto equity swaps from the
examples of mixed swaps that the Commissions provided in the
Proposing Release, characterizing them as ``very different.''
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Two commenters requested that the Commissions clarify the status of
LTRS on two or more loans.\675\ Both commenters stated that while the
statutory definition of the term ``security-based swap'' provides that
swaps based on a single loan are security-based swaps, it does not
explicitly provide whether swaps on indexes of loans are security-based
swaps.\676\ They requested clarification regarding the treatment of
loan based swaps, including both LTRS and loan index credit default
swaps.\677\
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\675\ See Allen & Overy Letter and July LSTA Letter.
\676\ See Allen & Overy Letter. Allen & Overy notes that a Title
VII Instrument that references two securities is a security-based
swap. It believes that treating an LTRS on two or more loans as a
swap would result in functionally and potentially economically
similar products being treated in an arbitrarily different way,
contrary to the spirit of the Dodd-Frank Act.
\677\ The Commissions address the comments regarding loan index
credit default swaps below. See infra note 768 and accompanying
text.
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The Commissions have provided the final interpretation discussed
above regarding LTRS based on two or more loans that are not
securities. The Commissions acknowledge that this interpretation
results in different treatment for an LTRS on two non-security loans (a
swap), as opposed to a Title VII instrument based on two securities (a
security-based swap). This result, however, is dictated by the statute.
D. Security-Based Swaps Based on a Single Security or Loan and Single-
Name Credit Default Swaps
The Commissions provided an interpretation in the Proposing Release
regarding security-based swaps based on a single security or loan and
single-name CDS \678\ and are restating such interpretation with
certain modifications in response to commenters.\679\ The second prong
of the statutory security-based swap definition includes a swap that is
based on ``a single security or loan, including any interest therein or
on the value thereof.'' \680\ The Commissions believe that under this
prong of the security-based swap definition, a single-name CDS that is
based on a single reference obligation would be a security-based swap
because it would be based on a single security or loan (or any interest
therein or on the value thereof).
---------------------------------------------------------------------------
\678\ See Proposing Release at 29843.
\679\ See infra note 689 and accompanying text.
\680\ Section 3(a)(68)(A)(ii)(II) of the Exchange Act, 15 U.S.C.
78c(a)(68)(A)(ii)(II). The first prong of the security-based swap
definition is discussed below. See infra part III.G.
---------------------------------------------------------------------------
In addition, the third prong of the security-based swap definition
includes a swap that is based on the occurrence of an event relating to
a ``single issuer of a security,'' provided that such event ``directly
affects the financial statements, financial condition, or financial
obligations of the issuer.'' \681\ This provision applies generally to
event-triggered swap contracts. With respect to a CDS, such events
could include, for example, the bankruptcy of an issuer, a default on
one of an issuer's debt securities, or the default on a non-security
loan of an issuer.\682\
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\681\ Section 3(a)(68)(A)(ii)(III) of the Exchange Act, 15
U.S.C. 78c(a)(68)(A)(ii)(III).
\682\ The Commissions understand that in the context of credit
derivatives on asset-backed securities or MBS, the events include
principal writedowns, failure to pay principal and interest
shortfalls.
---------------------------------------------------------------------------
The Commissions believe that if the payout on a CDS on a single
issuer of a security is triggered by the occurrence of an event
relating to that issuer, the CDS is a security-based swap under the
third prong of the statutory security-based swap definition.\683\
---------------------------------------------------------------------------
\683\ The Commissions understand that some single-name CDS now
trade with fixed coupon payments expressed as a percentage of the
notional amount of the transaction and payable on a periodic basis
during the term of the transaction. See Markit, ``The CDS Big Bang:
Understanding the Changes to the Global CDS Contract and North
American Conventions,'' 3, available at http://www.markit.com/cds/announcements/resource/cds_big_bang.pdf. The Commissions are
restating their view that the existence of such single-name CDS does
not change their interpretation.
---------------------------------------------------------------------------
In relation to aggregations of transactions under a single ISDA
Master Agreement,\684\ the Commissions are revising the example that
was included in the Proposing Release referring to single-name CDS to
clarify that the interpretation regarding aggregations of transactions
is non-exclusive and thus not limited to either CDS or single-reference
instruments.\685\
---------------------------------------------------------------------------
\684\ See Proposing Release at 29843.
\685\ See infra note 689 and accompanying text.
---------------------------------------------------------------------------
The Commissions believe that each transaction under an ISDA Master
Agreement would need to be analyzed to determine whether it is a swap
or security-based swap. For example, the Commissions believe that a
number of Title VII instruments that are executed at the same time and
that are documented under one ISDA Master Agreement, but in which a
separate confirmation is sent for each instrument, should be treated as
an aggregation of such Title VII instruments, each of which must be
analyzed separately under the swap and security-based swap
definitions.\686\ The Commissions believe that, as a practical and
economic matter, each such Title VII instrument would be a separate and
independent transaction. Thus, such an aggregation of Title VII
instruments would not constitute a Title VII instrument based on one
``index or group'' \687\ under the security-based swap definition but
instead would constitute multiple Title VII instruments. The
Commissions find that this interpretation is an appropriate way to
address CDS, TRS or other Title VII instruments referencing a single
security or loan or entity that is documented under a Master Agreement
or Master Confirmation and is designed to reduce the cost associated
with determining
[[Page 48268]]
whether such instruments are swaps or security-based swaps.\688\
---------------------------------------------------------------------------
\686\ See infra note 691.
\687\ The security-based swap definition further defines ``index
to include an ``index or group of securities.'' See section
3(a)(68)(E) of the Exchange Act, 15 U.S.C. 78c(a)(68)(E).
\688\ See supra part I, under ``Overall Economic
Considerations''.
---------------------------------------------------------------------------
Comments
The Commissions received two comments regarding the interpretation
regarding aggregation of Title VII instruments under a single ISDA
Master Agreement. One commenter requested that the Commissions clarify
that the interpretation applies to other types of instruments, such as
TRS, in addition to CDS.\689\ The commenter also stated that the
interpretation should be helpful with respect to use of a ``Master
Confirmation'' structure, which the commenter described as use of
general terms in a ``Master Confirmation'' that apply to a number of
instruments with separate underlying references but for which a
separate ``Supplemental Confirmation'' is sent for each separate
component.\690\
---------------------------------------------------------------------------
\689\ See July LSTA Letter.
\690\ Id.
---------------------------------------------------------------------------
A second commenter agreed with the Commissions' interpretation that
a number of single-name CDS that are executed at the same time and that
are documented under one ISDA Master Agreement, but in which a separate
confirmation is sent for each CDS, should not be treated as a single
index CDS and stated that this approach is consistent with market
practice.\691\
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\691\ See Letter from Richard M. McVey, Chairman and Chief
Executive Officer, MarketAxess Holdings, Inc. (``MarketAxess''),
July 22, 2011 (``MarketAxess Letter'').
---------------------------------------------------------------------------
As discussed above, in response to comments the Commissions are
expanding the example so it is clear that it applies beyond just
CDS.\692\
---------------------------------------------------------------------------
\692\ The Commissions believe, based on the July LSTA Letter,
that the ``Master Confirmation'' structure the commenter described
is the same general structure as the aggregation of single-name CDS
the Commissions provided as an example in the Proposing Release, but
that a ``Master Confirmation'' structure may not be limited to
single-reference instruments or to CDS and instead may be used for a
broader range of instruments. See July LSTA Letter. The Commissions
note that the following are examples of ``Master Confirmation''
structure to which the interpretive guidance would apply: 2009
Americas Master Equity Derivatives Confirmation Agreement, Stand-
alone 2007 Americas Master Variance Swap Confirmation Agreement, and
2004 Americas Interdealer Master Equity Derivatives Confirmation
Agreement and March 2004 Canadian Supplement to the Master
Confirmation. The Commissions believe the broader example in this
release provides the clarification the commenter requested.
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E. Title VII Instruments Based on Futures Contracts
The Commissions proposed an interpretation in the Proposing Release
regarding the treatment, generally, of swaps based on futures
contracts.\693\ The Commissions are restating the interpretation they
provided in the Proposing Release without modification. The Commissions
also discussed in the Proposing Release the unique circumstance
involving certain futures contracts on foreign government debt
securities and requested comment as to how Title VII instruments on
these futures contracts should be treated.\694\ In response to
commenters,\695\ the Commissions are adopting a rule regarding the
treatment of Title VII instruments on certain futures contracts on
foreign government debt securities.\696\
---------------------------------------------------------------------------
\693\ See Proposing Release at 29843-44.
\694\ Id.
\695\ See infra note 718 and accompanying text.
\696\ See rule 1.3(bbbb) under the CEA and rule 3a68-5 under the
Exchange Act.
---------------------------------------------------------------------------
A Title VII instrument that is based on a futures contract will
either be a swap or a security-based swap, or both (i.e., a mixed
swap), depending on the nature of the futures contract, including the
underlying reference of the futures contract. Thus, a Title VII
instrument where the underlying reference is a security future is a
security-based swap.\697\ In general, a Title VII instrument where the
underlying reference is a futures contract that is not a security
future is a swap.\698\ As the Commissions noted in the Proposing
Release,\699\ Title VII instruments involving certain futures contracts
on foreign government debt securities present a unique circumstance,
which is discussed below.
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\697\ A security future is defined in both the CEA and the
Exchange Act as a futures contract on a single security or a narrow-
based security index, including any interest therein or based on the
value thereof, except an exempted security under section 3(a)(12) of
the Exchange Act, 15 U.S.C. 78c(a)(12), as in effect on the date of
enactment of the Futures Trading Act of 1982 (other than any
municipal security as defined in section 3(a)(29) of the Exchange
Act, 15 U.S.C. 78c(a)(29), as in effect on the date of enactment of
the Futures Trading Act of 1982).
The term security future does not include any agreement,
contract, or transaction excluded from the CEA under sections 2(c),
2(d), 2(f), or 2(g) of the CEA, 7 U.S.C. 2(c), 2(d), 2(f), or 2(g),
as in effect on the date of enactment of the Commodity Futures
Modernization Act of 2000 (``CFMA'') or Title IV of the CFMA. See
section 1a(44) of the CEA, 7 U.S.C. 1a(44), and section 3(a)(55) of
the Exchange Act, 15 U.S.C. 78c(a)(55).
\698\ Depending on the underlying reference of the futures
contract, though, such swaps could be SBSAs. For example, a swap on
a future on the S&P 500 index would be an SBSA.
\699\ See Proposing Release at 29843.
---------------------------------------------------------------------------
Rule 3a12-8 under the Exchange Act exempts certain foreign
government debt securities, for purposes only of the offer, sale, or
confirmation of sale of futures contracts on such foreign government
debt securities, from all provisions of the Exchange Act which by their
terms do not apply to an ``exempted security,'' subject to certain
conditions.\700\ To date, the SEC has enumerated within rule 3a12-8 the
debt securities of 21 foreign governments solely for purposes of
futures trading (``21 enumerated foreign governments'').\701\
---------------------------------------------------------------------------
\700\ Specifically, rule 3a12-8 under the Exchange Act requires
as a condition to the exemption that the foreign government debt
securities not be registered under the Securities Act (or be the
subject of any American depositary receipt registered under the
Securities Act) and that futures contracts on such foreign
government debt securities ``require delivery outside the United
States, [and] any of its possessions or territories, and are traded
on or through a board of trade, as defined in [section 2 of the CEA,
7 U.S.C. 2].'' See rules 3a12-8(a)(2) and 3a12-8(b) under the
Exchange Act, 17 CFR 240.3a12-8(a)(2) and 240.3a12-8(b). These
conditions were ``designed to minimize the impact of the exemption
on securities distribution and trading in the United States. * * *''
See Exemption for Certain Foreign Government Securities for Purposes
of Futures Trading, 49 FR 8595 (Mar. 8, 1984) at 8596-97 (citing
Futures Trading Act of 1982).
\701\ See rule 3a12-8(a)(1) under the Exchange Act (designating
the debt securities of the governments of the United Kingdom,
Canada, Japan, Australia, France, New Zealand, Austria, Denmark,
Finland, the Netherlands, Switzerland, Germany, Ireland, Italy,
Spain, Mexico, Brazil, Argentina, Venezuela, Belgium, and Sweden).
---------------------------------------------------------------------------
The Commissions recognize that as a result of rule 3a12-8, futures
contracts on the debt securities of the 21 enumerated foreign
governments that satisfy the conditions of rule 3a12-8 are subject to
the CFTC's exclusive jurisdiction and are not considered security
futures. As a result, applying the interpretation above to a Title VII
instrument that is based on a futures contract on the debt securities
of these 21 enumerated foreign governments would mean that the Title
VII instrument would be a swap.\702\ The Commissions note, however,
that the conditions in rule 3a12-8 were established specifically for
purposes of the offer and sale of ``qualifying foreign futures
contracts'' (as defined in rule 3a12-8) \703\ on the debt securities of
the 21 enumerated foreign governments,\704\ not Title VII instruments
based on futures contracts on the debt securities
[[Page 48269]]
of the 21 enumerated governments. Further, the Commissions note that
the Dodd-Frank Act did not exclude swaps on foreign government debt
securities generally from the definition of the term ``security-based
swap.'' Accordingly, a Title VII instrument that is based directly on
foreign government debt securities, including those of the 21
enumerated governments, is a security-based swap or a swap under the
same analysis as any other Title VII instruments based on securities.
---------------------------------------------------------------------------
\702\ The Commissions note, by contrast, that a Title VII
instrument that is based on the price or value of, or settlement
into, a futures contract on the debt securities of one of the 21
enumerated foreign governments and that also has the potential to
settle directly into such debt securities would be a security-based
swap and, depending on other features of the Title VII instrument,
possibly a mixed swap.
\703\ Rule 3a12-8(b) under the Exchange Act defines ``qualifying
foreign futures contracts'' as ``contracts for the purchase or sale
of a designated foreign government security for future delivery, as
`future delivery' is defined in 7 U.S.C. 2, provided such contracts
require delivery outside the United States, any of its possessions
or territories, and are traded on or through a board of trade, as
defined at 7 U.S.C. 2.'' 17 CFR 240.3a12-8(b).
\704\ See supra note 700.
---------------------------------------------------------------------------
The Commissions indicated in the Proposing Release that they would
evaluate whether Title VII instruments based on futures contracts on
the debt securities of the 21 enumerated foreign governments that
satisfy the conditions of rule 3a12-8 should be characterized as swaps,
security-based swaps, or mixed swaps.\705\ In response to
commenters,\706\ the Commissions are adopting rule 1.3(bbbb) under the
CEA and rule 3a68-5 under the Exchange Act, which address the treatment
of these Title VII instruments.
---------------------------------------------------------------------------
\705\ See Proposing Release at 29844.
\706\ See infra note 718 and accompanying text.
---------------------------------------------------------------------------
The final rules provide that a Title VII instrument that is based
on or references a qualifying foreign futures contract on the debt
securities of one or more of the 21 enumerated foreign governments is a
swap and not a security-based swap, provided that the Title VII
instrument satisfies the following conditions:
The futures contract on which the Title VII instrument is
based or that is referenced is a qualifying foreign futures contract
(as defined in rule 3a12-8) \707\ on the debt securities of any one or
more of the 21 enumerated foreign governments that satisfies the
conditions of rule 3a12-8;
---------------------------------------------------------------------------
\707\ See supra note 703.
---------------------------------------------------------------------------
The Title VII instrument is traded on or through a board
of trade (as defined in section 1a(6) of the CEA);
The debt securities on which the qualifying foreign
futures contract is based or referenced and any security used to
determine the cash settlement amount pursuant to the fourth condition
below are not covered by an effective registration statement under the
Securities Act or the subject of any American depositary receipt
covered by an effective registration statement under the Securities
Act;
The Title VII instrument may only be cash settled; and
The Title VII instrument is not entered into by the issuer
of the securities upon which the qualifying foreign futures contract is
based or referenced (including any security used to determine the cash
payment due on settlement of such Title VII instrument), an affiliate
(as defined in the Securities Act and the rules and regulations
thereunder) \708\ of the issuer, or an underwriter with respect to such
securities.
---------------------------------------------------------------------------
\708\ See, e.g., rule 405 under the Securities Act, 17 CFR
230.405.
---------------------------------------------------------------------------
Under the first condition, the final rules provide that the futures
contract on which the Title VII instrument is based or referenced must
be a qualifying foreign futures contract that satisfies the conditions
of rule 3a12-8 and may only be based on the debt of any one or more of
the enumerated 21 foreign governments. If the conditions of rule 3a12-8
are not satisfied, then there cannot be a qualifying foreign futures
contract, the futures contract is a security future, and a swap on such
a security future is a security-based swap.
The second condition of the final rules provides that the Title VII
instrument on the qualifying foreign futures contract must itself be
traded on or through a board of trade because a qualifying foreign
futures contract on the debt securities of one or more of the 21
enumerated foreign governments itself is required to be traded on a
board of trade. The Commissions believe that swaps on such futures
contracts should be traded subject to rules applicable to such futures
contracts themselves.
The third condition of the final rules provides that the debt
securities on which the qualifying foreign futures contract is based or
referenced and any security used to determine the cash settlement
amount pursuant to the fourth condition cannot be registered under the
Securities Act or be the subject of any American depositary receipt
registered under the Securities Act. This condition is intended to
prevent circumvention of registration and disclosure requirements of
the Securities Act applicable to foreign government issuances of their
securities. This condition is similar to a condition included in rule
3a12-8.\709\
---------------------------------------------------------------------------
\709\ See supra note 700.
---------------------------------------------------------------------------
The fourth condition of the final rules provides that the Title VII
instrument must be cash settled. Although, as the Commissions
recognize, rule 3a12-8 permits a qualifying foreign futures contract to
be physically settled so long as delivery is outside the United States,
any of its possessions or territories,\710\ in the context of Title VII
instruments, only cash settled Title VII instruments based on
qualifying foreign futures contracts on the debt securities of the 21
enumerated foreign governments will be considered swaps. The
Commissions believe that this condition is appropriate in order to
provide consistent treatment of Title VII instruments based on
qualifying foreign futures contracts on the debt securities of the 21
enumerated foreign governments with the Commissions' treatment of swaps
and security-based swaps generally.\711\
---------------------------------------------------------------------------
\710\ Id.
\711\ See infra part III.H.
---------------------------------------------------------------------------
The fifth condition of the final rules provides that for a Title
VII instrument to be a swap under such rules, it cannot be entered into
by the issuer of the securities upon which the qualifying foreign
futures contract is based or referenced (including any security used to
determine the cash payment due on settlement of such Title VII
instrument), an affiliate of the issuer, or an underwriter of the
issuer's securities. The Commissions have included this condition to
address the concerns raised by the SEC in the Proposing Release that
the characterization of a Title VII instrument that is based on a
futures contract on the debt securities of one of the 21 enumerated
foreign governments may affect Federal securities law provisions
relating to the distribution of the securities upon which the Title VII
instrument is based or referenced.\712\
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\712\ See Proposing Release at 29844.
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The Dodd-Frank Act included provisions that would not permit
issuers, affiliates of issuers, or underwriters to use security-based
swaps to offer or sell the issuers' securities underlying a security-
based swap without complying with the requirements of the Securities
Act.\713\ This provision applies regardless of whether the Title VII
instrument allows the parties to physically settle any such security-
based swap. In addition, the Dodd-Frank Act provided that any offer or
sale of security-based swaps to non-ECPs would have to be registered
under the Securities Act.\714\ For example, if a Title VII instrument
that is based on a futures contract on the debt securities of one of
the 21 enumerated foreign governments is characterized as a swap, and
not a security-based swap, then the provisions of the Dodd-Frank Act
enacted to ensure that there could not be offers and sales of
securities made without compliance with the Securities Act, either by
issuers, their affiliates, or underwriters or to non-ECPs, would not
apply to such swap transactions.
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\713\ See section 2(a)(3) of the Securities Act, 15 U.S.C.
77b(a)(3), as amended by the Dodd-Frank Act.
\714\ See section 5 of the Securities Act, 15 U.S.C. 77e, as
amended by the Dodd-Frank Act.
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Only those Title VII instruments that are based on qualifying
foreign futures contracts on the debt securities of the 21
[[Page 48270]]
enumerated foreign governments and that satisfy these five conditions
will be swaps, not security-based swaps. The Commissions note that the
final rules are intended to provide consistent treatment (other than
with respect to method of settlement) of qualifying foreign futures
contracts and Title VII instruments based on qualifying foreign futures
contracts on the debt securities of the 21 enumerated foreign
governments.\715\ The Commissions understand that many of the
qualifying foreign futures contracts on the debt securities of the 21
enumerated foreign governments trade with substantial volume through
foreign trading venues under the conditions set forth in rule 3a12-8
\716\ and permitting swaps on such futures contracts subject to similar
conditions would not raise concerns that such swaps could be used to
circumvent the conditions of rule 3a12-8 and the Federal securities
laws concerns that such conditions are intended to protect.\717\
Further, providing consistent treatment for qualifying foreign futures
contracts on the debt securities of the 21 enumerated foreign
governments and Title VII instruments based on futures contracts on the
debt securities of the 21 enumerated foreign governments will allow
trading of these instruments through designated contract markets on
which such futures are listed.
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\715\ The Commissions note that the final rules provide
consistent treatment of qualifying foreign futures contracts on the
debt securities of the 21 enumerated foreign governments and Title
VII instruments based on qualifying foreign futures contracts on the
debt securities of the 21 enumerated foreign governments unless the
Title VII instrument is entered into by the issuer of the securities
upon which the qualifying foreign futures contract is based or
referenced (including any security used to determine the cash
payment due on settlement of such Title VII instrument), an
affiliate of the issuer, or an underwriter with respect to such
securities.
\716\ For the quarter that ended December 31, 2011, the trading
volume reported to the CFTC of qualifying foreign futures contracts
on the debt securities of the 21 enumerated foreign governments made
available for trading by direct access from the U.S. on foreign
trading venues granted direct access no-action relief by the CFTC
that exceeded 100,000 contracts per quarter from the U.S. were as
follows: (i) 7,985,959 contracts for 3 Year Treasury Bond Futures on
the Australian Securities Exchange's ASX Trade24 platform; (ii)
1,872,592 contracts for 10-Year Government of Canada Bond Futures on
the Bourse de Montreal; (iii) 47,874,911 contracts for Euro Bund
Futures on Eurex Deutschland (``Eurex''); (iv) 26,434,713 contracts
for Euro Bobl Futures on Eurex; (v) 30,489,427 contracts for Euro
Schatz Futures on Eurex; and (vi) 8,292,222 contracts for Long Gilt
Futures on the NYSE LIFFE.
\717\ See supra note 712 and accompanying text.
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The Commissions recognize that the rules may result in a different
characterization of a Title VII instrument that is based directly on a
foreign government debt security and one that is based on a qualifying
foreign futures contract on a debt security of one of the 21 enumerated
foreign governments. However, the Commissions note that this is the
case today (i.e., different treatments) with respect to other
instruments subject to CFTC regulation and/or SEC regulation, such as
futures on broad-based security indexes and futures on a single
security or narrow-based security index.
Comments
Commenters did not address the interpretation as it applied to
Title VII instruments based on futures contracts generally. Two
commenters addressed Title VII instruments based on futures contracts
on debt securities of the 21 enumerated foreign governments.\718\ Both
commenters requested that the Commissions treat these Title VII
instruments as swaps.\719\ The Commissions agree that these instruments
should be treated as swaps under certain conditions and, therefore, are
adopting rule 1.3(bbbb) under the CEA and rule 3a68-5 under the
Exchange Act as discussed above to treat Title VII instruments based on
qualifying foreign futures contracts on the debt securities of the 21
enumerated foreign governments as swaps, provided such Title VII
instruments satisfy certain conditions.
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\718\ See CME Letter and SIFMA Letter.
\719\ Id. Both commenters stated their belief that the range of
factors considered by the SEC in designating the debt securities of
the 21 enumerated foreign governments as exempted securities
indicated that there is sufficient disclosure about the 21
enumerated foreign governments and their securities such that the
further disclosure should not be necessary. Both commenters also
indicated that subjecting futures contracts on the debt securities
of the 21 enumerated foreign governments to CFTC regulation, while
subjecting Title VII instruments based on these futures contracts to
SEC regulation, would be problematic. Id.
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F. Use of Certain Terms and Conditions in Title VII Instruments
The Commissions provided an interpretation in the Proposing Release
regarding the use of certain fixed terms in Title VII instruments and
are restating that interpretation without modification.\720\ The
Commissions are aware that market participants' setting of certain
fixed terms or conditions of Title VII instruments may be informed by
the value or level of a security, rate, or other commodity at the time
of the execution of the instrument. The Commissions believe that, in
evaluating whether a Title VII instrument with such a fixed term or
condition is a swap or security-based swap, the nature of the security,
rate, or other commodity that informed the setting of such fixed term
or condition should not itself impact the determination of whether the
Title VII instrument is a swap or a security-based swap, provided that
the fixed term or condition is set at the time of execution and the
value or level of that fixed term or condition may not vary over the
life of the Title VII instrument.\721\
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\720\ See Proposing Release at 29845.
\721\ This interpretation relates solely to the determination
regarding whether a Title VII instrument is a swap or security-based
swap. The Commissions are not expressing a view regarding whether
such Title VII instrument would be a security-based swap agreement.
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For example, a Title VII instrument, such as an interest rate swap,
in which floating payments based on three-month LIBOR are exchanged for
fixed rate payments of five percent would be a swap, and not a
security-based swap, even if the five percent fixed rate was informed
by, or quoted based on, the yield of a security, provided that the five
percent fixed rate was set at the time of execution and may not vary
over the life of the Title VII instrument.\722\ Another example would
be where a private sector or government borrower that issues a five-
year, amortizing $100 million debt security with a semi-annual coupon
of LIBOR plus 250 basis points also, at the same time, chooses to enter
into a five-year interest rate swap on $100 million notional in which
this same borrower, using the same amortization schedule as the debt
security, receives semi-annual payments of LIBOR plus 250 basis points
in exchange for five percent fixed rate payments. The fact that the
specific terms of the interest rate swap (e.g., five-year, LIBOR plus
250 basis points, $100 million notional, fixed amortization schedule)
were set at the time of execution to match related terms of a debt
security does not cause the interest rate swap to become a security-
based swap. However, if the interest rate swap contained additional
terms that were in fact contingent on a characteristic of the debt
security that may change in the future, such as an adjustment to future
interest rate swap payments based on the future price or yield of the
debt security, then this Title VII instrument would be a security-based
swap that would be a mixed swap.
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\722\ However, to the extent the fixed term or condition is set
at a future date or at a future value or level of a security, rate,
or other commodity rather than the value or level of such security,
rate, or other commodity at the time of execution of the Title VII
instrument, the discussion above would not apply, and the nature of
the security, rate, or other commodity used in determining the terms
or conditions would be considered in evaluating whether the Title
VII instrument is a swap or security-based swap.
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[[Page 48271]]
Comments
One commenter agreed with the Commissions' interpretation
generally, but believed that the Commissions should broaden the
interpretation to allow a swap to reflect ``resets,'' or changes in the
referenced characteristic of a security, where those ``resets'' or
changes are ``intended to effect a purpose other than transmitting the
risk of changes in the characteristic itself,'' without causing a Title
VII instrument that is not a security-based swap to become a security-
based swap.\723\
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\723\ See ISDA Letter.
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The Commissions are not expanding the interpretation to allow
``resets'' of a fixed rate derived from a security. The interpretation
is consistent with the statutory swap and security-based swap
definitions. The Commissions believe that a Title VII instrument based
on a rate that follows a security, and that may ``reset'' or change in
the future based on changes in that security, is a security-based swap.
Further, any amendment or modification of a material term of a Title
VII instrument would result in a new Title VII instrument and a
corresponding reassessment of the instrument's status as either a swap
or a security-based swap.\724\
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\724\ See infra part III.G.5(a).
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G. The Term ``Narrow-Based Security Index'' in the Security-Based Swap
Definition
1. Introduction
As noted above, a Title VII instrument in which the underlying
reference of the instrument is a ``narrow-based security index'' is a
security-based swap subject to regulation by the SEC, whereas a Title
VII instrument in which the underlying reference of the instrument is a
security index that is not a narrow-based security index (i.e., the
index is broad-based) is a swap subject to regulation by the CFTC. The
Commissions proposed an interpretation and rules regarding usage of the
term ``narrow-based security index'' in the security-based swap
definition, including:
The existing criteria for determining whether a security
index is a narrow-based security index and the applicability of past
guidance of the Commissions regarding those criteria to Title VII
instruments;
New criteria for determining whether a CDS where the
underlying reference is a group or index of entities or obligations of
entities (typically referred to as an ``index CDS'') is based on an
index that is a narrow-based security index;
The meaning of the term ``index'';
Rules governing the tolerance period for Title VII
instruments on security indexes traded on DCMs, SEFs, foreign boards of
trade (``FBOTs''), security-based SEFs, or NSEs, where the security
index temporarily moves from broad-based to narrow-based or from
narrow-based to broad-based; and
Rules governing the grace period for Title VII instruments
on security indexes traded on DCMs, SEFs, FBOTs, security-based SEFs,
or NSEs, where the security index moves from broad-based to narrow-
based or from narrow-based to broad-based and the move is not
temporary.\725\
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\725\ See Proposing Release at 29845-58.
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As discussed below, the Commissions are restating the
interpretation set forth in the Proposing Release with certain further
clarifications and adopting the rules as proposed with certain
modifications.
2. Applicability of the Statutory Narrow-Based Security Index
Definition and Past Guidance of the Commissions to Title VII
Instruments
The Commissions provided an interpretation in the Proposing Release
regarding the applicability of the statutory definition of the term
``narrow-based security index'' and past guidance of the Commissions
relating to such term to Title VII instruments.\726\ The Commissions
are restating the interpretation set out in the Proposing Release
without modification.
---------------------------------------------------------------------------
\726\ See Proposing Release at 29845-48.
---------------------------------------------------------------------------
As defined in the CEA and Exchange Act,\727\ an index is a narrow-
based security index if, among other things, it meets any one of the
following four criteria:
---------------------------------------------------------------------------
\727\ Sections 3(a)(55)(B) and (C) of the Exchange Act, 15
U.S.C. 78c(a)(55)(B) and (C), include a definition of ``narrow-based
security index'' in the same paragraph as the definition of security
future. See also sections 1a(35)(A) and (B) of the CEA, 7 U.S.C.
1a(35)(A) and (B). A security future is a contract for future
delivery on a single security or narrow-based security index
(including any interest therein or based on the value thereof). See
section 3(a)(55) of the Exchange Act, 15 U.S.C. 78c(a)(55), and
section 1a(44) of the CEA, 7 U.S.C. 1a(44).
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It has nine or fewer component securities;
A component security comprises more than 30 percent of the
index's weighting;
The five highest weighted component securities in the
aggregate comprise more than 60 percent of the index's weighting; or
The lowest weighted component securities comprising, in
the aggregate, 25 percent 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 percent
of the index's weighting, such securities shall be ranked from lowest
to highest dollar value of average daily trading volume and shall be
included in the calculation based on their ranking starting with the
lowest ranked security.\728\
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\728\ See section 3(a)(55)(B) of the Exchange Act, 15 U.S.C.
78c(a)(55)(B). See also sections 1a(35)(A) and (B) of the CEA, 7
U.S.C. 1a(35)(A) and (B).
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The first three criteria apply to the number and concentration of
the ``component securities'' in the index. The fourth criterion applies
to the average daily trading volume of an index's ``component
securities.'' \729\
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\729\ The narrow-based security index definition in the CEA and
Exchange Act also excludes from its scope security indexes that
satisfy certain specified criteria. See sections 3(a)(55)(C)(i)-(vi)
of the Exchange Act, 15 U.S.C. 78c(a)(55)(C)(i)-(vi), and sections
1a(35)(B)(i)-(vi) of the CEA, 7 U.S.C. 1a(35)(B)(i)-(vi).
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This statutory narrow-based security index definition focuses on
indexes composed of equity securities and certain aspects of the
definition, in particular the evaluation of average daily trading
volume, are designed to take into account the trading patterns of
individual stocks.\730\ However, the Commissions, pursuant to authority
granted in the CEA and the Exchange Act,\731\ previously have extended
the definition to other categories of indexes but modified the
definition to take into account the characteristics of those other
categories. Specifically, the Commissions have previously provided
guidance regarding the application of the narrow-based security index
definition to futures contracts on volatility indexes \732\ and debt
security indexes.\733\ Today, then, there exists guidance for
determining what constitutes a narrow-based security index.
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\730\ See Joint Order Excluding Indexes Comprised of Certain
Index Options From the Definition of Narrow-Based Security Index, 69
FR 16900 (Mar. 31, 2004) (``March 2004 Index Options Joint Order'').
\731\ See section 1a(35)(B)(vi) of the CEA, 7 U.S.C.
1a(35)(B)(vi), and section 3(a)(55)(C)(vi) of the Exchange Act, 15
U.S.C. 78c(a)(55)(C)(vi).
\732\ See March 2004 Index Options Joint Order.
\733\ See Joint Final Rules: Application of the Definition of
Narrow-Based Security Index to Debt Securities Indexes and Security
Futures on Debt Securities, 71 FR 39434 (Jul. 13, 2006) (``July 2006
Debt Index Release'').
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Volatility indexes are indexes composed of index options. The
Commissions issued a joint order in
[[Page 48272]]
2004 to define when a volatility index is not a narrow-based security
index. Under this joint order, a volatility index is not a narrow-based
security index if the index meets all of the following criteria:
The index measures the magnitude of changes (as calculated
in accordance with the order) in the level of an underlying index that
is not a narrow-based security index pursuant to the statutory criteria
for equity indexes discussed above;
The index has more than nine component securities, all of
which are options on the underlying index;
No component security of the index comprises more than 30
percent of the index's weighting;
The five highest weighted component securities of the
index in the aggregate do not comprise more than 60 percent of the
index's weighting;
The average daily trading volume of the lowest weighted
component securities in the underlying index (those comprising, in the
aggregate, 25 percent of the underlying index's weighting) have a
dollar value of more than $50,000,000 (or $30,000,000 in the case of an
underlying index with 15 or more component securities), except if there
are 2 or more securities with equal weighting that could be included in
the calculation of the lowest weighted component securities comprising,
in the aggregate, 25 percent of the underlying index's weighting, such
securities shall be ranked from lowest to highest dollar value of
average daily trading volume and shall be included in the calculation
based on their ranking starting with the lowest ranked security;
Options on the underlying index are listed and traded on
an NSE registered under section 6(a) of the Exchange Act; \734\ and
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\734\ 15 U.S.C. 78f(a).
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The aggregate average daily trading volume in options on
the underlying index is at least 10,000 contracts calculated as of the
preceding 6 full calendar months.\735\
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\735\ See March 2004 Index Options Joint Order. In 2009, the
Commissions issued a joint order that provided that, instead of the
index options having to be listed on an NSE, the index options must
be listed on an exchange and pricing information for the index
options, and the underlying index, must be computed and disseminated
in real time through major market data vendors. See Joint Order To
Exclude Indexes Composed of Certain Index Options From the
Definition of Narrow-Based Security Index, 74 FR 61116 (Nov. 23,
2009) (expanding the criteria necessary for exclusion under the
March 2004 Index Options Joint Order to apply to volatility indexes
for which pricing information for the underlying broad-based
security index, and the options that compose such index, is current,
accurate, and publicly available).
---------------------------------------------------------------------------
With regard to debt security indexes, the Commissions issued joint
rules in 2006 (``July 2006 Debt Index Rules'') to define when an index
of debt securities \736\ is not a narrow-based security index. The
first three criteria of that definition are similar to the statutory
definition for equities and the order regarding volatility indexes in
that a debt security index would not be narrow-based if:
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\736\ Under the rules, debt securities include notes, bonds,
debentures or evidence of indebtedness. See rule 41.15(a)(1)(i)
under the CEA, 17 CFR 41.15(a)(1)(i) and rule 3a55-4(a)(1)(i) under
the Exchange Act, 17 CFR 240.3a55-4(a)(1)(i). See also July 2006
Debt Index Release.
---------------------------------------------------------------------------
It is comprised of more than nine debt 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 percent of the index's weighting; and
The securities of any five non-affiliated issuers in the
index do not comprise more than 60 percent of the index's weighting.
In the July 2006 Debt Index Rules, instead of the statutory average
daily trading volume test, however, the Commissions adopted a public
information availability requirement. Under this requirement, assuming
the aforementioned number and concentration criteria were satisfied, a
debt security index would not be a narrow-based security index if the
debt securities or the issuers of debt securities in the index met any
one of the following criteria:
The issuer of the debt security is required to file
reports pursuant to section 13 or section 15(d) of the Securities
Exchange Act of 1934; \737\
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\737\ 15 U.S.C. 78m or 78o(d).
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The issuer of the debt security has a worldwide market
value of its outstanding common equity held by non-affiliates of $700
million or more;
The issuer of the debt security has outstanding securities
that are notes, bonds, debentures, or evidence 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 Securities Exchange Act of 1934 \738\ and the rules
promulgated thereunder; or
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\738\ 15 U.S.C. 78c(a)(12).
---------------------------------------------------------------------------
The issuer of the security is a government of a foreign
country or a political subdivision of a foreign country.\739\
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\739\ See July 2006 Debt Index Rules. The July 2006 Debt Index
Rules also provided that debt securities in the index must satisfy
certain minimum outstanding principal balance criteria, established
certain exceptions to these criteria and the public information
availability requirement, and provided for the treatment of indexes
that include exempted securities (other than municipal securities).
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In the Dodd-Frank Act, Congress included the term ``narrow-based
security index'' in the security-based swap definition, and thus the
statutory definition of the term ``narrow-based security index'' \740\
also applies in distinguishing swaps (on security indexes that are not
narrow-based, also known as ``broad-based'') and security-based swaps
(on narrow-based security indexes).\741\ The Commissions have
determined that their prior guidance with respect to what constitutes a
narrow-based security index in the context of volatility indexes \742\
and debt security indexes \743\ applies in determining whether a Title
VII instrument is a swap or a security-based swap, except as the rules
the Commissions are adopting provide for other treatment with respect
to index CDS as discussed below.\744\
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\740\ See sections 3(a)(55)(B) and (C) of the Exchange Act, 15
U.S.C. 78c(a)(55)(B) and (C). See also sections 1a(35)(A) and (B) of
the CEA, 7 U.S.C. 1a(35)(A) and (B).
\741\ The statutory definition of the term ``narrow-based
security index'' for equities, and the Commissions' subsequent
guidance as to what constitutes a narrow-based security index with
respect to volatility and debt indexes, is applicable in the context
of distinguishing between futures contracts and security futures
products.
\742\ See March 2004 Index Options Joint Order.
\743\ See July 2006 Debt Index Rules.
\744\ See infra part III.G.3.
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To make clear that the Commissions are applying the prior guidance
and rules to Title VII instruments, the Commissions are adopting rules
to further define the term ``narrow-based security index'' in the
security-based swap definition. Under paragraph (1) of rule 1.3(yyy)
under the CEA and paragraph (a) of rule 3a68-3 under the Exchange Act,
for purposes of the security-based swap definition, the term ``narrow-
based security index'' has the same meaning as the statutory definition
set forth in section 1a(35) of the CEA and section 3(a)(55) of the
Exchange Act,\745\ and the rules, regulations, and orders issued by the
Commissions relating to such definition. As a result, except as the
rules the Commissions are adopting provide for other treatment with
respect to index CDS as discussed below,\746\ market participants
generally may use the Commissions' past guidance in determining whether
certain Title VII instruments based on a security index are swaps or
security-based swaps.
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\745\ 7 U.S.C. 1a(35) and 15 U.S.C. 78c(a)(55).
\746\ See infra part III.G.3.
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The Commissions also are providing an interpretation and adopting
additional rules establishing criteria for indexes composed of
securities, loans, or issuers of securities referenced by an
[[Page 48273]]
index CDS.\747\ The interpretation and rules also address the
definition of an ``index'' \748\ and the treatment of broad-based
security indexes that become narrow-based and narrow-based indexes that
become broad-based, including rule provisions regarding tolerance and
grace periods for swaps on security indexes that are traded on CFTC-
regulated trading platforms and security-based swaps on security
indexes that are traded on SEC-regulated trading platforms.\749\ These
rules and interpretation are discussed below.
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\747\ Id.
\748\ See infra part III.G.4.
\749\ See infra part III.G.5.
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3. Narrow-Based Security Index Criteria for Index Credit Default Swaps
(a) In General
The Commissions provided an interpretation in the Proposing Release
regarding the narrow-based security index criteria for index CDS and
are restating it without modification.\750\ While the Commissions
understand that the underlying reference for most cleared CDS is a
single entity or an index of entities rather than a single security or
an index of securities, the underlying reference for CDS also could be
a single security or an index of securities.\751\ A CDS where the
underlying reference is a single entity (i.e., a single-name CDS), a
single obligation of a single entity (e.g., a CDS on a specific bond,
loan, or asset-backed security, or any tranche or series of any bond,
loan, or asset-backed security), or an index CDS where the underlying
reference is a narrow-based security index or the issuers of securities
in a narrow-based security index is a security-based swap. An index CDS
where the underlying reference is not a narrow-based security index or
the issuers of securities in a narrow-based security index (i.e., a
broad-based index) is a swap.\752\
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\750\ See Proposing Release at 29847-48.
\751\ See, e.g., Markit, ``Markit CDX'' (describing the Markit
CDX indexes and the number of ``names'' included in each index),
available at http://www.markit.com/en/products/data/indices/credit-and-loan-indices/cdx/cdx.page; Markit, ``Markit iTraxx Indices,''
(stating that the ``Markit iTraxx indices are comprised of the most
liquid names in the European and Asian markets'') (emphasis added),
available at http://www.markit.com/en/products/data/indices/credit-and-loan-indices/itraxx/itraxx.page . Examples of indexes based on
securities include the Markit ABX.HE and CMBX indexes. See Markit,
``Markit ABX.HE,'' (describing the Markit ABX.HE index as ``a
synthetic tradeable index referencing a basket of 20 subprime
mortgage-backed securities''), available at http://www.markit.com/en/products/data/indices/structured-finance-indices/abx/abx.page;
and Markit, ``Markit CMBX,'' (describing the Markit CMBX index as
``a synthetic tradeable index referencing a basket of 25 commercial
mortgage-backed securities''), available at http://www.markit.com/en/products/data/indices/structured-finance-indices/cmbx/cmbx.page.
\752\ Similarly, an option to enter into a single-name CDS or a
CDS referencing a narrow-based security index as described above
would be a security-based swap, while an option to enter into a CDS
on a broad-based security index or the issuers of securities in a
broad-based security index would be a swap. Index CDS where the
underlying reference is a broad-based security index would be SBSAs.
The SEC has enforcement authority with respect to swaps that are
SBSAs, as discussed further in section V., infra.
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The statutory definition of the term ``narrow-based security
index,'' as explained above, was designed with the U.S. equity markets
in mind.\753\ Thus, the statutory definition is not necessarily
appropriate for determining whether an index underlying an index CDS is
broad or narrow-based. Nor is the guidance that the Commissions have
previously issued with respect to the narrow-based security index
definition discussed above necessarily appropriate, because that
guidance was designed to address and was uniquely tailored to the
characteristics of volatility indexes and debt security indexes in the
context of futures. Accordingly, the Commissions are clarifying that
the guidance that the Commissions have previously issued with respect
to the narrow-based security index definition discussed above does not
apply to index CDS. Instead, the Commissions are adopting rules as
discussed below that include separate criteria for determining whether
an index underlying an index CDS is a narrow-based security index.
---------------------------------------------------------------------------
\753\ See July 2006 Debt Index Rules.
---------------------------------------------------------------------------
The Commissions are further defining the term ``security-based
swap,'' and the use of the term ``narrow-based security index'' within
that definition, to modify the criteria applied in the context of index
CDS in assessing whether the index is a narrow-based security index.
The third prong of the security-based swap definition includes a Title
VII instrument based on the occurrence of an event relating to 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.'' \754\ The first
prong of the security-based swap definition includes a Title VII
instrument that is based on a narrow-based security-index.\755\ Because
the third prong of the security-based swap definition relates to
issuers of securities, while the first prong of such definition relates
to securities, the Commissions are further defining both the term
``narrow-based security index'' and the term ``issuers of securities in
a narrow-based security index'' in the context of the security-based
swap definition as applied to index CDS. The Commissions believe it is
important to further define both terms in order to assure consistent
analysis of index CDS.\756\ While the wording of the two definitions as
adopted differs slightly, the Commissions expect that they will yield
the same substantive results in distinguishing narrow-based and broad-
based index CDS.\757\
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\754\ Section 3(a)(68)(A)(ii)(III) of the Exchange Act, 15
U.S.C. 78c(a)(68)(A)(ii)(III).
\755\ Section 3(a)(68)(A)(ii)(I) of the Exchange Act, 15 U.S.C.
78c(a)(68)(A)(ii)(I).
\756\ Because they apply only with respect to index CDS, the
definitions of ``issuers of securities in a narrow-based security
index'' and ``narrow-based security index'' as adopted do not apply
with respect to other types of event contracts, whether analyzed
under the first or third prong.
\757\ For example, if the reference entities included in one
index are the same as the issuers of securities included in another
index, application of the two definitions should result in both
indexes being either broad-based or narrow-based.
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(b) Rules Regarding the Definitions of ``Issuers of Securities in a
Narrow-Based Security Index'' and ``Narrow-Based Security Index'' for
Index Credit Default Swaps
The Commissions proposed rules to further define the terms
``issuers of securities in a narrow-based security index'' and
``narrow-based security index'' in order to provide appropriate
criteria for determining whether an index composed of issuers of
securities referenced by an index CDS and an index composed of
securities referenced by an index CDS are narrow-based security
indexes.\758\ The Commissions are adopting rules 1.3(zzz) and 1.3(aaaa)
under the CEA and rules 3a68-1a and 3a68-1b under the Exchange Act as
proposed with certain modifications.\759\
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\758\ See Proposing Release at 29848.
\759\ The discussion throughout this section refers to
``reference entities'' and ``issuers'' in discussing the final
rules. The term ``reference entity'' is defined in paragraph (c)(3)
of rule 1.3(zzz) under the CEA and rule 3a68-1a under the Exchange
Act and the term ``issuer'' is defined in paragraph (c)(3) of rule
1.3(aaaa) under the CEA and rule 3a68-1b under the Exchange Act. The
final rules provide that the term ``reference entity'' includes: (i)
An issuer of securities; (ii) an issuer of securities that is an
issuing entity of asset-backed securities is a reference entity or
issuer, as applicable; and (iii) an issuer of securities that is a
borrower with respect to any loan identified in an index of
borrowers or loans is a reference entity. The final rules provide
that the term ``issuer'' includes: (i) An issuer of securities; and
(ii) an issuer of securities that is an issuing entity of asset-
backed securities is a reference entity or issuer, as applicable.
See paragraph (c)(3) of rules 1.3(zzz) and 1.3(aaaa) under the CEA
and rule 3a68-1a and 3a68-1b under the Exchange Act.
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In formulating the criteria in the final rules, and consistent with
the guidance and rules the Commissions have
[[Page 48274]]
previously issued and adopted regarding narrow-based security indexes
in the context of security futures, the Commissions believe that there
should be public information available about a predominant percentage
of the reference entities included in the index, or, in the case of an
index CDS on an index of securities, about the issuers of the
securities or the securities underlying the index, in order to reduce
the likelihood that non-narrow-based indexes referenced in index CDS or
the component securities or issuers of securities in that index would
be readily susceptible to manipulation, as well as to help prevent the
misuse of material non-public information through the use of CDS based
on such indexes.
To satisfy these objectives, the Commissions are adopting rules
that are based on the criteria developed for debt indexes discussed
above \760\ but that tailor these criteria to address index CDS.\761\
These criteria are included solely for the purpose of defining the
terms ``narrow-based security index'' and ``issuers of securities in a
narrow-based security index'' in the first and third prongs of the
security-based swap definition with respect to index CDS and will not
affect any other interpretation or use of the term ``narrow-based
security index'' or any other provision of the Dodd-Frank Act, the CEA,
or the Exchange Act.
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\760\ See discussion of July 2006 Debt Index Rules.
\761\ The Commissions note that the language of the rules is
intended, in general, to be consistent with the criteria developed
for debt indexes discussed above. Certain changes from the criteria
developed for debt indexes are necessary to address differences
between futures on debt indexes and index CDS. Certain other changes
are necessary because the rules for debt indexes define under what
conditions an index is not a narrow-based security index, whereas
the rules for index CDS define what is a narrow-based security
index. For example, an index is not a narrow-based security index
under the rule for debt indexes if it is not a narrow-based security
index under either subparagraph (a)(1) or paragraph (a)(2) of the
rule. See July 2006 Debt Index Rules. Under the rules for index CDS,
however, an index is a narrow-based security index if it meets the
requirements of both of the counterpart paragraphs in the rules
regarding index CDS (paragraphs (1)(i) and (1)(ii) of rules 1.3(zzz)
and 1.3(aaaa) under the CEA and paragraph (a)(1) and paragraph
(a)(2) of rules 3a68-1a and 3a68-1b under the Exchange Act), even
though the criteria in the debt index rules and the rules for index
CDS include generally the same criteria and structure.
---------------------------------------------------------------------------
Further, in response to commenters,\762\ the Commissions are
clarifying that if an index CDS is based on an index of loans that are
not securities,\763\ an event relating to a loan in the index, such as
a default on a loan, is an event ``relating to'' the borrower.\764\ To
the extent that the borrower is an issuer of securities, the index CDS
based on such index of loans will be analyzed under the third prong of
the security-based swap definition in the same manner as any other
index CDS.
---------------------------------------------------------------------------
\762\ See infra note 768 and accompanying text.
\763\ If the loans underlying the index of loans are securities,
the index CDS would be analyzed in the same manner as any other
index CDS based on an index of securities.
\764\ An index CDS referencing loans also may be based on events
relating to the borrower, such as bankruptcy, and to defaults on any
obligation of the borrower.
---------------------------------------------------------------------------
Comments
The Commissions received two general comments requesting that the
proposed rules further defining the terms ``issuers of securities in a
narrow-based security index'' and ``narrow-based security index'' be
simplified.\765\ One commenter believed that the rules were exceedingly
complicated.\766\ Another commenter thought that the criteria should
allow transactions to be readily and transparently classifiable as a
swap or security-based swap.\767\ The commenters did not provide
analysis supporting their comments or recommend language changes.
---------------------------------------------------------------------------
\765\ See ISDA Letter and MarketAxess Letter.
\766\ See MarketAxess Letter. This commenter stated that ``The
Proposed Rules layout an exceedingly complex process for determining
whether an index CDS is broad-based or narrow-based.'' Id.
\767\ See ISDA Letter.
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The Commissions are adopting the rules regarding index CDS
essentially as proposed with certain modifications to address
commenters' concerns. While the final rules contain a number of
elements that are similar or identical to elements contained in the
statutory narrow-based security index definition, in order to enable
the narrow-based security index definition to apply appropriately to
index CDS, the final rules contain some alternative tests to those set
forth in the statutory definition.
The Commissions also recognize the diversity of Title VII
instruments. While the final rules for index CDS are based on the July
2006 Debt Index Rules, the substantive differences between the final
rules in the index CDS and the equity or debt security contexts are
intended to reflect the particular characteristics of the CDS
marketplace, in which, for example, index components may be entities
(issuers of securities) as well as specific equity and debt securities.
The Commissions also received three comments requesting
clarification regarding the applicability of the index CDS rules to CDS
based on indexes of loans.\768\ One commenter noted that the
Commissions did not address in the Proposing Release the question of
whether an index composed exclusively of loans should be treated as a
narrow-based security index.\769\ This commenter noted that because the
first and third prongs of the statutory security-based swap definition
do not explicitly reference loans, the statutory definition does not
expressly categorize Title VII instruments based on more than one loan,
or contingent on events that occur with respect to more than one loan
borrower, unless such borrowers are also ``issuers of securities.''
\770\ Based on this commenter's view of the statutory definition, this
commenter requested that the Commissions clarify the treatment of
indexes composed exclusively of loans.\771\ Another commenter provided
similar comments and also requested clarification regarding the
treatment of CDS based on indexes of loans.\772\ A third commenter
stated its view that the third prong of the statutory security-based
swap definition implies that Title VII instruments on a basket of loans
are security-based swaps if the lenders would satisfy the criteria for
issuers of a ``narrow-based security index'' and encouraged the
Commissions to clarify this issue.\773\ The Commissions agree with
commenters that an index CDS based on an index of loans that are not
securities is analyzed under the third prong of the statutory security-
based swap definition and, therefore, are clarifying the treatment of
these Title VII instruments above.\774\
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\768\ See Allen & Overy Letter; July LSTA Letter; and SIFMA
Letter.
\769\ See Allen & Overy Letter.
\770\ Id.
\771\ Id.
\772\ See July LSTA Letter. This commenter noted that prong
(III) of the statutory security-based swap definition does not
clearly reference borrowers of loans or indexes of borrowers.
However, this commenter noted that because most borrowers that are
named as reference entities in loan CDS transactions are corporate
entities that issue equity interests to one or more shareholders
(although they may not issue public securities or become subject to
public reporting requirements), this commenter believes that prong
(III) can be interpreted to include swaps that reference a single
borrower or borrowers of loans in an index. Id.
\773\ See SIFMA Letter.
\774\ The Commissions also are providing guidance with respect
to TRS based on two or more loans that are not securities. See supra
part III.C.
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(i) Number and Concentration Percentages of Reference Entities or
Securities
The Commissions believe that the first three criteria of the debt
security index test (which are based on the statutory narrow-based
security index definition) discussed above (i.e., the number and
concentration weighting requirements) are appropriate to apply to index
CDS,
[[Page 48275]]
whether CDS on indexes of securities or indexes of issuers of
securities.\775\ Accordingly, the Commissions are adopting the first
three criteria of rule 1.3(zzz) under the CEA and rule 3a68-1a under
the Exchange Act as proposed with certain modifications in response to
commenters' concerns.\776\ These rules contain the same number and
concentration criteria as proposed, but modify the method of
calculating affiliation among issuers and reference entities in
response to commenters.\777\ Further, in response to commenters,\778\
the Commissions are providing an additional interpretation with respect
to the application of these criteria to two particular types of CDS,
commonly known as ``nth-to-default CDS'' and ``tranched CDS.''
---------------------------------------------------------------------------
\775\ See infra notes 792 and 793 and accompanying text.
\776\ See paragraphs (a)(1)(i)-(iii) of rules 1.3(zzz) and
1.3(aaaa) under the CEA and rules 3a68-1a and 3a68-1b under the
Exchange Act.
\777\ See infra note 804 and accompanying text.
\778\ See infra notes 795 and 796 and accompanying text.
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The first three criteria provide that, for purposes of determining
whether an index CDS is a security-based swap under section
3(a)(68)(A)(ii)(III) of the Exchange Act,\779\ the term ``issuers of
securities in a narrow-based security index'' includes issuers of
securities identified in an index (including an index referencing loan
borrowers) in which:
---------------------------------------------------------------------------
\779\ 15 U.S.C. 78c(a)(68)(A)(ii)(III).
---------------------------------------------------------------------------
Number: There are nine or fewer non-affiliated issuers of
securities that are reference entities included in the index, provided
that an issuer of securities shall not be deemed a reference entity
included in the index unless (i) a credit event with respect to such
reference entity would result in a payment by the credit protection
seller to the credit protection buyer under the index CDS based on the
related notional amount allocated to such reference entity; or (ii) the
fact of such credit event or the calculation in accordance with clause
(i) above of the amount owed with respect to such credit event is taken
into account in determining whether to make any future payments under
the index CDS with respect to any future credit events;
Single Component Concentration: The effective notional
amount allocated to any reference entity included in the index
comprises more than 30 percent of the index's weighting; or
Largest Five Component Concentration: The effective
notional amount allocated to any five non-affiliated reference entities
included in the index comprises more than 60 percent of the index's
weighting.\780\
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\780\ These rules refer to the ``effective notional amount''
allocated to reference entities or securities in order to address
potential situations in which the means of calculating payout across
the reference entities or securities is not uniform. Thus, if one or
more payouts is leveraged or enhanced by the structure of the
transaction (i.e., 2x recovery rate), that amount would be the
``effective notional amount'' for purposes of the 30 percent and 60
percent tests in paragraphs (1)(i)(B) and (1)(i)(C) of rules
1.3(zzz) and 1.3(aaaa) and paragraphs (a)(1)(ii) and (a)(1)(iii) of
rules 3a68-1a and 3a68-1b. Similarly, if the aggregate notional
amount under a CDS is not uniformly allocated to each reference
entity or security, then the portion of the notional amount
allocated to each reference entity or security (which may be by
reference to the product of the aggregate notional amount and an
applicable percentage) would be the ``effective notional amount.''
---------------------------------------------------------------------------
Similarly, the Commissions are adopting as proposed the first three
criteria of rule 1.3(aaaa) under the CEA and rule 3a68-1b under the
Exchange Act. These three criteria provide that, for purposes of
determining whether an index CDS is a security-based swap under section
3(a)(68)(A)(ii)(I) of the Exchange Act,\781\ the term ``narrow-based
security index'' includes an index in which essentially the same
criteria apply, substituting securities for issuers. Under these
criteria, the term ``narrow-based security index'' would mean an index
in which:
---------------------------------------------------------------------------
\781\ 15 U.S.C. 78c(a)(68)(A)(ii)(I).
---------------------------------------------------------------------------
Number: There are nine or fewer securities, or securities
that are issued by nine or fewer non-affiliated issuers, included in
the index, provided that a security shall not be deemed a component of
the index unless (i) a credit event with respect to the issuer of such
security or a credit event with respect to such security would result
in a payment by the credit protection seller to the credit protection
buyer under the index CDS based on the related notional amount
allocated to such security, or (ii) the fact of such credit event or
the calculation in accordance with clause (i) above of the amount owed
with respect to such credit event is taken into account in determining
whether to make any future payments under the index CDS with respect to
any future credit events;
Single Component Concentration: The effective notional
amount allocated to the securities of any issuer included in the index
comprises more than 30 percent of the index's weighting; or
Largest Five Component Concentration: The effective
notional amount allocated to the securities of any five non-affiliated
issuers included in the index comprises more than 60 percent of the
index's weighting.
Thus, the applicability of the final rules depends on conditions
relating to the number of non-affiliated reference entities or issuers
of securities, or securities issued by non-affiliated issuers, as
applicable, included in an index and the weighting of notional amounts
allocated to the reference entities or securities included in the
index, as applicable. These first three criteria of the final rules
evaluate the number and concentration of the reference entities or
securities included in the index, as applicable, and ensure that an
index with a small number of reference entities, issuers, or securities
or concentrated in only a few reference entities, issuers, or
securities is narrow-based, and thus where such index is the underlying
reference of an index CDS, the index CDS is a security-based swap.
Further, as more fully described below,\782\ the final rules provide
that a reference entity or issuer of securities included in an index
and any of that reference entity's or issuer's affiliated entities (as
defined in the final rules) that also are included in the index are
aggregated for purposes of determining whether the number and
concentration criteria are met.
---------------------------------------------------------------------------
\782\ See infra part III.G.3(b)(ii), for a discussion of the
affiliation definition applicable to calculating the number and
concentration criteria. As noted above, the Commissions are
modifying the method of calculating affiliation for purposes of
these criteria.
---------------------------------------------------------------------------
Specifically, the final rules provide that an index meeting any one
of certain identified conditions would be a narrow-based security
index. The first condition in paragraph (1)(i)(A) of rule 1.3(zzz)
under the CEA and paragraph (a)(1)(i) of rule 3a68-1a under the
Exchange Act is that there are nine or fewer non-affiliated issuers of
securities that are reference entities in the index. An issuer of
securities counts toward this total only if a credit event with respect
to such entity would result in a payment by the credit protection
seller to the credit protection buyer under the index CDS based on the
notional amount allocated to such entity, or if the fact of such a
credit event or the calculation of the payment with respect to such
credit event is taken into account when determining whether to make any
future payments under the index CDS with respect to any future credit
events.
Similarly, the first condition in paragraph (1)(i)(A) of rule
1.3(aaaa) under the CEA and paragraph (a)(1)(i) of rule 3a68-1b under
the Exchange Act provides that a security counts toward the total
number of securities in the index only if a credit event with respect
to such security, or the issuer of such security, would result in a
payment by the credit protection seller to the credit
[[Page 48276]]
protection buyer under the index CDS based on the notional amount
allocated to such security, or if the fact of such a credit event or
the calculation of the payment with respect to such credit event is
taken into account when determining whether to make any future payments
under the index CDS with respect to any future credit events.
These provisions are intended to ensure that an index concentrated
in a few reference entities or securities, or a few reference entities
that are affiliated (as defined in the final rules) or a few securities
issued by issuers that are affiliated, are within the narrow-based
security index definition.\783\ These provisions also are intended to
ensure that an entity is not counted as a reference entity included in
the index, and a security is not counted as a security included in the
index, unless a credit event with respect to the entity, issuer, or
security affects payout under a CDS on the index.\784\
---------------------------------------------------------------------------
\783\ This requirement is generally consistent with the
definition of ``narrow-based security index'' in section 1a(35)(A)
of the CEA, 7 U.S.C. 1a(35)(A), and section 3(a)(55)(B) of the
Exchange Act, 15 U.S.C. 78c(a)(55)(B), and the July 2006 Debt Index
Rules.
\784\ Id.
---------------------------------------------------------------------------
Further, as this condition is in the alternative (i.e., either
there must be a credit event resulting in a payment under the index CDS
or a credit event is considered in determining future CDS payments),
the tests encompass all index CDS. For example, and in response to a
commenter,\785\ the test would cover an nth-to-default CDS,\786\ in
which default with respect to a specified component of an index (such
as the first default or fifth default) triggers the CDS payment, even
if the CDS payment is not made with respect to such particular credit
event. As another example, and in response to another commenter,\787\
the test applies to a tranched CDS \788\ if the payments are made on
only a tranche, or portion, of the potential aggregate notional amount
of the CDS (often expressed as a percentage range of the total notional
amount of the CDS) because the CDS payment takes into account a credit
event with respect to an index component, even if the credit event
itself does not result in such a payment.
---------------------------------------------------------------------------
\785\ See infra note 795 and accompanying text.
\786\ An ``nth-to-default CDS'' is a CDS in which the payout is
linked to one in a series of defaults (such as first-, second- or
third-to-default), with the contract terminating at that point. See
SIFMA Letter.
\787\ See infra note 796 and accompanying text.
\788\ A ``tranched CDS'' is a CDS in which the counterparties
agree to buy and sell credit protection on only a portion of the
potential losses that could occur on an underlying portfolio of
reference entities. The portion is typically denoted as a specified
percentage range of aggregate losses (e.g., 2 percent to 5 percent,
meaning the credit protection seller would not make payments until
aggregate losses exceed 2 percent of the notional of the
transaction, and would no longer be obligated to make payments after
aggregate losses reach 5 percent). See SIFMA Letter.
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The second condition, in paragraphs (1)(i)(B) of rules 1.3(zzz) and
1.3(aaaa) under the CEA and paragraphs (a)(1)(ii) of rules 3a68-1a and
3a68-1b under the Exchange Act, is that the effective notional amount
allocated to any reference entity or security of any issuer included in
the index comprises more than 30 percent of the index's weighting.
The third condition, in paragraphs (1)(i)(C) of rules 1.3(zzz) and
1.3(aaaa) under the CEA and paragraphs (a)(1)(iii) of rules 3a68-1a and
3a68-1b under the Exchange Act, is that the effective notional amount
allocated to any five non-affiliated reference entities, or to the
securities of any five non-affiliated issuers, included in the index
comprises more than 60 percent of the index's weighting.
Given that Congress determined that these concentration percentages
are appropriate to characterize an index as a narrow-based security
index, and the Commissions have determined they are appropriate for
debt security indexes in the security futures context,\789\ the
Commissions believe that these concentration percentages are
appropriate to apply to the notional amount allocated to reference
entities and securities in order to apply similar standards to indexes
that are the underlying references of index CDS. Moreover, with respect
to both the number and concentration criteria, the markets have had
experience with these criteria with respect to futures on equity
indexes, volatility indexes, and debt security indexes.\790\
---------------------------------------------------------------------------
\789\ See July 2006 Debt Index Rules.
\790\ As noted above, the Commissions are modifying the method
of calculating affiliation for purposes of the number and
concentration criteria. See infra part III.G.3(b)(ii).
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Comments
One commenter expressed its view that the Commissions should
increase the percentage test in the largest five component
concentration.\791\ The Commissions are adopting the number and
concentration criteria as proposed. The statutory definition of the
term ``security-based swap'' references the definition of the term
``narrow-based security index'' contained in the Exchange Act and the
CEA,\792\ which includes the same number and concentration percentages
as the Commissions are adopting in this release. The Commissions are
not modifying the statutory definition to change the percentages. The
statutory definition included the concentration percentages, which the
Commissions understand are intended to assure that a security index
could not be used as a surrogate for the underlying securities in order
to avoid application of the Federal securities laws. The Commissions
also previously determined to retain these statutory percentages in
connection with rules relating to debt security indexes in the security
futures context.\793\ The Commissions believe that these percentages
are similarly appropriate to apply to indexes on which index CDS are
based. Moreover, with respect to the number and concentration criteria,
as these are in the statutory definition of the term ``narrow-based
security index'' applicable to security futures, market participants
have experience in analyzing indexes, including equity, volatility and
debt security indexes, to determine compliance with these criteria. As
discussed below,\794\ though, the Commissions are modifying the
affiliation definition used in analyzing the number and concentration
criteria for an index.
---------------------------------------------------------------------------
\791\ See ISDA Letter. According to this commenter, the
``operational complexity'' of the number and concentration criteria
will increase costs and compliance risks. Id.
\792\ See 15 U.S.C. 78c(a)(55)(B) and 7 U.S.C. 1a(35).
\793\ See July 2006 Debt Index Rules.
\794\ See infra part III.G.3(b)(ii).
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Two commenters requested clarification regarding nth-to-default
CDS, stating their view that such CDS should be treated as security-
based swaps to reflect their single-entity triggers.\795\ Two
commenters requested clarification regarding tranched index CDS,
including whether the CDS would be classified based on the underlying
index.\796\ As discussed above, the Commissions are providing an
interpretation on the applicability of the first three criteria of the
rules to nth-to-default CDS and tranched CDS. As noted above, the
Commissions believe the rules encompass all index CDS, regardless of
the type or payment
[[Page 48277]]
structure, such as whether there is a single-entity payment based on
credit events of other index components or whether the payment is based
on a specific entity.
---------------------------------------------------------------------------
\795\ See ISDA Letter and SIFMA Letter. One of these commenters
noted that such an approach also made sense for nth-to-default CDS
because they are typically based on baskets of less than 10
securities. See ISDA Letter.
\796\ See Markit Letter and SIFMA Letter. One of these
commenters stated that classifying tranches underlying index CDS
according to attachment or detachment points is not appropriate
because it is impossible to know for certain at inception of the CDS
the number of credit events that will ultimately affect actual
payments, which typically depend on the severity of loss associated
with each credit event. See SIFMA Letter.
---------------------------------------------------------------------------
(ii) Affiliation of Reference Entities and Issuers of Securities With
Respect to Number and Concentration Criteria
The Commissions are adopting the affiliation definition that
applies when calculating the number and concentration criteria with
certain modifications from the proposal to address commenters'
concerns.\797\ The final rules provide that the terms ``reference
entity included in the index'' and ``issuer of the security included in
the index'' include a single reference entity or issuer of securities
included in an index, respectively, or a group of affiliated reference
entities or issuers included in an index, respectively.\798\ For
purposes of the rules, affiliated reference entities or issuers of
securities included in an index or securities included in an index
issued by affiliated issuers will be counted together for determining
whether the number and concentration criteria are met. However, with
respect to asset-backed securities, the final rules provide that each
reference entity or issuer of securities included in an index that is
an issuing entity of an asset-backed security is considered a separate
reference entity or issuer, as applicable, and will not be considered
affiliated with other reference entities or issuers of securities
included in the index.
---------------------------------------------------------------------------
\797\ See infra note 804 and accompanying text.
\798\ See paragraph (c)(4) of rules 1.3(zzz) and 1.3(aaaa) under
the CEA and rule 3a68-1a and 3a68-1b under the Exchange Act.
---------------------------------------------------------------------------
The final rules provide that a reference entity or issuer of
securities included in an index is affiliated with another reference
entity or issuer of securities included in the index if it controls, is
controlled by, or is under common control with, that other reference
entity or issuer.\799\ The final rules define control, solely for
purposes of this affiliation definition, to mean ownership of more than
50 percent of a reference entity's or issuer's equity or the ability to
direct the voting of more than 50 percent of a reference entity's or
issuer's voting equity.\800\ The affiliation definition in the final
rules differs from the definition included in the proposal, which
provided for a control threshold of 20 percent ownership.\801\ This
change is based on the Commissions' consideration of comments
received.\802\ By using a more than 50 percent (i.e., majority
ownership) test rather than a 20 percent ownership test for the control
threshold, there is a greater likelihood that there will be an
alignment of economic interests of the affiliated entities that is
sufficient to aggregate reference entities or issuers of securities
included in an index for purposes of the number and concentration
criteria.\803\
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\799\ See paragraph (c)(1) of rules 1.3(zzz) and 1.3(aaaa) under
the CEA and rules 3a68-1a and 3a68-1b under the Exchange Act.
\800\ See paragraph (c)(2) of rules 1.3(zzz) and 1.3(aaaa) under
the CEA and rules 3a68-1a and 3a68-1b under the Exchange Act.
\801\ See Proposing Release at 29849.
\802\ See infra note 804 and accompanying text. The Commissions
note that another alternative would have been to include a
requirement that the entities satisfy the 20 percent control
threshold and also be consolidated with each other in financial
statements. The Commissions did not include a requirement that the
entities be consolidated with each other in financial statements
because they do not believe that the scope of the affiliation
definition should be exposed to the risk of future changes in
accounting standards. Further, the use of a majority ownership
control threshold (more than 50 percent) is generally consistent
with consolidation under generally accepted accounting principles.
See FASB ASC section 810-10-25, Consolidation--Overall--Recognition
(stating that consolidation is appropriate if a reporting entity has
a controlling financial interest in another entity and a specific
scope exception does not apply).
\803\ In such a case, as noted by commenters, the affiliated
entities are viewed as part of group for which aggregation of these
entities is appropriate. See infra note 806 and accompanying text.
---------------------------------------------------------------------------
As the affiliation definition is applied to the number criterion,
affiliated reference entities or issuers of securities included in an
index will be viewed as a single reference entity or issuer of
securities to determine whether there are nine or fewer non-affiliated
reference entities included in the index or securities that are issued
by nine or fewer non-affiliated issuers. Similarly, as the affiliation
definition is applied to the concentration criteria, the notional
amounts allocated to affiliated reference entities included in an index
or the securities issued by a group of affiliated issuers of securities
included in an index must be aggregated to determine the level of
concentration of the components of the index for purposes of the 30-
percent and 60-percent concentration criteria.
Comments
Three commenters requested that the Commissions revise the
affiliation definition that applies when calculating the number and
concentration criteria to increase the control threshold from 20
percent ownership to majority ownership.\804\ These commenters noted
that majority ownership is consistent with current market practice,
including the definition of affiliate included in the 2003 ISDA Credit
Derivatives Definitions.\805\ One commenter also stated its belief that
affiliated entities should only be aggregated where the reference
entities' credit risks are substantially similar and credit decisions
are made by the same group of individuals.\806\ This commenter stated
its view that 20 percent ownership is too low and that majority
ownership is necessary for credit risk and credit decisions to be
aligned enough as to warrant collapsing two issuers into one for
purposes of the number and concentration criteria.\807\
---------------------------------------------------------------------------
\804\ See ISDA Letter (requesting a threshold of at least 50
percent); Markit Letter (requesting a threshold of at least 50
percent); and SIFMA Letter (requesting a threshold of majority
ownership, or 51 percent). One commenter also requested that the
Commissions clarify the application of the affiliation definition.
See Markit Letter. The Commissions have provided above and in infra
part III.G.3(b)(ii), several examples illustrating the application
of the affiliation definition in response to this commenter.
\805\ Id.
\806\ See SIFMA Letter. The ISDA Letter provides a similar
rationale that ``the control threshold was too low and potentially
disruptive when viewed against entities that the swap markets now
trade as separate entities. In the CDS market, for example, entities
that share ownership ties of substantially more than 20 percent
trade quite independently. These entities may have completely
disparate characteristics for the purpose of an index grouping of
one sort or another.'' See ISDA Letter.
\807\ See SIFMA Letter.
---------------------------------------------------------------------------
As stated above, the Commissions are modifying the affiliation
definition that applies when calculating the number and concentration
criteria in response to commenters to use an affiliation test based on
majority ownership. Based on commenters' letters, the Commissions
understand that the current standard CDS documentation and the current
approach used by certain index providers for index CDS with respect to
the inclusion of affiliated entities in the same index use majority
ownership rather than 20 percent ownership to determine affiliation.
The Commissions are persuaded by commenters that, in the case of index
CDS only it is more appropriate to use majority ownership because
majority-owned entities are more likely to have their economic
interests aligned and be viewed by the market as part of a group. The
Commissions believe that revising the affiliation definition in this
manner for purposes of calculating the number and concentration
criteria responds to commenters' concerns that the percentage control
threshold may inadvertently include entities that are not viewed as
part of a group. Thus, as revised, the affiliation definition will
include only those reference entities or issuers included in an index
that satisfy the more than 50 percent (i.e., majority ownership)
control threshold. The
[[Page 48278]]
Commissions believe that determining affiliation in this manner for
purposes of calculating the number and concentration criteria responds
to the commenters' concerns.
The Commissions also believe that the modified affiliation
definition addresses commenters' concerns noted above \808\ that the
rules further defining the terms ``issuers of securities in a narrow-
based security index'' and ``narrow-based security index'' should be
simplified. The modified affiliation definition enables market
participants to make an affiliation determination for purposes of
calculating the number and concentration criteria by measuring the more
than 50 percent (i.e., majority ownership) control threshold.
---------------------------------------------------------------------------
\808\ See supra note 765 and accompanying text.
---------------------------------------------------------------------------
(iii) Public Information Availability Regarding Reference Entities and
Securities
In addition to the number and concentration criteria, the debt
security index test also includes, as discussed above, a public
information availability test. The public information availability test
is intended as the substitute for the average daily trading volume
(``ADTV'') provision in the statutory narrow-based security index
definition. An ADTV test is designed to take into account the trading
of individual stocks and, because Exchange Act registration of the
security being traded is a listing standard for equity securities, the
issuer of the security being traded must be subject to the reporting
requirements under the Exchange Act. Based on the provisions of the
statutory ADTV test, the Commissions have determined that the ADTV test
is not useful for purposes of determining the status of the index on
which the index CDS is based because index CDS most commonly reference
entities, which do not ``trade,'' or debt instruments, which commonly
are not listed, and, therefore, do not have a significant trading
volume. However, the underlying rationale of such provision, that there
is sufficient trading in the securities and therefore public
information and market following of the issuer of the securities,
applies to index CDS.
In general, if an index is not narrow-based under the number and
concentration criteria, it will be narrow-based if one of the reference
entities or securities included in the index fails to meet at least one
of the criteria in the public information availability test. This test
was designed to reduce the likelihood that broad-based debt security
indexes or the component securities or issuers of securities in that
index would be readily susceptible to manipulation. The fourth
condition in the index CDS rules sets out a similar public information
availability test that is intended solely for purposes of determining
whether an index underlying a CDS is narrow-based.\809\ The Commissions
are adopting the public information availability test essentially as
proposed with certain modifications to address commenters' concerns,
including modifications to the definition of affiliation for purposes
of satisfying certain criteria of the public information availability
test.\810\
---------------------------------------------------------------------------
\809\ See Proposing Release at 29850.
\810\ See infra notes 845, 847, 849 and 867 and accompanying
text.
---------------------------------------------------------------------------
The Commissions are adopting final rules under which an index CDS
will be considered narrow-based (except as discussed below) if a
reference entity or security included in the index does not meet any of
the following criteria: \811\
---------------------------------------------------------------------------
\811\ See paragraphs (a)(1)(iv)(A)-(G) of rules 1.3(zzz) and
1.3(aaaa) under the CEA and rule 3a68-1a and 3a68-1b under the
Exchange Act.
---------------------------------------------------------------------------
The reference entity or the issuer of the security
included in the index is required to file reports pursuant to the
Exchange Act or the regulations thereunder;
The reference entity or the issuer of the security
included in the index is eligible to rely on the exemption provided in
rule 12g3-2(b) under the Exchange Act; \812\
---------------------------------------------------------------------------
\812\ 17 CFR 240.12g3-2(b).
---------------------------------------------------------------------------
The reference entity or the issuer of the security
included in the index has a worldwide market value of its outstanding
common equity held by non-affiliates of $700 million or more; \813\
---------------------------------------------------------------------------
\813\ See July 2006 Debt Index Rules (noting that issuers having
worldwide equity market capitalization of $700 million or more are
likely to have public information available about them).
---------------------------------------------------------------------------
The reference entity or the issuer of the security
included in the index (other than a reference entity or an issuer of
the security included in the index that is an issuing entity of an
asset-backed security as defined in section 3(a)(77) of the Exchange
Act \814\) has outstanding notes, bonds, debentures, loans, or
evidences of indebtedness (other than revolving credit facilities)
having a total remaining principal amount of at least $1 billion; \815\
---------------------------------------------------------------------------
\814\ 15 U.S.C. 78c(a)(77).
\815\ See July 2006 Debt Index Rules (noting that issuers having
at least $1 billion in outstanding debt are likely to have public
information available about them).
---------------------------------------------------------------------------
The reference entity included in the index is an issuer of
an exempted security, or the security included in the index is an
exempted security, each as defined in section 3(a)(12) of the Exchange
Act \816\ and the rules promulgated thereunder (except a municipal
security);
---------------------------------------------------------------------------
\816\ 15 U.S.C. 78c(a)12.
---------------------------------------------------------------------------
The reference entity or the issuer of the security
included in the index is a government of a foreign country or a
political subdivision of a foreign country; or
If the reference entity or the issuer of the security
included in the index is an issuing entity of asset-backed securities
as defined in section 3(a)(77) of the Exchange Act,\817\ such asset-
backed security was issued in a transaction registered under the
Securities Act and has publicly available distribution reports.
---------------------------------------------------------------------------
\817\ 15 U.S.C. 78c(a)(77).
---------------------------------------------------------------------------
However, so long as the effective notional amounts allocated to
reference entities or securities included in the index that satisfy the
public information availability test comprise at least 80 percent of
the index's weighting, failure by a reference entity or security
included in the index to satisfy the public information availability
test will be disregarded if the effective notional amounts allocated to
that reference entity or security comprise less than five percent of
the index's weighting.\818\ In this situation, the public information
availability test for purposes of the index would be satisfied.
---------------------------------------------------------------------------
\818\ See paragraph (b) of rules 1.3(zzz) and 1.3(aaaa) under
the CEA and rule 3a68-1a and 3a68-1b under the Exchange Act.
---------------------------------------------------------------------------
The determination as to whether an index CDS is narrow-based is
conditioned on the likelihood that information about a predominant
percentage of the reference entities or securities included in the
index is publicly available.\819\ For example, a reference entity or an
issuer of securities
[[Page 48279]]
included in the index that is required to file reports pursuant to the
Exchange Act or the regulations thereunder makes regular and public
disclosure through those filings. Moreover, a reference entity or an
issuer of securities included in the index that does not file reports
with the SEC but that is eligible to rely on the exemption in rule
12g3-2(b) under the Exchange Act (i.e., foreign private issuers) is
required to make certain types of financial information publicly
available in English on its Web site or through an electronic
information delivery system generally available to the public in its
primary trading markets.\820\
---------------------------------------------------------------------------
\819\ Most of the thresholds in the public information
availability test are similar to those the Commissions adopted in
their joint rules regarding the application of the definition of the
term ``narrow-based security index'' to debt security indexes and
security futures on debt securities. See July 2006 Debt Index Rules.
The July 2006 Debt Index Rules also included an additional
requirement regarding the minimum principal amount outstanding for
each security in the index. The Commissions have not included this
requirement in rule 1.3(zzz) under the CEA and rule 3a68-1a under
the Exchange Act. That requirement was intended as a substitute
criterion for trading volume because the trading volume of debt
securities with a principal amount outstanding above that minimum
amount was found to be generally larger than debt securities with a
principal amount outstanding below that minimum amount. See July
2006 Debt Index Release. There is no similar criterion that would be
applicable in the context of index CDS. The numerical thresholds
also are similar to those the SEC adopted in other contexts,
including in the existing definitions of ``well-known seasoned
issuer'' and ``large accelerated filer.'' See rule 405 under the
Securities Act, 17 CFR 230.405, and rule 12b-2 under the Exchange
Act, 17 CFR 240.12b-2.
\820\ 17 CFR 240.12g3-2(b).
---------------------------------------------------------------------------
The Commissions believe that other reference entities or issuers of
securities included in the index that do not file reports with the SEC,
but that have worldwide equity market capitalization of $700 million or
more, have at least $1 billion in outstanding debt obligations (other
than in the case of issuing entities of asset-backed securities), issue
exempted securities (other than municipal securities), or are foreign
sovereign entities either are required to or are otherwise sufficiently
likely, solely for purposes of the ``narrow-based security-index'' and
``issuers of securities in a narrow-based security index'' definitions,
to have public information available about them.\821\
---------------------------------------------------------------------------
\821\ It is important to note that the public information
availability test is designed solely for purposes of distinguishing
between index CDS that are swaps and index CDS that are security-
based swaps. The proposed criteria are not intended to provide any
assurance that there is any particular level of information actually
available regarding a particular reference entity or issuer of
securities. Meeting one or more of the criteria for the limited
purpose here--defining the terms ``narrow-based security index'' and
``issuers of securities in a narrow-based security index'' in the
first and third prongs of the security-based swap definition with
respect to index CDS--would not substitute for or satisfy any other
requirement for public disclosure of information or public
availability of information for purposes of the Federal securities
laws.
---------------------------------------------------------------------------
In response to commenters,\822\ the Commissions are modifying the
outstanding debt threshold criterion in the public information
availability test to include any indebtedness, including loans, so long
as such indebtedness is not a revolving credit facility. The
Commissions believe that expanding the definition of indebtedness to
include loans (other than revolving credit) for purposes of the debt
threshold determination is consistent with the view that entities that
have significant outstanding indebtedness likely will have public
information available about them.\823\
---------------------------------------------------------------------------
\822\ See infra note 845 and accompanying text.
\823\ See July 2006 Debt Index Release.
---------------------------------------------------------------------------
As more fully described below,\824\ for purposes of satisfying one
of these issuer eligibility criteria, the final rules provide that a
reference entity or an issuer of securities included in an index may
rely upon the status of an affiliated entity as an Exchange Act
reporting company or foreign private issuer or may aggregate the
worldwide equity market capitalization or outstanding indebtedness of
an affiliated entity, regardless of whether such affiliated entity
itself or its securities are included in the index.
---------------------------------------------------------------------------
\824\ See infra part III.G.3(b)(iv), for a discussion regarding
the affiliation definition applicable to the public information
availability test. As noted above, the Commissions are modifying the
method of calculating affiliation for purposes of this test.
---------------------------------------------------------------------------
In the case of indexes including asset-backed securities, or
reference entities that are issuing entities of asset-backed
securities, information about the reference entity or issuing entity of
the asset-backed security will not alone be sufficient and,
consequently, the rules provide that the public information
availability test will be satisfied only if certain information also is
available about the asset-backed securities. An issuing entity (whether
or not a reference entity) of asset-backed securities will meet the
public information availability test if such asset-backed securities
were issued in a transaction for which the asset-backed securities
issued (which includes all tranches) \825\ were registered under the
Securities Act and distribution reports about such asset-backed
securities are publicly available. In response to commenters,\826\ the
Commissions note that distribution reports, which sometimes are
referred to as servicer reports, delivered to the trustee or security
holders, as the case may be, are filed with the SEC on Form 10-D. In
addition, because of the lack of public information regarding many
asset-backed securities, despite the size of the outstanding amount of
securities,\827\ the rules do not permit such reference entities and
issuers to satisfy the public information availability test by having
at least $1 billion in outstanding indebtedness. Characterizing an
index with reference entities or securities for which public
information is not likely to be available as narrow-based, and thus
index CDS where the underlying references or securities are such
indexes as security-based swaps, should help to ensure that the index
cannot be used to circumvent the Federal securities laws, including
those relating to Securities Act compliance and the antifraud,
antimanipulation and insider trading prohibitions with respect to the
index components or the securities of the reference entities.
---------------------------------------------------------------------------
\825\ Under this part of the public information availability
test, all offerings of the asset-backed securities will have to be
covered by a registration statement under the Securities Act,
including all tranches, so that public information would exist for
any tranche included in an index. However, as noted below, CDS that
are offered to ECPs only may rely on alternatives to satisfy the
public information test for asset-backed securities.
\826\ See infra note 849 and accompanying text.
\827\ See generally Asset-Backed Securities, 75 FR 23328 (May 3,
2010).
---------------------------------------------------------------------------
As noted above, if an index is not narrow-based under the number
and concentration criteria, it will be narrow-based if one of the
reference entities or securities included in the index fails to meet at
least one of the criteria in the public information availability test.
However, even if one or more of the reference entities or securities
included in the index fail the public information availability test,
the final rules provide that the index will not be considered ``issuers
of securities in a narrow-based security index'' or a ``narrow-based
security index,'' so long as the applicable reference entity or
security that fails the test represents less than five percent of the
index's weighting, and so long as reference entities or securities
comprising at least 80 percent of the index's weighting satisfy the
public information availability test.
An index that includes a very small proportion of reference
entities or securities that do not satisfy the public information
availability test will be treated as a broad-based security index if
the other elements of the definition, including the five percent and 80
percent thresholds, are satisfied prior to execution, but no later than
when the parties offer to enter into the index CDS.\828\ The five-
percent weighting threshold is designed to provide that reference
entities or securities not satisfying the public information
availability test comprise only a very small portion of the index, and
the 80-percent weighting threshold is designed to provide that a
predominant percentage of the reference entities or securities in the
index satisfy the public information availability test. As a result,
these thresholds provide market participants with flexibility in
constructing an index. The Commissions believe that these thresholds
are appropriate and that providing such flexibility is not likely to
increase the likelihood that an index that satisfies these provisions
or the component securities or issuers of securities in that index
would be readily susceptible to manipulation or that there would be
misuse of material non-public information about the component
[[Page 48280]]
securities or issuers of securities in that index through the use of
CDS based on such indexes.
---------------------------------------------------------------------------
\828\ See supra note 625 and accompanying text.
---------------------------------------------------------------------------
The final rules also provide that, for index CDS entered into
solely between ECPs, there are alternative means to satisfy the public
information availability test. Under the final rules, solely for index
CDS entered into between ECPs, an index will be considered narrow-based
if a reference entity or security included in the index does not meet
(i) any of the criteria enumerated above or (ii) any of the following
criteria: \829\
---------------------------------------------------------------------------
\829\ See paragraph (a)(1)(iv)(H) of rules 1.3(zzz) and
1.3(aaaa) under the CEA and rule 3a68-1a and 3a68-1b under the
Exchange Act.
---------------------------------------------------------------------------
The reference entity or the issuer of the security
included in the index (other than a reference entity or issuer included
in the index that is an issuing entity of an asset-backed security)
makes available to the public or otherwise makes available to such ECP
information about such reference entity or issuer pursuant to rule
144A(d)(4) under the Securities Act; \830\
---------------------------------------------------------------------------
\830\ 17 CFR 230.144A(d)(4).
---------------------------------------------------------------------------
Financial information about the reference entity or the
issuer of the security included in the index (other than a reference
entity or issuer included in the index that is an issuing entity of an
asset-backed security) is otherwise publicly available; or
In the case of an asset-backed security included in the
index, or a reference entity included in the index that is an issuing
entity of an asset-backed security, information of the type and level
included in public distribution reports for similar asset-backed
securities is publicly available about both the reference entity or
issuing entity and the asset-backed security.
As more fully described below, for purposes of satisfying either
the rule 144A information criterion or the financial information
otherwise publicly available criterion, the final rules provide that a
reference entity or an issuer of securities included in an index may
look to an affiliated entity to determine whether it satisfies one of
these criterion, regardless of whether such affiliated entity itself or
its securities are included in the index.\831\
---------------------------------------------------------------------------
\831\ See infra part III.G.3(b)(iv), for a discussion regarding
the affiliation definition applicable to the public information
availability test applicable to index CDS entered into solely
between ECPs. As noted above, the Commissions are modifying the
method of calculating affiliation for purposes of this test.
---------------------------------------------------------------------------
In response to commenters,\832\ the Commissions are revising the
rule 144A information criterion of the public information availability
test applicable to index CDS entered into solely between ECPs to
clarify that the rule 144A information must either be made publicly
available or otherwise made available to the ECP. In addition, the
Commissions are clarifying that financial information about the
reference entity or the issuer of the security may otherwise be
publicly available through an issuer's Web site, through public filings
with other regulators or exchanges, or through other electronic means.
This method of satisfying the public information availability test does
not specify the precise method by which financial information must be
available.
---------------------------------------------------------------------------
\832\ See infra note 847 and accompanying text.
---------------------------------------------------------------------------
As with other index CDS, with respect to index CDS entered into
solely with ECPs, if the percentage of the effective notional amounts
allocated to reference entities or securities satisfying this expanded
public information availability test comprise at least 80 percent of
the index's weighting, then a reference entity or security included in
the index that fails to satisfy the alternative public information test
criteria will be disregarded so long as the effective notional amount
allocated to that reference entity or security comprises less than five
percent of the index's weighting.
Comments
The Commissions received a number of general and specific comments
regarding the public information availability test.
A number of commenters believed that the public information
availability test should not be included in the final rules for various
reasons, including the potential disparate treatment between products
based on indexes due to changes in index components,\833\ the impact of
the migration of indexes from narrow-based to broad-based and vice-
versa,\834\ and assertions that the test was not needed due to the
types of participants engaged in swap and security-based swap
transactions.\835\ One commenter suggested replacing the public
information availability test with a volume trading test.\836\
---------------------------------------------------------------------------
\833\ See SIFMA Letter. This commenter expressed its concern
that transactions on the same or similar indexes may result in
differing regulatory treatment due to changes in index components as
a result of component adjustments or as the availability of
information relating to a component issuer changes over time. Id.
\834\ See Markit Letter. According to this commenter,
determining whether an index of loans or borrowers meets the public
information availability test would be more difficult and more
costly than making the same determination for an index of
securities, which ``are generally subject to national or exchange-
based reporting and disclosure regimes'' and could create regulatory
uncertainty. Id. This commenter also expressed its belief that the
public information availability test would cause indexes to switch
between a narrow-based and broad-based classification, which could
result in unnecessary cost, confusion, and market disruption. Id.
\835\ See ISDA Letter. This commenter expressed its belief that
the public information availability test is not needed given the
largely institutional nature of the existing over-the-counter
market. Id. See also July LSTA Letter.
\836\ See Markit Letter. This commenter expressed its belief
that a volume-based classification process would be preferable to
the public information availability test for several reasons. First,
the statutory definition of ``narrow-based security index'' includes
a volume-based factor. Second, a volume-based factor could be
applied easily and transparently because the outstanding notional
volume of CDS referencing each index constituent is captured by the
Trade Information Warehouse. Third, an index classification based on
outstanding notional amount as opposed to the public information
availability test would result in less indices migrating from broad-
to narrow-based classifications, and vice versa. This commenter also
expressed its belief that a volume-based test would ensure that
broad-based indices are not readily susceptible to manipulation
because indexes based on constituents with high volumes are likely
to have significant public information available. Id.
---------------------------------------------------------------------------
The Commissions are adopting the public information availability
test as proposed with certain modifications described above. As
discussed above, the public information availability test is intended
as the substitute for the ADTV provision in the statutory narrow-based
security index definition, which the Dodd-Frank Act included as the
method for determining whether index CDS are swaps or security-based
swaps. Based on the reasons discussed above, the Commissions have
retained the public information availability test as the underlying
rationale of such provision, that there is sufficient trading in the
securities and therefore public information and market following of the
issuer of the securities, applies to index CDS. Accordingly, the
Commissions believe that there should be public information available
about a predominant percentage of the reference entities or issuers of
securities underlying the index in order to prevent circumvention of
other provisions of the Federal securities laws through the use of CDS
based on such indexes, to reduce the likelihood that the index, the
component securities, or the named issuers of securities in the index
could be readily susceptible to manipulation, and to prevent the misuse
of material non-public information about such an index, the component
securities, or the reference entities.
The Commissions understand that the characterization of an index
underlying a CDS as broad-based or narrow-based may change because of
changes to the index, such as addition or removal of components, or
changes regarding the
[[Page 48281]]
specific components of the index, such as a decrease in the amount of
outstanding common equity for a component. However, these types of
changes are contemplated by the statutory narrow-based security index
definition, which the Dodd-Frank Act used to establish whether index
CDS are swaps or security-based swaps.\837\ Moreover, the Commissions
have provided that the determination of whether a Title VII instrument
is a swap, security-based swap or mixed swap is made prior to
execution, but no later than when the parties offer to enter into the
Title VII instrument,\838\ and does not change if a security index
underlying such instrument subsequently migrates from broad to narrow
(or vice versa) during its life. Accordingly, even if the public
information availability test would cause indexes underlying index CDS
to migrate as suggested by a commenter, that will not affect the
classification of outstanding index CDS entered into prior to such
migration. However, if an amendment or change is made to such
outstanding index CDS that would cause it to be a new purchase or sale
of such index CDS, that could affect the classification of such
outstanding index CDS. Further, as is true for other products using the
narrow-based security index definition, the Commissions also believe
that the effects of changes to an index underlying a CDS traded on an
organized platform are addressed through the tolerance period and grace
period rules the Commissions are adopting, which rules are based on
tolerance period and grace period rules for security futures to which
the statutory narrow-based security index definition applies.\839\
---------------------------------------------------------------------------
\837\ The index migration issue exists for all products in which
the ``narrow-based security index'' definition is used. Thus, as is
true for security futures, the migration issue exists for debt
security indexes and the statutory definition of the term ``narrow-
based security index,'' under which an index's characterization may
be affected by a change to the index itself or to the components of
the index.
\838\ See supra note 625 and accompanying text.
\839\ See infra part III.G.6.
---------------------------------------------------------------------------
The Commissions are not adopting a volume-based test based on the
trading of the CDS or the trading of the index, either as a replacement
for the public information availability test or as an alternative means
of satisfying it, as one commenter suggested.\840\ The Commissions
believe that using a volume-based test based on the trading of the CDS
or the trading of the index would not work in the index CDS context
because the character of the index CDS would have to be determined
before any trading volume could exist and, therefore, the index CDS
would fail a volume-based test. The Commissions also believe that a
volume-based test based either on the CDS components of the index or
the index itself would not be an appropriate substitute for or an
alternative to a public information availability test with respect to
the referenced entity, issuer of securities, or underlying security
because such a volume-based test would not provide transparency on such
underlying entities, issuers of securities or securities.\841\
---------------------------------------------------------------------------
\840\ See supra note 836 and accompanying text.
\841\ In the context of equity securities indexes to which the
ADTV test applies, there likely is information regarding the
underlying entities, issuers of securities or securities because, as
noted above, Exchange Act registration of the security being traded
is a listing standard for equity securities and, therefore, the
issuer of the security being traded must be subject to the reporting
requirements under the Exchange Act. However, in the context of
index CDS, there are no comparable listing standards that would be
applicable to provide transparency on the underlying entities,
issuers of securities or securities.
---------------------------------------------------------------------------
The Commissions believe that the public information availability
test in the index CDS rules allows more flexibility with respect to the
types of components included in indexes underlying index CDS. For many
indexes, such as bespoke indexes, trading volume for CDS on individual
components may not be significant even though the index component would
otherwise have no trouble satisfying one of the criteria of the public
information availability test. The public information availability test
in the index CDS rules also is very similar to the test in the rules
for debt security indexes, which, as noted above, apply in the context
of Title VII instruments, thus providing a consistent set of rules
under which index compilers and market participants can analyze the
characterization of CDS.
One commenter also had concerns regarding specific types of indexes
and specific types of index components, including the applicability of
the public information availability test to indexes of loans or
borrowers.\842\ As discussed above, however, the Commissions believe
that index CDS based on indexes of loans or borrowers should be
analyzed under the third prong of the statutory security-based swap
definition in the same manner as any other index CDS. Although this
commenter noted such indexes may include a higher proportion of
``private'' borrowers (those borrowers who are not public reporting
companies or that do not register offerings of their securities) and
thus may themselves not satisfy any of the criteria for the public
information availability test,\843\ the Commissions believe that the
information tests of the rule as modified will address these concerns.
The modified rule will add loans to the categories of instruments to be
aggregated for purposes of the outstanding indebtedness criterion and,
as discussed below, will aggregate outstanding indebtedness of
affiliates.\844\ As a result of these modifications, the Commissions
believe that the indexes the commenter was concerned about may be more
likely to satisfy the public information availability test.
---------------------------------------------------------------------------
\842\ See July LSTA Letter.
\843\ Id.
\844\ As noted above, the Commissions are modifying the method
of calculating affiliation for purposes of certain criteria of the
public information availability test. See infra part III.G.3(b)(iv).
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One commenter agreed with including an outstanding debt threshold
as a criterion in the public information availability test, but
requested that the Commissions change this criterion to include loans
that are not within the definition of security, as well as affiliate
debt guaranteed by the issuer of securities or reference entity, and to
reduce the required outstanding debt threshold from $1 billion to $100
million.\845\ As discussed above, the Commissions are revising the
rules to expand the types of debt that are counted toward the $1
billion debt threshold to include any indebtedness, including loans, so
long as such indebtedness is not a revolving credit facility. The
Commissions have made no other changes to the $1 billion debt
threshold.
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\845\ See Markit Letter. This commenter suggested that the debt
threshold should be reduced to $100 million because debt issuances
in some debt markets, such as the high yield markets, tend to be
relatively small. This commenter also suggested that the debt
threshold should include debt guaranteed by the issuer of the
securities or reference entity because in many cases the issuer of
the securities or reference entity is merely guaranteeing debt of
its affiliates and not issuing the debt. Finally, this commenter
requested clarification as to whether the debt threshold included
loans and leveraged loans.
---------------------------------------------------------------------------
The Commissions believe that the fact that an entity has guaranteed
the obligations of another entity will not affect the likelihood that
public information is available about either the borrower on the
guaranteed obligation or on the guarantor entity. However, the
Commissions note that they are providing an additional interpretation
on the affiliation definition of the index CDS rules, including
modifying the method of calculating affiliation, that should address
this commenter's concerns regarding guaranteed affiliate
[[Page 48282]]
debt.\846\ The Commissions also believe that the $1 billion debt
threshold, which is the same amount as the outstanding debt threshold
in the rules for debt security indexes, is set at the appropriate level
to achieve the objective that such entities are likely to have public
information available about them.
---------------------------------------------------------------------------
\846\ See infra part III.G.3(b)(iv).
---------------------------------------------------------------------------
One commenter suggested that the proposed rule 144A information
criterion of the public information availability test applicable to
index CDS entered into solely between ECPs should be satisfied if the
issuer made the rule 144A information available upon request to the
public or to the ECP in question, rather than being required to provide
the information.\847\ In response to this commenter, the Commissions
are revising the rule 144A information criterion of the public
information availability test applicable to index CDS entered into
solely between ECPs to clarify that the rule 144A information must be
made publicly available or otherwise made available to the ECP.
---------------------------------------------------------------------------
\847\ See SIFMA Letter.
---------------------------------------------------------------------------
The Commissions received one comment regarding the criteria of the
public information availability test that relate specifically to asset-
backed securities.\848\ The commenter was concerned that the test for
asset-backed securities underlying an index may be difficult to apply
because all asset-backed securities underlying an index are not always
registered under the Securities Act.\849\ This commenter also was
concerned that the term ``distribution reports'' may not be the same as
monthly service reports, which this commenter indicated are available
through the deal trustee and/or the SEC Web site.\850\ This commenter
also believed that it was unclear whether these monthly service reports
would qualify as ``distribution reports'' for purposes of the public
information availability test and whether information regarding Agency
MBS pools, which are available on Agency Web sites, would be sufficient
to satisfy the public information availability test.\851\ In addition,
this commenter requested that the Commissions clarify that not all
tranches of a transaction need to be registered under the Securities
Act to satisfy the publicly available distribution report
requirement.\852\
---------------------------------------------------------------------------
\848\ See Markit Letter.
\849\ Id.
\850\ Id.
\851\ Id.
\852\ Id.
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The Commissions are adopting as proposed the provisions of the
public information availability test applicable to indexes based on
asset-backed securities. The Commissions note that there are two
possible ways to satisfy the public information availability test for
index CDS based on asset-backed securities or asset-backed issuers. For
index CDS available to non-ECPs, all asset-backed securities in the
index or of the issuer in the index must have been sold in registered
offerings under the Securities Act and have publicly available
distribution reports. The Commissions are clarifying that monthly
service reports filed with the SEC will satisfy the requirement for
publicly available distribution reports.\853\ However, for index CDS
being sold only to ECPs, the public information availability test with
respect to the index components is satisfied, regardless of whether the
asset-backed securities have been sold in registered offerings under
the Securities Act, if information of the type and level included in
public distribution reports for similar asset-backed securities is
publicly available about both the issuing entity and such asset-backed
securities. The Commissions believe that requiring such information
about the asset-backed securities and the assets in the pools
underlying such asset-backed securities is consistent with existing
disclosure requirements for asset-backed securities and existing
practices of ABS issuers.
---------------------------------------------------------------------------
\853\ Distribution reports, which sometimes are referred to as
servicer reports, delivered to the trustee or security holders, as
the case may be, are filed with the SEC on Form 10-D.
---------------------------------------------------------------------------
(iv) Affiliation of Reference Entities and Issuers of Securities With
Respect to Certain Criteria of the Public Information Availability Test
The Commissions are adopting the affiliation definition that
applies to certain criteria of the public information availability test
with certain modifications from the proposals to address commenters'
concerns.\854\ The Commissions are making modifications to this
affiliation definition that are the same as the modifications the
Commissions are making to the affiliation definition that applies when
calculating the number and concentration criteria.\855\
---------------------------------------------------------------------------
\854\ See infra note 867 and accompanying text.
\855\ See supra part III.G.3(b)(ii).
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This affiliation definition applies for purposes of determining
whether a reference entity or issuer of securities included in an index
satisfies one of the following four criteria of the public information
availability test: (i) The reference entity or issuer of the security
included in the index is required to file reports pursuant to the
Exchange Act or the regulations thereunder; \856\ (ii) the reference
entity or issuer of the security included in the index is eligible to
rely on the exemption provided in rule 12g3-2(b) under the Exchange Act
for foreign private issuers; \857\ (iii) the reference entity or issuer
of the security included in the index has a worldwide market value of
its outstanding common equity held by non-affiliates of $700 million or
more; \858\ and (iv) the reference entity or issuer of the security
included in the index has outstanding notes, bonds, debentures, loans,
or evidences of indebtedness (other than revolving credit facilities)
having a total remaining principal amount of at least $1 billion.\859\
This affiliation definition also applies for purposes of determining
whether a reference entity or issuer of securities included in an index
satisfies one of the following two criteria of the alternative public
information availability test applicable to index CDS entered into
solely between ECPs: (i) The reference entity or issuer of the security
included in the index makes available rule 144A information; \860\ and
(ii) financial information about the reference entity or issuer of the
security included in the index is otherwise publicly available.\861\
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\856\ See paragraph (a)(1)(iv)(A) of rules 1.3(zzz) and
1.3(aaaa) under the CEA and rule 3a68-1a and 3a68-1b under the
Exchange Act.
\857\ See paragraph (a)(1)(iv)(B) of rules 1.3(zzz) and
1.3(aaaa) under the CEA and rule 3a68-1a and 3a68-1b under the
Exchange Act.
\858\ See paragraph (a)(1)(iv)(C) of rules 1.3(zzz) and
1.3(aaaa) under the CEA and rule 3a68-1a and 3a68-1b under the
Exchange Act.
\859\ See paragraph (a)(1)(iv)(D) of rules 1.3(zzz) and
1.3(aaaa) under the CEA and rule 3a68-1a and 3a68-1b under the
Exchange Act.
\860\ See paragraph (a)(1)(iv)(H)(1) of rules 1.3(zzz) and
1.3(aaaa) under the CEA and rule 3a68-1a and 3a68-1b under the
Exchange Act.
\861\ See paragraph (a)(1)(iv)(H)(2) of rules 1.3(zzz) and
1.3(aaaa) under the CEA and rule 3a68-1a and 3a68-1b under the
Exchange Act.
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The final rules provide that the terms ``reference entity included
in the index'' and ``issuer of the security included in the index''
include a single reference entity or issuer of securities included in
an index, respectively, or a group of affiliated entities.\862\ For
purposes of the rules, a reference entity or issuer of securities
included in an index may rely upon an affiliated entity to satisfy
certain criteria of the public information availability test. However,
with respect to asset-backed securities, the final rules provide that
each reference entity or issuer of securities included in an index
[[Page 48283]]
that is an issuing entity of an asset-backed security is considered a
separate reference entity or issuer, as applicable, and will not be
considered affiliated with any other entities.
---------------------------------------------------------------------------
\862\ See paragraph (c)(4) of rules 1.3(zzz) and 1.3(aaaa) under
the CEA and rule 3a68-1a and 3a68-1b under the Exchange Act.
---------------------------------------------------------------------------
The final rules provide that a reference entity or issuer of
securities included in an index is affiliated with another entity if it
controls, is controlled by, or is under common control with, that other
entity.\863\ The final rules define control, solely for purposes of
this affiliation definition, to mean ownership of more than 50 percent
of a reference entity's or issuer's equity or the ability to direct the
voting of more than 50 percent of a reference entity's or issuer's
voting equity.\864\ This revision is the same as the modification the
Commissions are making to the affiliation definition that applies when
calculating the number and concentration criteria, which is discussed
above.\865\
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\863\ See paragraph (c)(1) of rules 1.3(zzz) and 1.3(aaaa) under
the CEA and rule 3a68-1a and 3a68-1b under the Exchange Act.
\864\ See paragraph (c)(2) of rules 1.3(zzz) and 1.3(aaaa) under
the CEA and rule 3a68-1a and 3a68-1b under the Exchange Act.
\865\ See supra part III.G.3(b)(ii).
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As the Commissions noted above, this change is based on the
Commissions' consideration of comments received. By using a more than
50 percent (i.e., majority ownership) test rather than a 20 percent
ownership test for the control threshold, there is a greater likelihood
that there will be information available about the reference entity or
issuer of securities included in the index because the market likely
will view the affiliated entity and the reference entity or issuer of
securities included in the index as a single company or economic
entity.\866\ Accordingly, to the extent information regarding the
affiliated entity is publicly available, there may be information
regarding the reference entity or issuer of securities included in the
index that also is publicly available. This modified control threshold
will permit such reference entity or issuer of securities to rely upon
an affiliated entity to satisfy one of the criteria of the public
information availability test. Further, unlike the affiliation
definition that applies when calculating the number and concentration
criteria, the affiliation definition that applies to certain criteria
of the public information availability test does not require that the
affiliated entity or its securities be included in the index.
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\866\ The more than 50 percent (i.e., majority ownership) test
is generally consistent with consolidation under U.S. generally
accepted accounting principles. See FASB ASC section 810-10-25,
Consolidation--Overall--Recognition (stating that consolidation is
appropriate if a reporting entity has a controlling financial
interest in another entity and a specific scope exception does not
apply). Accordingly, using a more than 50 percent (i.e., majority
ownership) test will make it more likely that the reference entity
or issuer of securities included in the index and the affiliated
entity will be consolidated with each other in financial statements.
Consolidated financial statements present the financial position and
results of operations for a parent (controlling entity) and one or
more subsidiaries (controlled entities) as if the individual
entities actually were a single company or economic entity.
---------------------------------------------------------------------------
As the affiliation definition applies to the Exchange Act reporting
company and foreign private issuer criteria of the public information
availability test, a reference entity or an issuer of securities
included in an index that itself is not required to file reports
pursuant to the Exchange Act or the regulations thereunder or is not
eligible to rely on the exemption provided in rule 12g3-2(b) under the
Exchange Act for foreign private issuers may rely upon the status of an
affiliated entity as an Exchange Act reporting company or foreign
private issuer, regardless of whether that affiliated entity itself or
its securities are included in the index, to satisfy one of these
criteria. For example, a majority-owned subsidiary included in an index
may rely upon the status of its parent, which may or may not be
included in the index, to satisfy the issuer eligibility criteria if
the parent is required to file reports under the Exchange Act or is a
foreign private issuer.
Similarly, as the affiliation definition applies to the worldwide
equity market capitalization and outstanding indebtedness criteria of
the public information availability test, a reference entity or an
issuer of securities included in an index that itself does not have a
worldwide market value of its outstanding common equity held by non-
affiliates of $700 million or more or outstanding notes, bonds,
debentures, loans, or evidences of indebtedness (other than revolving
credit facilities) having a total remaining principal amount of at
least $1 billion, may aggregate the worldwide equity market
capitalization or outstanding indebtedness of an affiliated entity,
regardless of whether that affiliated entity itself or its securities
are included in the index, to satisfy one of these criteria. For
example, a majority-owned subsidiary included in an index may aggregate
the worldwide equity market capitalization or outstanding indebtedness
of its parent and/or other affiliated entities, such as other majority-
owned subsidiaries of the parent, to satisfy one of these criteria.
Finally, as the affiliation definition applies to the rule 144A
information and financial information otherwise publicly available
criteria of the alternative public information availability test
applicable to index CDS entered into solely between ECPs, a reference
entity or an issuer of securities included in an index that itself does
not make available rule 144A information or does not have financial
information otherwise publicly available may rely upon an affiliated
entity, regardless of whether that affiliated entity itself or its
securities are included in the index, to satisfy one of these criteria.
Comments
One commenter requested that the Commissions revise the affiliation
definition that applies for purposes of the public information
availability test to increase the threshold from 20 percent ownership
to majority ownership.\867\ This commenter noted that majority
ownership is consistent with current market practice, including the
definition of affiliate included in the 2003 ISDA Credit Derivatives
Definitions.\868\ This commenter also noted that the current approach
with respect to the inclusion of affiliated entities in the same index
uses majority ownership rather than 20 percent ownership to determine
affiliation.\869\ This commenter also requested that the Commissions
clarify the application of the affiliation definition to the public
information availability test.\870\ Further, this commenter requested
that the worldwide equity market capitalization criterion should
include all affiliated entities because the reference entity included
in the index may not be the member of a corporate group that issues
public equity.\871\ Finally, this commenter was concerned that the
outstanding indebtedness criterion would not include affiliate debt
guaranteed by the reference entity or issuer of securities included in
the index.\872\ Further, as noted above,\873\ another commenter was
concerned that index CDS may include a higher proportion of ``private''
borrowers (those borrowers that are not public reporting companies or
that do not register offerings of their securities) and thus may
themselves not satisfy each of the
[[Page 48284]]
criteria for the public information availability test.\874\
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\867\ See Markit Letter (requesting a threshold of at least 50
percent).
\868\ Id.
\869\ Id.
\870\ Id.
\871\ Id. This commenter provided Kinder Morgan Kansas Inc.
(CDS) and Kinder Morgan Inc. (equity) as an example of where the
reference entity and issuer of equity among a corporate group are
not the same. Id.
\872\ Id.
\873\ See supra note 842 and accompanying text.
\874\ See July LSTA Letter.
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The Commissions note the commenters' concerns. The Commissions are
modifying the method of determining affiliation that applies for
purposes of satisfying certain criteria of the public information
availability test. The final rules provide that a reference entity or
issuer of securities included in an index may rely upon an affiliated
entity (meeting the more than 50 percent control threshold) to satisfy
one of the criterion of the public information availability test. This
modification is similar to the one the Commissions are making to the
affiliation definition that applies for purposes of calculating the
number and concentration criteria. As noted above, based on commenters'
letters, the Commissions understand that the current standard CDS
documentation and the current approach with respect to the inclusion of
affiliated entities in the same index use majority ownership rather
than 20 percent ownership to determine affiliation. The Commissions
agree with commenters that in the case of index CDS only it is more
appropriate to use a more than 50 percent (i.e., majority ownership)
test rather than a 20 percent ownership test. The Commissions believe
that because reference entities or issuers of securities included in an
index may rely on an affiliated entity to help satisfy the public
information availability test a threshold of majority ownership rather
than 20 percent ownership will increase the likelihood that there is
information available about the reference entity or issuer of
securities included in the index. The Commissions believe that
determining affiliation in this manner for purposes of the public
availability of information test responds to the commenter's concerns.
Further, the Commissions are providing several illustrative
examples of the way in which the affiliation definition works in the
context of the public availability of information criteria to address
the commenter's concerns regarding the application of the affiliation
definition in that context. The Commissions also note that the final
rules respond to the commenter's concerns regarding the applicability
of the affiliation definition to the worldwide equity market
capitalization criterion by providing that the worldwide market
capitalization of an affiliate can be counted in determining whether
the reference entity or issuer of securities included in the index
meets the worldwide equity market capitalization criterion. Moreover,
the Commissions note that the final rules respond to the commenter's
concerns regarding affiliate debt by providing that indebtedness of an
affiliate can be counted in determining whether the reference entity or
issuer of securities included in the index meets the outstanding
indebtedness criterion. Finally, the Commissions note that the
affiliation definition as modified responds to the commenter's concerns
regarding ``private'' borrowers because the modified affiliation
definition will allow a reference entity or issuer of securities
included in an index to consider the indebtedness, the outstanding
equity, and the reporting status of an affiliate in determining whether
the public information availability test is satisfied.
As noted above, the Commissions also believe that the modified
affiliation definition responds to commenters' concerns noted above
that the rules further defining the terms ``issuers of securities in a
narrow-based security index'' and ``narrow-based security index''
should be simplified. The modified affiliation definition enables
market participants to make an affiliation determination for purposes
of the public information availability test criteria by measuring the
more than 50 percent (i.e., majority ownership) control threshold.
(v) Application of the Public Information Availability Requirements to
Indexes Compiled by a Third-Party Index Provider
The Commissions requested comment in the Proposing Release as to
whether the public information availability test should apply to an
index compiled by an index provider that is not a party to an index CDS
(``third-party index provider'') that makes publicly available general
information about the construction of the index, index rules, identity
of components, and predetermined adjustments, and which index is
referenced by an index CDS that is offered on or subject to the rules
of a DCM or SEF, or by direct access in the U.S. from an FBOT that is
registered with the CFTC.\875\ Two commenters stated that the presence
of a third-party index provider would assure that sufficient
information is available regarding the index CDS itself.\876\ Neither
commenter provided any analysis to explain how or whether a third-party
index provider would be able to provide information about the
underlying securities or issuers of securities in the index. The
Commissions are not revising the rules to exclude from the public
information availability test any index compiled by a third-party index
provider.
---------------------------------------------------------------------------
\875\ See Proposing Release at 29851-52.
\876\ See ISDA Letter and SIFMA Letter.
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(vi) Treatment of Indexes Including Reference Entities That Are Issuers
of Exempted Securities or Including Exempted Securities
The Commissions are adopting the rules regarding the treatment of
indexes that include exempted securities or reference entities that are
issuers of exempted securities as proposed without modification.\877\
The Commissions believe such treatment is consistent with the objective
and intent of the statutory definition of the term ``security-based
swap,'' as well as the approach taken in the context of security
futures.\878\ Accordingly, paragraph (1)(ii) of rules 1.3(zzz) and
1.3(aaaa) under the CEA and paragraph (a)(2) of rules 3a68-1a and 3a68-
1b under the Exchange Act provide that, in the case of an index that
includes exempted securities, or reference entities that are issuers of
exempted securities, in each case as defined as of the date of
enactment of the Futures Trading Act of 1982 (other than municipal
securities), such securities or reference entities are excluded from
the index when determining whether the securities or reference entities
in the index constitute a ``narrow-based security index'' or ``issuers
of securities in a narrow-based security index'' under the rules.
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\877\ See rules 1.3(zzz)(1)(i) and 1.3(aaaa)(1)(i) under the CEA
and rules 3a68-1a(a)(2) and 3a68-1b(a)(2) under the Exchange Act;
and July 2006 Debt Index Rules. The Commissions did not receive any
comments on the proposed rules regarding the treatment of indexes
that include exempted securities or reference entities that are
issuers of exempted securities.
\878\ See section 3(a)(68)(C) of the Exchange Act, 15 U.S.C.
78c(a)(68)(C) (providing that ``[t]he term `security-based swap'
does not include any agreement, contract, or transaction that meets
the definition of a security-based swap only because such agreement,
contract, or transaction references, is based upon, or settles
through the transfer, delivery, or receipt of an exempted security
under paragraph (12) [of the Exchange Act], as in effect on the date
of enactment of the Futures Trading Act of 1982 (other than any
municipal security as defined in paragraph (29) [of the Exchange
Act] as in effect on the date of enactment of the Futures Trading
Act of 1982), unless such agreement, contract, or transaction is of
the character of, or is commonly known in the trade as, a put, call,
or other option'').
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Under paragraph (1)(ii) of rules 1.3(zzz) and 1.3(aaaa) under the
CEA and paragraph (a)(2) of rules 3a68-1a and 3a68-1b) under the
Exchange Act, an index composed solely of securities that are, or
reference entities that are issuers of, exempted securities (other than
municipal securities) will not be a
[[Page 48285]]
``narrow-based security index'' or an index composed of ``issuers of
securities in a narrow-based security index.'' In the case of an index
where some, but not all, of the securities or reference entities are
exempted securities (other than municipal securities) or issuers of
exempted securities (other than municipal securities), the index will
be a ``narrow-based security index'' or an index composed of ``issuers
of securities in a narrow-based security index'' only if the index is
narrow-based when the securities that are, or reference entities that
are issuers of, exempted securities (other than municipal securities)
are disregarded. The Commissions believe this approach should result in
consistent treatment for indexes regardless of whether they include
securities that are, or issuers of securities that are, exempted
securities (other than municipal securities) while helping to ensure
that exempted securities (other than municipal securities) and issuers
of exempted securities (other than municipal securities) are not
included in an index merely to make the index either broad-based or
narrow-based under the rules.
4. Security Indexes
The Dodd-Frank Act defines the term ``index'' as ``an index or
group of securities, including any interest therein or based on the
value thereof.'' \879\ The Commissions provided an interpretation in
the Proposing Release regarding how to determine when a portfolio of
securities is a narrow-based or broad-based security index, and the
circumstances in which changes to the composition of a security index
(including a portfolio of securities) \880\ underlying a Title VII
instrument would affect the characterization of such Title VII
instrument.\881\ The Commissions are restating the interpretation set
forth in the Proposing Release with one clarification in response to a
commenter.\882\ Specifically, the Commissions are clarifying what is
meant by ``predetermined'' for purposes of whether criteria or a self-
executing formula for adjusting the security index underlying a Title
VII instrument qualify under the interpretation. The Commissions find
that this interpretation is an appropriate way to address how to
determine when a portfolio of securities is a narrow-based or broad-
based security index, and the circumstances in which changes to the
composition of a security index (including a portfolio of securities)
underlying a Title VII instrument would affect the characterization of
such Title VII instrument, and is designed to reduce costs associated
with making such a determination.\883\
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\879\ See section 3(a)(68)(E) of the Exchange Act, 15 U.S.C.
78c(a)(68)(E).
\880\ The Commissions noted in the Proposing Release that a
``portfolio'' of securities could be a group of securities and
therefore an ``index'' for purposes of the Dodd-Frank Act. See
Proposing Release at 29854. To the extent that changes are made to
the securities underlying the Title VII instrument and each such
change is individually confirmed, then those substituted securities
are not part of a security index as defined in the Dodd-Frank Act,
and therefore a Title VII instrument on each of those substituted
securities is a security-based swap.
\881\ Solely for purposes of the discussion in this section, the
terms ``security index'' and ``security portfolio'' are intended to
include either securities or the issuers of securities.
\882\ See infra note 891 and accompanying text.
\883\ See supra part I, under ``Overall Economic
Considerations''.
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A security index in most cases is designed to reflect the
performance of a market or sector by reference to representative
securities or interests in securities. There are several well-known
security indexes established and maintained by recognized index
providers currently in the market.\884\ However, instead of using these
established indexes, market participants may enter into a Title VII
instrument where the underlying reference of the Title VII instrument
is a portfolio of securities selected by the counterparties or created
by a third-party index provider at the behest of one or both
counterparties. In some cases, the Title VII instrument may give one or
both of the counterparties, either directly or indirectly (e.g.,
through an investment adviser or through the third-party index
provider), discretionary authority to change the composition of the
security portfolio, including, for example, by adding or removing
securities in the security portfolio on an ``at-will'' basis during the
term of the Title VII instrument.\885\ Where the counterparties, either
directly or indirectly (e.g., through an investment adviser or through
the third-party index provider), have this discretionary authority to
change the composition or weighting of securities in a security
portfolio, that security portfolio will be treated as a narrow-based
security index, and therefore a Title VII instrument on that security
portfolio is a security-based swap.\886\
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\884\ One example is the S&P 500[supreg] Index, an index that
gauges the large cap U.S. equities market.
\885\ Alternatively, counterparties may enter into Title VII
instruments where a third-party investment manager selects an
initial portfolio of securities and has discretionary authority to
change the composition of the security portfolio in accordance with
guidelines agreed upon with the counterparties. Under the final
guidance the Commissions are issuing today, such security portfolios
are treated as narrow-based security indexes, and Title VII
instruments on those security portfolios are security-based swaps.
\886\ The Commissions understand that a security portfolio could
be labeled as such or could just be an aggregate of individual Title
VII instruments documented, for example, under a master agreement or
by amending an annex of securities attached to a master trade
confirmation. If the security portfolio were created by aggregating
individual Title VII instruments, each Title VII instrument must be
evaluated in accordance with the guidance to determine whether it is
a swap or a security-based swap. For the avoidance of doubt, if the
counterparties to a Title VII instrument exchanged payments under
that Title VII instrument based on a security index that was itself
created by aggregating individual security-based swaps, such Title
VII instrument would be a security-based swap. See supra part III.D.
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However, not all changes that occur to the composition or weighting
of a security index underlying a Title VII instrument will always
result in that security index being treated as a narrow-based security
index. Many security indexes are constructed and maintained by an index
provider pursuant to a published methodology.\887\ For instance, the
various Standard & Poor's security indexes are reconstituted and
rebalanced as needed and on a periodic basis pursuant to published
index criteria.\888\ Such indexes underlying a Title VII instrument
would be broad-based or narrow-based depending on the composition and
weighting of the underlying security index.
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\887\ See, e.g., NASDAQ, ``NASDAQ-100 Index'' (``The NASDAQ-100
Index is calculated under a modified capitalization-weighted
methodology. The methodology generally is expected to retain the
economic attributes of capitalization-weighting while providing
enhanced diversification. To accomplish this, NASDAQ will review the
composition of the NASDAQ-100 Index on a quarterly basis and adjust
the weightings of Index components using a proprietary algorithm, if
certain pre-established weight distribution requirements are not
met.''), available at http://dynamic.nasdaq.com/dynamic/nasdaq100_activity.stm.
\888\ Information regarding security indexes and their related
methodologies may be widely available to the general public or
restricted to licensees in the case of proprietary or ``private
label'' security indexes. Both public and private label security
indexes frequently are subject to intellectual property protection.
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In addition, counterparties to a Title VII instrument frequently
agree to use as the underlying reference of a Title VII instrument a
security index based on predetermined criteria where the security index
composition or weighting may change as a result of the occurrence of
certain events specified in the Title VII instrument at execution, such
as ``succession events.'' Counterparties to a Title VII instrument also
may use a predetermined self-executing formula to make other changes to
the composition or weighting of a security index underlying a Title VII
instrument. In either of these situations, the composition of a
security index may
[[Page 48286]]
change pursuant to predetermined criteria or predetermined self-
executing formulas without the Title VII instrument counterparties,
their agents, or third-party index providers having any direct or
indirect discretionary authority to change the security index.
In general, and by contrast to Title VII instruments in which the
counterparties, either directly or indirectly (e.g., through an
investment adviser or through the third-party index provider), have the
discretion to change the composition or weighting of the referenced
security index, where there is an underlying security index for which
there are predetermined criteria or a predetermined self-executing
formula for adjusting the security index that are not subject to change
or modification through the life of the Title VII instrument and that
are set forth in the Title VII instrument at execution (regardless of
who establishes the criteria or formula), a Title VII instrument on
such underlying security index is based on a broad-based or narrow-
based security index, depending on the composition and weighting of the
underlying security index. Subject to the interpretation discussed
below regarding security indexes that may shift from being a narrow-
based security index or broad-based security index during the life of
an existing Title VII instrument, the characterization of a Title VII
instrument based on a security index as either a swap or a security-
based swap will depend on the characterization of the security index
using the above interpretation.\889\
---------------------------------------------------------------------------
\889\ See supra note 886, regarding the aggregation of separate
trades.
---------------------------------------------------------------------------
The Commissions are clarifying in response to a commenter that, for
purposes of this interpretation, criteria or a self-executing formula
regarding composition of a security index underlying a Title VII
instrument shall be considered ``predetermined'' if it is bilaterally
agreed upon pre-trade by the parties to a transaction.\890\ In order to
qualify under this interpretation, however, the Commissions reiterate
that the ``predetermined'' criteria or self-executing formula, as
described above, must not be subject to change or modification through
the life of the Title VII instrument and must be set forth in the Title
VII instrument at execution (regardless of who establishes the criteria
or formula).
---------------------------------------------------------------------------
\890\ See infra note 891 and accompanying text.
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Comments
The Commissions requested comment on a number of issues regarding
the interpretation contained in this section as it was proposed,
including whether the terms ``predetermined criteria'' and
``predetermined self-executing formula'' are clear, and whether
additional interpretations should be provided with respect to these
terms. The Commissions received one comment on the interpretation
provided in the Proposing Release, in which the commenter requested
clarification that criteria affecting the composition of an index, when
such criteria are agreed bilaterally, pre-trade, by the counterparties
to a bespoke index trade, are ``predetermined'' for purposes of
determining whether the index is treated as narrow-based or broad-
based.\891\
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\891\ See ISDA Letter. While this commenter agrees with the
guidance that the predetermined changes described in this section
should not alter the character of an index (or the classification of
a Title VII instrument based thereon), this commenter disagrees that
the ability to make discretionary changes should cause an otherwise
broad-based security index to be a narrow-based security index. This
commenter requested that the Commissions classify transactions ``at
inception and upon actual change in respect of any classification-
related characteristic, be that change the product of a
renegotiation or a unilateral exercise of discretion.'' Id. The
Commissions note that if material terms of a Title VII instrument
are amended or modified during its life based on an exercise of
discretion and not through predetermined criteria or a predetermined
self-executing formula, the Commissions view the amended or modified
Title VII instrument as a new Title VII instrument. See infra part
III.G.5.
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The Commissions are restating the interpretation set forth in the
Proposing Release with one clarification in response to the commenter's
concerns. As discussed above, the Commissions are providing that not
all changes that occur to the composition or weighting of a security
index underlying a Title VII instrument will result in that security
index being treated as a narrow-based security index. Foremost among
these examples is a security index that is constructed and maintained
by an index provider pursuant to a published methodology.\892\ Changes
to such an index pursuant to such a methodology are not the type of
discretionary changes that will render an otherwise broad-based
security index a narrow-based security index. The Commissions believe
this clarification addresses the commenter's concerns.
---------------------------------------------------------------------------
\892\ Indeed, the Commissions specifically mentioned in this
regard, and have included in the final guidance above, the various
Standard & Poor's security indexes--some of which may be described
as ``common equity indices'' as alluded to in ISDA's comment--that
are reconstituted and rebalanced as needed and on a periodic basis
pursuant to published index criteria.
---------------------------------------------------------------------------
5. Evaluation of Title VII Instruments on Security Indexes That Move
from Broad-Based to Narrow-Based or Narrow-Based to Broad-Based
(a) In General
The determination of whether a Title VII instrument is a swap, a
security-based swap, or both (i.e., a mixed swap), is made prior to
execution, but no later than when the parties offer to enter into the
Title VII instrument.\893\ If the security index underlying a Title VII
instrument migrates from being broad-based to being narrow-based, or
vice versa, during the life of a Title VII instrument, the
characterization of that Title VII instrument will not change from its
initial characterization regardless of whether the Title VII instrument
was entered into bilaterally or was executed through a trade on or
subject to the rules of a DCM, SEF, FBOT, security-based SEF, or NSE.
For example, if two counterparties enter into a swap based on a broad-
based security index, and three months into the life of the swap the
security index underlying that Title VII instrument migrates from being
broad-based to being narrow-based, the Title VII instrument will remain
a swap for the duration of its life and will not be recharacterized as
a security-based swap.
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\893\ See supra note 625 and accompanying text.
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If the material terms of a Title VII instrument are amended or
modified during its life based on an exercise of discretion and not
through predetermined criteria or a predetermined self-executing
formula, the Commissions view the amended or modified Title VII
instrument as a new Title VII instrument.\894\ As a result, the
characteristics of the underlying security index must be reassessed at
the time of such an amendment or modification to determine whether the
security index has migrated from broad-based to narrow-based, or vice
versa. If the security index has migrated, then the characterization of
the amended or
[[Page 48287]]
modified Title VII instrument will be determined by evaluating the
underlying security index at the time the Title VII instrument is
amended or modified. Similarly, if a security index has migrated from
broad-based to narrow-based, or vice versa, any new Title VII
instrument based on that security index will be characterized pursuant
to an evaluation of the underlying security index at the execution of
that new Title VII instrument.
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\894\ For example, if, on its effective date, a Title VII
instrument tracks the performance of an index of 12 securities but
is amended during its term to track the performance of only 8 of
those 12 securities, the Commissions would view the amended or
modified Title VII instrument as a new Title VII instrument. Because
it is a new Title VII instrument, any regulatory requirements
regarding new Title VII instruments apply. Conversely, if, on its
effective date, a Title VII instrument tracks the performance of an
index of 12 securities but is amended during its term to reflect the
replacement of a departing ``key person'' of a hedge fund that is a
counterparty to the Title VII instrument with a new ``key person,''
the Commissions would not view the amended or modified Title VII
instrument as a new Title VII instrument because the amendment or
modification is not to a material term of the Title VII instrument.
---------------------------------------------------------------------------
The Commissions provided an interpretation in the Proposing Release
regarding circumstances in which the character of a security index on
which a Title VII instrument is based changes according to
predetermined criteria or a predetermined self-executing formula set
forth in the Title VII instrument (or in a related or other agreement
entered into by the counterparties or a third-party index provider to
the Title VII instrument) at execution. The Commissions are restating
this interpretation with one clarification in response to a
commenter.\895\
---------------------------------------------------------------------------
\895\ See infra note 898 and accompanying text.
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Where at the time of execution such criteria or such formula would
cause the underlying broad-based security index to become or assume the
characteristics of a narrow-based security index or vice versa during
the duration of the instrument,\896\ then the Title VII instrument
based on such security index is a mixed swap during the entire life of
the Title VII instrument.\897\ Although at certain points during the
life of the Title VII instrument, the underlying security index would
be broad-based and at other points the underlying security index would
be narrow-based, regulating such a Title VII instrument as a mixed swap
from the execution of the Title VII instrument and throughout its life
reflects the appropriate characterization of a Title VII instrument
based on a security index that migrates pursuant to predetermined
criteria or a predetermined self-executing formula.
---------------------------------------------------------------------------
\896\ Thus, for example, if a predetermined self-executing
formula agreed to by the counterparties of a Title VII instrument at
or prior to the execution of the Title VII instrument provided that
the security index underlying the Title VII instrument would
decrease from 20 to 5 securities after six months, such that the
security index would become narrow-based as a result of the reduced
number of securities, then the Title VII instrument is a mixed swap
at its execution. The characterization of the Title VII instrument
as a mixed swap will not change during the life of the Title VII
instrument.
\897\ As discussed in section III.G.4., supra, to the extent a
Title VII instrument permits ``at-will'' substitution of an
underlying security index, however, as opposed to the use of
predetermined criteria or a predetermined self-executing formula,
the Title VII instrument is a security-based swap at its execution
and throughout its life regardless of whether the underlying
security index was narrow-based at the execution of the Title VII
instrument.
---------------------------------------------------------------------------
The Commissions are clarifying what is meant by whether the pre-
determined criteria or pre-determined self-executing formula ``would
cause'' the underlying broad-based security index to become or assume
the characteristics of a narrow-based security index, or vice versa, as
noted above in the interpretation. The Commissions believe that, unless
the criteria or formula were intentionally designed to change the index
from narrow to broad, or vice versa, Title VII instruments based on
indexes that may, but will not necessarily, change from broad to narrow
(or vice versa) under such criteria or formula should be considered
swaps or security-based swaps, as appropriate, at execution and for the
term thereof, and not mixed swaps. In such circumstances, it is not the
case that the criteria or formula ``would cause'' the change within the
meaning of the Commission's interpretation.
The Commissions believe that this interpretation regarding the use
of predetermined criteria or a predetermined self-executing formula
will prevent potential gaming of the Commissions' interpretation
regarding security indexes, and prevent potential regulatory arbitrage
based on the migration of a security index from broad-based to narrow-
based, or vice versa. In particular, predetermined criteria and
predetermined self-executing formulas can be constructed in ways that
take into account the characteristics of a narrow-based security index
and prevent a narrow-based security index from becoming broad-based,
and vice versa.
Comments
The Commissions received two comments on the proposed
interpretation in this section regarding the classification of Title
VII Instruments based on security indexes that change from narrow-based
to broad-based, or vice versa, under predetermined criteria or a
predetermined self-executing formula, as mixed swaps. One commenter
requested that the Commissions clarify that a Title VII instrument
based on a security index that may, but will not necessarily, change
from narrow-based to broad-based, or vice versa, under predetermined
criteria or a predetermined self-executing formula should be
characterized at execution as a swap or security-based swap, as
applicable, and not as a mixed swap.\898\ This commenter believed that
the Commissions' interpretation should capture as mixed swaps only
those Title VII instruments on indexes that will change with certainty,
and not those that might change given specific market
circumstances.\899\ Moreover, this commenter believed that the
Commissions' statement that a Title VII instrument on a security index
governed by a pre-determined self-executing formula that ``would
cause'' a change from broad to narrow, or narrow to broad, means that
the change in character must be a certainty for the instrument to be
classified as a mixed swap.\900\ The Commissions have clarified their
interpretation in response to this commenter's concerns as discussed
above.
---------------------------------------------------------------------------
\898\ See SIFMA Letter.
\899\ Id.
\900\ Id.
---------------------------------------------------------------------------
Another commenter disagreed with the Commissions' proposed
interpretation that transactions on indexes under predetermined
criteria or a predetermined self-executing formula that would change
from broad to narrow, or narrow to broad, should be classified as mixed
swaps at inception.\901\ This commenter does not believe that
regulatory arbitrage is such a significant concern in this context that
would justify the challenges to market participants if these
transactions were treated as mixed swaps subject to the dual regulatory
authority of the Commissions.\902\
---------------------------------------------------------------------------
\901\ See ISDA Letter.
\902\ Id.
---------------------------------------------------------------------------
The Commissions believe that regulatory arbitrage is a sufficient
concern to justify mixed swap status and dual regulatory oversight for
Title VII instruments where the index would change from broad to
narrow, or narrow to broad, under the pre-determined criteria or
predetermined self-executing formula. Counterparties that are concerned
about regulatory burdens associated with mixed swap status can redesign
their formula to avoid the result, or enter into another swap or
security-based swap that is structured to achieve the same economic
result without mixed swap status.
(b) Title VII Instruments on Security Indexes Traded on Designated
Contract Markets, Swap Execution Facilities, Foreign Boards of Trade,
Security-Based Swap Execution Facilities, and National Securities
Exchanges
As was recognized in the Proposing Release, security indexes
underlying Title VII instruments that are traded on DCMs, SEFs, FBOTs,
security-based SEFs, or NSEs raise particular issues if an underlying
security index migrates
[[Page 48288]]
from broad-based to narrow-based, or vice versa.\903\ The Commissions
are adopting as proposed their interpretation clarifying that the
characterization of an exchange-traded Title VII instrument based on a
security index at its execution will not change through the life of the
Title VII instrument, regardless of whether the underlying security
index migrates from broad-based to narrow-based, or vice versa.
Accordingly, a market participant who enters into a swap on a broad-
based security index traded on or subject to the rules of a DCM, SEF or
FBOT that migrates from broad-based to narrow-based may hold that
position until the swap's expiration without any change in regulatory
responsibilities, requirements, or obligations; similarly, a market
participant who enters into a security-based swap on a narrow-based
security index traded on a security-based SEF or NSE that migrates from
narrow-based to broad-based may hold that position until the security-
based swap's expiration without any change in regulatory
responsibilities, requirements, or obligations.
---------------------------------------------------------------------------
\903\ See Proposing Release at 29856.
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In addition, the Commissions are adopting, as proposed, final rules
providing for tolerance and grace periods for Title VII instruments on
security indexes that are traded on DCMs, SEFs, FBOTs, security-based
SEFs and NSEs.\904\ As was noted in the Proposing Release,\905\ in the
absence of any action by the Commissions, if a market participant wants
to offset a swap or enter into a new swap on a DCM, SEF or FBOT where
the underlying security index has migrated from broad-based to narrow-
based, or to offset a security-based swap or enter into a new security-
based swap on a security-based SEF or NSE where the underlying security
index has migrated from narrow-based to broad-based, the participant
would be prohibited from doing so. That is because swaps may trade only
on DCMs, SEFs, and FBOTs, and security-based swaps may trade only on
registered NSEs and security-based SEFs.\906\ The rules being adopted
by the Commissions address how to treat Title VII instruments traded on
trading platforms where the underlying security index migrates from
broad-based to narrow-based or narrow-based to broad-based, so that
market participants will know where such Title VII instruments may be
traded and can avoid potential disruption of their ability to offset or
enter into new Title VII instruments on trading platforms when such
migration occurs.\907\
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\904\ See paragraphs (2), (3) and (4) of rule 1.3(yyy) under the
CEA and paragraphs (b), (c) and (d) of rule 3a68-3 under the
Exchange Act.
\905\ See Proposing Release at 29857.
\906\ If a swap were based on a security index that migrated
from broad-based to narrow-based, a DCM, SEF, or FBOT could no
longer offer the Title VII instrument because it is now a security-
based swap. Similarly, if a security-based swap were based on a
security index that migrated from narrow-based to broad-based, a
security-based SEF or NSE could no longer offer the Title VII
instrument because it is now a swap.
\907\ The rules apply only to the particular Title VII
instrument that is traded on or subject to the rules of a DCM, SEF,
FBOT, security-based SEF, or NSE. As the Commissions noted in the
Proposing Release, to the extent that a particular Title VII
instrument is not traded on such a trading platform (even if another
Title VII instrument of the same class or type is traded on such a
trading platform), the rules do not apply to that particular Title
VII instrument. See Proposing Release at 29857 n. 259.
---------------------------------------------------------------------------
As was noted in the Proposing Release,\908\ Congress and the
Commissions addressed a similar issue in the context of security
futures, where the security index on which a future is based may
migrate from broad-based to narrow-based or vice versa. Congress
provided in the definition of the term ``narrow-based security index''
in both the CEA and the Exchange Act \909\ for a tolerance period
ensuring that, under certain conditions, a futures contract on a broad-
based security index traded on a DCM may continue to trade, even when
the index temporarily assumes characteristics that would render it a
narrow-based security index under the statutory definition.\910\ In
general, an index is subject to this tolerance period, and therefore is
not a narrow-based security index, if: (i) A futures contract on the
index traded on a DCM for at least 30 days as a futures contract on a
broad-based security index before the index assumed the characteristics
of a narrow-based security index; and (ii) the index does not retain
the characteristics of a narrow-based security index for more than 45
business days over 3 consecutive calendar months. Pursuant to these
statutory provisions, if the index becomes narrow-based for more than
45 business days over 3 consecutive calendar months, the index is
excluded from the definition of the term ``narrow-based security
index'' for the following 3 calendar months as a grace period.
---------------------------------------------------------------------------
\908\ See Proposing Release at 29857.
\909\ CEA section 1a(35)(B)(iii), 7 U.S.C. 1a(35)(B)(iii);
section 3(a)(55)(C)(iii) of the Exchange Act, 15 U.S.C.
78c(a)(55)(C)(iii).
\910\ By joint rules, the Commissions have provided that
``[w]hen a contract of sale for future delivery on a security index
is traded on or subject to the rules of a foreign board of trade,
such index shall not be a narrow-based security index if it would
not be a narrow-based security index if a futures contract on such
index were traded on a designated contract market * * * .'' See rule
41.13 under the CEA, 17 CFR 41.13, and rule 3a55-3 under the
Exchange Act, 17 CFR 240.3a55-3. Accordingly, the statutory
tolerance period applicable to futures on security indexes traded on
DCMs applies to futures traded on FBOTs as well.
---------------------------------------------------------------------------
The Commissions believe that a similar tolerance period should
apply to swaps traded on DCMs, SEFs, and FBOTs and security-based swaps
traded on security-based SEFs and NSEs. Accordingly, the Commissions
are adopting the rules, as proposed, providing for tolerance periods
for swaps that are traded on DCMs, SEFs, or FBOTs \911\ and for
security-based swaps traded on security-based SEFs and NSEs.\912\
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\911\ See paragraph (2) of rule 1.3(yyy) under the CEA and
paragraph (b) of rule 3a68-3 under the Exchange Act.
\912\ See paragraph (3) of rule 1.3(yyy) under the CEA and
paragraph (c) of rule 3a68-3 under the Exchange Act.
---------------------------------------------------------------------------
The final rules provide that to be subject to the tolerance period,
a security index underlying a swap executed on or subject to the rules
of a DCM, SEF, or FBOT must not have been a narrow-based security index
\913\ during the first 30 days of trading.\914\ If the index becomes
narrow-based during the first 30 days of trading, the index must not
have been a narrow-based security index during every trading day of the
6 full calendar months preceding a date no earlier than 30 days prior
to the commencement of trading of a swap on such index.\915\ If either
of these alternatives is met, the index will not be a narrow-based
security index if it has been a narrow-based security index for no more
than 45 business days over 3 consecutive calendar months.\916\ These
provisions apply solely for purposes of swaps traded on or subject to
the rules of a DCM, SEF, or FBOT.
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\913\ For purposes of these rules, the term ``narrow-based
security index'' shall also mean ``issuers of securities in a
narrow-based security index.'' See supra part III.G.3(b),
(discussing the rules defining ``issuers of securities in a narrow-
based security index'').
\914\ This provision is consistent with the provisions of the
CEA and the Exchange Act applicable to futures contracts on security
indexes. CEA section 1a(35)(B)(iii)(I), 7 U.S.C. 1a(35)(B)(iii)(I);
section 3(a)(55)(C)(iii)(I) of the Exchange Act, 15 U.S.C.
78c(a)(55)(C)(iii)(I).
\915\ This alternative test is the same as the alternative test
applicable to futures contracts in CEA rule 41.12, 17 CFR 41.12, and
rule 3a55-2 under the Exchange Act, 17 CFR 240.3a55-2.
\916\ These provisions are consistent with the parallel
provisions in the CEA and Exchange Act applicable to futures
contracts on security indexes traded on DCMs. See CEA section
1a(35)(B)(iii)(II), 7 U.S.C. 1a(35)(B)(iii)(II), and section
3(a)(55)(C)(iii)(II) of the Exchange Act, 15 U.S.C.
78c(a)(55)(C)(iii)(II).
---------------------------------------------------------------------------
Similarly, the rules provide a tolerance period for security-based
swaps traded on security-based SEFs or NSEs. To be subject to the
tolerance period, a security index underlying a security-based swap
executed on a security-based SEF or NSE must have
[[Page 48289]]
been a narrow-based security index during the first 30 days of trading.
If the index becomes broad-based during the first 30 days of trading,
paragraph (3)(i)(B) of rule 1.3(yyy) under the CEA and paragraph
(c)(1)(ii) of rule 3a68-3 under the Exchange Act provide that the index
must have been a non-narrow-based (i.e., a broad-based) security index
during every trading day of the 6 full calendar months preceding a date
no earlier than 30 days prior to the commencement of trading of a
security-based swap on such index. If either of these alternatives is
met, the index will be a narrow-based security index if it has been a
security index that is not narrow-based for no more than 45 business
days over 3 consecutive calendar months.\917\ These provisions apply
solely for purposes of security-based swaps traded on security-based
SEFs or NSEs.
---------------------------------------------------------------------------
\917\ These provisions are consistent with the parallel
provisions in the CEA and the Exchange Act applicable to futures
contracts on security indexes traded on DCMs. See CEA section
1a(35)(B)(iii), 7 U.S.C. 1a(35)(B)(iii); section 3(a)(55)(C)(iii) of
the Exchange Act, 15 U.S.C. 78c(a)(55)(C)(iii).
---------------------------------------------------------------------------
In addition, the Commissions are adopting rules as proposed that,
once the tolerance period under the rules has ended, there will be a
grace period during which a Title VII instrument based on a security
index that has migrated from broad-based to narrow-based, or vice
versa, will be able to trade on the platform on which Title VII
instruments based on such security index were trading before the
security index migrated and can also, during such period, be
cleared.\918\ The final rules provide for an additional three-month
grace period applicable to a security index that becomes narrow-based
for more than 45 business days over three consecutive calendar months,
solely with respect to swaps that are traded on or subject to the rules
of DCMs, SEFs, or FBOTs. During the grace period, such an index will
not be considered a narrow-based security index. The rules apply the
same grace period to a security-based swap on a security index that
becomes broad-based for more than 45 business days over 3 consecutive
calendar months, solely with respect to security-based swaps that are
traded on a security-based SEF or NSE. During the grace period, such an
index will not be considered a broad-based security index.\919\ As a
result, this rule provides sufficient time for a Title VII instrument
based on a migrated security index to satisfy listing and clearing
requirements applicable to swaps or security-based swaps, as
appropriate.
---------------------------------------------------------------------------
\918\ See paragraph (4) of rule 1.3(yyy) under the CEA and
paragraph (d) of rule 3a68-3 under the Exchange Act.
\919\ These provisions are consistent with the parallel
provisions in the CEA and the Exchange Act applicable to futures
contracts on security indexes traded on DCMs. See CEA section
1a(35)(D), 7 U.S.C. 1a(35)(D); section 3(a)(55)(E) of the Exchange
Act, 15 U.S.C. 78c(a)(55)(E).
---------------------------------------------------------------------------
As was noted in the Proposing Release,\920\ there will be no
overlap between the tolerance and the grace periods under the rules and
no ``re-triggering'' of the tolerance period. For example, if a
security index becomes narrow-based for more than 45 business days over
3 consecutive calendar months, solely with respect to swaps that are
traded on or subject to the rules of DCMs, SEFs, or FBOTs, but as a
result of the rules is not considered a narrow-based security index
during the grace period, the tolerance period provisions will not
apply, even if the security-index migrated temporarily during the grace
period. After the grace period has ended, a security index will need to
satisfy anew the requirements under the rules regarding the tolerance
period in order to trigger a new tolerance period.
---------------------------------------------------------------------------
\920\ See Proposing Release at 29858.
---------------------------------------------------------------------------
The rules will not result in the re-characterization of any
outstanding Title VII instruments. In addition, the tolerance and grace
periods as adopted will apply only to Title VII instruments that are
traded on or subject to the rules of DCMs, SEFs, FBOTs, security-based
SEFs, and NSEs.
Comments
The Commissions received one comment on the proposed rules
described in this section.\921\ This commenter stated its view that
extending the ``grace period'' from three months to six months would
ease any disruption or dislocation associated with the delisting
process with respect to an index that has migrated from broad to
narrow, or narrow to broad, and that has failed the tolerance
period.\922\ This commenter also stated its view that where an index
CDS migrates, for entities operating both a SEF and a security-based
SEF, such entities should be permitted to move the index from one
platform to the other simply by providing a notice to the SEC and
CFTC.\923\
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\921\ See MarketAxess Letter.
\922\ Id.
\923\ Id.
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As discussed above, the Commissions are adopting the proposed rules
without modification. The Commissions note that the three-month grace
period applicable to security futures was mandated by Congress in that
context,\924\ and the commenter has provided no data or evidence for
its request that the Commissions diverge from that grace period and
provide for a longer grace period with respect to swaps and security-
based swaps. The Commissions believe that the three-month grace period
is similarly appropriate to apply in the context of a Title VII
instrument based on an index that has migrated to provide sufficient
time to execute off-setting positions. With respect to the commenter's
other suggestion that entities operating both a SEF and a security-
based SEF should be able to move the index from one platform to another
where an index CDS migrates simply by filing a notice with the SEC and
CFTC, the Commissions do not believe that this proposal is within the
scope of this rulemaking.
---------------------------------------------------------------------------
\924\ See July 2006 Debt Index Rules. The Commissions are not
aware of any disruptions caused by the three-month grace period in
the context of security futures.
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H. Method of Settlement of Index CDS
The method that the parties have chosen or use to settle an index
CDS following the occurrence of a credit event under such index CDS
also can affect whether such index CDS would be a swap, a security-
based swap, or both (i.e., a mixed swap). The Commissions provided an
interpretation in the Proposing Release regarding the method of
settlement of index CDS and are restating the interpretation without
modification. The Commissions find that this interpretation is an
appropriate way to address index CDS with different settlement methods
and is designed to reduce the cost associated with determining whether
such an index CDS is a swap or a security-based swap.\925\
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\925\ See supra part I, under ``Overall Economic
Considerations''.
---------------------------------------------------------------------------
If an index CDS that is not based on a narrow-based security index
under the Commissions' rules includes a mandatory physical settlement
provision that would require the delivery of, and therefore the
purchase and sale of, a non-exempted security \926\
[[Page 48290]]
or a loan in the event of a credit event, such an index CDS is a mixed
swap.\927\ Conversely, if an index CDS that is not based on a narrow-
based security index under the Commissions' rules includes a mandatory
cash settlement \928\ provision, such index CDS is a swap, and not a
security-based swap or a mixed swap, even if the cash settlement were
based on the value of a non-exempted security or a loan.
---------------------------------------------------------------------------
\926\ The Commissions note that section 3(a)(68)(C) of the
Exchange Act, 15 U.S.C. 78c(a)(68)(C), provides that ``[t]he term
``security-based swap'' does not include any agreement, contract, or
transaction that meets the definition of a security-based swap only
because such agreement, contract, or transaction references, is
based upon, or settles through the transfer, delivery, or receipt of
an exempted security under paragraph (12) [of the Exchange Act], as
in effect on the date of enactment of the Futures Trading Act of
1982 (other than any municipal security as defined in paragraph (29)
[of the Exchange Act] as in effect on the date of enactment of the
Futures Trading Act of 1982), unless such agreement, contract, or
transaction is of the character of, or is commonly known in the
trade as, a put, call, or other option.''
\927\ The SEC also notes that there must either be an effective
registration statement covering the transaction or an exemption
under the Securities Act would need to be available for such
physical delivery of securities and compliance issues under the
Exchange Act would also need to be considered.
\928\ The Commissions are aware that the 2003 Definitions
include ``Cash Settlement'' as a defined term and that such
``Settlement Method'' (also a defined term in the 2003 Definitions)
works differently than auction settlement pursuant to the ``Big Bang
Protocol'' or ``Auction Supplement'' (each as defined below). The
Commissions' use of the term ``cash settlement'' in this section
includes ``Cash Settlement,'' as defined in the 2003 Definitions,
and auction settlement, as described in the ``Big Bang Protocol'' or
``Auction Supplement.'' See infra note 929 and accompanying text.
---------------------------------------------------------------------------
An index CDS that is not based on a narrow-based security index
under the Commissions' rules and that provides for cash settlement in
accordance with the 2009 ISDA Credit Derivatives Determinations
Committees and Auction Settlement Supplement to the 2003 Definitions
(the ``Auction Supplement'') or with the 2009 ISDA Credit Derivatives
Determinations Committees and Auction Settlement CDS Protocol (``Big
Bang Protocol'') \929\ is a swap, and will not be considered a
security-based swap or a mixed swap solely because the determination of
the cash price to be paid is established through a securities or loan
auction.\930\ In 2009, auction settlement, rather than physical
settlement, became the default method of settlement for, among other
types of CDS, index CDS on corporate issuers of securities.\931\ The
amount of the cash settlement is determined through an auction
triggered by the occurrence of a credit event.\932\ The Auction
Supplement ``hard wired'' the mechanics of credit event auctions into
the 2003 Definitions.\933\ The Commissions understand that the credit
event auction process that is part of the ISDA terms works as follows.
---------------------------------------------------------------------------
\929\ See ISDA, ``2009 ISDA Credit Derivatives Determinations
Committees and Auction Settlement CDS Protocol,'' available at
http://www.isda.org/bigbangprot/docs/Big-Bang-Protocol.pdf.
\930\ The possibility that such index CDS may, in fact, be
physically settled if an auction is not held or if the auction fails
would not affect the characterization of the index CDS.
\931\ The Commissions understand that the Big Bang Protocol is
followed for index CDS involving corporate debt obligations but is
not followed for index CDS based on asset-backed securities, loan-
only CDS, and certain other types of CDS contracts. To the extent
that such other index CDS contain auction procedures similar to the
auction procedures for corporate debt to establish the cash price to
be paid, the Commissions also would not consider such other index
CDS that are not based on narrow-based security indexes under the
Commissions' rules to be mixed swaps.
\932\ The Commissions understand that other conditions may need
to be satisfied as well for an auction to be held.
\933\ See supra note 48.
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Following the occurrence of a credit event under a CDS, a
determinations committee (``DC'') established by ISDA, following a
request by any party to a credit derivatives transaction that is
subject to the Big Bang Protocol or Auction Supplement, will determine,
among other matters: (i) Whether and when a credit event occurred; (ii)
whether or not to hold an auction to enable market participants to
settle those of their credit derivatives transactions covered by the
auction; (iii) the list of deliverable obligations of the relevant
reference entity; and (iv) the necessary auction specific terms. The
credit event auction takes place in two parts. In the first part of the
auction, dealers submit physical settlement requests, which are
requests to buy or sell any of the deliverable obligations (based on
the dealer's needs and those of its counterparties), and an initial
market midpoint price is created based on dealers' initial bids and
offers. Following the establishment of the initial market midpoint, the
physical settlement requests are then calculated to determine the
amount of open interest.
The aggregate amount of open interest is the basis for the second
part of the auction. In the second part of the auction, dealers and
investors can determine whether to submit limit orders and the levels
of such limit orders. The limit orders, which are irrevocable, have a
firm price in addition to size and whether it is a buy or sell order.
The auction is conducted as a ``dutch'' auction, in which the open buy
interests and open sell interests are matched.\934\ The final price of
the auction is the last limit order used to match against the open
interest. The final price in the auction is the cash price used for
purposes of calculating the settlement payments in respect of the
orders to buy and sell the deliverable obligations and it is also used
to determine the cash settlement payment under the CDS.
---------------------------------------------------------------------------
\934\ The second part of the credit event auction process
involves offers and sales of securities that must be made in
compliance with the provisions of the Securities Act and the
Exchange Act. First, the submission of a physical settlement request
constitutes an offer by the counterparty to either buy or sell any
one of the deliverable obligations in the auction. Second, the
submission of the irrevocable limit orders by dealers or investors
are sales or purchases by such persons at the time of submission of
the irrevocable limit order. Through the auction mechanism, where
the open interest (which represents physical settlement requests) is
matched with limit orders, buyers and sellers are matched. Finally,
following the auction and determination of the final price, the
counterparty who has submitted the physical delivery request decides
which of the deliverable obligations will be delivered to satisfy
the limit order in exchange for the final price. The sale of the
securities in the auction occurs at the time the limit order is
submitted, even though the identification of the specific
deliverable obligation does not occur until the auction is
completed.
---------------------------------------------------------------------------
Comments
One commenter believed that a mandatory physical settlement
provision in an index CDS based on a broad-based security index should
not transform a swap into a mixed swap because (i) the SEC would retain
jurisdiction over a transfer of securities as part of such settlement
and (ii) application of the interpretation would be difficult since
many instruments contemplate physical settlement but have a cash
settlement option, or vice versa.\935\
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\935\ See ISDA Letter.
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As discussed above, the Commissions are restating the
interpretation regarding mandatory physical settlement as provided in
the Proposing Release. The Commissions' interpretation assures that the
Federal securities laws apply to the offer and sale of the underlying
securities at the time the index CDS is sold.\936\ The Commissions note
the commenter's concerns but believe that as a result of the
Commissions' understanding of the auction settlement process for index
CDS, which is the primary method by which index CDS are settled and
which addresses circumstances in which securities may be tendered in
the auction process separate from the CDS settlement payment, it is not
clear that there is in fact any significant number of circumstances in
which such index CDS may be optionally physically settled. The
Commissions note that this commenter did not elaborate on the
[[Page 48291]]
circumstances in which the auction process would not apply.
---------------------------------------------------------------------------
\936\ With respect to the applicability of the Federal
securities laws, the Commissions are concerned about the use of
index CDS to effect distributions of securities without compliance
with the requirements of the Securities Act. The Commissions
recognize that with respect to transactions in security-based swaps
by an issuer of an underlying security, an affiliate of the issuer,
or an underwriter the offer and sale of the underlying security (in
this case the security to be delivered) occur at the time that the
security-based swap is offered and sold, not at the time of
settlement. Further, the Commissions note the restrictions on offers
and sales of security-based swaps to non-ECPs without compliance
with the registration requirements of the Securities Act. See
section 5(e) of the Securities Act, 15 U.S.C. 77e(d).
---------------------------------------------------------------------------
I. Security-Based Swaps as Securities Under the Exchange Act and
Securities Act
Pursuant to the Dodd-Frank Act, a security-based swap is defined as
a ``security'' under the Exchange Act\937\ and Securities Act.\938\ As
a result, security-based swaps are subject to the Exchange Act and the
Securities Act and the rules and regulations promulgated
thereunder.\939\
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\937\ See section 761(a)(2) of the Dodd-Frank Act (inserting the
term ``security-based swap'' into the definition of ``security'' in
section 3a(10) of the Exchange Act, 15 U.S.C. 78c(a)(10)).
\938\ See section 768(a)(1) of the Dodd-Frank Act (inserting the
term ``security-based swap'' into the definition of ``security'' in
section 2(a)(1) of the Securities Act, 15 U.S.C. 77b(a)(1)).
\939\ Sections 761(a)(3) and (4) of the Dodd-Frank Act amend
sections 3(a)(13) and (14) of the Exchange Act, 15 U.S.C. 78c(a)(13)
and (14), and section 768(a)(3) of the Dodd-Frank Act adds section
2(a)(18) to the Securities Act, 15 U.S.C. 77b(a)(18), to provide
that the terms ``purchase'' and ``sale'' of a security-based swap
shall mean the ``the execution, termination (prior to its scheduled
maturity date), assignment, exchange, or similar transfer or
conveyance of, or extinguishing of rights or obligations under, a
security-based swap, as the context may require.''
---------------------------------------------------------------------------
The SEC did not provide interpretations in the Proposing Release on
the application of the Exchange Act and the Securities Act, and the
rules and regulations thereunder, to security-based swaps. However, the
SEC solicited comment on whether additional interpretations may be
necessary regarding the application of certain provisions of the
Exchange Act and the Securities Act, and the rules and regulations
promulgated thereunder, to security-based swaps. The SEC did not
receive any comments with respect to this issue in the context of this
rulemaking and is not providing any interpretations in this release.
IV. Mixed Swaps
A. Scope of the Category of Mixed Swap
The category of mixed swap is described, in both the definition of
the term ``security-based swap'' in the Exchange Act and the definition
of the term ``swap'' in the CEA, as a security-based swap that is also
based on the value of 1 or more interest or other rates, currencies,
commodities, instruments of indebtedness, indices, quantitative
measures, other financial or economic interest or property of any kind
(other than a single security or a narrow-based security index), or the
occurrence, non-occurrence, or the extent of the occurrence of an event
or contingency associated with a potential financial, economic, or
commercial consequence (other than an event described in subparagraph
(A)(ii)(III) [of section 3(a)(68) of the Exchange Act]).\940\
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\940\ Section 3(a)(68)(D) of the Exchange Act, 15 U.S.C.
78c(a)(68)(D); section 1a(47)(D) of the CEA, 7 U.S.C. 1a(47)(D).
---------------------------------------------------------------------------
A mixed swap, therefore, is both a security-based swap and a
swap.\941\ As stated in the Proposing Release, the Commissions believe
that the scope of mixed swaps is, and is intended to be, narrow.\942\
Title VII establishes robust and largely parallel regulatory regimes
for both swaps and security-based swaps and directs the Commissions to
jointly prescribe such regulations regarding mixed swaps as may be
necessary to carry out the purposes of the Dodd-Frank Act.\943\ More
generally, the Commissions believe the category of mixed swap was
designed so that there would be no gaps in the regulation of swaps and
security-based swaps. Therefore, in light of the statutory scheme
created by the Dodd-Frank Act for swaps and security-based swaps, the
Commissions believe the category of mixed swap covers only a small
subset of Title VII instruments.
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\941\ Id. The exclusion from the definition of the term ``swap''
for security-based swaps does not include security-based swaps that
are mixed swaps. See section 1a(47)(B)(x) of the CEA, 7 U.S.C.
1a(47)(B)(x).
\942\ See Proposing Release at 29860.
\943\ See section 712(a)(8) of the Dodd-Frank Act.
---------------------------------------------------------------------------
For example, a Title VII instrument in which the underlying
references are the value of an oil corporation stock and the price of
oil would be a mixed swap. Similarly, a Title VII instrument in which
the underlying reference is a portfolio of both securities (assuming
the portfolio is not an index or, if it is an index, that the index is
narrow-based) and commodities would be a mixed swap. Mixed swaps also
would include certain Title VII instruments called ``best of'' or ``out
performance'' swaps that require a payment based on the higher of the
performance of a security and a commodity (other than a security). As
discussed elsewhere in this release, the Commissions also believe that
certain Title VII instruments may be mixed swaps if they meet specified
conditions.
The Commissions also believe that the use of certain market
standard agreements in the documentation of Title VII instruments
should not in and of itself transform a Title VII instrument into a
mixed swap. For example, many instruments are documented by
incorporating by reference market standard agreements. Such agreements
typically set out the basis of establishing a trading relationship with
another party but are not, taken separately, a swap or security-based
swap. These agreements also include termination and default events
relating to one or both of the counterparties; such counterparties may
or may not be entities that issue securities.\944\ The Commissions
believe that the term ``any agreement * * * based on * * * the
occurrence of an event relating to a single issuer of a security,'' as
provided in the definition of the term ``security-based swap,'' was not
intended to include such termination and default events relating to
counterparties included in standard agreements that are incorporated by
reference into a Title VII instrument.\945\ Therefore, an instrument
would not be simultaneously a swap and a security-based swap (and thus
not a mixed swap) simply by virtue of having incorporated by reference
a standard agreement, including default and termination events relating
to counterparties to the Title VII instrument.
---------------------------------------------------------------------------
\944\ Those standard events include inter alia bankruptcy,
breach of agreement, cross default to other indebtedness, and
misrepresentations.
\945\ See section 3(a)(68)(A)(ii)(III) of the Exchange Act, 15
U.S.C. 78c(a)(68)(A)(ii)(III).
---------------------------------------------------------------------------
Comments
While the Commissions did not receive any comments on the
interpretation regarding the scope of the category of mixed swaps, one
commenter recommended that the Commissions require that market
participants disaggregate mixed swaps and enter into separate
simultaneous transactions so that they cannot employ mixed swaps to
obscure the underlying substance of transactions.\946\ The Commissions
are not adopting any rules or interpretations to require disaggregation
of mixed swaps into their separate components, as the Dodd-Frank Act
specifically contemplated that there would be mixed swaps comprised of
both swaps and security-based swaps.
---------------------------------------------------------------------------
\946\ See Better Markets Letter.
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B. Regulation of Mixed Swaps
1. Introduction
The Commissions are adopting as proposed paragraph (a) of rule 1.9
under the CEA and rule 3a68-4 under the Exchange Act to define a
``mixed swap'' in the same manner as the term is defined in both the
CEA and the Exchange Act. The Commissions also are adopting as proposed
two rules to address the regulation of mixed swaps. First, paragraph
(b) of rule 1.9 under the CEA and rule 3a68-4 under the Exchange Act
will provide a regulatory framework with which parties to bilateral
uncleared mixed swaps (i.e.,
[[Page 48292]]
mixed swaps that are neither executed on or subject to the rules of a
DCM, NSE, SEF, security-based SEF, or FBOT nor cleared through a DCO or
clearing agency), as to which at least one of the parties is dually
registered with both Commissions, will need to comply. Second,
paragraph (c) of rule 1.9 under the CEA and rule 3a68-4 under the
Exchange Act establishes a process for persons to request that the
Commissions issue a joint order permitting such persons (and any other
person or persons that subsequently lists, trades, or clears that class
of mixed swap)\947\ to comply, as to parallel provisions\948\ only,
with specified parallel provisions of either the CEA or the Exchange
Act, and related rules and regulations (collectively ``specified
parallel provisions''), instead of being required to comply with
parallel provisions of both the CEA and the Exchange Act.
---------------------------------------------------------------------------
\947\ All references to Title VII instruments in parts IV and VI
shall include a class of such Title VII instruments as well. For
example, a ``class'' of Title VII instrument would include
instruments that are of similar character and provide substantially
similar rights and privileges.
\948\ As stated in paragraph (c) of proposed rule 1.9 under the
CEA and rule 3a68-4 under the Exchange Act, ``parallel provisions''
means comparable provisions of the CEA and the Exchange Act that
were added or amended by Title VII with respect to security-based
swaps and swaps, and the rules and regulations thereunder.
---------------------------------------------------------------------------
2. Bilateral Uncleared Mixed Swaps Entered Into by Dually-Registered
Dealers or Major Participants
Swap dealers and major swap participants will be comprehensively
regulated by the CFTC, and security-based swap dealers and major
security-based swap participants will be comprehensively regulated by
the SEC.\949\ The Commissions recognize that there may be differences
in the requirements applicable to swap dealers and security-based swap
dealers, or major swap participants and major security-based swap
participants, such that dually-registered market participants may be
subject to potentially conflicting or duplicative regulatory
requirements when they engage in mixed swap transactions. In order to
assist market participants in addressing such potentially conflicting
or duplicative requirements, the Commissions are adopting, as proposed
with one modification explained below, rules that will permit dually-
registered swap dealers and security-based swap dealers and dually-
registered major swap participants and major security-based swap
participants to comply with an alternative regulatory regime when they
enter into certain mixed swaps under specified circumstances. The
Commissions received no comments on the proposed rules.
---------------------------------------------------------------------------
\949\ Section 712(a)(7)(A) of the Dodd-Frank Act requires the
Commissions to treat functionally or economically similar entities
in a similar manner.
---------------------------------------------------------------------------
Accordingly, as adopted, paragraph (b) of rule 1.9 under the CEA
and rule 3a68-4 under the Exchange Act provide that a bilateral
uncleared mixed swap,\950\ where at least one party is dually-
registered with the CFTC as a swap dealer or major swap participant and
with the SEC as a security-based swap dealer or major security-based
swap participant, will be subject to all applicable provisions of the
Federal securities laws (and SEC rules and regulations promulgated
thereunder). The rules as adopted also provide that such mixed swaps
will be subject to only the following provisions of the CEA (and CFTC
rules and regulations promulgated thereunder):
---------------------------------------------------------------------------
\950\ Under paragraph (b) of rule 1.9 under the CEA and rule
3a68-4 under the Exchange Act, a ``bilateral uncleared mixed swap''
will be a mixed swap that: (i) Is neither executed on nor subject to
the rules of a DCM, NSE, SEF, security-based SEF, or FBOT; and (ii)
will not be submitted to a DCO or registered or exempt clearing
agency to be cleared. To the extent that a mixed swap is subject to
the mandatory clearing requirement (see section 2(h)(1)(A) of the
CEA, 7 U.S.C. 2(h)(1)(A), and section 3C(a)(1) of the Exchange Act)
(and where a counterparty is not eligible to rely on the end-user
exclusion from the mandatory clearing requirement (see section
2(h)(7) of the CEA, 7 U.S.C. 2(h)(7), and section 3C(g) of the
Exchange Act)), this alternative regulatory treatment will not be
available.
---------------------------------------------------------------------------
Examinations and information sharing: CEA sections 4s(f)
and 8; \951\
---------------------------------------------------------------------------
\951\ 7 U.S.C. 6s(f) and 12, respectively.
---------------------------------------------------------------------------
Enforcement: CEA sections 2(a)(1)(B), 4(b), 4b, 4c,
4s(h)(1)(A), 4s(h)(4)(A), 6(c), 6(d), 6c, 6d, 9, 13(a), 13(b) and 23;
\952\
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\952\ 7 U.S.C. 2(a)(1)(B), 6(b), 6b, 6c, 6s(h)(1)(A),
6s(h)(4)(A), 9 and 15, 13b, 13a-1, 13a-2, 13, 13c(a), 13c(b), and
26, respectively.
---------------------------------------------------------------------------
Reporting to an SDR: CEA section 4r; \953\
---------------------------------------------------------------------------
\953\ 7 U.S.C. 6r.
---------------------------------------------------------------------------
Real-time reporting: CEA section 2(a)(13); \954\
---------------------------------------------------------------------------
\954\ 7 U.S.C. 2(a)(13).
---------------------------------------------------------------------------
Capital: CEA section 4s(e); \955\ and
---------------------------------------------------------------------------
\955\ 7 U.S.C. 6s(e).
---------------------------------------------------------------------------
Position Limits: CEA section 4a.\956\
---------------------------------------------------------------------------
\956\ 7 U.S.C. 6a.
---------------------------------------------------------------------------
The Commissions are modifying proposed rule 1.9(b)(3)(i) under the
CEA and Rule 3a68-4(b)(3)(i) to include additional ``enforcement''
authority. Specifically, as adopted, the rules provide that such swaps
will be subject to the anti-fraud, anti-manipulation, and other
provisions of the business conduct standards in CEA sections
4s(h)(1)(A) and 4s(h)(4)(A) and the rules promulgated thereunder for
mixed swaps.\957\ Rule 23.410 under the CEA,\958\ adopted under CEA
section 4s(h)(1)(A), applies to swap dealers and major swap
participants and prohibits fraud, manipulation, and other abusive
practices and also imposes requirements regarding the confidential
treatment of counterparty information, which will apply to mixed
swaps.\959\
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\957\ 7 U.S.C. 6s(h)(1)(A) and 6s(h)(4)(A).
\958\ 17 CFR 23.410.
\959\ Business Conduct Standards for Swap Dealers and Major Swap
Participants With Counterparties, 77 FR 9734, 9751-9755 (Feb. 17,
2012). The Commissions note that, while the introductory text of
rule 1.9(b)(3)(i)(A) through (F) under the CEA and rule 3a68-
4(b)(3)(i)(A) through (F) under the Exchange Act characterizes the
cited CEA sections (e.g., ``enforcement,'' ``capital,'' etc.), such
characterization is meant as guidance only. For example, final rule
1.9(b)(3)(i)(B) uses the word ``enforcement'' to characterize
certain of the cited CEA sections and the rules and regulations
promulgated thereunder that prohibit fraud, manipulation, or abusive
practices. Other cited provisions, such as the Whistleblower
protections under CEA section 23, or the related rules and
regulations, such as requirements to keep counterparty information
confidential under rule 23.410(c) under the CEA, 17 CFR 23.410(c),
are similarly enforcement provisions in that they protect market
participants from fraudulent or other abusive practices.
---------------------------------------------------------------------------
As discussed in the Proposing Release, the Commissions believe that
paragraph (b) of rule 1.9 under the CEA and rule 3a68-4 under the
Exchange Act will address potentially conflicting or duplicative
regulatory requirements for dually-registered dealers and major
participants that are subject to regulation by both the CFTC and the
SEC, while requiring dual registrants to comply with the regulatory
requirements the Commissions believe are necessary to provide
sufficient regulatory oversight for mixed swap transactions entered
into by such dual registrants. The CFTC also believe that paragraph (b)
of rule 1.9 under the CEA and rule 3a68-4 under the Exchange Act will
provide clarity to dually-registered dealers and major participants,
who are subject to regulation by both the CFTC and the SEC, as to the
requirements of each Commission that will apply to their bilateral
uncleared mixed swaps.
3. Regulatory Treatment for Other Mixed Swaps
Because mixed swaps are both security-based swaps and swaps,\960\
absent a joint rule or order by the Commissions permitting an
alternative regulatory approach, persons who desire or intend to list,
trade, or clear a mixed swap (or class thereof) will be required to
comply with all the statutory provisions in the CEA and the Exchange
Act (including all the rules and regulations thereunder) that were
added or amended by Title VII with respect to swaps or security-based
swaps.\961\ Such
[[Page 48293]]
dual regulation may not be appropriate in every instance and may result
in potentially conflicting or duplicative regulatory requirements.
However, before the Commissions can determine the appropriate
regulatory treatment for mixed swaps (other than the treatment
discussed above), the Commissions will need to understand better the
nature of the mixed swaps that parties want to trade. As a result, the
Commissions proposed paragraph (c) of rule 1.9 under the CEA and rule
3a68-4 under the Exchange Act to establish a process pursuant to which
any person who desires or intends to list, trade, or clear a mixed swap
(or class thereof) that is not subject to the provisions of paragraph
(b) of the rules (i.e., bilateral uncleared mixed swaps entered into by
at least one dual registrant) 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 provisions, instead of being required to comply with parallel
provisions of both the CEA and the Exchange Act.\962\ The Commissions
received no comments on the proposed rules and are adopting the rules
as proposed.
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\960\ See supra note 10.
\961\ Because security-based swaps are also securities,
compliance with the Federal securities laws and rules and
regulations thereunder (in addition to the provisions of the Dodd-
Frank Act and the rules and regulations thereunder) will also be
required. To the extent one of the Commissions has exemptive
authority with respect to other provisions of the CEA or the Federal
securities laws and the rules and regulations thereunder, persons
may submit separate exemptive requests or rulemaking petitions
regarding those provisions to the relevant Commission.
\962\ Other than with respect to the specified parallel
provisions with which such persons may be permitted to comply
instead of complying with parallel provisions of both the CEA and
the Exchange Act, any other provision of either the CEA or the
Federal securities laws that applies to swaps or security-based
swaps will continue to apply.
---------------------------------------------------------------------------
As adopted, paragraph (c) of rule 1.9 under the CEA and rule 3a68-4
under the Exchange Act further provide that a person submitting such a
request to the Commissions must provide the Commissions with:
(i) All material information regarding the terms of the specified,
or specified class of, mixed swap;
(ii) the economic characteristics and purpose of the specified, or
specified class of, mixed swap;
(iii) the specified parallel provisions, and the reasons the person
believes such specified parallel provisions would be appropriate for
the mixed swap (or class thereof);
(iv) an analysis of (1) the nature and purposes of the parallel
provisions that are the subject of the request; (2) the comparability
of such parallel provisions; and (3) the extent of any conflicts or
differences between such parallel provisions; and
(v) such other information as may be requested by either of the
Commissions.
This provision is intended to provide the Commissions with
sufficient information regarding the mixed swap (or class thereof) and
the proposed regulatory approach to make an informed determination
regarding the appropriate regulatory treatment of the mixed swap (or
class thereof).
As adopted, paragraph (c) of rule 1.9 under the CEA and rule 3a68-4
under the Exchange Act also will allow a person to withdraw a request
regarding the regulation of a mixed swap at any time prior to the
issuance of a joint order by the Commissions. This provision is
intended to permit persons to withdraw requests that they no longer
need. This, in turn, will save the Commissions time and staff
resources.
As adopted, paragraph (c) of rule 1.9 under the CEA and rule 3a68-4
under the Exchange Act further provide that in response to a request
pursuant to the rules, the Commissions may jointly issue an order,
after public notice and opportunity for comment, permitting the
requesting 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 provisions (or
another subset of the parallel provisions that are the subject of the
request, as the Commissions determine is appropriate), instead of being
required to comply with parallel provisions of both the CEA and the
Exchange Act. In determining the contents of such a joint order, the
Commissions can consider, among other things:
(i) The nature and purposes of the parallel provisions that are the
subject of the request;
(ii) the comparability of such parallel provisions; and
(iii) the extent of any conflicts or differences between such
parallel provisions.
Finally, as adopted, paragraph (c) of rule 1.9 under the CEA and
rule 3a68-4 under the Exchange Act require the Commissions, if they
determine to issue a joint order pursuant to these rules, to do so
within 120 days of receipt of a complete request (with such 120-day
period being tolled during the pendency of a request for public comment
on the proposed interpretation). If the Commissions do not issue a
joint order within the prescribed time period, the rules require that
each Commission publicly provide the reasons for not having done so.
Paragraph (c) of rule 1.9 under the CEA and rule 3a68-4 under the
Exchange Act makes clear that nothing in the rules requires either
Commission to issue a requested joint order regarding the regulation of
a particular mixed swap (or class thereof).
These provisions are intended to provide market participants with a
prompt review of requests for a joint order regarding the regulation of
a particular mixed swap (or class thereof). The rules also will provide
transparency and accountability by requiring that at the end of the
review period, the Commissions issue the requested order or publicly
state the reasons for not doing so.
V. Security-Based Swap Agreements
A. Introduction
SBSAs are swaps over which the CFTC has regulatory and enforcement
authority but for which the SEC also has antifraud and certain other
authority.\963\ The term ``security-based swap agreement'' is defined
as a ``swap agreement'' (as defined in section 206A of the GLBA \964\)
of which ``a material term is based on the price, yield, value, or
volatility of any security or any group or index of securities,
including any interest therein'' but does not include a security-based
swap.\965\
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\963\ See section 3(a)(78) of the Exchange Act, 15 U.S.C.
78c(a)(78); CEA section 1a(47)(A)(v), 7 U.S.C. 1a(47)(A)(v). The
Dodd-Frank Act provides that certain CFTC registrants, such as DCOs
and SEFs, will keep records regarding SBSAs open to inspection and
examination by the SEC upon request. See, e.g., sections 725(e) and
733 of the Dodd-Frank Act. The Commissions are committed to working
cooperatively together regarding their dual enforcement authority
over SBSAs.
\964\ 15 U.S.C. 78c note. The Dodd-Frank Act amended the
definition of ``swap agreement'' in section 206A of the GLBA to
eliminate the requirements that a swap agreement be between ECPs, as
defined in section 1a(18)(C) of the CEA, 7 U.S.C. 1a(18)(C), and
subject to individual negotiation. See section 762(b) of the Dodd-
Frank Act. Sections 762(c) and (d) of the Dodd-Frank Act also made
conforming amendments to the Exchange Act and the Securities Act to
reflect the changes to the regulation of ``swap agreements'' that
are either ``security-based swaps'' or ``security-based swap
agreements'' under the Dodd-Frank Act.
\965\ See section 3(a)(78) of the Exchange Act, 15 U.S.C.
78c(a)(78). The CFMA amended the Exchange Act and the Securities Act
to exclude swap agreements from the definitions of security in those
statutes but subjected ``security-based swap agreements,'' as
defined in section 206B of the GLBA, 15 U.S.C. 78c note, to the
antifraud, anti-manipulation, and anti-insider trading provisions of
the Exchange Act and Securities Act. See CFMA, supra note 697, title
III.
The CEA does not contain a stand-alone definition of
``security-based swap agreement,'' but includes the definition
instead in subparagraph (A)(v) of the swap definition in CEA section
1a(47), 7 U.S.C. 1a(47). The only difference between these
definitions is that the definition of SBSA in the Exchange Act
specifically excludes security-based swaps (see section 3(a)(78)(B)
of the Exchange Act, 15 U.S.C. 78c(a)(78)(B)), while the definition
of SBSA in the CEA does not contain a similar exclusion. Instead,
the exclusion for security-based swaps is placed in the general
exclusions from the swap definition in the CEA (see CEA section
1a(47)(B)(x), 7 U.S.C. 1a(47)(B)(x)).
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[[Page 48294]]
B. Swaps That are Security-Based Swap Agreements
Although the Commissions believe it is not possible to provide a
bright line test to define an SBSA, the Commissions believe that it is
possible to clarify that certain types of swaps clearly fall within the
definition of SBSA. For example, as the Commissions noted in the
Proposing Release, a swap based on an index of securities that is not a
narrow-based security index (i.e., a broad-based security index) would
fall within the definition of an SBSA under the Dodd-Frank Act.\966\
Similarly, an index CDS that is not based on a narrow-based security
index or on the ``issuers of securities in a narrow-based security
index,'' as defined in rule 1.3(zzz) under the CEA and rule 3a68-1a
under the Exchange Act, would be an SBSA. In addition, a swap based on
a U.S. Treasury security or on certain other exempted securities other
than municipal securities would fall within the definition of an SBSA
under the Dodd-Frank Act.\967\
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\966\ See Proposing Release at 29863. Swaps based on indexes
that are not narrow-based security indexes are not included within
the definition of the term security-based swap under the Dodd-Frank
Act. See section 3(a)(68)(A)(ii)(I) of the Exchange Act, 15 U.S.C.
78c(a)(68)(A)(ii)(I), and discussion supra part III.G. However, such
swaps have a material term that is ``based on the price, yield,
value, or volatility of any security or any group or index of
securities, or any interest therein,'' and therefore such swaps fall
within the SBSA definition.
\967\ Swaps on U.S. Treasury securities that do not have any
other underlying references involving securities are expressly
excluded from the definition of the term ``security-based swap''
under the Dodd-Frank Act. See section 3(a)(68)(C) of the Exchange
Act, 15 U.S.C. 78c(a)(68)(C) (providing that an agreement, contract,
or transaction that would be a security-based swap solely because it
references, is based on, or settles through the delivery of one or
more U.S. Treasury securities (or certain other exempted securities)
is excluded from the security-based swap definition). However, swaps
on U.S. Treasury securities or on other exempted securities covered
by subparagraph (C) of the security-based swap definition have a
material term that is ``based on the price, yield, value, or
volatility of any security or any group or index of securities, or
any interest therein,'' and therefore fall within the SBSA
definition.
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The Commissions received no comments on the examples provided in
the Proposing Release regarding SBSAs. Accordingly, the Commissions are
not further defining SBSA beyond restating the examples above.\968\
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\968\ The Commissions noted that certain transactions that were
not ``security-based swap agreements'' under the CFMA are
nevertheless included in the definition of security-based swap under
the Dodd-Frank Act--including, for example, a CDS on a single loan.
Accordingly, although such transactions were not subject to insider
trading restrictions under the CFMA, under the Dodd-Frank Act they
are subject to the Federal securities laws, including insider
trading restrictions.
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C. Books and Records Requirements for Security-Based Swap Agreements
The Commissions are adopting rule 1.7 under the CEA and rule 3a68-3
under the Exchange Act, as proposed, to clarify that there will not be
additional books and records requirements regarding SBSAs other than
those that are required for swaps. The Dodd-Frank Act provides that the
Commissions shall adopt rules regarding the books and records required
to be kept for SBSAs.\969\ As discussed above, SBSAs are swaps over
which the CFTC has regulatory authority, but for which the SEC has
antifraud, anti-manipulation, and certain other authority. In the
Proposing Release, the Commissions noted that the CFTC had proposed
rules governing books and records for swaps, which would apply to swaps
that also are SBSAs.\970\ The Commissions further stated their belief
that those proposed rules would provide sufficient books and records
regarding SBSAs, and that additional books and records requirements
were not necessary for SBSAs.\971\ The Commissions received no comments
on the proposed rules.
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\969\ Specifically, section 712(d)(2)(B) of the Dodd-Frank Act
requires the Commissions, in consultation with the Board, to jointly
adopt rules governing books and records requirements for SBSAs by
persons registered as SDRs under the CEA, including uniform rules
that specify the data elements that shall be collected and
maintained by each SDR. Similarly, section 712(d)(2)(C) of the Dodd-
Frank Act requires the Commissions, in consultation with the Board,
to jointly adopt rules governing books and records for SBSAs,
including daily trading records, for swap dealers, major swap
participants, security-based swap dealers, and major security-based
swap participants.
\970\ See Swap Data Recordkeeping and Reporting Requirements, 75
FR 76573 (Dec. 8, 2010) (proposed rules regarding swap data
recordkeeping and reporting requirements for SDRs, DCOs, DCMs, SEFs,
swap dealers, major swap participants, and swap counterparties who
are neither swap dealers nor major swap participants); See
Reporting, Recordkeeping, and Daily Trading Records Requirements for
Swap Dealers and Major Swap Participants, 75 FR 76666 (Dec. 9, 2010)
(proposed rules regarding reporting and recordkeeping requirements
and daily trading records requirements for swap dealers and major
swap participants). These rules have been adopted by the CFTC. See
Swap Data Recordkeeping and Reporting Requirements, 77 FR 2136 (Jan.
13, 2012) (final rules regarding swap data recordkeeping and
reporting requirements for SDRs, DCOs, DCMs, SEFs, swap dealers,
major swap participants, and swap counterparties who are neither
swap dealers or major swap participants); See Swap Dealer and Major
Swap Participant Recordkeeping, Reporting, and Duties Rules; Futures
Commission Merchant and Introducing Broker Conflicts of Interest
Rules; and Chief Compliance Officer Rules for Swap Dealers, Major
Swap Participants, and Futures Commission Merchants, 77 FR 20128
(Apr. 3, 2012) (final rules regarding reporting and recordkeeping
requirements and daily trading records requirements for swap dealers
and major swap participants).
\971\ See Proposing Release at 29863.
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Accordingly, rule 1.7 under the CEA and rule 3a68-3 under the
Exchange Act provide that persons registered as SDRs under the CEA and
the rules and regulations thereunder are not required to (i) keep and
maintain additional books and records regarding SBSAs other than the
books and records regarding swaps that SDRs would be required to keep
and maintain pursuant to the CEA and rules and regulations thereunder;
and (ii) collect and maintain additional data regarding SBSAs other
than the data regarding swaps that SDRs are required to collect and
maintain pursuant to the CEA and rules and regulations thereunder. In
addition, rule 1.7 under the CEA and rule 3a68-3 under the Exchange Act
provide that persons registered as swap dealers or major swap
participants under the CEA and the rules and regulations thereunder, or
registered as security-based swap dealers or major security-based swap
participants under the Exchange Act and the rules and regulations
thereunder, are not required to keep and maintain additional books and
records, including daily trading records, regarding SBSAs other than
the books and records regarding swaps that those persons are required
to keep and maintain pursuant to the CEA and the rules and regulations
thereunder.\972\
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\972\ Rule 1.7 under the CEA and Rule 3a69-3 under the Exchange
Act provide that the term ``security-based swap agreement'' has the
meaning set forth in CEA section 1a(47)(A)(v), 7 U.S.C.
1a(47)(A)(v), and section 3(a)(78) of the Exchange Act, 15 U.S.C.
78c(a)(78), respectively.
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VI. Process for Requesting Interpretations of the Characterization of a
Title VII Instrument
The Commissions recognize that there may be Title VII instruments
(or classes of Title VII instruments) that may be difficult to
categorize definitively as swaps or security-based swaps. Further,
because mixed swaps are both swaps and security-based swaps,
identifying a mixed swap may not always be straightforward.
Section 712(d)(4) of the Dodd-Frank Act provides that any
interpretation of, or guidance by, either the CFTC or SEC regarding a
provision of Title VII shall be effective only if issued jointly by the
Commissions (after consultation with the Board) on issues where Title
VII requires the CFTC and SEC to issue joint regulations to implement
the provision. The Commissions believe that any interpretation or
guidance regarding whether a Title VII instrument is a
[[Page 48295]]
swap, a security-based swap, or both (i.e., a mixed swap), must be
issued jointly pursuant to this requirement.
The Commissions proposed rules in the Proposing Release to
establish a process for interested persons to request a joint
interpretation by the Commissions regarding whether a particular Title
VII instrument (or class of Title VII instruments) is a swap, a
security-based swap, or both (i.e., a mixed swap).\973\ The Commissions
are adopting the rules as proposed.
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\973\ See Proposing Release at 29864-65.
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Section 718 of the Dodd-Frank Act establishes a process for
determining the status of ``novel derivative products'' that may have
elements of both securities and futures contracts. Section 718 of the
Dodd-Frank Act provides a useful model for a joint Commission review
process to appropriately categorize Title VII instruments. As a result,
the final rules include various attributes of the process established
in section 718 of the Dodd-Frank Act. In particular, to permit an
appropriate review period that provides sufficient time to ensure
Federal regulatory interests are satisfied that also does not unduly
delay the introduction of new financial products, the adopted process,
like the process established in section 718, includes a deadline for
responding to a request for a joint interpretation.\974\
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\974\ The Commissions note that section 718 of the Dodd-Frank
Act is a separate process from the process the Commissions are
adopting, and that any future interpretation involving the process
under section 718 would not affect the process being adopted here,
nor will any future interpretation involving the process adopted
here affect the process under section 718.
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The Commissions are adopting rule 1.8 under the CEA and rule 3a68-2
under the Exchange Act that establish a process for parties to request
a joint interpretation regarding the characterization of a particular
Title VII instrument (or class thereof). Specifically, the final rules
provide that any person may submit a request to the Commissions to
provide a public joint interpretation of whether a particular Title VII
instrument is a swap, a security-based swap, or both (i.e., a mixed
swap).\975\
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\975\ See paragraph (a) of rule 1.8 under the CEA and rule 3a68-
2 under the Exchange Act.
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The final rules afford market participants with the opportunity to
obtain greater certainty from the Commissions regarding the regulatory
status of particular Title VII instruments under the Dodd-Frank Act.
This provision should decrease the possibility that market participants
inadvertently might fail to meet the regulatory requirements applicable
to a particular Title VII instrument.
The final rules provide that a person requesting an interpretation
as to the characterization of a Title VII instrument as a swap, a
security-based swap, or both (i.e., a mixed swap), must provide the
Commissions with the person's determination of the characterization of
the instrument and supporting analysis, along with certain other
documentation.\976\ Specifically, the person must provide the
Commissions with the following information:
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\976\ See paragraph (b) of rule 1.8 under the CEA and rule 3a68-
2 under the Exchange Act.
---------------------------------------------------------------------------
All material information regarding the terms of the Title
VII instrument;
A statement of the economic characteristics and purpose of
the Title VII instrument;
The requesting person's determination as to whether the
Title VII instrument should be characterized as a swap, a security-
based swap, or both (i.e., a mixed swap), including the basis for such
determination; and
Such other information as may be requested by either
Commission.
This provision should provide the Commissions with sufficient
information regarding the Title VII instrument at issue so that the
Commissions can appropriately evaluate whether it is a swap, a
security-based swap, or both (i.e., a mixed swap).\977\ By requiring
that requesting persons furnish a determination regarding whether they
believe the Title VII instrument is a swap, a security-based swap, or
both (i.e., a mixed swap), including the basis for such determination,
this provision also will assist the Commissions in more quickly
identifying and addressing the relevant issues involved in arriving at
a joint interpretation of the characterization of the instrument.
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\977\ The Commissions also may use this information to issue
(within the timeframe for issuing a joint interpretation) a joint
notice of proposed rulemaking to further define one or more of the
terms ``swap,'' ``security-based swap,'' or ``mixed swap.'' See
paragraph (f) of rule 1.8 under the CEA and rule 3a68-2 under the
Exchange Act, which are discussed below.
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The final rules provide that a person may withdraw a request at any
time prior to the issuance of a joint interpretation or joint notice of
proposed rulemaking by the Commissions.\978\ Notwithstanding any such
withdrawal, the Commissions may provide an interpretation regarding the
characterization of the Title VII instrument that was the subject of a
withdrawn request.
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\978\ See paragraph (c) of rule 1.8 under the CEA and rule 3a68-
2 under the Exchange Act.
---------------------------------------------------------------------------
This provision will permit parties to withdraw requests for which
the party no longer needs an interpretation. This, in turn, should save
the Commissions time and staff resources. If the Commissions believe
such an interpretation is necessary regardless of a particular request
for interpretation, however, the Commissions may provide such a joint
interpretation of their own accord.
The final rules provide that if either Commission receives a
proposal to list, trade, or clear an agreement, contract, or
transaction (or class thereof) that raises questions as to the
appropriate characterization of such agreement, contract, or
transaction (or class thereof) as a swap, security-based swap, or both
(i.e., a mixed swap), the receiving Commission promptly shall notify
the other.\979\ This provision of the final rules further provides that
either Commission, or their Chairmen jointly, may submit a request for
a joint interpretation to the Commissions as to the characterization of
the Title VII instrument where no external request has been received.
---------------------------------------------------------------------------
\979\ See paragraph (d) of rule 1.8 under the CEA and rule 3a68-
2 under the Exchange Act.
---------------------------------------------------------------------------
This provision is intended to ensure that Title VII instruments do
not fall into regulatory gaps and will help the Commissions to fulfill
their responsibility to oversee the regulatory regime established by
Title VII of the Dodd-Frank Act by making sure that Title VII
instruments are appropriately characterized, and thus appropriately
regulated. An agency, or their Chairmen jointly, submitting a request
for an interpretation as to the characterization of a Title VII
instrument under this paragraph will be required to submit the same
information as, and could withdraw a request in the same manner as, a
person submitting a request to the Commissions. The bases for these
provisions are set forth above with respect to paragraphs (b) and (c)
of the final rules.
The final rules require that the Commissions, if they determine to
issue a joint interpretation as to the characterization of a Title VII
instrument, do so within 120 days of receipt of the complete external
or agency submission (unless such 120-day period is tolled during the
pendency of a request for public comment on the proposed
interpretation).\980\ If the Commissions do not issue a joint
interpretation within the prescribed time period, the final rules
require that each Commission publicly provide the reasons for not
having done so within
[[Page 48296]]
such prescribed time period. This provision of the final rules also
incorporates the mandate of the Dodd-Frank Act that any joint
interpretation by the Commissions be issued only after consultation
with the Board of Governors of the Federal Reserve System.\981\
Finally, the rules make clear that nothing requires either Commission
to issue a requested joint interpretation regarding the
characterization of a particular instrument.
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\980\ See paragraph (e) of rule 1.8 under the CEA and rule 3a68-
2 under the Exchange Act. This 120-day period is based on the
timeframe set forth in section 718(a)(3) of the Dodd-Frank Act.
\981\ See section 712(d)(4) of the Dodd-Frank Act.
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These provisions are intended to assure market participants a
prompt review of submissions requesting a joint interpretation of
whether a Title VII instrument is a swap, a security-based swap, or
both (i.e., a mixed swap). The final rules also provide transparency
and accountability by requiring that at the end of the review period,
the Commissions issue the requested interpretation or publicly state
the reasons for not doing so.
The final rules permit the Commissions, in lieu of issuing a
requested interpretation, to issue (within the timeframe for issuing a
joint interpretation) a joint notice of proposed rulemaking to further
define one or more of the terms ``swap,'' ``security-based swap,'' or
``mixed swap.'' \982\ Under the final rules, the 120-day period to
provide a response will be tolled during the pendency of a request for
public comment on any such proposed interpretation. Such a rulemaking,
as required by Title VII, would be required to be done in consultation
with the Board of Governors of the Federal Reserve System. This
provision is intended to provide the Commissions with needed
flexibility to address issues that may be of broader applicability than
the particular Title VII instrument that is the subject of a request
for a joint interpretation.
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\982\ See paragraph (f) of rule 1.8 under the CEA and rule 3a68-
2 under the Exchange Act.
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Comments
Three commenters discussed the proposed process for requesting
interpretations of the characterization of a Title VII instrument,\983\
and while supporting such joint interpretive process, suggested certain
changes, including extending it to SBSAs,\984\ mandating that the
Commissions issue a response to a request,\985\ and suggesting that the
Commissions should seek expedited judicial review in the event the
Commissions do not agree on the interpretation.\986\
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\983\ See Better Markets Letter; CME Letter; and SIFMA Letter.
\984\ See Better Markets Letter.
\985\ See CME Letter and SIFMA Letter. These commenters
suggested that the Commissions should be required to issue a joint
interpretation for all joint interpretive requests that are not
withdrawn. Id.
\986\ See CME Letter. This commenter suggested that the
Commissions should seek expedited judicial review to determine the
characterization of a Title VII instrument if the Commissions cannot
agree on a joint interpretation. Id.
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The Commissions are adopting the final rules as proposed and are
not including SBSAs in the process. The joint interpretive process is
intended to decrease the possibility that market participants
inadvertently might fail to meet regulatory requirements that are
applicable to swaps, security-based swaps, or mixed swaps and, as such,
provides a mechanism for market participants to request whether an
instrument will be regulated by the CFTC, the SEC, or both. However,
the Commissions do not believe it is appropriate to predetermine
whether particular swaps also are SBSAs as SBSAs are already swaps over
which the CFTC has regulatory and enforcement authority and as to which
the SEC has antifraud and certain other related authorities.\987\
Predetermining whether particular swaps may be SBSAs under this process
is not needed to provide certainty as to the applicable regulatory
treatment of these instruments.
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\987\ See section 3(a)(78) of the Exchange Act, 15 U.S.C.
78c(a)(78), and section 1a(47)(A)(v) of the CEA, 7 U.S.C.
1a(47)(A)(v). The Dodd-Frank Act provides that certain CFTC
registrants, such as DCOs and SEFs, will keep records regarding
security-based swap agreements open to inspection and examination by
the SEC upon request. See, e.g., sections 725(e) and 733 of the
Dodd-Frank Act.
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The Commissions also are retaining in the final rules the framework
for providing or not providing joint interpretations. As noted above,
section 718 of the Dodd-Frank Act contains a framework for evaluating
novel derivative products that may have elements of both securities and
futures contracts (other than swaps, security-based swaps or mixed
swaps). The Commissions believe that establishing a joint interpretive
process for swaps, security-based swaps and mixed swaps that is modeled
in part on this statutory framework should facilitate providing
interpretations to market participants in a timely manner, if the
Commissions determine to do so. Establishing a process by rule will
provide market participants with an understandable method by which they
can request an interpretation from the Commissions. As the Commissions
have the authority, but not the obligation, under the Dodd-Frank Act to
further define the terms ``swap,'' ``security-based swap,'' and ``mixed
swap,'' the Commissions are retaining the flexibility in the
interpretive process rules to decide whether or not to issue joint
interpretations. The Commissions believe, however, that it is
appropriate to advise market participants of the reasons why such
interpretation is not being issued and the final rules retain the
requirement that the Commissions publicly explain the reasons for not
issuing a joint interpretation.
Further, the Commissions are not revising the final rules to
provide for expedited judicial review. The Dodd-Frank Act does not
contain any provision that provides for expedited judicial review if
the Commissions do not issue a joint interpretation with respect to a
Title VII instrument. Although the Commissions note that section 718 of
the Dodd-Frank Act contains a statutorily mandated expedited judicial
review of one of the Commission's actions (if sought by the other
Commission) regarding novel derivative products that may have elements
of both securities and futures contracts, such statutory provision does
not apply to Title VII instruments.\988\ Further, Title VII provides
flexibility to the Commissions to determine the methods by which joint
interpretations are provided. Title VII does not contain any required
expedited judicial review of Commission actions, and the Commissions do
not have the authority to require expedited judicial review under Title
VII, with respect to a Title VII instrument. Accordingly, the
Commissions do not believe that including such a provision is
appropriate in the context of providing interpretations to market
participants regarding the definitions of swap, security-based swap, or
mixed swap.
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\988\ The Commissions note that judicial review provisions in
section 718 relating to the status of novel derivative products only
provide that either Commission (either the SEC or the CFTC) has the
right to petition for review of a final order of the other
Commission with respect to novel derivative products that may have
elements of both securities and futures that affects jurisdictional
issues. Nothing in section 718 requires that the Commissions issue
exemptions or interpretations pursuant to such section or provides
any person other than the Commissions the right to petition for
Court review of a Commission order issued pursuant to section 718.
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Two commenters were concerned about the length of the review period
and believed that the Commissions should shorten such time period.\989\
The
[[Page 48297]]
Commissions are not modifying the final rules from those proposed with
respect to the length of the review period. The 120-day review period
is based on a timeframe established by Congress with respect to
determining the status of novel derivative products.\990\ The
Commissions believe that this length of the review period also is
appropriate for other derivative products such as swaps, security-based
swaps, and mixed swaps. Further, the Commissions believe the 120-day
review period is necessary to enable the Commissions to obtain the
necessary information regarding a Title VII instrument, thoroughly
analyze the instrument, and formulate any joint interpretation
regarding the instrument. In a related comment, one commenter suggested
that the Commissions allow a requesting party, while awaiting a joint
interpretation, to make a good faith characterization of a particular
Title VII instrument and engage in transactions based on such
characterization.\991\ The Commissions believe that it is essential
that the characterization of an instrument be established prior to any
party engaging in the transactions so that the appropriate regulatory
schemes apply. The Commissions do not believe that allowing market
participants to make such a determination as to the status of a product
is either appropriate or consistent with the statutory provisions
providing for the Commissions to further define the terms ``swap,''
``security-based swap'' and ``mixed swap.'' Further, allowing market
participants to determine the status of a product could give rise to
regulatory arbitrage and inconsistent treatment of similar products.
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\989\ See CME Letter and Markit Letter. One of these commenters
suggested that the Commissions should reduce the 120-day review
period to 30 days because the value of receiving a joint
interpretation would be negated if a market participant had to wait
120 days. This commenter also suggested that foreign competitors
will gain a competitive advantage to U.S. market participants
because they will not need to wait for a joint interpretation before
trading similar or identical products. See CME Letter. The
Commissions note that to the extent foreign competitors are engaging
in swap and security-based swap transactions subject to either
Commission's jurisdiction, they will be subject to the same process
for requesting interpretations of the characterization of Title VII
instruments as U.S. market participants. The other commenter
requested that the Commissions issue a joint interpretation for each
``widely-utilized index,'' at the time of the index series' launch,
within a two-week period rather than the proposed 120-day period for
novel derivative products under section 718 of the Dodd-Frank Act.
This commenter did not recognize that the joint interpretive process
would be available in this case, and that it may be initiated by an
index provider. See paragraph (a) of rule 1.8 under the CEA and rule
3a68-2 under the Exchange Act (providing that ``[a]ny person'' may
submit a request for a joint interpretation). See Markit Letter.
\990\ See section 718(a)(3) of the Dodd-Frank Act.
\991\ See SIFMA Letter. This commenter also suggested that while
the requesting party, and all other market participants, would be
bound by the joint interpretation when issued, they should not face
retroactive re-characterization of a transaction executed during the
review period and prior to the issuance of the joint interpretation.
Id.
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Finally, some commenters expressed concern about the public
availability of information regarding the joint interpretive process
and asked that the parties be able to seek confidential treatment of
their submissions.\992\ The Commissions note that under existing rules
of both Commissions, 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.\993\ The Commissions also note that even if
confidential treatment has been requested, all joint interpretive
requests, as well 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.\994\
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\992\ One commenter suggested that the Commissions should permit
the parties seeking a joint interpretation to request confidential
treatment from the Commissions during the course of the review
period in order to protect proprietary information and deal
structures. See SIFMA Letter. Another commenter suggested that the
Commissions should make public all requests for joint
interpretations, any guidance actually provided in response to such
requests, and any decisions not to provide guidance in response to
such requests (along with an explanation of the grounds for any such
decision). See Better Markets Letter.
\993\ See 17 CFR 200.81 and 17 CFR 140.98. The Commissions note
that the joint interpretive process is intended to provide, among
other things, notification to all market participants as to the
regulatory classification of a particular Title VII instrument. In
this regard, the Commissions do not believe it is appropriate to
provide a joint interpretation only to the market participants
requesting the interpretation, while delaying publication of the
same joint interpretation to market participants generally.
Therefore, CFTC staff will not exercise its discretion under 17 CFR
140.98(b) to delay publication of a joint interpretation. SEC staff
does not have discretion under 17 CFR 200.81(b) to delay publication
of a joint interpretation.
\994\ The CFTC's publication of any joint interpretative request
and the joint interpretation itself will be subject to the
restrictions of section 8 of the CEA. See 7 U.S.C. 12. Subject to
limited exceptions, CEA section 8 generally restricts the CFTC from
publishing ``data and information that would separately disclose the
business transactions or market positions of any person and trade
secrets or names of customers[hellip]'' Id. The CFTC and its staff
have a long history of providing interpretive guidance with respect
to the regulatory status of specific proposed transactions in
compliance with CEA section 8. However, market participants making a
joint interpretive request should be aware that the SEC is not
subject to CEA section 8 and, therefore, is not subject to the
restrictions of CEA section 8. The CFTC anticipates that most joint
interpretive requests will not contain CEA Section 8 information.
However, given that the SEC is not subject to the restrictions of
CEA section 8, the CFTC intends to work with requesting parties to
assure that joint interpretive requests do not include CEA section 8
information. Nevertheless, given the foregoing, market participants
should not submit CEA section 8 information in their joint
interpretive requests.
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VII. Anti-Evasion
A. CFTC Anti-Evasion Rules
1. CFTC's Anti-Evasion Authority
(a) Statutory Basis for the Anti-Evasion Rules
Pursuant to the authority in sections 721(c) and 725(g)(2) of the
Dodd-Frank Act and CEA sections 1a(47)(E) and 2(i),\995\ the CFTC is
promulgating the anti-evasion rules as they were proposed and restating
the accompanying interpretation with modifications in response to
commenters. The CFTC also is providing an additional interpretation
regarding rules 1.3(xxx)(6) and 1.6 under the CEA.
---------------------------------------------------------------------------
\995\ 7 U.S.C. 1a(47)(E) and 2(i).
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Section 721(c) of the Dodd-Frank Act requires the CFTC to further
define the terms ``swap,'' ``swap dealer,'' ``major swap participant,''
and ``eligible contract participant,'' in order ``[t]o include
transactions and entities that have been structured to evade'' subtitle
A of Title VII (or an amendment made by subtitle A of the CEA).
Moreover, as the CFTC noted in the Proposing Release,\996\ several
other provisions of Title VII reference the promulgation of anti-
evasion rules, including:
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\996\ Proposing Release at 29866.
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Subparagraph (E) of the definition of ``swap'' provides
that foreign exchange swaps and foreign exchange forwards shall be
considered swaps unless the Secretary of the Treasury makes a written
determination that either foreign exchange swaps or foreign exchange
forwards, or both, among other things, ``are not structured to evade
the [Dodd-Frank Act] in violation of any rule promulgated by the [CFTC]
pursuant to section 721(c) of that Act;'' \997\
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\997\ CEA section 1a(47)(E), 7 U.S.C. 1a(47)(E).
---------------------------------------------------------------------------
Section 722(d) of the Dodd-Frank Act provides that the
provisions of the CEA relating to swaps shall not apply to activities
outside the United States unless those activities, among other things,
``contravene such rules or regulations as the [CFTC] may prescribe or
promulgate as are necessary or appropriate to prevent the evasion of
any provision of [the CEA] that was enacted by the [Title VII];'' \998\
and
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\998\ CEA section 2(i), 7 U.S.C. 2(i). New CEA section 2(i), as
added by section 722(d) of the Dodd-Frank Act, also provides that
the provisions of Title VII relating to swaps shall not apply to
activities outside the United States unless those activities ``have
a direct and significant connection with activities in, or effect
on, commerce of the United States.''
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Section 725(g) of the Dodd-Frank Act amends the Legal
Certainty for Bank Products Act of 2000 to provide that,
[[Page 48298]]
although identified banking products generally are excluded from the
CEA, that exclusion shall not apply to an identified banking product
that is a product of a bank that is not under the regulatory
jurisdiction of an appropriate Federal banking agency,\999\ meets the
definition of the terms ``swap'' or ``security-based swap,'' and ``has
been structured as an identified banking product for the purpose of
evading the provisions of the [CEA], the [Securities Act], or the
[Exchange Act].'' \1000\
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\999\ The term ``identified banking product'' is defined in
section 402 of the Legal Certainty for Bank Products Act of 2000, 7
U.S.C. 27. The term ``appropriate Federal banking agency'' is
defined in CEA section 1a(2), 7 U.S.C. 1a(2), and section 3(a)(72)
of the Exchange Act, 15 U.S.C. 78c(a)(72), which were added by
sections 721(a) and 761(a) of the Dodd-Frank Act, respectively.
\1000\ Section 741(b) of the Dodd-Frank Act amends section 6(e)
of the CEA, 7 U.S.C. 9a, to provide that any DCO, swap dealer, or
major swap participant ``that knowingly or recklessly evades or
participates in or facilitates an evasion of the requirements of
section 2(h) [of the CEA] shall be liable for a civil monetary
penalty in twice the amount otherwise available for a violation of
section 2(h) [of the CEA].'' This anti-evasion provision is not
dependent upon the promulgation of a rule under section 721(c) of
the Dodd Frank Act, and hence the proposed rule and interpretive
guidance is not meant to apply to CEA section 6(e).
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Comments
One commenter asserted the CFTC has no statutory basis to
promulgate the anti-evasion rules, as proposed.\1001\ Specifically,
this commenter stated that neither CEA sections 2(h)(4)(A) nor 6(e)
grant the CFTC authority to prescribe an anti-evasion rule and
interpretation as described in the Proposing Release.\1002\ Moreover,
this commenter argued that CEA section 2(i) limits the CFTC to
prescribing anti-evasion rules related only to activities occurring
outside of the United States.\1003\ The CFTC finds these comments
misplaced because CEA sections 2(h)(4)(A) and 6(e) provide the CFTC
with additional authority to prescribe anti-evasion rules for specific
purposes above and beyond the authority provided by sections 721(c) and
725(g) of the Dodd-Frank Act and CEA sections 1a(47)(E) and 2(i), upon
which the CFTC is relying in this rulemaking.\1004\ In addition,
section 2(i) of the CEA provides that activities conducted outside the
United States, including entering into agreements, contracts and
transactions or structuring entities, which willfully evade or attempt
to evade any provision of the CEA, shall be subject to the provisions
of Subtitle A of Title VII of the Dodd-Frank Act; it does not limit the
CFTC's other authorities cited above. Accordingly, nothing in CEA
sections 2(h)(4)(A), 2(i) or 6(e) prevent the CFTC from prescribing
rules 1.3(xxx)(6) and 1.6.
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\1001\ See IECA Letter.
\1002\ Id.; 7 U.S.C. 2(h)(4)(A) and 9a.
\1003\ See IECA Letter; 7 U.S.C. 2(i).
\1004\ CEA section 2(h)(4)(A), 7 U.S.C. 2(h)(4)(A), provides:
The Commission shall prescribe rules under this subsection (and
issue interpretations of rules prescribed under this subsection) as
determined by the Commission to be necessary to prevent evasions of
the mandatory clearing requirements under this Act.
CEA section 6(e), 7 U.S.C. 9a, in relevant part, provides: (4)
Any designated clearing organization that knowingly or recklessly
evades or participates in or facilitates an evasion of the
requirements of section 2(h) shall be liable for a civil money
penalty in twice the amount otherwise available for a violation of
section 2(h). (5) Any swap dealer or major swap participant that
knowingly or recklessly evades or participates in or facilitates an
evasion of the requirements of section 2(h) shall be liable for a
civil money penalty in twice the amount otherwise available for a
violation of section 2(h).
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Two commenters supported the proposal's ``principles-based''
approach to anti-evasion,\1005\ while several others suggested
modifications.\1006\ Two commenters believed that the Proposing Release
is overly broad and that, if the CFTC does finalize anti-evasion rules,
such rules should be narrower in scope.\1007\ Similarly, one other
commenter asserted that the CFTC erred in the Proposing Release by
placing too great an emphasis on the flexibility of the rules as
opposed to providing clarity for market participants.\1008\ The CFTC
continues to believe a ``principles-based'' approach to its anti-
evasion rules is appropriate. The CFTC is not adopting an alternative
approach, whereby it provides a bright-line test of non-evasive
conduct, because such an approach may provide potential wrongdoers with
a roadmap for structuring evasive transactions. Notwithstanding this
concern, as described below, the CFTC is providing an additional
interpretation and examples of evasion in order to provide clarity to
market participants.\1009\
---------------------------------------------------------------------------
\1005\ See Barnard Letter and Better Markets Letter.
\1006\ See CME Letter; ISDA Letter; and SIFMA Letter.
\1007\ See ISDA Letter and SIFMA Letter.
\1008\ See CME Letter.
\1009\ Examples described in the guidance are illustrative and
not exhaustive of the transactions, instruments or entities that
could be considered evasive. In considering whether a transaction,
instrument or entity is evasive, the CFTC will consider the facts
and circumstances of each situation.
---------------------------------------------------------------------------
One commenter suggested an alternative standard for a finding of
evasion should be ``whether the transaction is lawful or not'' under
the CEA, CFTC rules and regulations, orders, or other applicable
federal, state or other laws.\1010\ The CFTC is not adopting this
suggested alternative standard for evasion because to adopt this
standard would blur the distinction between whether a transaction (or
entity) is lawful and whether it is structured in a way to evade the
Dodd-Frank Act and the CEA. The anti-evasion rules provided herein are
concerned with the latter conduct, not the former.\1011\ Thus, the CFTC
does not believe it is appropriate to limit the enforcement of its
anti-evasion authority to only unlawful transactions.
---------------------------------------------------------------------------
\1010\ See WGCEF Letter.
\1011\ If a transaction is unlawful, the CFTC (or another
authority) may be able to bring an action alleging a violation of
the applicable rule, regulation, order or law.
---------------------------------------------------------------------------
2. Final Rules
(a) Rule 1.3(xxx)(6)
The CFTC is adopting the Rule 1.3(xxx)(6) as proposed. As adopted,
Rule 1.3(xxx)(6)(i) under the CEA generally defines as swaps those
transactions that are willfully structured to evade the provisions of
Title VII governing the regulation of swaps. Furthermore, rules
1.3(xxx)(6)(ii) and (iii) effectuate CEA section 1a(47)(E)(i) and
section 725(g) of the Dodd-Frank Act, respectively, and will be applied
in a similar fashion as rule 1.3(xxx)(6)(i). Rule 1.3(xxx)(6)(ii)
applies to currency and interest rate swaps that are willfully
structured as foreign exchange forwards or foreign exchange swaps to
evade the new regulatory regime for swaps enacted in Title VII. Rule
1.3(xxx)(6)(iii) applies to transactions of a bank that are not under
the regulatory jurisdiction of an appropriate Federal banking agency
and where the transaction is willfully structured as an identified
banking product to evade the new regulatory regime for swaps enacted in
Title VII.
Rule 1.3(xxx)(6)(iv) provides that in determining whether a
transaction has been willfully structured to evade rules 1.3(xxx)(6)(i)
through (iii), the CFTC will not consider the form, label, or written
documentation dispositive.\1012\ This approach is intended to prevent
evasion through clever draftsmanship of a form, label, or other written
documentation.
---------------------------------------------------------------------------
\1012\ See supra part II.D.1.
---------------------------------------------------------------------------
Rule 1.3(xxx)(6)(v) further provides that transactions, other than
transactions structured as securities, willfully structured to evade
(as provided in rules 1.3(xxx)(6)(i) through (iii)) will be considered
in determining whether a person is a swap dealer or major swap
participant.
Lastly, rule 1.3(xxx)(6)(vi) provides that rule 1.3(xxx)(6) will
not apply to any agreement, contract or transaction structured as a
security (including a security-based swap) under the
[[Page 48299]]
securities laws as defined in section 3(a)(47) of the Exchange
Act.\1013\
---------------------------------------------------------------------------
\1013\ 15 U.S.C. 78c(a)(47).
---------------------------------------------------------------------------
(b) Rule 1.6
The CFTC is adopting rule 1.6 as proposed. Section 2(i) of the CEA
states that the provisions of the CEA relating to swaps that were
enacted by Title VII (including any rule prescribed or regulation
promulgated thereunder) shall not apply to activities outside the
United States unless, among other things, those activities ``contravene
such rules or regulations as the [CFTC] may prescribe or promulgate as
are necessary or appropriate to prevent the evasion of any provision of
[the CEA] that was enacted by [Title VII].''
Pursuant to this authority, rule 1.6(a), as adopted, makes it
unlawful to conduct activities outside the United States, including
entering into transactions and structuring entities, to willfully evade
or attempt to evade any provision of the CEA as enacted under Title VII
or the rules and regulations promulgated thereunder.
In addition, rule 1.6(b) provides that in determining whether a
transaction or entity has been entered into or structured willfully to
evade, as provided in rule 1.6(a), the CFTC will not consider the form,
label, or written documentation as dispositive.
Rule 1.6(c) provides that an activity conducted outside the United
States to evade, as described in proposed rule 1.6(a), shall be subject
to the provisions of Subtitle A of Title VII of the Dodd-Frank Act. As
the CFTC explained in the Proposing Release,\1014\ such provisions are
necessary to fully prevent those who seek to willfully evade the
regulatory requirements established by Congress in Title VII relating
to swaps from enjoying any benefits from their efforts to evade.
---------------------------------------------------------------------------
\1014\ Proposing Release at 29866.
---------------------------------------------------------------------------
Lastly, rule 1.6(d) provides that no agreement, contract or
transaction structured as a security (including a security-based swap)
under the securities laws shall be deemed a swap pursuant to rule 1.6.
(c) Interpretation of the Final Rules
The CFTC is providing an interpretation of the final rules in
response to commenters, addressing (i) the applicability of the anti-
evasion rules to transactions that qualify for the forward exclusion,
(ii) the applicability of the anti-evasion rules to transactions
executed on a SEF, (iii) the treatment of evasive transactions after
they are discovered, and (iv) documentation considerations.\1015\
---------------------------------------------------------------------------
\1015\ The CFTC also is adopting the interpretive guidance from
the Proposing Release, as proposed, but with certain clarifications.
See infra part VII.A.3.
---------------------------------------------------------------------------
With regard to the forward exclusion, the CFTC is clarifying, in
response to a commenter,\1016\ that entering into transactions that
qualify for the forward exclusion from the swap definition shall not be
considered evasive. However, in circumstances where a transaction does
not, in fact, qualify for the forward exclusion, the transaction may or
may not be evasive depending on an analysis of all relevant facts and
circumstances.\1017\
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\1016\ See COPE Letter (requesting clarification that
transacting in the physical markets (e.g., entering into
nonfinancial commodity forward contracts), as opposed to executing a
swap, would not be considered evasion).
\1017\ The CFTC is aware that there are circumstances where a
forward contract can perform the same or a substantially similar
economic function as a swap through alternative delivery procedures.
Further, there are circumstances where a person who deals in both
forwards and swaps may make decisions regarding financial risk
assessment that will involve the consideration of regulatory
obligations. The CFTC will carefully scrutinize the facts and
circumstances associated with forward contracts.
---------------------------------------------------------------------------
Concerning the applicability of the anti-evasion rules to
transactions executed on a SEF, the CFTC is clarifying, in response to
comments,\1018\ that a transaction that has been self-certified by a
SEF (or a DCM), or that has received prior approval from the CFTC, will
not be considered evasive.\1019\
---------------------------------------------------------------------------
\1018\ See MarketAxess Letter (commenting that the anti-evasion
rules should not apply to transactions executed on, or subject to
the rules of, a SEF, because before a SEF may list a swap, it must
self-certify or voluntarily obtain CFTC approval to list the
product).
\1019\ Pursuant to part 40 of the CFTC's regulations, 17 CFR
Part 40, registered SEFs and DCMs must self-certify with the CFTC
that any products that they list ``[comply] with the [CEA] and
regulations thereunder'' and are liable for any false self-
certifications. Therefore, market participants that have entered
into such transactions will not be considered to be engaging in
evasion, while a SEF or DCM could be found to have falsely self-
certified.
---------------------------------------------------------------------------
With respect to the treatment of evasive transactions after they
are discovered, the CFTC is clarifying, in response to comments,\1020\
that in instances where one party willfully structures a transaction to
evade but the counterparty does not, the transaction, which meets the
swap definition under rule 1.3(xxx)(6), or is subject to the provisions
of Subtitle A of Title VII pursuant to rule 1.6, will be subject to all
CEA provisions and the regulations thereunder (as applied to the party
who willfully structures a transaction to evade). In rare situations
where there is a true ``innocent party,''\1021\ it will likely be due
to fraud or misrepresentation by the evading party and the business
consequences and remedies will be the same as for any such
victim.\1022\ The CFTC will impose appropriate sanctions only on the
willful evader for violations of the relevant provisions of the CEA and
CFTC regulations since the individual agreement, contract or
transaction was (and always should have been) subject to them.\1023\
Further, on a prospective basis for future transactions or instruments
similar to those of the particular evasive swap, the CFTC will consider
these transactions or instruments to be swaps within the meaning of the
Dodd-Frank Act (as applied to both the party who willfully structures a
transaction to evade and the ``innocent party'').
---------------------------------------------------------------------------
\1020\ See WGCEF Letter (generally expressing concern that the
penalty for anti-evasion is ``draconian'') and IECA Letter
(commenting that the non-evading party should not become a party to
an evasive ``swap'' transaction, and thus subject to the regulatory
requirements of the Dodd-Frank Act.) .
\1021\ The analysis of whether a party is ``innocent'' is based
on the facts and circumstances of a particular transaction as well
as a course of dealing by each of the parties.
\1022\ This is not dissimilar to an enforcement action for
trading illegal off-exchange futures contracts in violation of CEA
section 4(a), 7 U.S.C. 6(a). The CFTC regularly seeks restitution
for victims in enforcement actions where applicable. Additionally,
victims retain their private rights of action for breach of contract
and any related equitable remedies.
\1023\ In considering which provisions of the CEA and CFTC
regulations are relevant, the CFTC will evaluate which CEA
provisions and CFTC regulations the evasive swap would have had to
comply with had it not evaded the definition of swap (e.g.,
reporting, recordkeeping, clearing, etc.). However, where both
parties have willfully structured to evade or attempted to evade the
requirements of the Dodd-Frank Act, the CFTC may subject the
agreement, contract, instrument, or transaction itself to the full
regulatory regime and the willful evaders to applicable sanctions.
---------------------------------------------------------------------------
Moreover, evasive transactions will count toward determining
whether each evading party with the requisite intent is a swap dealer
or major swap participant.\1024\ In response to a commenter's
suggestion that, as proposed, rule 1.3(xxx)(6)(v) should require a
pattern of transactions,\1025\ the CFTC is not requiring a pattern of
evasive transactions as a prerequisite to prove evasion, although such
a pattern may be one factor in analyzing whether evasion has occurred
under rules 1.3(xxx)(6) or 1.6. Further, in
[[Page 48300]]
determining whether such a transaction is a swap, the CFTC will
consider whether the transaction meets the definition of the term
``swap'' as defined by statute and as it is further defined in this
rulemaking.\1026\
---------------------------------------------------------------------------
\1024\ In other words, the evasive transaction would count
toward the relevant thresholds (e.g., de minimis (with respect to
determining swap dealer status, if the evasive transaction
constituted dealing activity) and substantial position (with respect
to determining major swap participant status)).
\1025\ See IECA Letter. This same commenter suggested that rule
1.3(xxx)(6)(v) should be applied only to the authorities regarding
evasion provided by Congress and refer to the entity structuring the
evading transaction have been addressed above.
\1026\ Thus, for example, if a person, in seeking to evade Title
VII, structures a product that is a privilege on a certificate of
deposit, the CFTC's anti-evasion rules would not be implicated
because CEA section 1a(47)(B)(iii), 7 U.S.C. 1a(47)(B)(iii),
excludes such a product from the swap definition.
---------------------------------------------------------------------------
As an illustration of some of the foregoing concepts, if the market
for foreign exchange forwards on a particular currency settles on a T+
4 basis, but two counterparties agree to expedite the settlement of an
foreign exchange forward on such currency to characterize the
transaction falsely as a spot transaction in order to avoid reporting
the transaction, rule 1.3(xxx)(6)(i) would define the transaction as a
swap. In this example, both parties may be subject to sanctions if they
both have the requisite intent (i.e., willfully evaded). However, had
the counterparty with the reporting obligation in this example
convinced the other counterparty, by using a false rationale unrelated
to avoiding reporting, to expedite the foreign exchange forward
settlement in order to avoid reporting, then the only party that would
be at risk for sanctions (i.e., the only party with the requisite
intent) would be the counterparty with the reporting obligation who
deceived the other counterparty.
With regard to documentation considerations, as discussed above,
the CFTC is adopting rules 1.3(xxx)(6)(iv) and 1.6(b), as
proposed,\1027\ but is providing the following interpretation. As
stated in the Proposing Release,\1028\ the structuring of instruments,
transactions, or entities to evade the requirements of the Dodd-Frank
Act may be ``limited only by the ingenuity of man.''\1029\ Therefore,
the CFTC will look beyond manner in which an instrument, transaction,
or entity is documented to examine its actual substance and purpose to
prevent any evasion through clever draftsmanship--an approach
consistent with the CFTC's case law in the context of determining
whether a contract is a futures contract and the CFTC's interpretations
in this release regarding swaps.\1030\ The documentation of an
instrument, transaction, or entity (like its form or label) is a
relevant, but not dispositive, factor in determining whether evasion
has occurred.
---------------------------------------------------------------------------
\1027\ Rules 1.3(xxx)(6)(iv) and 1.6(b) provide that ``in
determining whether a transaction has been willfully structured to
evade, neither the form, label, nor written documentation of the
transaction shall be dispositive.''
\1028\ Proposing Release at 29866.
\1029\ Cargill v. Hardin, 452 F.2d 1154, 1163 (8th Cir. 1971).
\1030\ See supra part II.D.1.
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Comments
The CFTC received a number of comments on various aspects of
proposed rules 1.3(xxx)(6) and 1.6.
Several commenters requested clarity as to what types of
transactions might be considered evasive under proposed rule
1.3(xxx)(6) and 1.6.\1031\ One commenter requested that the CFTC
clarify that transacting in the physical markets (e.g., entering into
nonfinancial commodity forward contracts), as opposed to executing a
swap, would not be considered evasion.\1032\ As discussed above, the
CFTC has provided an interpretation regarding the applicability of the
anti-evasion rules to transactions that qualify for the forward
exclusion. Another commenter requested that the CFTC clarify that the
anti-evasion rules would not apply to transactions executed on a SEF
because, before a SEF may list a swap, it must self-certify or
voluntarily obtain CFTC permission to list that product.\1033\ The CFTC
has provided an interpretation discussed above to address this comment.
---------------------------------------------------------------------------
\1031\ See CME Letter; COPE Letter; IECA Letter; MarketAxess
Letter; and WGCEF Letter.
\1032\ See COPE Letter.
\1033\ See MarketAxess Letter.
---------------------------------------------------------------------------
Two commenters expressed concern regarding the penalty to the
counterparties to a transaction that is deemed to violate the CFTC's
anti-evasion provisions.\1034\ Pursuant to the final rule, when a
transaction violates the anti-evasion rules, the CFTC will consider the
transaction a swap. One of these commenters said that the non-evading
party should not unilaterally become a party to a swap, and thus be
subject to the regulatory requirements of the Dodd-Frank Act.\1035\
This commenter believed the rule should be clear that only the
``evading'' party would become a party to a swap, but the ``non-
evading'' party would not.\1036\ The other comments believed that a
transaction that is determined to have violated the CFTC's anti-evasion
rules should be considered a swap only if it meets all other aspects of
the statutory definition of the term ``swap.'' \1037\ The CFTC agrees
that the anti-evasion rules are not meant to ``punish the innocent,''
but rather to appropriately address the evading counterparty's or
counterparties' failure to meet the requirements of the Dodd-Frank Act.
Therefore, the CFTC has provided an interpretation described above
about how a transaction, discovered to have evaded the CEA or the Dodd-
Frank Act (and therefore, a swap under rule 1.3(xxx)(6) or subject to
the provisions of Subtitle A under rule 1.6) will be treated after the
evasion is discovered.
---------------------------------------------------------------------------
\1034\ See IECA Letter and WGCEF Letter.
\1035\ See IECA Letter.
\1036\ Id.
\1037\ See WGCEF Letter.
---------------------------------------------------------------------------
Furthermore, the CFTC agrees that a transaction that is determined
to have violated the CFTC's anti-evasion rules will be considered a
swap only if it meets the definition of the term ``swap,'' and has
provided an interpretation to address this comment. In response to both
comments, the CFTC also has provided an example to illustrate the
concepts in the interpretation.
The CFTC received one comment regarding rules 1.3(xxx)(6)(iv) and
1.6(b). This commenter believed that a difference exists between
``documentation,'' which contains terms, conditions, etc. of an
agreement, and the ``form or label.'' \1038\ Thus, because a form or
label may be duplicitously assigned to a transaction, this commenter
agreed that neither the form nor the label should be dispositive.\1039\
However, because documentation contains the substance of an agreement,
this commenter believed that documentation should be dispositive in
determining whether a given contract has been entered to willfully
evade because the substance of a contract is derived from its
documentation.\1040\ Alternatively, this commenter requested that if
the CFTC does not amend its proposal, the CFTC clarify what evidence or
subject matter would be dispositive of willful evasion.\1041\ The CFTC
disagrees with these comments and has provided an interpretation
discussed above that the documentation of an instrument, transaction,
or entity is a relevant, but not dispositive, factor. This view not
only is consistent with CFTC case law, and the CFTC's interpretations
herein, but reduces the possibility of providing a potential roadmap
for evasion.
---------------------------------------------------------------------------
\1038\ See CME Letter.
\1039\ Id.
\1040\ Id.
\1041\ Id.
---------------------------------------------------------------------------
Two commenters raised issues applicable to proposed rule 1.6 alone.
One commenter believed that proposed rule 1.6 should not be adopted
until the cross-border application of the swap provisions of Title VII
is addressed.\1042\ The CFTC disagrees and believes that the rule
provides sufficient clarity to market participants even though the CFTC
has not yet finalized guidance
[[Page 48301]]
regarding the cross-border application of the swap provisions of the
Dodd-Frank Act. The other commenters believed that the proposed rule
text and interpretation does not fully explain how the CFTC would apply
proposed rule 1.6 in determining whether a swap subject to foreign
jurisdiction and regulated by a foreign regulator is evasive.\1043\ As
stated above, an agreement, contract, instrument or transaction that is
found to have been willfully structured to evade will be subject to CEA
provisions and the regulations thereunder pursuant to rule 1.6(c).
---------------------------------------------------------------------------
\1042\ See ISDA Letter.
\1043\ See CME Letter.
---------------------------------------------------------------------------
3. Interpretation Contained in the Proposing Release
The CFTC is restating the interpretation contained in the Proposing
Release,\1044\ but is providing additional clarification regarding
certain types of circumstances that may (or may not) constitute an
evasion of the requirements of Title VII. However, the CFTC notes that
each activity will be evaluated on a case-by-case basis with
consideration given to all relevant facts and circumstances.
---------------------------------------------------------------------------
\1044\ See Proposing Release at 29865.
---------------------------------------------------------------------------
In developing its interpretation, the CFTC considered legislative,
administrative, and judicial precedent with respect to the anti-evasion
provisions in other Federal statutes. For example, the CFTC examined
the anti-evasion provisions in the Truth in Lending Act,\1045\ the Bank
Secrecy Act,\1046\ and the Internal Revenue Code.\1047\
---------------------------------------------------------------------------
\1045\ 15 U.S.C. 1604(a) provides, in relevant part, that the
Federal Reserve Board: shall prescribe regulations to carry out the
purposes of this subchapter * * *. [T]hese regulations may contain
such classifications, differentiations, or other provisions, and may
provide for such adjustments and exceptions for any class of
transactions, as in the judgment of the Board are necessary or
proper to effectuate the purposes of this subchapter, to prevent
circumvention or evasion thereof, or to facilitate compliance
therewith.
In affirming the Board's promulgation of Regulation Z, the
Supreme Court noted that anti-evasion provisions such as section
1604(a) evince Congress's intent to ``stress[] the agency's power to
counteract attempts to evade the purposes of a statute.'' Mourning
v. Family Publ'ns Serv., Inc., 411 U.S. 356, 370 (1973) (citing
Gemsco v. Walling, 324 U.S. 244 (1945) (giving great deference to a
regulation promulgated under similar prevention-of-evasion
rulemaking authority in the Fair Labor Standards Act)).
\1046\ 31 U.S.C. 5324 (stating, in pertinent part, that ``[n]o
person shall, for the purpose of evading the reporting requirements
of [the Bank Secrecy Act (BSA) or any regulation prescribed
thereunder] * * * . structure or assist in structuring, or attempt
to structure or assist in structuring, any transaction with one or
more domestic financial institutions''). The Federal Deposit
Insurance Corporation regulations implementing the BSA require banks
to report transactions that ``the bank knows, suspects, or has
reason to suspect'' are ``designed to evade any regulations
promulgated under the Bank Secrecy Act.'' 12 CFR 353.3 (2010).
\1047\ The Internal Revenue Code makes it unlawful for any
person willfully to attempt ``in any manner to evade or defeat any
tax * * * .'' 26 U.S.C. 7201. While a considerable body of case law
has developed under the tax evasion provision, the statute itself
does not define the term, but generally prohibits willful attempts
to evade tax.
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The CFTC will not consider transactions, entities, or instruments
structured in a manner solely motivated by a legitimate business
purpose to constitute willful evasion (``Business Purpose Test'').
Additionally, relying on Internal Revenue Service (``IRS'') concepts,
when determining whether particular conduct is an evasion of the Dodd-
Frank Act, the CFTC will consider the extent to which the conduct
involves deceit, deception, or other unlawful or illegitimate activity.
(a) Business Purpose Test
Interpretation
Consistent with the Proposing Release,\1048\ the CFTC recognizes
that transactions may be structured, and entities may be formed, in
particular ways for legitimate business purposes, without any intention
of circumventing the requirements of the Dodd-Frank Act with respect to
swaps. Thus, in evaluating whether a person is evading or attempting to
evade the swap requirements with respect to a particular instrument,
entity, or transaction, the CFTC will consider the extent to which the
person has a legitimate business purpose for structuring the instrument
or entity or entering into the transaction in that particular manner.
Although different means of structuring a transaction or entity may
have differing regulatory implications and attendant requirements,
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.
However, to the extent a purpose in structuring an entity or instrument
or entering into a transaction is to evade the requirements of Title
VII with respect to swaps, the structuring of such instrument, entity,
or transaction may be found to constitute willful evasion.\1049\
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\1048\ Proposing Release at 29867.
\1049\ As the CFTC observed in the Proposing Release, a similar
concept applies with respect to tax evasion. See Proposing Release
at 29867 n. 324. A transaction that is structured to avoid the
payment of taxes but that lacks a valid business purpose may be
found to constitute tax evasion. See, e.g., Gregory v. Helvering,
293 U.S. 465, 469 (1935) (favorable tax treatment disallowed because
transaction lacked any business or corporate purpose). Under the
``sham-transaction'' doctrine, ``a transaction is not entitled to
tax respect if it lacks economic effects or substance other than the
generation of tax benefits, or if the transaction serves no business
purpose.'' Winn-Dixie Stores, Inc. v. Comm'r, 254 F.3d 1313, 1316
(11th Cir. 2001) (citing Knetsch v. United States, 364 U.S. 361
(1960)). ``The doctrine has few bright lines, but `it is clear that
transactions whose sole function is to produce tax deductions are
substantive shams.' '' Id. (quoting United Parcel Serv. of Am., Inc.
v. Comm'r, 254 F.3d 1014, 1018 (11th Cir. 2001)). To be clear,
though, while the Proposing Release references the use of the
business purpose test in tax law, the CFTC is not using the
legitimate business purpose consideration in the same manner as the
IRS.
---------------------------------------------------------------------------
Although some commenters suggest that the determination that there
is a legitimate business purpose, and the use of that concept as a
relevant fact in the determination of the possibility of evasion, will
not provide appropriate clarity, it is a recognized analytical method
and would be useful in the overall analysis of potentially willful
evasive conduct.
The CFTC fully expects that a person acting for legitimate business
purposes within its respective industry will naturally weigh a
multitude of costs and benefits associated with different types of
financial transactions, entities, or instruments, including the
applicable regulatory obligations. In that regard, and in response to
commenters, the CFTC is clarifying that a person's specific
consideration of regulatory burdens, including the avoidance thereof,
is not dispositive that the person is acting without a legitimate
business purpose in a particular case. The CFTC will view legitimate
business purpose considerations on a case-by-case basis in conjunction
with all other relevant facts and circumstances.
Moreover, the CFTC recognizes that it is possible that a person
intending to willfully evade Dodd-Frank may attempt to justify its
actions by claiming that they are legitimate business practices in its
industry; therefore, the CFTC will retain the flexibility, via an
analysis of all relevant facts and circumstances, to confirm not only
the legitimacy of the business purpose of those actions but whether the
actions could still be determined to be willfully evasive. For example,
a person may attempt to disguise a product that may be a swap by
employing accounting practices that are not appropriate for swaps.
Whether or not the method of
[[Page 48302]]
accounting or employed accounting practices are determined to be for
legitimate business purposes, that alone will not be dispositive in
determining whether it is willfully evasive according to either rule
1.3(xxx)(6) or 1.6.
Because transactions and instruments are regularly structured, and
entities regularly formed, in a particular way for various, and often
times multiple, reasons, it is essential that all relevant facts and
circumstances be considered. Where a transaction, instrument, or entity
is structured solely for legitimate business purposes, it is not
willfully evasive. By contrast, where a consideration of all relevant
facts and circumstances reveals the presence of a purpose that is not a
legitimate business purpose, evasion may exist.
Comments
Two commenters believed the proposed business purpose test is
inappropriate for determining if a transaction is structured to evade
Title VII.\1050\ One of these commenters stated that the CFTC
misunderstood how the ``business purpose'' test is applied by the IRS
in the tax evasion context resulting in misguided proposed interpretive
guidance.\1051\ As stated above, the CFTC believes that it is
appropriate to consider legitimate business purposes in determining if
a transaction is structured to evade Title VII. In response to this
comment, although the interpretation references the use of legitimate
business purpose in tax law, the CFTC is not bound to use the
legitimate business purpose consideration in the same manner as the IRS
and, accordingly, is not adopting the IRS's interpretation.
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\1050\ See CME Letter and WGCEF Letter.
\1051\ See CME Letter.
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Two commenters urged the CFTC to clarify that considering the costs
of regulation is a legitimate business purpose when structuring a
transaction. Accordingly, they request that the CFTC clarify that
entering into a transaction to avoid costly regulations, even though
that transaction could otherwise be structured as a swap, will not be
considered per se evasion/evasive.\1052\ Finally, one commenter took
issue with the statement that ``absent other indicia of evasion, [the
CFTC] would not consider transactions, entities, or instruments in a
manner solely motivated by a legitimate business purpose to constitute
evasion.'' \1053\ Because ``transactions, entities, or instruments''
are rarely structured a certain way solely for one purpose, this
commenter believed such a statement does not give market participants
any relief or guidance.\1054\ The CFTC has addressed these comments
received on the business purpose test through the clarifications to its
interpretation discussed above and reiterates that the CFTC will
consider all relevant facts and circumstances in determining whether an
action is willfully evasive.
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\1052\ See ISDA Letter and WGCEF Letter.
\1053\ See SIFMA Letter.
\1054\ Id.
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(b) Fraud, Deceit or Unlawful Activity
Interpretation
When determining whether a particular activity constitutes willful
evasion of the CEA or the Dodd-Frank Act, the CFTC will consider the
extent to which the activity involves deceit, deception, or other
unlawful or illegitimate activity. This concept was derived from the
IRS's delineation of what constitutes tax evasion, as elaborated upon
by the courts. The IRS distinguishes between tax evasion and legitimate
means for citizens to minimize, reduce, avoid or alleviate the tax that
they pay under the Internal Revenue Code.\1055\ Similarly, persons that
craft derivatives transactions, structure entities, or conduct
themselves in a deceptive or other illegitimate manner in order to
avoid regulatory requirements should not be permitted to enjoy the
fruits of their deceptive or illegitimate conduct.
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\1055\ Whereas permissible means of reducing tax (or ``tax
avoidance,'' as the IRS refers to the practice) is associated with
full disclosure and explanation of why the tax should be reduced
under law, 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.'' The IRS explains:
Avoidance of taxes is not a criminal offense. Any attempt to
reduce, avoid, minimize, or alleviate taxes by legitimate means is
permissible. The distinction between avoidance and evasion is fine,
yet definite. 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. For example, the creation of a bona
fide partnership to reduce the tax liability of a business by
dividing the income among several individual partners is tax
avoidance. However, the facts of a particular investigation may show
that an alleged partnership was not, in fact, established and that
one or more of the alleged partners secretly returned his/her share
of the profits to the real owner of the business, who, in turn, did
not report this income. This would be an instance of attempted
evasion. IRS, Internal Revenue Manual, part 9.1.3.3.2.1, available
at http://www.irs.gov/irm/part9/irm_09-001-003.html#d0e169.
---------------------------------------------------------------------------
Although it is likely that fraud, deceit, or unlawful activity will
be present where willful evasion has occurred, the CFTC does not
believe that these factors are prerequisites to an evasion finding. As
stated throughout this release, the presence or absence of fraud,
deceit, or unlawful activity is one fact (or circumstance) the CFTC
will consider when evaluating a person's activity. That said, the anti-
evasion rules do require willfulness, i.e. ``scienter.'' In response to
the commenter who requests the CFTC define ``willful conduct,'' the
CFTC will interpret ``willful'' consistent with how the CFTC has in the
past, that a person acts ``willfully'' when they act either
intentionally or with reckless disregard.\1056\
---------------------------------------------------------------------------
\1056\ See In re Squadrito, [1990-1992 Transfer Binder] Comm.
Fut. L. Rep. (CCH) ] 25,262 (CFTC Mar. 27, 1992) (adopting
definition of ``willful'' in McLaughlin v. Richland Shoe Co., 486
U.S. 128 (1987)).
---------------------------------------------------------------------------
Comments
One commenter, although generally supportive of the use of the IRS
``tax evasion'' concept as a guidepost for this criterion, requested
the CFTC provide examples of legitimate versus evasive conduct in a
manner similar to what is contained in the Internal Revenue
Manual.\1057\ The CFTC does not believe it is appropriate to provide an
example because such an example may provide a guidepost for evasion.
---------------------------------------------------------------------------
\1057\ See CME Letter.
---------------------------------------------------------------------------
Two commenters suggested that a finding of fraud, deceit, or
unlawful activity should be a prerequisite to any finding of
evasion.\1058\ As noted above, the CFTC disagrees that such activity
should be a prerequisite to a finding of evasion, but its presence or
absence is one relevant fact and circumstance the CFTC will consider.
Finally, one commenter requested further guidance defining willful
conduct in the context of deliberate and knowing wrongdoing.\1059\ As
noted above, the CFTC has considered the suggestion that the CFTC
provide guidance on what defines ``willful behavior,'' with some
commenters submitting that some definitional guidance should be offered
or that the standard should be whether or not a transaction is
``lawful.'' \1060\ The CFTC agrees with the need for legal clarity and
believes that the concept of willfulness is a well-recognized legal
concept of which there is substantial case law and legal commentary
familiar to the financial industry.\1061\
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\1058\ See ISDA Letter and SIFMA Letter.
\1059\ See ISDA Letter (citing U.S. v. Tarallo, 380 F.3d 1174,
1187 (9th Cir. 2004), and Merck & Co. v. Reynolds, 130 S. Ct. 1784,
1796 (2010)).
\1060\ See CME Letter; ISDA Letter; and WGCEF Letter.
\1061\ See supra note 1056.
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[[Page 48303]]
B. SEC Position Regarding Anti-Evasion Rules
Section 761(b)(3) of the Dodd-Frank Act grants discretionary
authority to the SEC to define the terms ``security-based swap,''
``security-based swap dealer,'' ``major security-based swap
participant,'' and ``eligible contract participant,'' with regard to
security-based swaps, ``for the purpose of including transactions and
entities that have been structured to evade'' subtitle B of Title VII
(or amendments made by subtitle B).
The SEC did not propose rules under section 761(b)(3) regarding
anti-evasion but requested comment on whether SEC rules or interpretive
guidance addressing anti-evasion with respect to security-based swaps,
security-based swap dealers, major security-based swap participants, or
ECPs were necessary. Two commenters responded to the request for
comment and recommended that the SEC adopt anti-evasion rules and
interpretive guidance.\1062\ One commenter suggested that the SEC model
its anti-evasion rules and interpretive guidance on the CFTC's anti-
evasion rules.\1063\
---------------------------------------------------------------------------
\1062\ See Barnard Letter and Better Markets Letter.
\1063\ See Barnard Letter.
---------------------------------------------------------------------------
The SEC is not adopting anti-evasion rules under section 761(b)(3)
at this time. The SEC notes that since security-based swaps are
``securities'' for purposes of the Federal securities laws, unless the
SEC grants a specific exemption,\1064\ all of the SEC's existing
regulatory authority will apply to security-based swaps. Since existing
regulations, including antifraud and anti-manipulation provisions, will
apply to security-based swaps, the SEC believes that it is unnecessary
to adopt additional anti-evasion rules for security-based swaps under
section 761(b)(3) at this time.
---------------------------------------------------------------------------
\1064\ See Effective Date and Implementation infra part IX.
---------------------------------------------------------------------------
VIII. Miscellaneous Issues
A. Distinguishing Futures and Options From Swaps
The Commissions did not propose rules or interpretations in the
Proposing Release regarding distinguishing futures from swaps. One
commenter requested that the CFTC clarify that nothing in the release
was intended to limit a DCM's ability to list for trading a futures
contract regardless of whether it could be viewed as a swap if traded
over-the-counter or on a SEF, since futures and swaps are
indistinguishable in material economic effects.\1065\ This commenter
further recommended that the CFTC adopt a final rule that further
interprets the statutory ``swap'' definition.\1066\
---------------------------------------------------------------------------
\1065\ See CME Letter.
\1066\ Id. CME suggested that the CFTC modify the futures
contract exclusion in CEA Section 1a(47)(B)(i) so that the modified
language would read as follows: (B) EXCLUSIONS.--The term `swap'
does not include-- (i) any contract for the sale of a commodity for
future delivery listed for trading by a designated contract market
(or option on such contract) * * * CME believes that such a rule
would clarify the scope of Section 4(a) of the CEA, which makes it
illegal to trade a futures contract except on or subject to the
rules of a DCM.
CME believed that such a modification would clarify the scope of
Section 4(a) of the CEA, 7 U.S.C. 6(a), which makes it unlawful to
trade a futures contract except on or subject to the rules of a DCM.
---------------------------------------------------------------------------
The CFTC declines to provide the requested clarification or adopt a
rule. Prior distinctions that the CFTC relied upon (such as the
presence or absence of clearing) to distinguish between futures and
swaps may no longer be relevant.\1067\ As a result, it is difficult to
distinguish between futures and swaps on a blanket basis as the
commenter suggested. However, a case-by-case approach for
distinguishing these products may lead to more informed decision-making
by the CFTC. Moreover, the CFTC notes that a DCM may self-certify its
contracts pursuant to Part 40 of the CFTC's rules,\1068\ subject to the
CFTC's oversight authority. If a DCM has a view that a particular
product is a futures contract, it may self-certify the contract
consistent with that view. The DCM also has a number of other options,
including seeking prior approval from the CFTC, requesting an
interpretation, or requesting a rulemaking if it is in doubt about
whether a particular agreement, contract or transaction should be
classified as a futures contract or a swap.
---------------------------------------------------------------------------
\1067\ See, e.g., Swap Policy Statement, supra note 214.
\1068\ 17 CFR Part 40.
---------------------------------------------------------------------------
B. Transactions Entered Into by Foreign Central Banks, Foreign
Sovereigns, International Financial Institutions, and Similar Entities
The swap definition excludes ``any agreement, contract, or
transaction a counterparty of which is a Federal Reserve bank, the
Federal Government, or a Federal agency that is expressly backed by the
full faith and credit of the United States.'' \1069\ Some commenters to
the ANPR suggested that the Commissions should exercise their authority
to further define the terms ``swap'' to similarly exclude transactions
in which a counterparty is a foreign central bank, a foreign sovereign,
an international financial institution (``IFI''),\1070\ or similar
organization. ANPR commenters advanced international comity, national
treatment, limited regulatory resources, limits on the Commissions'
respective extraterritorial jurisdiction, and international
harmonization as rationales for such an approach. The Proposing Release
was silent on this issue.\1071\
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\1069\ CEA section 1a(47)(B)(ix), 7 U.S.C. 1a(47)(B)(ix).
\1070\ For this purpose, we consider the ``international
financial institutions'' to be those institutions defined as such in
22 U.S.C. 262r(c)(2) and the institutions defined as ``multilateral
development banks'' in the Proposal for the Regulation of the
European Parliament and of the Council on OTC Derivative
Transactions, Central Counterparties and Trade Repositories, Council
of the European Union Final Compromise Text, Article 1(4a(a)) (March
19, 2012). There is overlap between the two definitions, but
together they include the following institutions: the International
Monetary Fund, International Bank for Reconstruction and
Development, European Bank for Reconstruction and Development,
International Development Association, International Finance
Corporation, Multilateral Investment Guarantee Agency, African
Development Bank, African Development Fund, Asian Development Bank,
Inter-American Development Bank, Bank for Economic Cooperation and
Development in the Middle East and North Africa, Inter-American
Investment Corporation, Council of Europe Development Bank, Nordic
Investment Bank, Caribbean Development Bank, European Investment
Bank and European Investment Fund. (The term international financial
institution includes entities referred to as multilateral
development banks. The International Bank for Reconstruction and
Development, the International Finance Corporation and the
Multilateral Investment Guarantee Agency are parts of the World Bank
Group.) The Bank for International Settlements, which also submitted
a comment, is a bank in which the Federal Reserve and foreign
central banks are members. Another commenter, KfW, is a corporation
owned by the government of the Federal Republic of Germany and the
German State governments and backed by the ``full faith and credit''
of the Federal Republic of Germany.
\1071\ But see Dissent of Commissioner Sommers, Proposing
Release at 29899.
---------------------------------------------------------------------------
Comments
Several commenters asserted that swaps transactions to which an IFI
is a counterparty should be excluded from the swap and security-based
swap definitions.\1072\ In addition to the arguments noted above,
commenters asserted that certain IFIs have been granted certain
statutory immunities by the United States, and that regulation under
the Dodd-Frank Act of their
[[Page 48304]]
activities would be inconsistent with the grant of these immunities.
---------------------------------------------------------------------------
\1072\ See Letter from G[uuml]nter Pleines and Diego Devos, Bank
for International Settlements, dated July 20, 2011; Letter from
Jacques Mirante-P[eacute]r[eacute] and Jan De Bel, Council of Europe
Development Bank, dated July 22, 2011; Letter from Isabelle Laurant,
European Bank for Reconstruction and Development, dated July 22,
2011; Letter from A. Querejeta and B. de Mazi[egrave]res, European
Investment Bank, dated July 22, 2011; Letter from J. James Spinner
and S[oslash]ren Elbech, Inter-American Development Bank, dated July
22, 2011; Letter from Lutze-Christian Funke and Frank Czichowski,
KfW, dated August 12, 2011; Letter from Heikki Cantell and Lars
Eibeholm, Nordic Investment Bank, dated August 2, 2011; and Letter
from Vicenzo La Via, World Bank Group, dated July 22, 2011.
---------------------------------------------------------------------------
The CFTC declines to provide an exclusion from the swap definition
along the lines suggested by these commenters.\1073\ An exclusion from
the swap definition for swap transactions entered into by foreign
sovereigns, foreign central banks, IFIs and similar entities, would
mean that swaps entered into by such entities would be completely
excluded from Dodd-Frank regulation. Their counterparties, who may be
swap dealers or major swap participants, or security-based swap dealers
or major security-based swap participants, would have no regulatory
obligations with respect to such swaps. These regulated counterparties
could develop significant exposures to the foreign sovereigns, foreign
central banks, IFIs and similar entities, without the knowledge of the
Commissions.
---------------------------------------------------------------------------
\1073\ The commenters' suggested exclusion from the swap
definition would also exclude their transactions from the security-
based swap definition, which is based on the definition of swap.
---------------------------------------------------------------------------
In addition, swaps entered into by foreign sovereigns, foreign
central banks, IFIs and similar entities undeniably are swaps. To be
sure, the Commissions have adopted rules and interpretations to further
define the term ``swap'' to exclude certain transactions, which prior
to the enactment of the Dodd-Frank Act generally would not have been
considered swaps. However, the CFTC is not using its authority to
further define the term ``swap'' to effectively exempt transactions
that are, in fact, swaps. While, as noted above, Congress included a
counterparty-specific exclusion for swaps entered into by the Federal
Reserve Board, the Federal government and certain government agencies,
Congress did not provide a similar exemption for foreign central banks,
foreign sovereigns, IFIs, or similar organizations.
C. Definition of the Terms ``Swap'' and ``Security-Based Swap'' as Used
in the Securities Act
The SEC is adopting a technical rule that provides that the terms
``swap'' and ``security-based swap'' as used in the Securities Act
\1074\ have the same meanings as in the Exchange Act \1075\ and the
rules and regulations thereunder.\1076\ The SEC is adopting such
technical rule to assure consistent definitions of these terms under
the Securities Act and the Exchange Act.
---------------------------------------------------------------------------
\1074\ See section 2(a)(17) of the Securities Act, 15 U.S.C.
77b(a)(17).
\1075\ See sections 3(a)(69) of the Exchange Act, 15 U.S.C.
78c(a)(69), and 3(a)(68) of the Exchange Act, 15 U.S.C. 78c(a)(68).
The definitions of the terms ``swap'' and ``security-based swap'' in
the Exchange Act are the same as the definitions of these terms in
the CEA. See section 1a of the CEA, 7 U.S.C. 1a.
\1076\ See rule 194 under the Securities Act.
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IX. Effective Date and Implementation
Consistent with sections 754 and 774 of the Dodd-Frank Act, the
final rules and interpretations will be effective October 12, 2012. The
compliance date for the final rules and interpretations also will be
October 12, 2012; with the following exceptions:
The compliance date for the interpretation regarding
guarantees of swaps will be the effective date of the rules proposed in
the separate CFTC release when such rules are adopted by the CFTC.
Solely for the purposes of the Order Granting Temporary
Exemptions under the Securities Exchange Act of 1934 in Connection with
the Pending Revision of the Definition of ``Security'' to Encompass
Security-Based Swaps \1077\ and the Exemptions for Security-Based
Swaps,\1078\ the compliance date for the final rules further defining
the term ``security-based swap'' will be February 11, 2013.
---------------------------------------------------------------------------
\1077\ 76 FR 39927 (Jul. 7, 2011) (``Exchange Act Exemptive
Order''). The Exchange Act Exemptive Order grants temporary relief
and provides interpretive guidance to make it clear that a
substantial number of the requirements of the Exchange Act do not
apply to security-based swaps as a result of the revised definition
of ``security'' going into effect on July 16, 2011. The Exchange Act
Exemptive Order also provided temporary relief from provisions of
the Exchange Act that allow the voiding of contracts made in
violation of those laws.
\1078\ Rule 240 under the Securities Act, 17 CFR 230.240, rules
12a-11 and 12h-1(i) under the Exchange Act 1934, 17 CFR 240.12a-11
and 240.12h-1(i), and Rule 4d-12 under the Trust Indenture Act of
1939, 17 CFR 260.4d-12 (``SB Swaps Interim Final Rules''). See also
76 FR 40605 (Jul. 11, 2011). The SB Swaps Interim Final Rules
provide exemptions under the Securities Act, the Exchange Act, and
the Trust Indenture Act of 1939 for those security-based swaps that
prior to July 16, 2011, were security-based swap agreements and are
defined as ``securities'' under the Securities Act and the Exchange
Act as of July 16, 2011, due solely to the provisions of the Dodd-
Frank Act. The SB Swaps Interim Final Rules exempt offers and sales
of these security-based swaps from all provisions of the Securities
Act, other than the Section 17(a) anti-fraud provisions, as well as
exempt these security-based swaps from Exchange Act registration
requirements and from the provisions of the Trust Indenture Act of
1939, provided certain conditions are met.
---------------------------------------------------------------------------
The CFTC believes that it is appropriate to make the compliance
date for the interpretation regarding guarantees of swaps the same as
the effective date of the rules proposed in the separate CFTC release
when such rules are adopted by the CFTC in order to relieve market
participants from compliance obligations that would arise as a result
of the interpretation. As described in the Exchange Act Exemptive Order
and as provided in the SB Swaps Interim Final Rules, the exemptions
granted pursuant to the Exchange Act Exemptive Order and the SB Swaps
Interim Final Rules will expire upon the compliance date of the final
rules further defining the terms ``security-based swap'' and ``eligible
contract participant.'' The final rules further defining the term
``eligible contract participant,'' adopted in the Entity Definitions
Release,\1079\ were published in the Federal Register on May 23, 2012.
The compliance date and the effective date for such final rules is the
same, July 23, 2012. The SEC believes that establishing a compliance
date for the definition of ``security-based swap'' solely for purposes
of the Exchange Act Exemptive Order and the SB Swaps Interim Final
Rules that is February 11, 2013 (i.e. 120 days after the effective
date) is appropriate because doing so will leave in place the
exemptions granted by the Exchange Act Exemptive Order and the SB Swaps
Interim Final Rules for a period of time that is sufficient to
facilitate consideration of that order and rule. Specifically, the SEC
will consider the appropriate treatment of security-based swaps under
the provisions of the Exchange Act not amended by the Dodd-Frank Act
before expiration of the exemptions set forth in the Exchange Act
Exemptive Order, and will consider the appropriate treatment of
security-based swaps for purposes of the registration provisions of the
Securities Act, the registration provisions of the Exchange Act, and
the indenture qualification provisions of the Trust Indenture Act of
1939 before the expiration of the exemptions set forth in the SB Swaps
Interim Final Rules.\1080\
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\1079\ See supra note 12.
\1080\ The SEC has received a request for certain permanent
exemptions upon the expiration of the exemptions contained in the
Exchange Act Exemptive Order. See SIFMA SBS Exemptive Relief Request
(Dec. 5, 2011), which is available at http://www.sec.gov/comments/s7-27-11/s72711-10.pdf. The SEC also has received comments regarding
the exemptions under the Securities Act, the Exchange Act, and the
Trust Indenture Act of 1939. See Letter from Kenneth E. Bentsen,
Jr., Executive Vice President, Public Policy and Advocacy, SIFMA,
and Robert Pickel, Chief Executive Officer, ISDA, dated Apr. 20,
2012, which is available at http://www.sec.gov/comments/s7-26-11/s72611-5.pdf. The SEC is reviewing the request for exemptive relief
and each related comment and will consider any appropriate actions
regarding such request.
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If any provision of these final rules or interpretations, or the
application thereof to any person or circumstance, is held to be
invalid, such invalidity shall not affect other provisions or
application of such provisions to other persons or circumstances that
can be
[[Page 48305]]
given effect without the invalid provision or application.
X. Administrative Law Matters--CEA Revisions
A. Paperwork Reduction Act
1. Introduction
The Paperwork Reduction Act of 1995 (``PRA'') imposes certain
requirements on Federal agencies in connection with their conducting or
sponsoring any collection of information as defined by the PRA.\1081\
An agency may not conduct or sponsor, and a person is not required to
respond to, a collection of information unless it displays a currently
valid control number. Certain provisions of this rule will result in
new collection of information requirements within the meaning of the
PRA. With the exception of the new ``book-out'' confirmation
requirement discussed below, the CFTC believes that the burdens that
will be imposed on market participants under rules 1.8 and 1.9 already
have been accounted for within the SEC's calculations regarding the
impact of this collection of information under the PRA and the request
for a control number submitted by the SEC to OMB for rule 3a68-2
(``Interpretation of Swaps, Security-Based Swaps, and Mixed Swaps'')
and rule 3a68-4 (``Regulation of Mixed Swaps: Process for Determining
Regulatory Treatment for Mixed Swaps''). In response to this
submission, OMB issued control number 3235-0685. The responses to these
collections of information will be mandatory.\1082\ The CFTC will
protect proprietary information according to the Freedom of Information
Act and 17 CFR part 145, headed ``Commission Records and Information.''
In addition, the CFTC emphasizes that section 8(a)(1) of the CEA \1083\
strictly prohibits the Commission, unless specifically authorized by
the CEA, from making public ``data and information that would
separately disclose the business transactions or market positions of
any person and trade secrets or names of customers.'' The CFTC also is
required to protect certain information contained in a government
system of records pursuant to the Privacy Act of 1974.
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\1081\ 44 U.S.C. 3501 et seq.
\1082\ As discussed below, the ``collection of information''
related to the new ``book out'' confirmation requirement was not
included in the SEC's submission and will be the subject of a
request for a control number by the CFTC to OMB.
\1083\ 7 U.S.C. 12(a)(1).
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2. Rules 1.8 and 1.9
As discussed in the proposal, Rules 1.8 and 1.9 under the CEA will
result in new ``collection of information'' requirements within the
meaning of the PRA. Rule 1.8 under the CEA will allow persons to submit
a request for a joint interpretation from the Commissions regarding
whether an agreement, contract or transaction (or a class thereof) is a
swap, security-based swap, or mixed swap. Rule 1.8 provides that a
person requesting an interpretation as to the nature of an agreement,
contract, or transaction as a swap, security-based swap, or mixed swap
must provide the Commissions with the person's determination of the
nature of the instrument and supporting analysis, along with certain
other documentation, including a statement of the economic purpose for,
and a copy of all material information regarding the terms of, each
relevant agreement, contract, or transaction (or class thereof). The
Commissions also may request the submitting person to provide
additional information. In response to the submission, the Commissions
may issue a joint interpretation regarding the status of that
agreement, contract, or transaction (or class of agreements, contracts,
or transactions) as a swap, security-based swap, or mixed swap.
Rule 1.9 of the CEA enables persons to submit requests to the
Commissions for joint orders providing an alternative regulatory
treatment for particular mixed swaps. Under rule 1.9, a person will
provide to the Commissions a statement of the economic purpose for, and
a copy of all material information regarding, the relevant mixed swap.
In addition, the person will provide the specific alternative
provisions that the person believes should apply to the mixed swap, the
reasons the person believes it would be appropriate to request an
alternative regulatory treatment, and an analysis of: (i) The nature
and purposes of the specified provisions; (ii) the comparability of the
specified provisions to other statutory provisions of Title VII of the
Dodd-Frank Act and the rules and regulations thereunder; and (iii) the
extent of any conflicting or incompatible requirements of the specified
provisions and other statutory provisions of Title VII and the rules
and regulations thereunder. The Commissions also may request the
submitting person to provide additional information.
(a) Information Provided by Reporting Entities
The burdens imposed by rules 1.8 and 1.9 under the CEA are the same
as the burdens imposed by the SEC's rules 3a68-2 and 3a68-4. Therefore,
the burdens that will be imposed on market participants under rules 1.8
and 1.9 already have been accounted for within the SEC's calculations
regarding the impact of this collection of information under the PRA
and the request for a control number submitted by the SEC to OMB.\1084\
(b) Information Collection Comments
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\1084\ 44 U.S.C. 3501-3521. See also 44 U.S.C. 3509 and 3510.
---------------------------------------------------------------------------
In the Proposing Release, the CFTC invited public comment on the
reporting and recordkeeping burdens discussed above with regard to
rules 1.8 and 1.9. Pursuant to 44 U.S.C. 3506(c)(2)(B), the CFTC
solicited comments in order to: (i) Evaluate whether the proposed
collections of information are necessary for the proper performance of
the functions of the CFTC, including whether the information will have
practical utility; (ii) evaluate the accuracy of the CFTC's estimate of
the burden of the proposed collections of information; (iii) determine
whether there are ways to enhance the quality, utility, and clarity of
the information to be collected; and (iv) minimize the burden of the
collections of information on those who are to respond, including
through the use of automated collection techniques or other forms of
information technology.
No comments were received with respect to the reporting and
recordkeeping burdens discussed in the proposing release. In response
to the request for a control number by the SEC, OMB issued control
number 3235-0685.
3. Book-Out Confirmation
As noted above, the CFTC believes that its interpretation which
clarifies that oral book-out agreements must be followed in a
commercially reasonable timeframe by a confirmation in some type of
written or electronic form would result in a new ``collection of
information'' requirement within the meaning of the PRA. Therefore, the
CFTC is submitting the new ``book-out'' information collection to OMB
for review in accordance with 44 U.S.C. 3506(c)(2)(A) and 5 CFR
1320.8(d). The CFTC will, by separate action, publish in the Federal
Register a notice on the paperwork burden associated with the
interpretation's requirement that oral book-outs be followed in a
commercially reasonable timeframe by confirmation in some type of
written or electronic form in accordance with 5 CFR 1320.8 and 1320.10.
If approved, this new collection of information will be mandatory.
[[Page 48306]]
B. Regulatory Flexibility Act
The Regulatory Flexibility Act (``RFA'') requires that agencies
consider whether the rules they propose will have a significant
economic impact on a substantial number of small entities and, if so,
provide a regulatory flexibility analysis respecting the impact.\1085\
A regulatory flexibility analysis or certification typically is
required for ``any rule for which the agency publishes a general notice
of proposed rulemaking pursuant to'' the notice-and-comment provisions
of the Administrative Procedure Act, 5 U.S.C. 553(b).
---------------------------------------------------------------------------
\1085\ 5 U.S.C. 601 et seq.
---------------------------------------------------------------------------
With respect to the proposed release, while the CFTC provided an
RFA statement that the proposed rule would have a direct effect on
numerous entities, specifically DCMs, SDRs, SEFs, SDs, MSPs, ECPs,
FBOTs, DCOs, and certain ``appropriate persons'' who relied on the
Energy Exemption,\1086\ the Chairman, on behalf of the CFTC, certified
that the rulemaking would not have a significant economic effect on a
substantial number of small entities. Comments on that certification
were sought.
---------------------------------------------------------------------------
\1086\ See 76 FR 29868-89.
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In the Proposing Release, the CFTC provided that it previously had
established that certain entities subject to the CFTC's jurisdiction--
namely, DCMs, DCOs and ECPs--are not small entities for purposes of the
RFA.\1087\ As the CFTC previously explained, because of the central
role they play in the regulatory scheme concerning futures trading, the
importance of futures trading in the national economy, and the
financial requirements needed to comply with the regulatory
requirements imposed on them under the CEA, DCMs and DCOs have long
been determined not to be small entities.\1088\ Based on the definition
of ECP in the Commodity Futures Modernization Act of 2000 (``CFMA'')
and the legislative history underlying that definition, the CFTC
determined that ECPs were not small entities.\1089\ In light of its
past determination, and the increased thresholds on ECPs added by the
Dodd-Frank Act making it more difficult for entities to qualify as an
ECP, the CFTC determined in its proposed rulemakings that ECPs are not
small entities.
---------------------------------------------------------------------------
\1087\ See respectively, Policy Statement and Establishment of
Definitions of ``Small Entities'' for Purposes of the Regulatory
Flexibility Act, supra note 331, at 18619 (DCMs); A New Regulatory
Framework for Clearing Organizations, 66 FR 45604, 45609 (Aug. 29,
2001) (DCOs); Opting Out of Segregation, 66 FR 20740, 20743 (Apr.
25, 2001) (ECPs).
\1088\ See respectively, Policy Statement and Establishment of
Definitions of ``Small Entities'' for Purposes of the Regulatory
Flexibility Act, supra note 331, at 18619 (DCMs); A New Regulatory
Framework for Clearing Organizations, 66 FR 45604, 45609, Aug. 29,
2001 (DCOs).
\1089\ See Opting Out of Segregation. 66 FR 20740, 20743, Apr.
25, 2001 (ECPs).
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Furthermore, the CFTC provided that certain entities that would be
subject to the proposed rule--namely SDs, MSPs, SDRs, SEFs, and FBOTs--
are entities for which the CFTC had not previously made a size
determination for RFA purposes. The CFTC determined that these entities
should not be considered small entities based on their size and
characteristics analogous to non-small entities that pre-dated the
adoption of Dodd-Frank,\1090\ and certified in rulemakings that would
have an economic impact on these entities that these entities are not
small entities for RFA purposes.\1091\
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\1090\ See 76 FR 29868-89.
\1091\ See respectively, Registration of Swap Dealers and Major
Swap Participants, 77 FR 2613, 2620, Jan. 19, 2012 (swap dealers and
major swap participants); Requirements for Derivatives Clearing
Organizations, Designated Contract Markets, and Swap Execution
Facilities Regarding the Mitigation of Conflicts of Interest, 75 FR
63732, 63745, Oct. 18, 2010 (SEFs); Swap Data Repositories, 76 FR
54538, 54575, Sept. 1, 2011; Registration of Foreign Boards of
Trade, 76 FR 80674, 80698, Dec. 23, 2011 (FBOTs).
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Finally, the CFTC recognized that, in light of the CFTC's proposed
withdrawal of the Energy Exemption, the proposed rule could have an
economic impact on certain ``appropriate persons'' who relied on the
Energy Exemption. The Energy Exemption listed certain ``appropriate
persons'' that could rely on the exemption and also required that, to
be eligible for this exemption, an ``appropriate person must have
demonstrable capacity or ability to make or take delivery.'' The Energy
Exemption stated: ``in light of the general nature of the current
participants in the market, the CFTC believes that smaller commercial
firms, which cannot meet [certain] financial criteria, should not be
included.'' \1092\ Therefore, the CFTC did not believe that the
``appropriate persons'' eligible for the Energy Exemption, and who may
be affected by its withdrawal, are ``small entities'' for purposes of
RFA. Moreover, as previously discussed, the CFTC is expanding the Brent
Interpretation to all nonfinancial commodities for both swaps and
future delivery definitions and is clarifying that certain alternative
delivery procedures discussed in the Energy Exemption will not
disqualify a transaction from the forward contract exclusion under the
Brent Interpretation.\1093\ Thus, to the extent any entities, small or
otherwise, relied on the Energy Exemption, such entities can now rely
on the expanded Brent Interpretation to qualify for the forward
contract exclusion. Accordingly, the withdrawal of the Energy Exemption
will not result in a significant economic impact on any entities.
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\1092\ Energy Exemption, supra note 207.
\1093\ See supra part II.B.2.(a)(i)(C).
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With respect to this rulemaking, which includes interpretations, as
well as general rules of construction and definitions that will largely
be used in other rulemakings, the CFTC received one comment respecting
its RFA certification. The commenter, an association that represents
producers, generators, processors, refiners, merchandisers and
commercial end users of nonfinancial energy commodities, including
energy and natural gas, contended that the CFTC's overall new
jurisdiction under the Dodd-Frank Act over ``swaps'' and the burdens
that the CFTC's rules place on nonfinancial entities, including small
entities such as its members \1094\ that execute such swaps, can only
be determined after the rules and interpretations in the product
definitions rulemaking are finalized. Moreover, the commenter asserted
that its small entity members seek to continue their use of
nonfinancial commodity ``swaps'' only to hedge the commercial risks of
their not-for profit public service activities. The commenter concluded
that the CFTC should conduct a regulatory flexibility analysis for the
entire mosaic of its rulemakings under the Dodd-Frank Act, taking into
consideration the products definition rulemaking.
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\1094\ See ETA Letter. In general, ETA states that the Small
Business Administration (``SBA'') has determined that many of its
members are ``small entities'' for purposes of the RFA. Id.
(references the comment letter filed by the NRECA, APPA and LLPC as
the ``Not-for-Profit Electric Coalition'' in response to the
Commodity Option NOPR's (76 FR 6095) assertion that there are no
ECPs that are ``small entities'' for RFA purposes).
---------------------------------------------------------------------------
The commenter did not provide specific information on how the
further defining of the terms swap, security-based swap and security-
based swap agreement, providing regulations regarding mixed swaps, and
providing regulations governing books and records requirements for
security-based swap agreements would have a significant impact on a
substantial number of small entities. Nonetheless, the CFTC has
reevaluated this rulemaking in light of the commenter's statements.
Upon consideration, the CFTC declines to consider the economic impacts
of the entire mosaic of rules under the Dodd-
[[Page 48307]]
Frank Act, since an agency is only required to consider the impact of
how it exercises its discretion to implement the statute through a
particular rule. In all rulemakings, the CFTC performs an RFA analysis
for that particular rule.
Moreover, as the commenter mentioned, most of the transactions into
which its members enter are based on nonfinancial commodities. The CFTC
has provided interpretations in this release clarifying the forward
exclusion in nonfinancial commodities from the swap definition (and the
forward exclusion from the definition of ``future delivery''),
including forwards with embedded volumetric options, and separately,
has provided for a trade option exemption.\1095\ The CFTC also has
provided an interpretation that certain customary commercial
transactions are excluded from the swap definition.\1096\
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\1095\ See Commodity Options, 77 FR 25320, Apr. 27, 2012.
\1096\ To the extent the transactions entered into by ETA
members are traded or executed on Regional Transmission
Organizations and Independent System Operators, or entered into
between entities described in section 201(f) of the Federal Power
Act, they may be addressed through the public interest waiver
process described in CEA section 4(c)(6).
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Accordingly, for the reasons stated in the proposal and the
foregoing discussion in response to the comment received, the CFTC
continues to believe that the rulemaking will not have a significant
impact on a substantial number of small entities. Therefore, the
Chairman, on behalf of the CFTC, hereby certifies pursuant to 5 U.S.C.
605(b) that the rules will not have a significant impact on a
substantial number of small entities.
C. Costs and Benefits Considerations
Section 15(a) of the CEA requires the CFTC to consider the costs
and benefits of its actions before promulgating a regulation or issuing
certain orders under the CEA.\1097\ Section 15(a) further specifies
that the costs and benefits shall be evaluated in light of the
following five broad areas of market and public concern: (1) Protection
of market participants and the public; (2) efficiency, competitiveness,
and financial integrity of markets; (3) price discovery; (4) sound risk
management practices; and (5) other public interest considerations. The
CFTC considers the costs and benefits resulting from its discretionary
determinations with respect to the Section 15(a) factors. The CFTC also
considers, qualitatively, costs and benefits relative to the status
quo, that is, the pre-Dodd Frank Act regulatory regime, for historical
context to help inform the reader.
---------------------------------------------------------------------------
\1097\ 7 U.S.C. 19(a).
---------------------------------------------------------------------------
In the Proposing Release, the CFTC assessed the costs and benefits
of the proposed rules in general, followed by assessments of the costs
and benefits of each of the rules, taking into account the
considerations described above. The CFTC also requested comment on
these assessments, and a number of comments were received. In this
Adopting Release, the CFTC will again assess the costs and benefits of
the rules in general followed by the individual rules in this
rulemaking, for each case taking into account the above considerations
and the comments received. These costs and benefits, to the extent
identified and, where possible, quantified have helped to inform the
decisions of and the actions taken by the CFTC that are described
throughout this release.
1. Introduction
Prior to the adoption of Title VII, swaps and security-based swaps
were by and large unregulated. The Commodity Futures Modernization Act
of 2000 (``CFMA'') excluded financial over-the-counter swaps from
regulation under the CEA, provided that trading occurred only among
``eligible contract participants.'' \1098\ Swaps based on exempt
commodities--including energy and metals--could be traded among ECPs
without CFTC regulation, but certain CEA provisions against fraud and
manipulation continued to apply to these markets. No statutory
exclusions were provided for swaps on agricultural commodities by the
CFMA, although they could be traded under certain regulatory exemptions
provided by the CFTC prior to its enactment. Swaps based on securities
were subject to certain SEC enforcement authorities, but the SEC was
prohibited from prophylactic regulation of such swaps.
---------------------------------------------------------------------------
\1098\ See 7 U.S.C. 1a(12) (2006).
---------------------------------------------------------------------------
In the fall of 2008, an economic crisis threatened to freeze U.S.
and global credit markets. The Federal government intervened to
buttress the stability of the U.S. financial system.\1099\ The crisis
revealed the vulnerability of the U.S. financial system and economy to
wide-spread systemic risk resulting from, among other things, poor risk
management practices of certain financial firms and the lack of
supervisory oversight for financial institutions as a whole.\1100\ More
specifically, the crisis demonstrated the need for regulation of the
over-the-counter derivatives markets.\1101\
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\1099\ On October 3, 2008, President Bush signed the Emergency
Economic Stabilization Act of 2008, which was principally designed
to allow the U.S. Treasury and other government agencies to take
action to help to restore liquidity and stability to the U.S.
financial system (e.g., the Trouble Asset Relief Program--also known
as TARP--under which the U.S. Treasury was authorized to purchase up
to $700 billion of troubled assets that weighed down the balance
sheets of U.S. financial institutions). See Public Law 110-343, 122
Stat. 3765 (2008).
\1100\ See Financial Crisis Inquiry Commission, ``The Financial
Crisis Inquiry Report: Final Report of the National Commission on
the Causes of the Financial and Economic Crisis in the United
States,'' Jan. 2011, at xxvii, available at http://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf.
\1101\ Id. at 25 (concluding that ``enactment of * * * [the
Commodity Futures Modernization Act of 2000 (``CFMA'')] to ban the
regulation by both the Federal and State governments of over-the-
counter (OTC) derivatives was a key turning point in the march
toward the financial crisis.''). See also id. at 343 (``Lehman, like
other large OTC derivatives dealers, experienced runs on its
derivatives operations that played a role in its failure. Its
massive derivatives positions greatly complicated its bankruptcy,
and the impact of its bankruptcy through interconnections with
derivatives counterparties and other financial institutions
contributed significantly to the severity and depth of the financial
crisis.'') and id. at 353 (``AIG's failure was possible because of
the sweeping deregulation of [OTC] derivatives, [* * *] including
capital and margin requirements that would have lessened the
likelihood of AIG's failure. The OTC derivatives market's lack of
transparency and of effective price discovery exacerbated the
collateral disputes of AIG and Goldman Sachs and similar disputes
between other derivatives counterparties.'').
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On July 21, 2010, President Obama signed the Dodd-Frank Act into
law. Title VII of the Dodd-Frank Act established a comprehensive new
regulatory framework for swaps and security-based swaps. As discussed
above, the legislation was enacted, among other reasons, to reduce
risk, increase transparency, and promote market integrity within the
financial system, including by: (i) Providing for the registration and
comprehensive regulation of swap dealers, security-based swap dealers,
major swap participants, and major security-based swap participants;
(ii) imposing clearing and trade execution requirements on swaps and
security-based swaps, subject to certain exceptions; (iii) creating
rigorous recordkeeping and real-time reporting regimes; and (iv)
enhancing the rulemaking and enforcement authorities of the Commissions
with respect to, among others, all registered entities and
intermediaries subject to the Commissions' oversight.\1102\
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\1102\ The CFTC has provided a table in the Appendix that cross-
references the costs and benefits considerations of the final rules
effectuated by the Product Definitions in order to provide more
transparency with respect to this qualitative assessment of the
programmatic costs. See Appendix, ``Rules Effectuated by Product
Definitions.'' The CFTC is not providing a quantitative estimate of
total programmatic costs, because it cannot be reliably estimated at
this time. Many rules have not been finalized, including capital and
margin which may have significant costs. Any estimate made of the
programmatic costs of the Product Definitions would be unreliable
and therefore may be misleading.
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[[Page 48308]]
Section 721 of the Dodd-Frank Act amends the Commodity Exchange Act
(``CEA'') by adding definitions of the terms ``swap,'' ``security-based
swap,'' and ``security-based swap agreement.'' Section 712(d)(1)
provides that the CFTC and the SEC, in consultation with the Federal
Reserve Board, shall jointly further define those terms. Section
712(a)(8) provides further that the Commissions shall jointly prescribe
such regulations regarding ``mixed swaps'' as may be necessary to carry
out the purposes of Title VII of the Dodd-Frank Act (``Title VII'').
Section 712(d)(2) requires the Commissions, in consultation with the
Federal Reserve Board, to jointly adopt rules governing books and
records requirements for security-based swap agreements.
Under the comprehensive framework for regulating swaps and
security-based swaps established in Title VII, the CFTC is given
regulatory authority over swaps, the SEC is given regulatory authority
over security-based swaps, and the Commissions jointly are to prescribe
such regulations regarding mixed swaps as may be necessary to carry out
the purposes of Title VII. In addition, the SEC is given antifraud
authority over, and access to information from, certain CFTC-regulated
entities regarding security-based swap agreements, which are a type of
swap related to securities over which the CFTC is given regulatory and
enforcement authority.
The statutory definitions of ``swap'' and ``security-based swap''
in Title VII are detailed and comprehensive. The Dodd-Frank Act directs
the Commissions, among other things, to ``further define'' these terms;
it does not direct the Commissions to provide definitions for them,
which are already provided for in the statute. Thus, even in the
absence of these rules, the Dodd-Frank Act would require regulating
products that meet the statutory definitions of these terms as swaps
and security-based swaps. Consequently, a large part of the costs and
benefits resulting from the regulation of swaps and security-based
swaps derives from the Dodd-Frank Act itself and not from these rules
that further define swaps.
Several commenters to the ANPR issued by the Commissions regarding
the definitions expressed a concern that the product definitions could
be read broadly to include certain types of transactions that
previously had never been considered swaps or security-based swaps. In
response to those comments, the rules and interpretations clarify that
certain traditional insurance products, consumer and commercial
agreements, and loan participations are not swaps or security-based
swaps, which will increase legal certainty and lower the costs of
assessing whether a product is a swap or security-based swap for market
participants. In this regard, the rules and interpretations are
intended to reduce unnecessary burdens on persons using such
agreements, contracts, or transactions, the regulation of which under
Title VII may not be necessary or appropriate to further the purposes
of Title VII.
In addition, the CFTC is clarifying the scope of the forward
contract exclusion \1103\ for nonfinancial commodities from the
statutory swap definition to provide legal certainty for market
participants as to which transactions will qualify for the exclusion.
In this regard, the CFTC is clarifying the circumstances under which
market participants may rely on past CFTC guidance regarding the
forward exclusion from the definition of ``future delivery,'' and in
particular the Brent Interpretation for booked-out transactions,\1104\
with respect to the forward exclusion from the swap definition. The
CFTC is extending the Brent Interpretation to all nonfinancial
commodities, and is withdrawing the Energy Exemption as proposed,
\1105\ with certain clarifications. The final interpretation with
clarifications in response to comments should enhance legal certainty
regarding the forward exclusions.
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\1103\ See supra part II.B.2.a).
\1104\ See supra part II.B.2.a)i)(B).
\1105\ See supra part II.B.2.a)i)(C).
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While the statutory definitions of swap and security-based swap are
detailed and comprehensive, the rules further clarify whether
particular types of transactions are swaps or security-based swaps. For
example, foreign exchange forwards and swaps are defined as swaps,
subject to the Treasury Secretary's determination to exempt them from
the swap definition. The statute provides that certain provisions of
the CEA apply to foreign exchange forwards and swaps, even if the
Treasury Secretary determines to exempt them, and the rules reflect
this. Specifically, these transactions still would be subject to
certain requirements for reporting swaps, and swap dealers and major
swap participants engaging in such transactions still would be subject
to certain business conduct standards. The rules also clarify that,
because certain foreign exchange products do not fall within the
definitions of foreign exchange swap and forward, such products are not
subject to the Treasury Secretary's determination to exempt. Outside of
the foreign exchange suite of products, the rules and interpretations
clarify that certain transactions are swaps or security-based swaps.
These products include forward rate agreements, certain contracts for
differences, swaptions and forward swaps. The rules and the
interpretations are intended to increase clarity and legal certainty
for market participants with respect to these products.
Next this release addresses the relationship between swaps and
security-based swaps and how to distinguish them. The Commissions are
clarifying whether particular agreements, contracts or transactions
that are subject to Title VII of the Dodd-Frank Act (which are referred
to as ``Title VII Instruments'' in this release) are swaps, security-
based swaps or both (i.e., mixed swaps). In addition, the Commissions
are clarifying the use of the term ``narrow-based security index'' in
the security-based swap definition. In general, the CFTC has
jurisdiction over Title VII instruments on broad-based security
indexes, while the SEC has jurisdiction over Title VII instruments on
narrow-based security indexes. This release clarifies that the existing
criteria for determining whether a security index is narrow-based, and
the past guidance of the Commissions regarding those criteria in the
context of security futures, apply to Title VII instruments. Credit
default swaps (``CDS'') also are subject to this same jurisdictional
division--CDS on broad-based security indexes are regulated by the
CFTC, while CDS on narrow-based security indexes (as well as CDS on
single name securities or loans) generally are regulated by the SEC.
This release provides new criteria tailored to CDS for determining
whether a CDS is based on an index that is a narrow-based security
index. Also, it explains the term ``index'' and adopts a final rule
governing tolerance and grace periods for Title VII instruments on
security indexes traded on trading platforms. These rules and
interpretations generally are designed to provide clarity and enhanced
legal certainty regarding the appropriate classification of Title VII
instruments as swaps, security-based swaps or mixed swaps, so that
market participants may ascertain the applicable regulatory
requirements more easily.
This release anticipates that mixed swaps, which are both swaps and
security-based swaps, will be a narrow category, but lists a few
examples of
[[Page 48309]]
mixed swaps and interprets how to distinguish one type of TRS that is a
mixed swap from another that is not. This release addresses the
regulatory treatment of bilateral, uncleared mixed swaps where one
counterparty is a dual registrant with the CFTC and SEC. It also
establishes a process for requesting a joint order from the Commissions
to determine the appropriate regulatory treatment of mixed swaps that
do not fall into the category of mixed swaps where one counterparty is
a dual registrant. Concerning ``security-based swap agreements'' (or
SBSAs), this release explains what types of transactions are SBSAs and
includes rules that provide that there will not be additional books and
records requirements regarding SBSAs other than those that have been
proposed by the CFTC for swaps in order to avoid duplicative regulation
and costs.
This release also includes rules establishing a process for members
of the public to request a joint interpretation from the Commissions
regarding whether a Title VII instrument is a swap, security-based swap
or a mixed swap. The process includes a deadline for a decision, as
well as a requirement that if the Commissions do not issue a joint
interpretation within the prescribed time period, each Commission must
publicly provide the reasons for not having done so.
Finally, this release includes anti-evasion rules and related
interpretations adopted by the CFTC, which in general would apply to
agreements, contracts, transactions and entities that are willfully
structured to evade Dodd-Frank requirements.
2. Costs and Benefits of the Definitions--In General
The rules and interpretations in this Adopting Release: further
define the terms ``swap,'' ``security-based swap,'' and ``security-
based swap agreement;'' provide for the regulation of ``mixed swaps;''
and address books and records requirements for security-based swap
agreements. In the discussion that follows, the CFTC considers the
costs and benefits resulting from its own discretionary determinations
with respect to the section 15(a) factors.
There are ``programmatic'' costs and benefits as well as
``assessment'' costs of the Product Definitions. Programmatic costs
result from subjecting certain agreements, contracts, or transactions
to the regulatory regime of Title VII.\1106\ Effectiveness of the
Products Definitions will trigger effectiveness of any statutory
provision or regulation that depends, in whole or in part, on the
effectiveness of this final rulemaking. By fulfilling the statutory
mandate, many of the programmatic benefits of Title VII and the CFTC's
implementing regulations are triggered, including risk reduction,
increasing transparency, and promoting market integrity and, by
extension, the increased possibility of preventing or reducing the
severity of another global financial crisis such as occurred in 2008.
Delimiting the scope of the terms ``swap,'' ``security-based swap,''
``security-based swap agreement,'' and ``mixed swaps'' also helps to
determine the scope of activities and entities that will be subject to
the various Title VII regulatory requirements. Requirements for
clearing and trade execution, capital and margin, business conduct, and
reporting and recordkeeping, all of which have been or will be
implemented in other CFTC rules, will lead to programmatic costs that
have been or will be addressed in the CFTC's rules to implement those
requirements. When considering the programmatic costs and benefits of
the Product Definitions, the CFTC recognizes the scope of activities
and entities affected by the further Product Definitions by reference
to the other final rulemakings under Title VII accomplished to date.
The costs that parties will incur to assess whether certain agreements,
contracts, or transactions are ``swaps,'' ``security-based swaps,''
``security-based swap agreements,'' or ``mixed swaps'' that are subject
to the Title VII regulatory regime, and, if so, costs to assess whether
such Title VII instrument is subject to the regulatory regime of the
SEC or the CFTC are referred to herein as assessment costs.
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\1106\ See Appendix, ``Rules Effectuated by Product
Definitions.''
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In general, many commenters have suggested that the statutory
definitions of swap and security-based swap are overbroad in that they
could be viewed to include agreements, contracts, and transactions that
the market had not considered to be swaps or security-based swaps prior
to the enactment of the Dodd-Frank Act, are (or could be) swaps or
security-based swaps. Thus, in response to these comments, the CFTC has
engaged in a qualitative analysis of various agreements, contracts, and
transactions of which the CFTC is aware and that commenters have
brought to its attention. Based on this analysis, the CFTC has
established rules and interpretations to identify agreements,
contracts, and transactions that are swaps or security-based swaps
where the statutory definition may be inadequate or ambiguous. In
developing the further definitions, the CFTC has endeavored to narrow
the scope of the terms ``swap'' and ``security-based swap'' without
excluding agreements, contracts and transactions that the CFTC has
determined should be regulated as swaps and security-based swaps.
Narrowing the scope of the statutory definitions should reduce the
overall programmatic costs of Title VII because fewer agreements,
contracts, and transactions will be subject to the full panoply of
Title VII regulation. Narrowing the scope of the statutory definitions
should also increase the net programmatic benefits of the CFTC's Title
VII regulations because the CFTC is targeting in the Product
Definitions rulemaking agreements, contracts and transactions that the
CFTC has determined, after considering comments received and
undertaking a qualitative analysis, are swaps or security-based swaps.
The CFTC anticipates that applying the full panoply of Title VII
regulation to only those agreements, contracts or transactions that the
CFTC has determined are swaps or security-based swaps will be most
effective in achieving the net benefits of Title VII regulation under
the Dodd-Frank Act.
(a) Costs
The scope of the terms ``swap,'' ``security-based swap,''
``security-based swap agreement,'' and ``mixed swap'' is an important
factor in determining the range of activities and entities that will be
subject to various requirements set forth in the Dodd-Frank Act, such
as trade execution, clearing, reporting, registration, business
conduct, and capital requirements. Complying with these requirements,
which will be implemented in other rules by the CFTC, are programmatic
costs, which also have been or will be addressed in the CFTC's rules to
implement those requirements.\1107\
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\1107\ See Appendix, ``Rules Effectuated by Product
Definitions.''
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The CFTC believes that the rulemaking to further define the terms
``swap,'' ``security-based swap,'' ``security-based swap agreement,''
and ``mixed swap'' is consistent with how market participants
understand these products. The further definitions increase legal
certainty and thereby reduce assessment costs by clarifying that
certain products that meet the requirements of the applicable rules and
interpretations, such as traditional insurance products, are not swaps.
(b) Benefits
Many of the benefits of Title VII and the CFTC's implementing
regulations, including risk reduction, increasing
[[Page 48310]]
transparency, and promoting market integrity are programmatic benefits
of the Products Definitions since they are effectuated by Product
Definitions. These programmatic benefits are difficult to quantify and
measure. Moreover, these benefits can be expected to manifest
themselves over the long run and be distributed over the market as a
whole.
The CFTC believes that the final rules and interpretations can be
consistently applied by substantially all market participants to
determine which agreements, contracts, or transactions are, and which
are not, swaps, security-based swaps, security-based swap agreements,
or mixed swaps. The benefits of the individual rules and
interpretations are discussed in their respective sections below.
(c) Comments and Consideration of Alternatives
The CFTC requested comment on the costs and benefits of the
proposed rules and interpretations regarding the definitions in general
for market participants, markets and the public. Further, the CFTC
requested comment as to whether there are any aspects of the proposed
rules and interpretive guidance regarding the definitions that are both
burdensome to apply and not helpful to achieving clarity as to the
scope of the defined terms, and whether there are less burdensome means
of providing clarity as to the scope of the defined terms.
A commenter \1108\ argued that a proper cost-benefit analysis can
only be performed once an integrated and complete mosaic of rules is
available for analysis and doubted that the definitions impose no
independent costs. The CFTC has considered, qualitatively, the costs
and benefits of the entire mosaic of CFTC rules under the Dodd-Frank
Act in this rulemaking. Due to data limitations and other uncertainty,
the CFTC cannot perform a meaningful quantitative analysis, yet. The
CFTC considers in this rulemaking the costs and benefits of how the
Commissions are exercising their discretion in further defining the
Product Definitions because Congress included in the Dodd-Frank Act
statutory definitions of these terms, over which the CFTC has no
discretion. Moreover, the CFTC has considered the independent costs
(i.e. costs imposed through exercising its discretion) that the
Products Definitions may impose through its determinations as discussed
below.
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\1108\ See ETA Letter. See also IECA Letter II (requesting a
comprehensive costs benefits analysis on all of Title VII).
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Another commenter \1109\ contended that the costs and benefits
considerations in the Proposing Release were not based on any empirical
data and are not consistent with the expected costs of compliance
anticipated by market participants. However, the CFTC cannot do a
comprehensive empirical analysis regarding costs and benefits of the
Products Definitions before actual data is available when the swap
regulatory regime has been implemented in full. Moreover, the CFTC did
use some empirical estimates in its costs and benefits considerations
in the Proposing Release, namely in assessment costs for the process to
seek an interpretation of whether a product is a swap, security-based
swap, or mixed swap, as well as in the process to determine regulatory
treatment for mixed swaps.\1110\ Commenters did not submit data or
other information to support an argument that the CFTC's estimates were
inaccurate.
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\1109\ See WGCEF Letter.
\1110\ See Proposing Release at 29874.
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Commenters \1111\ expressed concern about costs from regulatory
uncertainty imposed on swaps market participants resulting from other
Title VII rulemakings not yet being final. The consideration of
thousands of letters and the process of due deliberation and reasoned
decision-making by the CFTC has caused delays. Nevertheless, the CFTC
is working with deliberate speed to complete the rulemakings, and
eventually this particular type of legal uncertainty will be
eliminated.
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\1111\ See FIA Letter; IIB Letter; and ISDA Letter.
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A commenter \1112\ requested that inter-affiliate swaps be exempt
from the swap definition, arguing that regulating such swaps may
increase costs to consumers and undermine efficiencies from the use of
centralized hedging affiliates. The CFTC anticipates that it will
address inter-affiliate swaps in a subsequent rulemaking.
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\1112\ See Shell Trading Letter.
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Several commenters \1113\ argued that foreign central banks,
foreign sovereigns, international financial institutions, such as
multilateral development banks, and similar organizations should be
exempt from swap regulations, since regulations would impose costs on
these entities. Specifically, a commenter \1114\ asserted that
multilateral development banks should not have to register or be
subject to clearing and margin requirements and requested that
multilateral development banks' transactions be exempted from the
definition of a swap. As explained above, these transactions are swaps.
In addition, the proposed exclusion is overbroad because it would mean
that swaps and security-based swaps entered into by foreign central
banks, foreign sovereigns, international financial institutions, and
similar organizations would be completely excluded from Dodd-Frank
regulation. Their counterparties, who may be swap dealers and other
regulated entities, would have no regulatory obligations with respect
to such swaps, and could develop significant exposures without the
knowledge of the CFTC, other regulators and market participants. If
these transactions were not swaps, then no market participant would be
obligated to report them to a U.S.-registered swap data repository or
real-time report them. This lack of transparency might distort swap
pricing and impede proper risk management in as much as the market may
not be aware of the risk entailed in these opaque transactions and
might thwart price discovery.
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\1113\ See CEB Letter; EIB Letter; and World Bank Letter.
\1114\ See World Bank Letter.
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The Commissions did not propose rules or interpretations on how to
distinguish futures from swaps. A commenter requested that the CFTC
clarify that nothing in the release was intended to limit a DCM's
ability to list for trading a futures contract regardless of whether it
could be viewed as a swap if traded over-the-counter or on a SEF, since
futures and swaps are ``indistinguishable in material economic
effects.'' \1115\ The commenter further recommended that the CFTC adopt
a final rule that amends the statutory definition of the term ``swap''
by adding to the futures contract exclusion in CEA Section 1a(47)(B)(i)
the following language after the word ``delivery'': ``Listed for
trading by a designated contract market.'' The same commenter believed
that such a rule would clarify the scope of Section 4(a) of the
CEA,\1116\ which makes it illegal to trade a futures contract except on
or subject to the rules of a DCM.\1117\
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\1115\ See CME Letter.
\1116\ 7 U.S.C. 6(a).
\1117\ See CME Letter.
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Although it is potentially more costly to a DCM in terms of
providing additional analysis to support listing a futures contract on
its exchange, the CFTC is not adopting the distinction the commenter
advocates. Prior distinctions that the CFTC relied upon (such as the
presence or absence of clearing) to distinguish between futures and
swaps
[[Page 48311]]
may no longer be relevant.\1118\ As a result, it is difficult to
distinguish between futures and swaps on a blanket basis as the
commenter suggested. However, a case-by-case approach for
distinguishing these products may lead to more informed decision-making
by the CFTC.
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\1118\ See, e.g., Swap Policy Statement, supra note 214.
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The CFTC notes that a DCM may self-certify its contracts pursuant
to Part 40 of the CFTC's rules,\1119\ subject to the CFTC's oversight
authority. If a DCM has a view that a particular product is a futures
contract, it may self-certify the contract consistent with that view.
The DCM also has a number of other options, including seeking prior
approval from the CFTC, requesting an interpretation, or requesting a
rulemaking if it is in doubt about whether a particular agreement,
contract or transaction should be classified as a futures contract or a
swap.
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\1119\ 17 CFR Part 40.
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3. Costs and Benefits of Rules and Interpretations Regarding Insurance
Rule 1.3(xxx)(4)(i) under the CEA clarifies that agreements,
contracts or transactions that satisfy its provisions will not be swaps
or security-based swaps. Specifically, the term ``swap'' and
``security-based swap'' does not include an agreement, contract, or
transaction under rule 1.3(xxx)(4)(i)(A) that, by its terms or by law,
as a condition of performance on the agreement, contract, or
transaction: (i) Requires the beneficiary of the agreement, contract,
or transaction to have an insurable interest that is the subject of the
agreement, contract, or transaction and thereby carry the risk of loss
with respect to that interest continuously throughout the duration of
the agreement, contract, or transaction; (ii) requires that loss to
occur and be proved, and that any payment or indemnification therefor
be limited to the value of the insurable interest; (iii) is not traded,
separately from the insured interest, on an organized market or over-
the-counter; and (iv) with respect to financial guaranty insurance
only, in the event of payment default or insolvency of the obligor, any
acceleration of payments under the policy is at the sole discretion of
the insurer (the ``Product Test'').
Rule 1.3(xxx)(4)(i)(B) under the CEA provides that for an
agreement, contract, or transaction that meets the Product Test to be
excluded from the swap and security-based swap definitions as
insurance, it must be provided: (i) By a person 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 such agreement, contract, or transaction
is regulated as insurance applicable State law or the laws of the
United States (the ``first prong''); (ii) directly or indirectly by the
United States, any State, or any of their respective agencies or
instrumentalities, or pursuant to a statutorily authorized program
thereof (the ``second prong''); (iii) in the case of reinsurance only,
by a person to another person that satisfies the Provider Test,
provided that: such person is not prohibited by applicable State law or
the laws of the United States from offering such agreement, contract,
or transaction to such person that satisfies the Provider Test; the
agreement, contract, or transaction to be reinsured satisfies the
Product Test or is one of the Enumerated Products; and except as
otherwise permitted under applicable State law, the total amount
reimbursable by all reinsurers for such agreement, contract, or
transaction may not exceed the claims or losses paid by the cedant; or
(iv) in the case of non-admitted insurance by a person who: 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 meets the
eligibility criteria for non-admitted insurers under applicable State
law (the ``Provider Test'').
In response to commenters' requests that the Commissions codify the
proposed interpretation regarding certain enumerated types of insurance
products in the final rules, the interpretation is being codified in
paragraph (i)(C) of rule 1.3(xxx)(4) under the CEA. In addition, in
response to comments, the Commissions are expanding and revising the
list of traditional insurance products. As adopted, the rule provides
that the terms ``swap'' and ``security-based swap'' will not include an
agreement, contract, or transaction that is provided in accordance with
the conditions set forth in the Provider Test and is one of the
following types of products (collectively, ``Enumerated Products''):
surety bonds; fidelity bonds; life insurance; health insurance; long-
term care insurance; title insurance; property and casualty insurance;
annuities; disability insurance; insurance against default on
individual residential mortgages (commonly known as private mortgage
insurance, as distinguished from financial guaranty of mortgage pools);
and reinsurance (including retrocession) of any of the foregoing. Based
on comments received, the Commissions are adding three products to the
list of products as proposed, adding reinsurance (including
retrocession) of any of the traditional insurance products included in
the list, and deleting a requirement applicable to annuities that they
must be subject to tax treatment under section 72 of the Internal
Revenue Code.
The Commissions are also clarifying that the Product Test, the
Provider Test and the Enumerated Products in the rules are a non-
exclusive safe harbor (the ``Insurance Safe Harbor''), such that if a
product fails the Insurance Safe Harbor, that does not necessarily mean
that the product is a swap or security-based swap--further analysis may
be required in order to make that determination.
Rule 1.3(xxx)(4)(ii) provides a ``grandfather'' for insurance
transactions (as opposed to insurance products), pursuant to which
transactions that are entered into on or before the effective date of
the Product Definitions will not fall within the definition of swap or
security-based swap, provided that, at such time that it was entered
into, the transaction was provided in accordance with the Provider
Test.
The CFTC is interpreting the term ``swap'' (that is not a security-
based swap or mixed swap) to include a guarantee of such swap, to the
extent that a counterparty to a swap position would have recourse to
the guarantor in connection with the position. The CFTC is persuaded
that when a swap has the benefit of a guarantee, the guarantee is an
integral part of that swap. The CFTC finds that a guarantee of a swap
(that is not a security-based swap or mixed swap) is a term of that
swap that affects the price or pricing attributes of that swap. When a
swap counterparty typically provides a guarantee as credit support for
its swap obligations, the market will not trade with that counterparty
at the same price, on the same terms, or at all without the guarantee.
The guarantor's resources are added to the analysis of the swap; if the
guarantor is financially more capable than the swap counterparty, the
analysis of the swap becomes more dependent on the creditworthiness of
the guarantor. The CFTC anticipates that a ``full recourse'' guarantee
would have a greater effect on the price of a swap than a ``limited''
or ``partial recourse'' guarantee; nevertheless, the CFTC is
determining that the presence of any guarantee with recourse, no matter
how robust, is price forming and an integral part of a guaranteed swap.
The CFTC's
[[Page 48312]]
interpretation of the term ``swap'' to include guarantees of swap does
not limit or otherwise affect in any way the relief provided by the
Insurance Grandfather. In a separate release, the CFTC will address the
practical implications of interpreting the term ``swap'' to include
guarantees of swaps (the ``separate CFTC release'').
(a) Costs
A market participant will need to ascertain whether an agreement,
contract, or transaction satisfies the criteria set forth in rule
1.3(xxx)(4). This analysis will have to be performed prior to entering
into the agreement, contract, or transaction to ensure that the relief
provided by the Insurance Safe Harbor is available. The CFTC expects
that potential costs associated with any possible uncertainty cited by
commenters as to whether an agreement, contract, or transaction that
the participants consider to be insurance could instead be regulated as
a swap would be greater without the Insurance Safe Harbor than the cost
of the analysis under the final rule herein.
Although the Insurance Safe Harbor is designed to mitigate costs
associated with legal uncertainty and misclassification of products, to
the extent that it inadvertently fails to exclude certain types of
insurance products from the definitions, these failures could lead to
costs for market participants entering into agreements, contracts, or
transactions. Some insurance products might inadvertently be subjection
to regulation as swaps. To the extent that the Insurance Safe Harbor
leads to the inadvertent misclassification of some swaps as insurance,
costs for market participants entering into agreements, contracts, or
transactions that are inadvertently regulated as insurance products,
and not as swaps, may increase.\1120\ Similarly, insurance products
inadvertently mischaracterized as swaps could impose additional costs
on market participants, who could be required to meet certain
regulatory requirements applicable to swaps.
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\1120\ Improperly characterizing swaps as insurance may
theoretically cause market participants that are not licensed
insurance companies to become licensed insurance companies, if
applicable, thus imposing costs of complying with state insurance
regulation.
---------------------------------------------------------------------------
Assessment costs should be minimal or non-existent for traditional
insurance products,\1121\ but for a new and novel insurance product
that is more complex, the costs of analysis may be greater.
Nevertheless, it is anticipated that such cases will be infrequent.
Moreover, it may be difficult to assess whether products that do not
fall within the Insurance Safe Harbor are swaps or security-based swaps
rather than insurance. Market participants may need to request an
interpretation from the Commissions regarding such products, or obtain
an opinion of counsel, which will involve certain costs.\1122\ However,
the CFTC expects such cases will arise less frequently in light of the
increased clarity provided by the rule. An alternative to a safe harbor
approach under the rule--that failure to meet the rule and
interpretation would automatically mean that the product is a swap and
not insurance--would likely impose greater costs on market participants
and result in more frequent misclassification of products.
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\1121\ The CFTC anticipates that traditional insurance products
will either be easy to identify from the list of Enumerated Products
or will unambiguously satisfy the Products Test.
\1122\ The CFTC believes that $27,000 represents a reasonable
estimate of the upper end of the range of the costs to undertake the
legal analysis of the status of an agreement, contract, or
transaction as a swap or security-based swap. The average cost
incurred by market participants in connection with assessing whether
an agreement, contract, or transaction is a swap or security-based
swap is based upon the estimated amount of time that staff believes
will be required for both in-house counsel and outside counsel to
apply the definition. Staff estimates that some agreements,
contracts, or transactions will clearly satisfy the Insurance Safe
Harbor, Insurance Grandfather and an in-house attorney, without the
assistance of outside counsel, will be able to make a determination
in less than one hour. Based upon data from SIFMA's Management &
Professional Earnings in the Securities Industry 2011 (modified by
SEC staff to account for an 1800-hour-work-year and multiplied by
5.35 to account for bonuses, firm size, employee benefits and
overhead), staff estimates that the average national hourly rate for
an in-house counsel is $378. If an agreement, contract, or
transaction is more complex, the CFTC estimates the analysis will
require approximately 30 hours of in-house counsel time and 40 hours
of outside counsel time. The CFTC estimates the costs for outside
legal services to be $400 per hour. This is based on an estimated
$400 per hour cost for outside legal services. This is the same
estimate used by the SEC for these services in the release involving
Exemptions for Security-Based Swaps Issued By Certain Clearing
Agencies, Release No. 33-9308 (Mar. 30, 2012), 77 FR 20536 (Apr. 5,
2012). Accordingly, on the high end of the range the CFTC estimates
the cost to be $27,340 ($11,340 (based on 30 hours of in-house
counsel time [multi] $378) + $16,000 (based on 40 hours of outside
counsel [multi] $400). The estimate is rounded to two significant
digits to avoid the impression of false precision of the estimate.
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The CFTC is interpreting the term ``swap'' (that is not a security-
based swap or mixed swap) to include a guarantee of such swap, to the
extent that a counterparty to a swap position would have recourse to
the guarantor in connection with the position. The CFTC anticipates
minimal or no assessment costs from the interpretation with respect to
guarantees of swaps.\1123\ The CFTC does, however, anticipate that
there will be some programmatic costs associated with the requirements
that it will propose for guarantees of swaps in the separate CFTC
release.\1124\ The CFTC will carefully consider those costs in that
rulemaking.
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\1123\ Because a guarantee is a common and well-understood
product, that has been used in commerce since long before the
existence of swaps markets, the CFTC anticipates that whether a
guarantee is present or not will be obvious.
\1124\ As a result of interpreting the term ``swap'' (that is
not a security-based swap or mixed swap) to include a guarantee of
such swap, to the extent that a counterparty to a swap position
would have recourse to the guarantor in connection with the
position, and based on the reasoning set forth in the Entity
Definitions Release in connection with major swap participants, the
CFTC will not deem holding companies to be swap dealers as a result
of guarantees to certain U.S. entities that are already subject to
capital regulation. This interpretation mitigates the programmatic
costs imposed on potential swap dealers by not attributing to a
guarantor swap positions of a guaranteed entity that is already
subject to capital regulation.
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(b) Benefits
Subjecting traditional insurance products to Title VII could,
absent exception, prevent individuals who are not ECPs from obtaining
insurance to protect their properties or families against accidental
hazards or risks,\1125\ or require insurance sold to individuals who
are not ECPs to be traded on exchanges and be cleared. The Commissions
have found no evidence that Congress intended them to be regulated as
swaps or security-based swaps. In light of the above considerations,
the Commissions have determined to provide the Insurance Safe Harbor
and Insurance Grandfather in the final rules in order to assure market
participants that those agreements, contracts, or transactions that
meet their conditions will not fall within the swap or security-based
swap definitions. Limiting the number of unexpected product
classification outcomes for market participants provides the benefit of
predictability when entering into their transactions
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\1125\ An individual is considered an ECP if the individual
``has amounts invested on a discretionary basis, the aggregate of
which is in excess of--(i) $10,000,000; or (ii) $5,000,000 and who
enters into the agreement, contract, or transaction in order to
manage the risk associated with an asset owned or liability
incurred, or reasonable likely to be owned or incurred, by the
individual.'' Section 1a(18)(A)(xi) of the CEA, 7 U.S.C.
1a(18)(A)(xi).
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The business of insurance is already subject to established pre-
Dodd-Frank Act regulatory regimes. Requirements that may work well for
swaps and security-based swaps may not be appropriate for traditional
insurance products. To the extent that the final rules distinguish
insurance from swaps and security-based swaps, the CFTC should be able
to tailor rules for specific
[[Page 48313]]
products that are swaps or security-based swaps to achieve Title VII
regulatory objectives. In adopting the Insurance Safe Harbor, the CFTC
has sought to achieve those net benefits that may be obtained from not
supplanting existing insurance regulation that are consistent with the
regulatory objectives of Title VII.
Without the Insurance Safe Harbor, market participants might be
more uncertain about whether an agreement, contract, or transaction is
an insurance product rather than a swap. Rule 1.3(xxx)(4) is intended
to reduce the potential uncertainty of what constitutes a swap by
setting forth clear and objective criteria for distinguishing an
agreement, contract, or transaction that is insurance from a swap.
Providing such an objective rule and explanation mitigates the
potential additional costs of petitioning the Commissions, or obtaining
an opinion of counsel, about whether an agreement, contract, or
transaction is insurance or a swap.
The objective criteria provided by the rule also will aid sound
risk management practices because it will be easier for market
participants to decide whether a particular agreement, contract, or
transaction is insurance or a swap.
Further, the CFTC anticipates that the interpretation of the term
``swap'' to include guarantees of swaps and the separate CFTC release
will provide programmatic benefits by enabling the CFTC and market
participants to receive more price-forming data about swaps, which may
help improve price discovery for swaps. The CFTC will carefully
consider these and other benefits in the separate CFTC release.
(c) Comments and Consideration of Alternatives
The CFTC requested comment on the costs and benefits of proposed
rule 1.3(xxx)(4) and interpretive guidance to distinguish between
insurance products and swaps for market participants, markets, and the
public. Several commenters \1126\ argued that any additional
requirement beyond the requirement of the rules that a product is a
regulated insurance product creates legal uncertainty and imposes
costs. Specifically, a commenter \1127\ asserted that it is a burden to
introduce conditions that are neither universal nor fundamental, such
as showing a continuing risk of loss for some insurance contracts.
Another commenter \1128\ argued that legal uncertainty may result in
conflicting interpretations, which can be a significant burden for
financial guaranty transactions that typically require the delivery of
a legal opinion.
---------------------------------------------------------------------------
\1126\ See AFGI Letter; AIA Letter; and ISDA Letter.
\1127\ See ISDA Letter.
\1128\ See AFGI Letter.
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The Commissions have expanded the list of insurance products
excluded from the swap definition to cover certain traditional
insurance products that commenters have brought to their attention and
that the Commissions have determined are not swaps. The Commissions are
also clarifying that the Insurance Safe Harbor does not imply or
presume that an agreement, contract or transaction that does not meet
its requirements is a swap or security-based swap, but will require
further analysis of the applicable facts and circumstances, including
the form and substance of the agreement, contract, or transaction, to
determine whether it is insurance, and thus not a swap or security-
based swap. With regard to financial guaranty in particular, the
acceleration of payment criterion is designed to reflect market
practice and aid appropriate product classification. The Commissions
are stating that they intend to interpret concepts upon which the
Product Test relies that are derived from state law consistently with
the existing and developing laws of the relevant state(s) governing the
agreement, contract, or transaction in question. However, the
Commissions note their authority to diverge from state law if the
Commissions become aware of evasive conduct. While the CFTC cannot
anticipate under what circumstances or how often the Commissions might
diverge from state law, the CFTC believes that there will be more
consistent than inconsistent interpretations. Accordingly, the rules do
not present the increased burden or legal uncertainty that these
commenters suggested.
Several commenters also requested that the Commissions codify the
proposed interpretive guidance regarding enumerated insurance products
in rule text on the basis that codification would enhance legal
certainty, and thereby reduce costs.\1129\ The Commissions have decided
to include a list of products in rule text in response to these
commenters concerns.
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\1129\ See ACLI Letter; NAIC Letter; and RAA Letter.
---------------------------------------------------------------------------
A commenter proposed that the sole test for determining whether an
agreement, contract or transaction is insurance should be whether it is
subject to regulation as insurance by the insurance commissioner of the
applicable state(s).\1130\ While the commenter's test is potentially
easier and thus may be less costly to apply than the Commissions' test,
it would be inadequate because, as explained in section II.B.1.(d)
above, it would essentially delete the product prong of the insurance
safe harbor, and thus begging the question of how to distinguish
insurance from swaps and security-based swaps and allowing state
insurance regulators to supplant the Commissions' role in further
defining, or determining what is, a swap. Further, market participants
might misconstrue the commenter's test in close cases to mean that any
activity permitted by the insurance commissioner of the relevant
state(s) may not be regulated as swaps or security-based swaps.
However, insurance companies are in many circumstances permitted by
state insurance regulators to enter into swaps or security-based swaps,
illustrating that the fact that while an insurance company may enter
into an agreement, contract or transaction, it does not necessarily
mean that such agreement, contract or transaction is insurance.
Further, the domain of insurance regulation may change and then this
commenter's test would induce an evolving boundary between state and
CFTC regulation.
---------------------------------------------------------------------------
\1130\ See MetLife Letter.
---------------------------------------------------------------------------
Several commenters suggested an approach in which insurance
products that qualify for the exclusion contained in section 3(a)(8) of
the Securities Act of 1933 would be excluded from the swap
definition.\1131\ One commenter argued that ``Section 3(a)(8) has long
been recognized as the definitive provision as to where Congress
intends to separate securities products that are subject to SEC
regulation from `insurance' and `annuity' products that are to be left
to state insurance regulation'' and that the section 3(a)(8) criteria
are well understood and have a long history of interpretation by the
SEC and the courts.\1132\ Other commenters suggest that because section
3(a)(8) includes both a product and a provider requirement, if the
Commissions include it in their final rules, it should be a requirement
separate from the Product Test and the Provider Test, and should extend
to insurance products that are securities.\1133\
---------------------------------------------------------------------------
\1131\ See supra note 162
\1132\ See supra note 163.
\1133\ See supra note 164.
---------------------------------------------------------------------------
While the Commissions agree that the section 3(a)(8) criteria have
a long history of interpretations by the SEC and the courts, the
Commissions find that it is inappropriate to apply the section 3(a)(8)
criteria in this context. Although section 3(a)(8) contains some
[[Page 48314]]
conditions applicable to insurance providers that are similar to the
prongs of the Provider Test, it does not contain any conditions that
are similar to the prongs of the Product Test. Moreover, section
3(a)(8) provides an exclusion from the Securities Act and the CFTC has
no jurisdiction under the Federal securities laws. Congress directed
both agencies to further define the terms ``swap'' and ``security-based
swap.'' As such, the Commissions find that it is more appropriate to
have a standalone rule that incorporates features that distinguish
insurance products from swaps and security-based swaps and over which
both Commissions will have joint interpretative authority.
Another commenter proposed the following test for an agreement,
contract, or transaction to be insurance:
[It] [e]xists for a specified period of time;
Where the one party to the contract promises to make one or more
payments such as money, goods or services;
In exchange for another party's promise to provide a benefit of
pecuniary value for the loss, damage, injury, or impairment of an
identified interest of the insured as a result of the occurrence of
a specified event or contingency outside of the parties' control;
and
Where such payment is related to a loss occurring as a result of
a contingency or specified event.\1134\
---------------------------------------------------------------------------
\1134\ See NAIC Letter.
This test may not represent a less costly alternative to the
Commissions' test in light of its complexity, and in any event would
not distinguish swaps and security-based swaps from insurance more
effectively than the Commissions' test for two reasons. The
requirements of a specified term and the payment of premiums are
present in both insurance products and in agreements, contracts, or
transactions that are swaps or security-based swaps, and therefore such
requirements do not help to distinguish between them. A test based
solely on these requirements, then, would be over-inclusive and exclude
from the Dodd-Frank regulatory regime agreements, contacts, and
transactions that have not traditionally been considered insurance.
Also, the third and fourth requirements of the commenter's test
collapse into the Product Prong's requirement that the loss must occur
and be proved, and any payment or indemnification therefor must be
limited to the value of the insurable interest.
Another commenter offered a 3-part test\1135\ in lieu of the
Commissions' test:
---------------------------------------------------------------------------
\1135\ See also CAI Letter and Nationwide Letter.
---------------------------------------------------------------------------
(1) The insurance contract must be issued by an insurance company
and subject to state insurance regulation;
(2) The insurance contract must be the type of contract issued by
insurance companies; and
(3) The insurance contract must not be of a type that the CFTC and
SEC determine to regulate.\1136\
---------------------------------------------------------------------------
\1136\ See ACLI ANPR Letter.
---------------------------------------------------------------------------
The commenter stated that its approach does not contain a
definition of insurance, and for that reason believes that is
preferable to the Commissions' approach, which it believes creates
legal uncertainty because any attempted definition of insurance has the
potential to be over- or under-inclusive.\1137\
---------------------------------------------------------------------------
\1137\ See ACLI Letter.
---------------------------------------------------------------------------
While the commenter's test may appear simpler on its face, the CFTC
does not believe that it represents a less costly alternative. The
first two requirements of the commenter's test do not help to
distinguish swaps from insurance; the third provides no greater
certainty than the Commissions' facts and circumstances approach.
Moreover, as discussed in section II.B.1(d) above, the Commissions'
rules and related interpretations are not intended to define insurance.
Rather, they provide a safe harbor for certain types of traditional
insurance products by reference to factors that may be used to
distinguish insurance from swaps and security-based swaps. Agreements,
contracts, and transactions that do not qualify for the Insurance Safe
Harbor may or may not be swaps, depending upon the facts and
circumstances. Thus, the Commissions' test neither creates legal
uncertainty as suggested by the commenter, nor the costs associated
with such uncertainty.
Another commenter proposed different approaches for existing
products and new products. According to the commenter, if an existing
type of agreement, contract or transaction is currently reportable as
insurance in the provider's regulatory and financial reports under a
state or foreign jurisdiction's insurance laws, then that agreement,
contract or transaction would be insurance rather than a swap or
security-based swap. On the other hand, for new products, if this
approach is inconclusive, the commenter recommended that the
Commissions use the product prong of the Commissions' test only.\1138\
---------------------------------------------------------------------------
\1138\ See AIA Letter.
---------------------------------------------------------------------------
The commenter's proposal may represent a less costly alternative
than the Commissions' test. However, rather than treating existing
products and new products differently, the Commissions as discussed
above are providing ``grandfather'' protection for agreements,
contracts, and transactions entered into on or before the effective
date of the Products Definitions. Moreover, the commenter's test would
eliminate the provider test for new products, which the Commissions
believe is important to help prevent products that are swaps or
security-based swaps from being characterized as insurance.
In sum, the CFTC finds that, while some of the alternatives
proposed by commenters may appear less costly to apply than the
Commissions' test, in all cases they would sweep out of the Dodd-Frank
Act regulatory regime for swaps agreements, contracts, and transactions
that have not historically been considered insurance, and that should,
in appropriate circumstances, be regulated as swaps or security-based
swaps. Accordingly, the CFTC does not find these alternative tests
proposed by commenters to be better tools than the Insurance Safe
Harbor for limiting the scope of the statutory definitions of swap and
security-based swap. Excluding agreements, contracts, and transactions
that are, in fact, swaps from the further definition of the term
``swap'' is inconsistent with the CFTC's regulatory objectives and
could increase risk to the U.S. financial system.
Three commenters provided comments regarding the treatment of
guarantees of swaps. Two commenters \1139\ opposed treating insurance
or guarantees of swaps as swaps. Suggesting that the products are not
economically similar, one commenter argued that insurance wraps of
swaps do not ``necessarily replicate the economics of the underlying
swap, and only following default could the wrap provider end up with
the same payment obligations as a wrapped defaulting swap
counterparty.'' \1140\ This commenter also stated that the non-
insurance guarantees are not swaps because the result of most
guarantees is that the guarantor is responsible for monetary claims
against the defaulting party, which in this commenter's view is a
different obligation than the arrangement provided by the underlying
swap itself.\1141\
---------------------------------------------------------------------------
\1139\ See AFGI Letter, ISDA Letter.
\1140\ ISDA Letter.
\1141\ Id.
---------------------------------------------------------------------------
One commenter supported treating financial guaranty insurance of a
swap or security-based swap as itself a swap or a security-based swap.
This commenter argued that financial guaranty insurance of a swap or
security-based swap transfers the risk of counterparty non-performance
to the guarantor, making it an embedded and essential feature of the
insured swap or
[[Page 48315]]
security-based swap. This commenter further argued that the value of
such swap or security-based swap is largely determined by the
likelihood that the proceeds from the financial guaranty insurance
policy will be available if the counterparty does not meet its
obligations.\1142\ This commenter maintained that financial guaranty
insurance of swaps and security-based swaps serves a similar function
to credit default swaps in hedging counterparty default risk.\1143\
---------------------------------------------------------------------------
\1142\ See Better Markets Letter.
\1143\ See Better Markets Letter.
---------------------------------------------------------------------------
While the CFTC is not further defining guarantees of swaps to be
swaps, the CFTC is persuaded that when a swap (that is not a security-
based swap or mixed swap) has the benefit of a guarantee, the guarantee
and related guaranteed swap should be analyzed together. The events
surrounding the failure of AIG Financial Products (``AIGFP'') highlight
how guarantees can cause major risks to flow to the guarantor.\1144\
The CFTC finds that the regulation of swaps and the risk exposures
associated with them, which is an essential concern of the Dodd-Frank
Act, would be less effective if the CFTC did not interpret the term
``swap'' to include a guarantee of a swap.
---------------------------------------------------------------------------
\1144\ ``AIGFP's obligations were guaranteed by its highly rated
parent company * * * an arrangement that facilitated easy money via
much lower interest rates from the public markets, but ultimately
made it difficult to isolate AIGFP from its parent, with disastrous
consequences.'' Congressional Oversight Panel, The AIG Rescue, Its
Impact on Markets, and the Government's Exit Strategy 20 (2010).
---------------------------------------------------------------------------
Two commenters cautioned against unnecessary and duplicative
regulation. One commented that, because the underlying swap, and the
parties to it, will be regulated and reported to the extent required by
Title VII, there is no need for regulation of non-insurance
guarantees.\1145\ The other commented that an insurance policy on a
swap would be subject to state regulation; without addressing non-
insurance guarantees, this commenter stated that additional Federal
regulation would be duplicative.\1146\ The CFTC disagrees with these
arguments. As stated above, the CFTC is treating financial guaranty
insurance of swaps and all other guarantees of swaps in a similar
manner because they are functionally or economically similar products.
If a guarantee of a swap is not treated as an integral part of the
underlying swap, price forming terms of swaps and the risk exposures
associated with the guarantees may remain hidden from regulators and
may not be regulated appropriately. Moreover, treating guarantees of
swaps as part of the underlying swaps ensures that the CFTC will be
able to take appropriate action if, after evaluating information
collected with respect to the guarantees and the underlying swaps, such
guarantees of swaps are revealed to pose particular problems in
connection with the swaps markets. The separate CFTC release clarifies
the limited practical effects of the CFTC's interpretation, which
should address industry concerns regarding duplicative regulation.
---------------------------------------------------------------------------
\1145\ See ISDA Letter.
\1146\ See AFGI Letter.
---------------------------------------------------------------------------
One commenter also argued that regulating financial guaranty of
swaps as swaps would cause monoline insurers to withdraw from the
market, which could adversely affect the U.S. and international public
finance, infrastructure and structured finance markets, given that
insuring a related swap often is integral to the insurance of municipal
bonds and other securities.\1147\ The CFTC finds this argument
unpersuasive. The CFTC understands that the 2008 global financial
crisis severely affected most monolines and only one remains active in
U.S. municipal markets. Thus, it appears that the monolines have, for
the most part, already exited these markets. In addition, as stated
above, the separate CFTC release clarifies the limited practical
effects of the CFTC's interpretation, which should address industry
concerns.
---------------------------------------------------------------------------
\1147\ See AFGI Letter. Of the members of AFGI, only Assured
Guaranty (or its affiliates) is currently writing financial guaranty
insurance policies on U.S. municipal obligations.
---------------------------------------------------------------------------
4. Costs and Benefits of the Withdrawing the Energy Exemption and
Interpretation Regarding the Forward Contract Exclusion From the Swap
Definition
The CFTC is clarifying that the forward contract exclusion from the
swap definition for nonfinancial commodities should be read
consistently with the forward contract exclusion from the CEA
definition of the term ``future delivery.'' In that regard, the CFTC is
retaining the Brent Interpretation and extending it to apply to all
nonfinancial commodities, and withdrawing the Energy Exemption, which
had extended the Brent Interpretation regarding the forward contract
exclusion from the term ``future delivery'' to energy commodities other
than oil, as it is no longer necessary. Although the CFTC is
withdrawing the Energy Exemption, the CFTC is providing that certain
alternative delivery procedures, such as physical netting agreements,
that are mentioned in the Energy Exemption, are consistent with the
intent of the book out provision in the Brent Interpretation--provided
that the parties had a bona fide intent, when entering into the
transactions, to make or take (as applicable) delivery of the commodity
covered by those transactions. The CFTC also is providing an
interpretation regarding documentation of orally booked-out
transactions.
In addition, the CFTC is clarifying that its prior guidance
regarding commodity options embedded in forward contracts should be
applied as well to the treatment of forward contracts in nonfinancial
commodities that contain embedded options under the Dodd-Frank Act. The
final interpretation also explains the CFTC's position with regard to
forwards with embedded volumetric optionality, including an explanation
of how it would treat some of the specific contracts described by
commenters, such as full requirements contracts. It also explains the
CFTC's view with respect to certain contractual provisions, such as
liquidated damages and renewable/evergreen provisions that do not
disqualify the transactions in which they are contained from the
forward exclusions. The CFTC has also provided an interpretation
regarding nonfinancial commodities, including environmental
commodities, and interpretations concerning physical exchange
transactions, fuel delivery agreements, certain physical commercial
agreements, and energy management agreements.
(a) Costs
The CFTC's statement that it will construe the forward contract
exclusion consistently with respect to the definitions of the terms
``swap'' and ``future delivery,'' as discussed herein, will not impose
any new material costs on market participants. It also will establish a
uniform interpretation of the forward contract exclusion from the
definitions of both statutory terms, which will avoid the significant
costs that some commenters state would result if the forward contract
exclusion were construed differently in these two contexts.\1148\ In
addition, the CFTC's
[[Page 48316]]
clarification regarding the continued viability of the alternative
delivery procedures in the Energy Exemption should reduce costs to the
industry by conferring legal certainty that their transactions may
continue to have these procedures without losing their eligibility for
the forward exclusions.
---------------------------------------------------------------------------
\1148\ See EEI Letter (``Without legal certainty as to the
regulatory treatment of their forward contracts, EEI's members and
other end users who rely on the forward contract exclusion likely
will face higher transaction costs due to greater uncertainty. These
increased transaction costs may include: (i) More volatile or higher
commodity prices; and (ii) increased credit costs, in each case
caused by changes in market liquidity as end users change the way
they transact in the commodity markets. A single regulatory approach
that uses the same criteria to confirm that a forward contract is
excluded from the Commission's jurisdiction over swaps and futures
will reduce this uncertainty and the associated costs to end
users.'' (footnote omitted)).
---------------------------------------------------------------------------
As noted in section II.B.2.(a)(ii) above, the CFTC has explained
its position regarding nonfinancial commodities. This should help the
industry to determine whether their transactions are eligible for the
forward exclusions, and consequently reduce costs to the industry for
transactions involving non-financial commodities such as renewable
energy credits that may be eligible for the forward exclusions. The
final interpretation regarding forwards with embedded volumetric
optionality should reduce costs to the industry, because these
transactions may qualify for the forward exclusions from the swap and
``future delivery'' definitions. The explanation of how the CFTC will
view specific contracts mentioned by commenters under this
interpretation should enhance legal certainty and thereby reduce costs.
The clarification that certain contractual provisions do not
disqualify transactions from the forward exclusion also should reduce
costs to the industry by providing increased legal certainty that these
provisions will not render their transactions subject to Dodd-Frank Act
regulation. Similar cost reductions should be achieved through enhanced
legal certainty provided by the CFTC's interpretations of physical
exchange transactions, fuel delivery agreements, and certain physical
commercial agreements, all of which may qualify for the forward
exclusions under these interpretations. The interpretation regarding
energy management agreements, which provides that the fact that a
particular transaction is done under the auspices of such agreements
does not alter the nature of that transaction, should likewise enhance
legal certainty and reduce costs. While the CFTC's interpretation
regarding documentation of oral book-outs--that an oral book-out be
followed by a confirmation in a commercially reasonable time in written
or electronic form--may impose costs for industries that do not
document their orally booked out transactions, the CFTC believes that
this requirement is consistent with prudent business practices and is
necessary to prevent abuse of the Brent safe harbor.
Market participants will need to assess whether products are
forward contracts that qualify for the forward exclusions from the swap
and future delivery definitions, and may need to request an
interpretation regarding such products, or obtain an opinion of
counsel, which will involve certain costs. \1149\
---------------------------------------------------------------------------
\1149\ The CFTC believes that $20,000 represents a reasonable
estimate of the upper end of the range of the costs to undertake the
legal analysis of the status of an agreement, contract, or
transaction as a forward contract that qualifies for the forward
exclusions. The average cost incurred by market participants in
connection with assessing whether an agreement, contract, or
transaction is a forward contract is based upon the estimated amount
of time that staff believes will be required for both in-house
counsel and outside counsel to apply the definition. The staff
estimates that costs associated with determining whether an
agreement, contract, or transaction is a forward contract will range
up to $20,000 after rounding to two significant digits. Staff
estimates that some agreements, contracts, or transactions will
clearly fall within the Brent safe harbor, and an internal attorney,
without the assistance of outside counsel, will be able to make a
determination in less than one hour. Based upon data from SIFMA's
Management & Professional Earnings in the Securities Industry 2011
(modified by CFTC staff to account for an 1800-hour-work-year and
multiplied by 5.35 to account for bonuses, firm size, employee
benefits and overhead), staff estimates that the average national
hourly rate for an internal attorney is $378. If an agreement,
contract, or transaction is more complex, the CFTC estimates the
analysis will require approximately 20 hours of in-house counsel
time and 30 hours of outside counsel time. The CFTC estimates the
costs for outside legal services to be $400 per hour. Accordingly,
on the high end of the range the CFTC estimates the cost to be
$19,560 ($7,560 (based on 20 hours of in-house counsel time x $378)
+ $12,000 (based on 30 hours of outside counsel x $400) which is
then rounded to two significant digits to $20,000.
---------------------------------------------------------------------------
(b) Benefits
The CFTC's interpretations regarding the forward exclusions should
provide market participants with greater legal certainty regarding
whether their transactions qualify for the forward exclusion from the
swap definition, which should facilitate commercial merchandising
activity. For example, the interpretation regarding forwards with
embedded volumetric options should facilitate commercial merchandising
activity of the electricity, natural gas, and other industries that
employ these contracts where delivery quantities are flexible, while
the conditions in the interpretations should help to assure that these
contracts are bona fide forwards.
In addition, the interpretation should result in the appropriate
classification of transactions as commercial merchandising transactions
(and thus forward contracts) that are not subject to Title VII
regulation. This will enhance market participants' efficient use of the
swaps markets and, as described above, reduce costs on industry.
Documenting oral book-outs should promote good business practices and
aid the CFTC in preventing evasion through abuse of the forward
exclusion. Finally, the CFTC's interpretation regarding commercial
market participants should ensure that the forward exclusions may only
be used for commercial merchandising activity and not for speculative
purposes. \1150\
---------------------------------------------------------------------------
\1150\ If contracts are being used for speculative purposes they
are probably swaps and should be subject regulation under Title VII.
---------------------------------------------------------------------------
The CFTC's position regarding nonfinancial commodities should help
the industry to determine whether their transactions are eligible for
the forward exclusions, which should facilitate commercial
merchandising activity for transactions involving non-financial
commodities such as renewable energy credits that may be eligible for
the forward exclusions.
(c) Comments and Consideration of Alternatives
The CFTC requested comment in the Proposing Release on the costs
and benefits of the proposed interpretive guidance regarding the
forward contract exclusion and the withdrawal of the Energy Exemption
for market participants, markets and the public.
Several commenters requested that the CFTC codify its proposed
guidance regarding the forward contract exclusion in rule text to
provide greater legal certainty, which they argued may mitigate
costs.\1151\ However, upon consideration, the CFTC is not codifying its
interpretation in rule text. As discussed in section II.B.2.(a)(i),
above, the CFTC has never codified its prior interpretations of the
forward contract exclusion with respect to the future delivery
definition as a rule or regulation. Publishing an interpretation in
this release is consistent with the manner in which the CFTC has
interpreted the forward exclusion in the past. The additional research
costs associated with an interpretation as opposed to codification in
the Code of Federal Regulations will be small, because the CFTC has
placed this interpretation, and all other product interpretations, in
this adopting release for the convenience of practitioners. Moreover,
courts may rely upon agency interpretations; thus, the CFTC believes
that codification would not mitigate costs much.
---------------------------------------------------------------------------
\1151\ See BGA Letter; COPE Letter; ETA Letter; FERC Staff
Letter; and Just Energy Letter.
---------------------------------------------------------------------------
[[Page 48317]]
Some commenters\1152\ argued that physical options should be
considered forward contracts excluded from the definition of a swap,
because increased regulation would cause harm to physical commodity
markets without providing significant benefits. The statutory
definition of ``swap'' provides that options--including physical
options--are swaps. Accordingly, the CFTC may not exclude such options
from the swap definition. Further, treating physical options as forward
contracts would be inconsistent with longstanding CFTC precedent.
Nonetheless, the CFTC has provided relief using its plenary authority
under CEA Section 4c(b)\1153\ over commodity options through the trade
option exemption. While certain capacity contracts on RTOs and ISOs and
certain contracts entered into by section 201(f) entities may be
considered options and therefore would be swaps, regulation of these
contracts may be addressed through the public interest waiver process
in CEA section 4(c)(6).
---------------------------------------------------------------------------
\1152\ See Just Energy Letter; NEMA Letter; NGSA/NCGA Letter;
ONEOK Letter; and WGCEF Letter.
\1153\ 7 U.S.C. 6c(b).
---------------------------------------------------------------------------
Several commenters\1154\ argued that renewable energy credits
should not be swaps; rather, renewable energy credits should be
considered nonfinancial commodities eligible for the forward exclusion
from the swap definition. They asserted that swap regulations would
raise transaction costs making it more difficult and expensive to
support renewable energy. The CFTC is clarifying that renewable energy
credits are nonfinancial commodities and that transactions therein are
eligible for the forward exclusion if they satisfy the terms thereof.
So if these transactions meet the forward exclusion, they will bear no
increased costs.
---------------------------------------------------------------------------
\1154\ See 3Degrees Letter; AWEA Letter; CERP Letter; EMA
Letter; GreenX Letter; PMAA/NEFI Letter; REMA Letter; and WGCEF
Letter.
---------------------------------------------------------------------------
A commenter\1155\ requested that tolling contracts be considered
forwards and not swaps, seeking to avoid unnecessary cost of regulatory
uncertainty and unintended conflict between the CFTC and other
regulators. The CFTC has not provided blanket interpretations regarding
particular products in the rulemaking, but has provided an
interpretation regarding the forward contract exclusions provided above
in section II.B.2. To the extent a commenter still is uncertain about
the treatment of a specific type of transaction, the commenter may
request an interpretation from the CFTC.
---------------------------------------------------------------------------
\1155\ See California Utilities Letter.
---------------------------------------------------------------------------
Another commenter argued more generally that any embedded option
(for example, price, quantity, delivery point, delivery date, contract
term) that does not permit a unilateral election of financial
settlement based upon the value change in an underlying cash market
should not render the contract a swap.\1156\ While the commenter's
approach with respect to ``any'' embedded option may result in lower
costs for market participants because more contracts likely would be
excluded as forwards from the swap definition and thus not be subject
to regulation under the Dodd-Frank Act, such an expansive approach may
inappropriately classify contracts as forwards. The CFTC is providing
an interpretation with respect to forwards with embedded volumetric
options to address commenters' concerns. The CFTC is also explaining
its position above regarding price optionality, optionality with
respect to delivery points and delivery dates specifically in response
to the commenter's letter, and optionality as to certain contract terms
(such as evergreen and renewal provisions) to address particular
concerns raised by commenters.
---------------------------------------------------------------------------
\1156\ See COPE Letter, Appendix.
---------------------------------------------------------------------------
Another commenter suggested that an option to purchase or sell a
physical commodity, whether embedded in a forward contract or stand
alone, should either (i) fall within the statutory forward exclusion
from the swap definition, or (ii) alternatively, if deemed by the CFTC
to be a swap, should be exempt from the swap definition pursuant to a
modified trade option exemption pursuant to CEA Section 4c(b).\1157\
Although this proposal may on its face appear to be simpler than the
CFTC's, it is substantively similar to the one the CFTC is adopting.
The CFTC has modified the proposed interpretive guidance regarding
forwards with embedded options as discussed in section II.B.2.(b)(ii)
above; contracts with embedded options that are swaps under the final
interpretation may nevertheless qualify for the modified trade option
exemption recently adopted by the CFTC.\1158\ The CFTC is not adopting
an approach that forwards with any type of embedded option should fall
within the statutory forward exclusion from the swap definition. Such
an approach would be overbroad because it would exclude contracts that
are not appropriately classified as forwards. The commenter also
requested that trade option exemptions be granted for physical
commodities. The costs and benefits of the trade option exemption are
addressed in that rulemaking.
---------------------------------------------------------------------------
\1157\ See WGCEF Letter; 7 U.S.C. 6c(b).
\1158\ See Commodity Options, 77 FR 25320, April 27, 2012. 17
CFR 32.3. Encana Marketing (USA) Inc. (``Encana'') believes that the
guidance on forwards with embedded options should include embedded
physical delivery options because it asserts that many of the
contracts currently used by participants in the wholesale natural
gas market contain an option for the physical delivery of natural
gas. See Encana Letter. To the extent that Encana's comment goes
beyond volumetric optionality, commodity options are discussed above
in section II.B.2.(b)(i).
---------------------------------------------------------------------------
Another commenter urged the CFTC to broadly exempt commercial
forward contracting from swap regulation by generally excluding from
the swap definition any forward contract with embedded optionality
between end users ``whose primary purpose is consistent with that of an
`end user', and in which any embedded option is directly related to
`end use.' ''\1159\
---------------------------------------------------------------------------
\1159\ See NMPF Letter.
---------------------------------------------------------------------------
While this alternative may appear to be less costly than the CFTC's
interpretation, its vagueness may create significant legal uncertainty
about the scope of the forward exclusion, which may increase costs on
market participants. Even if this approach does represent a lower cost
alternative, however, it is overbroad and likely would result in the
inappropriate classification of transactions as forward contracts, and
thus would not achieve the CFTC's objective of appropriately
classifying transactions that should qualify for the forward
exclusions.
Another commenter believed that the CFTC's ``facts and
circumstances'' approach to forwards with embedded options does not
provide the legal certainty required by nonfinancial entities engaging
in commercial contracts in the normal course of business.\1160\ The
commenter further argued that many option-like contract terms could be
determined to ``target the delivery term'' under a facts and
circumstances analysis. Accordingly, the commenter believed that the
CFTC should provide in its rules that an embedded option or embedded
optionality will not result in a nonfinancial forward being a swap
[[Page 48318]]
unless: (1) Delivery is optional; (2) financial settlement is allowed;
and (3) transfer and trading of the option separately from the forward
is permitted.\1161\
---------------------------------------------------------------------------
\1160\ See ETA Letter at 19 n. 47. Similarly, COPE comments that
a nonfinancial commodity forward contract that, ``by its terms,'' is
intended to settle physically should be permitted to contain
optionality without being transformed into a swap unless such
optionality negates the physical settlement element of the contract.
That is, if one party can exercise an option to settle the contract
financially based upon the value change in an underlying cash
market, then the intent for physical settlement is not contained in
``the four corners of the contract'' and may render the contract a
swap. COPE Letter. While COPE's approach may impose less costs on
market participants (as more transactions likely would qualify for
the forward exclusion, as discussed in section II.B.2.(b)(ii),
above, the CFTC has eschewed approaches to the forward exclusion
that rely on the ``four corners of the contract,'' which can provide
a roadmap to evasion of statutory requirements.
\1161\ See ETA Letter.
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The CFTC has long applied a facts and circumstances approach to the
forward exclusion, including with respect to forwards with embedded
options, an approach with which market participants are familiar. That
approach balances the need for legal certainty against protecting
market participants, market integrity and the risk of providing
opportunities for evasion.\1162\ By contrast, the commenter's bright-
line approach may be simpler to apply, but could undermine market
integrity and creates greater evasion opportunities. Moreover, the
CFTC's additional interpretation noted above, including clarification
about the meaning of the phrase ``target the delivery term,'' and
forwards with embedded volumetric optionality, provides enhanced legal
certainty in response to the commenter's concerns, which should
mitigate the costs of the CFTC's approach to market participants.\1163\
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\1162\ See also NCFC Letter (supporting the CFTC's guidance
because it provides legal certainty).
\1163\ See also Commodity Options, 77 FR 25320, 25324 n. 25,
April 27, 2012 (discussing the CFTC's conclusion that an ``option[]
to redeem'' under the USDA Commodity Credit Corporation's marketing
loan program constitutes a cotton producer's contractual right to
repay its marketing loan and ``redeem'' the collateral (cotton) to
sell in the open market).
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Another commenter \1164\ stated its view that the full costs of
applying the Dodd-Frank regulatory apparatus to physical energy
transactions, or of energy companies being forced to abandon full-
requirements bilateral contracting will significantly increase the
costs to be paid by U.S. consumers. The CFTC is sensitive to these
concerns. The CFTC is providing relief for full-requirements contracts
so long as they satisfy the conditions set forth in the interpretation.
---------------------------------------------------------------------------
\1164\ See IECA II Letter.
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The CFTC is also providing relief for other types of physical
energy contracts that may qualify for the forward exclusions.
Separately, the CFTC has provided relief for trade options in another
rulemaking.\1165\
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\1165\ See Commodity Options, 77 FR 25320, April 27, 2012.
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5. Loan Participations
In the Proposing Release, the Commissions proposed guidance that
they do not interpret the swap and security-based swap definitions to
include loan participations in which: (i) The purchaser is acquiring a
current or future direct or indirect ownership interest in the related
loan; and (ii) the loan participations are ``true participations'' (the
participant acquires a beneficial ownership interest in the underlying
loans). One commenter expressed concern with the second prong of the
proposed guidance. Specifically, the commenter said that the ``true
participation'' requirement may result in the improper classification
of loan participations as swaps, because LMA-style loan participations
may not qualify. Moreover, because of legal uncertainty associated with
the ``true participation'' terminology derived from U.S. bankruptcy
law, LSTA-style loan participations may be subject to improper
classification as well. The commenter proposed an alternative test
described in section II.B.3., above.
The Commissions largely are adopting the recommendation from the
commenter regarding the Commissions' proposed guidance concerning loan
participations as not swaps or security-based swaps, with certain
modifications. This reduces costs for market participants because the
Commissions' test for loan participations from the proposal included a
``true participation'' requirement that commenters suggested is subject
to legal uncertainty. Benefits of the rule include enhanced legal
certainty that loan participations that meet the requirements of the
interpretation are not swaps, which should facilitate loan
participation market activity.
6. Interpretation Regarding Commercial/Consumer Transactions
The Commissions are stating that certain customary consumer and
commercial transactions that have not previously been considered swaps
or security-based swaps do not fall within the statutory definitions of
those terms. Specifically with regard to consumer transactions, the
Commissions are adopting as proposed the interpretation that certain
transactions entered into by consumers (natural persons) as principals
or their agents primarily for personal, family or household purposes
would not be considered swaps or security-based swaps. The Commissions
have added to the list of consumer transactions certain residential
fuel storage contracts; service contracts; consumer options to buy,
sell or lease real or personal property; and certain consumer
guarantees of loans (credit cards, automobile, and mortgage). The
Commissions have also clarified that consumer transactions used to
purchase nonfinancial energy commodities are not swaps or security-
based swaps. With respect to commercial transactions, the Commissions
are adopting as proposed the interpretation that certain commercial
transactions involving customary business arrangements (whether or not
involving a for-profit entity) would not be considered swaps or
security-based swaps. The Commissions also are clarifying that
commercial loans by the Federal Home Loan Banks and Farm Credit
Institutions are not swaps. Finally, the Commissions are explaining the
factors characteristic of consumer and commercial transactions that the
Commissions will consider in determining whether other consumer and
commercial transactions that are not specifically listed in the
interpretation should be considered swaps or security-based swaps.
(a) Costs
The CFTC believes that the forgoing interpretation should mitigate
costs because it increases legal certainty that specific customary
consumer and commercial transactions are not swaps or security-based
swaps subject to Dodd-Frank regulation. As a result of this
interpretation, consumers and industry participants will not have to
seek legal advice regarding whether these transactions are swaps or
security-based swaps. The interpretation regarding commercial loans
made by the Federal Home Loan Banks and Farm Credit Institutions also
reduces costs by not subjecting these transactions to additional Dodd-
Frank Act regulation. To the extent a customary consumer or commercial
transaction is not included in the interpretation, consumers and market
participants may incur costs in seeking an interpretation from the
Commissions regarding the status of their transactions or an opinion of
counsel. However, the CFTC has emphasized that the lists are not
exclusive, and has provided the factors it will consider for
determining whether other consumer and commercial transactions that are
not specifically listed in the interpretation should be considered
swaps or security-based swaps, which should assist consumers and market
participants in deciding whether to seek an interpretation and thus
mitigate these costs.
(b) Benefits
The foregoing interpretation provides increased legal certainty
benefits for market participants and should ensure that customary
consumer and commercial transactions, which have never been considered
swaps or security-based swaps, will not be subject to Dodd-Frank Act
regulation, and may facilitate consumer and
[[Page 48319]]
commercial activity. As discussed above, the interpretation regarding
the factors that the Commissions will consider in determining whether
transactions that are not listed in the interpretation are swaps or
security-based swaps should assist market participants in determining
whether to seek an interpretation regarding such transactions.
Therefore, this interpretation helps to mitigate costs of legal
uncertainty.
(c) Comments and Consideration of Alternatives
Several commenters believed that the proposed interpretive guidance
regarding consumer/commercial transactions does not provide sufficient
legal certainty and request that the Commissions codify such guidance
in regulations in order to provide greater legal certainty, which may
mitigate costs.\1166\ The Commissions decline to codify the
interpretation into rule text. The interpretation is intended to
provide guidance to assist consumers and commercial and non-profit
entities in evaluating whether certain arrangements that they enter
into will be regulated as swaps or security-based swaps. The
interpretation is intended to allow the flexibility necessary,
including the consideration of the applicable facts and circumstances
by the Commissions, in evaluating consumer and commercial arrangements
to ascertain whether they may be swaps or security-based swaps. The
representative characteristics and factors taken together are
indicators that a consumer or commercial arrangement is not a swap or
security-based swap, and the Commissions have provided specific
examples demonstrating how these characteristics and factors apply to
some common types of consumer and commercial arrangements. However, as
the interpretation is not intended to be a bright-line test for
determining whether a particular consumer or commercial arrangement is
a swap or security-based swap, if the particular arrangement does not
meet all of the identified characteristics and factors, the arrangement
will be evaluated based on its particular facts and circumstances.
Also, the courts may rely on the interpretation and as such, the CFTC
does not believe that the adoption of rule text as opposed to an
interpretation will mitigate costs associated with perceived legal
uncertainty.\1167\
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\1166\ See ETA Letter; ICEA Letter; and Just Energy Letter.
\1167\ The additional research costs associated with an
interpretation as opposed to codification in the Code of Federal
Regulations will be small, because the CFTC has placed this
interpretation, and all other products interpretations, in this
adopting release for the convenience of practitioners.
---------------------------------------------------------------------------
A commenter \1168\ asserted that Federal courts will have to hear
more disputes, because proposed CFTC jurisdiction would pre-empt
significant aspects of state and Federal law concerning the purchase
and sale of goods and services. This rulemaking includes safe-harbors
from the definition of a swap for customary consumer and commercial
transactions. The Commissions have expanded the list of consumer
transactions that are excluded from the swap definition. While it may
be possible that Federal courts will nevertheless hear more disputes,
that would be a result of the statutory swap definition and not from
the interpretation being adopted by the Commissions (which should
reduce the number of such disputes).
---------------------------------------------------------------------------
\1168\ See IECA Letter.
---------------------------------------------------------------------------
Another commenter \1169\ agreed with the general factors proposed
for identifying agreements, contracts, or transactions that are not
swaps, but requested additional clarity with respect to particular
transactions. Specifically, the commenter requested that commercial
loans and financing facilities with embedded interest rate options
should not be considered swaps. To clarify, interest rate options are
swaps. As discussed in section II.B.3. above, plain vanilla interest
rate options embedded in a loan, such as rate locks, rate caps and rate
collars, are not swaps. If a product is more complex, it may be
appropriate for the CFTC to consider it in response to a specific
request for interpretation.
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\1169\ See FCC Letter.
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7. Residential Exchange Program (``REP'')
The REP \1170\ was established by Congress ``[t]o extend the
benefits of low cost Federal System hydro power to residential and
small farm electric power consumers throughout the Pacific Northwest
Region.'' \1171\ A commenter requests that the CFTC further define the
term ``swap'' to exclude consumer benefits under the Pacific Northwest
Electric Power Planning and Conservation Act of 1980 (``Northwest Power
Act'') \1172\ and transactions under the REP \1173\ to allow a subsidy
to continue to be received by residential and small farm utilities.
---------------------------------------------------------------------------
\1170\ The BPA refers to the implementation of Section 5(c) of
the Northwest Power Act, 16 U.S.C. 839c(c), as the ``Residential
Exchange Program.''
\1171\ Id. at 3.
\1172\ 16 U.S.C. Chapter 12H.
\1173\ See Bonneville Letter.
---------------------------------------------------------------------------
The Commissions do not consider the REP transactions described by
the commenter to be swaps or security-based swaps. Consequently, this
rulemaking clarifies that Dodd-Frank regulatory costs will not be
imposed on REPs and allows the subsidy to continue to be provided to
residential and small farm utilities.
8. Costs and Benefits of Rule Regarding Foreign Exchange Products and
Forward Rate Agreements
CFTC rule 1.3(xxx)(2) under the CEA explicitly defines the term
``swap'' to include an agreement, contract, or transaction that is a
cross-currency swap, currency option, foreign currency option, foreign
exchange option, foreign exchange rate option, foreign exchange
forward, foreign exchange swap, forward rate agreement, and non-
deliverable forward involving foreign exchange, unless such agreement,
contract, or transaction is otherwise excluded by section 1a(47)(B) of
the CEA. Rule 1.3(xxx)(3) provides that: (i) A foreign exchange forward
or a foreign exchange swap shall not be considered a swap if the
Secretary of the Treasury makes the determination described in CEA
section 1a(47)(E)(i); and (ii) notwithstanding any such determination,
certain provisions of the CEA will apply to such a foreign exchange
forward or foreign exchange swap (specifically, the reporting
requirements in section 4r of the CEA \1174\ and regulations thereunder
and, in the case of a swap dealer or major swap participant that is a
party to a foreign exchange swap or foreign exchange forward, the
business conduct standards in section 4s of the CEA \1175\ and
regulations thereunder). Rule 1.3(xxx)(3) further clarifies that a
currency swap, cross-currency swap, currency option, foreign currency
option, foreign exchange option, foreign exchange rate option, or non-
deliverable forward involving foreign exchange is not a foreign
exchange forward or foreign exchange swap subject to a determination by
the Secretary of the Treasury as described in the preamble.
---------------------------------------------------------------------------
\1174\ 7 U.S.C. 6r.
\1175\ 7 U.S.C. 6s.
---------------------------------------------------------------------------
The Commissions are also clarifying that a bona fide foreign
exchange spot transaction, i.e., a foreign exchange transaction that is
settled on the customary timeline \1176\ of the relevant
[[Page 48320]]
spot market, is not within the definition of the term ``swap.'' In
addition, the interpretation clarifies that retail foreign currency
options described in CEA Section 2(c)(2)(B) are not swaps. This
clarification allows market participants to engage in these
transactions with non-ECP customers who would otherwise have to engage
in on-exchange transactions.
---------------------------------------------------------------------------
\1176\ As discussed in section II.C.2.(c) above, in general, a
foreign exchange transaction will be considered a bona fide 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. In particular, a foreign exchange transaction that
is entered into solely to effect the purchase or sale of a foreign
security is a bona fide spot transaction where certain conditions
are met.
---------------------------------------------------------------------------
(a) Costs
In complying with rule 1.3(xxx)(2), a market participant will need
to ascertain whether an agreement, contract, or transaction is a swap
under the definition. This analysis will have to be performed upon
entering into the agreement, contract, or transaction. However, any
costs associated with this analysis are expected to be less than the
costs of doing the same analysis absent the rule, particularly given
potential confusion in the event of a determination by the Secretary of
the Treasury that foreign exchange forwards and/or foreign exchange
swaps not be considered swaps. To the extent that rule 1.3(xxx)(2)
improperly includes certain types of agreements, contracts, and
transactions in the swap definition, and therefore the imposition of
additional requirements and obligations, these requirements and
obligations could lead to costs for market participants entering into
such agreements, contracts, or transactions. However, the CFTC has
carefully considered each of the agreements, contracts and transactions
described above that it is further defining as swaps under rule
1.3(xxx)(2) and believe that they are appropriately classified as such,
subject to the statutory exclusions.
(b) Benefits
Because the statutory definition of the term ``swap'' includes a
process by which the Secretary of the Treasury may determine that
certain agreements, contracts, and transactions that meet the statutory
definition of a ``foreign exchange forward'' or ``foreign exchange
swap,'' respectively,\1177\ shall not be considered swaps, the CFTC is
concerned that application of the definition, without further
clarification, may cause uncertainty about whether, if the Secretary of
the Treasury makes such a determination, certain agreements, contracts,
or transactions would be swaps. Rule 1.3(xxx)(3) increases legal
certainty that a currency swap, cross-currency swap, currency option,
foreign currency option, foreign exchange option, foreign exchange rate
option, or non-deliverable forward involving foreign exchange, is a
swap (unless it is otherwise excluded by the statutory definition of
the term ``swap''). The rule also increases legal certainty that
reporting requirements, and business conduct requirements for swap
dealers and major swap participants, are applicable to foreign exchange
forwards and foreign exchange swaps even if the Secretary of the
Treasury determines that they should not be considered swaps, and is
consistent with the statute. The CFTC also is concerned that confusion
could be generated by the ``forward'' label of non-deliverable forwards
involving foreign exchange, and forward rate agreements. Rule
1.3(xxx)(2) increases legal certainty that these types of agreements,
contracts, and transactions are swaps.
---------------------------------------------------------------------------
\1177\ CEA section 1a(24), 7 U.S.C. 1a(24)(definition of a
``foreign exchange forward''); CEA section 1a(25), 7 U.S.C.
1a(25)(definition of a ``foreign exchange swap'').
---------------------------------------------------------------------------
Providing such a rule to market participants to determine whether
certain types of agreements, contracts, or transactions are swaps
alleviates additional costs to persons of inquiring with the
Commissions, or obtaining an opinion of counsel, about whether such
agreements, contracts, or transactions are swaps. In addition, such a
rule regarding the requirements that apply to foreign exchange forwards
and foreign exchange swaps that are subject to a determination by the
Secretary of the Treasury similarly alleviates additional costs to
persons of inquiring with the Commissions, or obtaining an opinion of
counsel, to determine the requirements that are applicable to such
foreign exchange forwards and foreign exchange swaps. As with the other
rules comprising the Product Definitions, enhanced legal certainty will
help market participants to engage in sound risk management practices,
which will benefit both market participants and the public.
The interpretation concerning bona fide foreign exchange spot
transactions should result in the appropriate classification of such
transactions as not subject to Dodd-Frank Act regulation. The
interpretation regarding retail foreign currency options subject to CEA
Section 2(c)(2)(B) as not swaps provides clarity and reduces costs for
market participants, who could not offer the product to non-ECP
customers off-exchange in accordance with the provisions of CEA Section
2(c)(2)(B).
In addition, including certain FX transactions, forward rate
agreements and certain other transactions in the swap definition
protects the public by explicitly subjecting these transactions to
Dodd-Frank regulation.
(c) Comments and Consideration of Alternatives
The CFTC requested comment as to the costs and benefits of proposed
rules 1.3(xxx)(2) and (3). As discussed in the preamble, some
commenters \1178\ argued that non-deliverable foreign exchange forward
transactions should be regulated as foreign exchange forwards, because
regulating them as swaps would increase the cost of hedging foreign
currency exposures in emerging markets.
---------------------------------------------------------------------------
\1178\ See CEIBA Letter; Covington Letter; ISDA Letter; and MFA
Letter.
---------------------------------------------------------------------------
Non-deliverable forward transactions do not satisfy the statutory
definition of foreign exchange forwards, as explained in section
II.C.2.(b)(ii), supra. They do satisfy the swap definition, however.
Accordingly, the CFTC lacks discretion not to define them as swaps.
9. Costs and Benefits of Rule Regarding Title VII Instruments on
Futures on Foreign Sovereign Debt Under Exchange Act Rule 3a12-8
Rule 1.3(bbbb) provides that a Title VII instrument that is based
on or references a qualifying foreign futures contract on the debt
securities of one or more of the 21 enumerated foreign governments is a
swap and not a security-based swap if the Title VII instrument
satisfies the following conditions:
The futures contract on which the Title VII instrument is
based or that is referenced must be a qualifying foreign futures
contract (as defined in rule 3a12-8) on the debt securities of any one
or more of the 21 enumerated foreign governments that satisfies the
conditions of rule 3a12-8;
The Title VII instrument is traded on or through a board
of trade (as defined in section 1a(6) of the CEA);
The debt securities on which the qualifying foreign
futures contract is based or referenced and any security used to
determine the cash settlement amount pursuant to the fourth condition
below are not registered under the Securities Act or the subject of any
American depositary receipt registered under the Securities Act;
The Title VII instrument may only be cash settled; and
The Title VII instrument is not entered into by the issuer
of the securities upon which the qualifying
[[Page 48321]]
foreign futures contract is based or referenced (including any security
used to determine the cash payment due on settlement of such Title VII
instrument), an affiliate (as defined in the Securities Act and the
rules and regulations thereunder) \1179\ of the issuer, or an
underwriter with respect to such securities.
---------------------------------------------------------------------------
\1179\ See, e.g., rule 405 under the Securities Act, 17 CFR
230.405.
---------------------------------------------------------------------------
Only those Title VII instruments that are based on qualifying
foreign futures contracts on the debt securities of the 21 enumerated
foreign governments and that satisfy these five conditions will be
swaps. The final rules are intended to provide consistent treatment
(other than with respect to method of settlement) of qualifying foreign
futures contracts and Title VII instruments based on qualifying foreign
futures contracts on the debt securities of the 21 enumerated foreign
governments.\1180\ The Commissions understand that many of the
qualifying foreign futures contracts on the debt securities of the 21
enumerated foreign governments trade with substantial volume through
foreign trading venues under the conditions set forth in rule 3a12-8
\1181\ and permitting swaps on such futures contracts subject to
similar conditions would not raise concerns that such swaps could be
used to circumvent the conditions of rule 3a12-8 and the Federal
securities laws concerns that such conditions are intended to
protect.\1182\ Further, providing consistent treatment for qualifying
foreign futures contracts on the debt securities of the 21 enumerated
foreign governments and Title VII instruments based on futures
contracts on the debt securities of the 21 enumerated foreign
governments will allow trading of these instruments through DCMs on
which such futures are listed. There may also be cross-margining
benefits when different contracts are margined at the same derivatives
clearing organization, such as may be the case if a swap on a futures
contract and a corresponding futures contract trade on the same DCM.
This cross-margining would enhance sound risk management practices.
---------------------------------------------------------------------------
\1180\ The Commissions note that the final rules provide
consistent treatment of qualifying foreign futures contracts on the
debt securities of the 21 enumerated foreign governments and Title
VII instruments based on qualifying foreign futures contracts on the
debt securities of the 21 enumerated foreign governments unless the
Title VII instrument is entered into by the issuer of the securities
upon which the qualifying foreign futures contract is based or
referenced (including any security used to determine the cash
payment due on settlement of such Title VII instrument), an
affiliate of the issuer, or an underwriter with respect to such
securities.
\1181\ See supra note 716 and accompanying text.
\1182\ See supra note 712 and accompanying text.
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The CFTC believes that the assessment cost associated with
determining whether a swap on certain futures contracts on foreign
government securities constitute a swap or security-based swap under
rule 1.3(bbbb) should be minimal. Currently, qualifying foreign futures
contracts on debt securities of the 21 enumerated foreign governments
are traded on exchanges or boards of trade. Market participants may
look at the exchange or board of trade listing to determine what they
are. Therefore, the assessment, in accordance with the rule, would
primarily focus on whether such swap itself is traded on or through a
board of trade; whether the swap is cash-settled; whether the futures
is traded on a board of trade; whether any security used to determine
the cash settlement amount are not registered under the Securities Act
or the subject of any American depositary receipt registered under the
Securities Act; and whether the swap is entered into by the foreign
government issuing the debt securities upon which the qualifying
futures contract is based or referenced, an affiliate of such foreign
government or an underwriter of such foreign government securities. All
of these determinations may be readily and quickly ascertained by the
parties entering into the agreement, contract, or transaction.
Therefore, the assessment costs associated with rule 1.3(bbbb) should
be nominal because parties should be able to make assessments in less
than an hour.
10. Costs and Benefits of Rules and Interpretations Regarding Title VII
Instruments Where the Underlying Reference Is a Security Index
Historically, the market for index CDS did not divide along
jurisdictional divisions between the CFTC and SEC; \1183\ however, the
Dodd-Frank Act created a jurisdictional divide between swaps and
security-based swaps. Under the jurisdictional division, the CFTC has
jurisdiction over Title VII instruments based on non-narrow-based
security indexes while the SEC has jurisdiction over Title VII
instruments based on narrow-based security indexes. The SEC also has
jurisdiction over Title VII instruments based on a single security or
loan, and certain events related to an issuer of securities or issuers
of securities in a narrow-based security index.
---------------------------------------------------------------------------
\1183\ For example, index CDS and single name CDS have typically
been traded on the same trading desk, and customers have typically
held their positions in a single account. The CFTC notes that the
jurisdictional divide will impact among other things portfolio
margining.
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Rule 1.3(yyy)(1) under the CEA provides that, for purposes of the
security-based swap definition, the term ``narrow-based security
index'' would have the same meaning as the statutory definition set
forth in CEA section 1a(35), and the rules, regulations, and orders
issued by the Commissions relating to such definition. As a result,
except where the new rules the Commissions are adopting provide for
other treatment, market participants generally will be able to use the
Commissions' past guidance in determining whether certain Title VII
instruments based on a security index are swaps or security-based
swaps.
The Commissions are promulgating additional rules and providing
interpretations regarding Title VII instruments based on a security
index. The interpretations and additional rules set forth new narrow-
based security index criteria with respect to indexes composed of
securities, loans, or issuers of securities referenced by an index CDS.
The interpretations and rules also address the definition of an
``index'' and the treatment of broad-based security indexes that become
narrow-based and narrow-based indexes that become broad-based,
including rule provisions regarding tolerance and grace periods for
swaps on security indexes that are traded on CFTC-regulated and SEC-
regulated trading platforms.
(a) Costs
In complying with the rules and interpretations, a market
participant will need to ascertain whether a Title VII instrument is a
swap or a security-based swap according to the criteria set forth in
the definitions of the terms ``issuers of securities in a narrow-based
security index'' and ``narrow-based security index'' as used in the
security-based swap definition. This analysis will have to be performed
prior to the execution of, but no later than an offer to enter into, a
Title VII instrument, and when the material terms of a Title VII
instrument are amended or modified, to ensure compliance with rules
1.3(yyy), 1.3(zzz) or 1.3(aaaa).
However, any such costs are expected to be less than the costs of
doing the same analysis absent the rules, which the CFTC believes would
be more difficult and lead to greater uncertainty. In particular, rule
1.3(yyy) allows market participants to reduce the costs of determining
whether a Title VII instrument based on a security index, other than an
index CDS, is a swap or security-based swap by clarifying that they
will be able to use the
[[Page 48322]]
Commissions' past guidance regarding narrow-based security index in
making that determination. In the context of index CDS, the
Commissions' past guidance regarding narrow-based security indexes does
not establish criteria on whether index CDS is a swap or a security-
based swap. Accordingly, without further explanation, it would not be
clear on which side of the CFTC/SEC jurisdictional divide index CDS
would fall. CFTC rules 1.3(zzz) and 1.3(aaaa) allow market participants
to reduce the costs of determining whether an index CDS is a swap or a
security-based swap by providing a test with objective criteria that is
similar to a test with which they already are familiar in the security
futures context, yet tailored to index CDS in particular.
Additionally, absent rule 1.3(yyy), which applies the tolerance
period rules, if a security index underlying a Title VII instrument
traded on a trading platform migrated from being broad-based to being
narrow-based, market participants may suffer disruption of their
ability to offset or enter into new Title VII instruments, and incur
additional costs as a result.
DCMs and SEFs will incur costs in assessing whether an index
underlying a Title VII instrument is broad-based, in monitoring the
index for migration from broad to narrow-based. There will also be
other costs resulting from the migration such as delisting costs. Such
migration costs are mitigated by the tolerance period of 45 business
days over three calendar months which should reduce the incidence of
migration. Similarly, the three-month grace period following an indexes
failure of the tolerance period should mitigate delisting and other
costs. There will be a range of assessment costs depending on how
customized the index underlying an index CDS is.\1184\
---------------------------------------------------------------------------
\1184\ Additionally, the number of components in an index may
impact the assessment costs based on having to determine whether the
indexes components satisfy the various tests within the rule.
---------------------------------------------------------------------------
In determining whether a Title VII instrument is a swap or a
security-based swap, market participants will need to apply the
criteria found in CFTC rules 1.3(yyy), 1.3(zzz) and 1.3(aaaa). Market
participants may conduct such analysis in-house or employ outside
third-party service providers to conduct such analysis. The costs
associated with obtaining such outside professional services would vary
depending on the relevant facts and circumstances, particularly the
composition of the index. The CFTC believes, however, that $20,000
represents a reasonable estimate of the upper end of the range of the
costs of obtaining the services of outside professional in undertaking
the analysis.\1185\ The CFTC believes that some index CDS based on an
established index would not need the assistance of outside counsel, and
a determination can be made in less than one hour. If an agreement,
contract, or transaction is more complex, the CFTC estimates the
analysis will require up to approximately 20 hours of in-house counsel
time and 30 hours of outside counsel time.
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\1185\ The average cost incurred by market participants in
connection with assessing whether an agreement, contract, or
transaction is a swap or security-based swap is based upon the
estimated amount of time that staff believes will be required for
both in-house counsel and outside counsel to apply the definition.
The staff estimates that costs associated with determining whether
an agreement, contract, or transaction is a swap or security-based
swap will range up to $20,000 after rounding to two significant
digits. Staff estimates that some index CDS will be standard and an
internal attorney, without the assistance of outside counsel will be
able to make a determination in less than one hour. Based upon data
from SIFMA's Management & Professional Earnings in the Securities
Industry 2011 (modified by CFTC staff to account for an 1800-hour-
work-year and multiplied by 5.35 to account for bonuses, firm size,
employee benefits and overhead), staff estimates that the average
national hourly rate for an internal attorney is $378. If an
agreement, contract, or transaction is more complex, the CFTC
estimates the analysis will require approximately 20 hours of in-
house counsel time and 30 hours of outside counsel time. The CFTC
estimates the costs for outside legal services to be $400 per hour.
Accordingly, on the high end of the range the CFTC estimates the
cost to be $19,560 ($7,560 (based on 20 hours of in-house counsel
time x $378) + $12,000 (based on 30 hours of outside counsel x $400)
which is then rounded to two significant digits to $20,000.
---------------------------------------------------------------------------
(b) Benefits
Rules 1.3(zzz) and 1.3(aaaa) clarify the treatment of an index CDS
as either a swap or a security-based swap by setting forth objective
criteria for meeting the definition of the terms ``issuers of
securities in a narrow-based security index'' and ``narrow-based
security index,'' respectively. These objective rules alleviate
additional costs to persons trading index CDS of inquiring with the
Commissions, or obtaining an opinion of counsel, to make complex
determinations regarding whether an index is broad- or narrow-based,
and whether an index CDS based on such an underlying index is a swap or
security-based swap.
Also, rules 1.3(zzz) and 1.3(aaaa) should reduce the potential for
market participants to use an index CDS to evade regulations, because
they set objective requirements relating to the concentration of the
notional amount allocated to each reference entity or security included
in the index, as well as the eligibility conditions for reference
entities and securities. Finally, these rules benefit the public by
requiring that the providers of index CDS make publicly available
sufficient information regarding the reference entities in an index
underlying the index CDS. By requiring that such information be made
publicly available, rules 1.3(zzz) and 1.3(aaaa) seek to assure the
transparency of the index components that will be beneficial to market
participants who trade such instruments and to the public.
Separately, rule 1.3(yyy) addresses exchange-traded swaps based on
security indexes where the underlying index migrates from broad-based
to narrow-based. The rule includes provisions that many market
participants are familiar with from security futures trading. The CFTC
believes that by using a familiar regulatory scheme, market
participants will be able to more readily understand the rule as
compared to a wholly new regulatory scheme. Also, the use of a
``tolerance period'' for swaps on security indexes that migrate from
broad-based to narrow-based also creates greater clarity by
establishing a 45-day timeframe (and subsequent grace period) on which
market participants may rely. This tolerance period results in cost
savings when compared to the alternative scenario where no tolerance
period is provided and a migration of an index from broad-based to
narrow-based would result in potential impediments to the ability of
market participants to offset their swap positions.
Finally, the Commissions are stating that the determination of
whether a Title VII instrument is a swap, a security-based swap, or
both (i.e., a mixed swap), is made prior to the execution of, but no
later than an offer to enter into, the Title VII instrument. If the
security index underlying a Title VII instrument migrates from being
broad-based to being narrow-based, or vice versa, during the life of a
Title VII instrument, the characterization of that Title VII instrument
would not change from its initial characterization regardless of
whether the Title VII instrument was entered into bilaterally or was
executed through a trade on or subject to the rules of a DCM, SEF,
FBOT, security-based SEF, or NSE. Absent this interpretation, market
participants potentially would need to expend additional resources to
continually monitor their swaps to see if the indexes on which they are
based have migrated from broad-based to narrow-based. Since the rule
provides that the initial determination prevails regardless of whether
the underlying index migrates from broad-based to narrow-based, market
participants do
[[Page 48323]]
not need to expend these monitoring costs.
(c) Comments and Consideration of Alternatives
A commenter asserted that the regulatory complexity for index CDS
is not worth the high compliance costs.\1186\ The statute provides that
the CFTC has jurisdiction over swaps on broad-based security indices,
and the SEC has jurisdiction over swaps on narrow-based security
indices, single securities or loans, and certain events related to the
issuers of securities. The Commissions need to establish criteria for
index CDS, because their past guidance regarding narrow-based security
indices does not address them. Without further explanation, it would
not be clear on which side of the CFTC/SEC jurisdictional division
certain products would fall. The number and concentration limits are
derived from criteria that Congress has imposed in the security futures
context. The public information availability test does not require that
index constituents satisfy all of its requirements; rather, the
constituents may satisfy any one of them for the index to be broad-
based, and there is a de minimis level for noncompliance.
---------------------------------------------------------------------------
\1186\ See ISDA Letter.
---------------------------------------------------------------------------
Another commenter \1187\ stated that the proposed interpretation
needs to be clearer on loan-based swap transactions and that it is
costly to determine whether a particular set of loans or borrowers
meets the Commissions' public information availability requirement. The
Commissions are clarifying that a TRS on two or more loans is not
subject to the broad-based/narrow-based jurisdictional divide, but is a
swap under the CFTC's jurisdiction. With respect to loan index CDS, the
Commissions believe that the index CDS rules, including the public
information availability requirement, should apply to indexes of loans
underlying index CDS. However, the Commissions are amending the
proposed rules to include loans within the categories of instruments to
be aggregated for the total principal amount of debt outstanding
threshold of the public information availability requirement, and will
aggregate outstanding debt of affiliates for purposes of the test,
which the CFTC believes should address the commenter's concerns.
---------------------------------------------------------------------------
\1187\ See LSTA Letter.
---------------------------------------------------------------------------
A commenter \1188\ pointed out that there may be costs to relist
index-based CDS when the index stops being, or becomes, broad-based.
Another commenter \1189\ believed that the public information
availability test will cause indices to switch between narrow-based and
broad-based classification, which could result in unnecessary cost,
confusion, and market disruption.
---------------------------------------------------------------------------
\1188\ See MarketAxess Letter.
\1189\ See Markit Letter.
---------------------------------------------------------------------------
The statutory framework requires delisting and relisting. These
costs are mitigated by the tolerance period for migration, which may
help to prevent frequent migration of indices from broad-based to
narrow-based or vice versa. Moreover, it is the case for both on and
off-exchange Title VII instruments that the Commissions are stating
that the determination of whether a Title VII instrument on a security
index is a swap or security-based swap is made prior to execution, but
no later than the offer to enter into the instrument, and remains the
same throughout the life of the instrument. Accordingly, even if the
public information availability test would cause indexes underlying
index CDS to migrate as suggested by a commenter, that will not affect
the classification of outstanding index CDS entered into prior to such
migration. However, if an amendment or change is made to such
outstanding index CDS that would cause it to be a new purchase or sale
of such index CDS, that could affect the classification of such
outstanding index CDS.
A commenter asserted that extending the ``grace period'' from three
months to six months would ease any disruption or dislocation
associated with the delisting process with respect to an index that has
migrated from broad to narrow, or narrow to broad, and that has failed
the tolerance period.\1190\ The commenter further suggested that where
an index CDS migrates, for entities operating both a SEF and a
security-based SEF, such entities should be permitted to move the index
from one platform to the other simply by providing a notice to the SEC
and CFTC.
---------------------------------------------------------------------------
\1190\ See MarketAxess Letter.
---------------------------------------------------------------------------
The Commissions are adopting the proposed rules without
modification. As discussed in Section III.G.5(b) above, the Commissions
note that the three-month grace period applicable to security futures
was mandated by Congress in that context,\1191\ and the commenter has
provided no data or evidence for its request that the Commissions
diverge from that grace period and provide for a longer grace period
with respect to swaps and security-based swaps. The Commissions believe
that the three-month grace period is similarly appropriate to apply in
the context of an index that has migrated to provide sufficient time to
execute off-setting positions. With respect to the commenter's other
suggestion that entities operating both a SEF and a security-based SEF
should be able to move the index from one platform to another where an
index CDS migrates simply by filing a notice with the SEC and CFTC, the
Commissions do not believe that this proposal is within the scope of
this rulemaking.
---------------------------------------------------------------------------
\1191\ See July 2006 Debt Index Rules. The Commissions are not
aware of any disruptions caused by the three-month grace period in
the context of security futures.
---------------------------------------------------------------------------
Many commenters offered alternatives to the various tests in
proposed rules 1.3(zzz) and 1.3(aaaa).\1192\ As discussed more fully
above in Section III.G.3.(b), the Commissions have incorporated many of
the suggested alternatives into the final rules and interpretations and
rejected, after careful consideration, other suggested alternatives.
For example, three commenters requested that the Commissions revise the
affiliation definition that applies when calculating the number and
concentration criteria to require a majority control affiliation
threshold, rather than the 20 percent threshold in the proposed
rules.\1193\ As discussed in section III.G.3.(b) above, the Commissions
are modifying the affiliation definition that applies when calculating
the number and concentration criteria in response to commenters to use
an affiliation test based on majority ownership. Based on commenters'
letters, the Commissions understand that the current standard CDS
documentation and the current approach used by certain index providers
for index CDS with respect to the inclusion of affiliated entities in
the same index use majority ownership rather than 20 percent ownership
to determine affiliation. The Commissions are persuaded by commenters
that in the case of index CDS only it is more appropriate to use
majority ownership because majority-owned entities are more likely to
have their economic interests aligned and be viewed by the market as
part of a group. The Commissions believe that revising the affiliation
definition in this manner for purposes of calculating the number and
concentration criteria responds to commenters' concerns that the
percentage control threshold may inadvertently include entities that
are not viewed as part of a group. Thus, as revised, the affiliation
definition will include only those reference entities or issuers
included in an index that satisfy
[[Page 48324]]
the more than 50 percent (i.e., majority ownership) control threshold.
---------------------------------------------------------------------------
\1192\ See section III.G.3.(b).
\1193\ See ISDA Letter; Markit Letter; and SIFMA Letter.
---------------------------------------------------------------------------
Due to the high compliance costs resulting from the public
information availability test in particular, a commenter \1194\ argued
that the Commissions should abandon that test. The final rules retain
the public information availability test, which does not present
significant compliance costs because it does not require that
constituents satisfy all of the requirements and permits a de minimis
level of noncompliance.
---------------------------------------------------------------------------
\1194\ See SIFMA Letter.
---------------------------------------------------------------------------
One commenter offered an alternative to the public information
availability test based on the volume of trading.\1195\ After careful
consideration and as described more fully above in section II.G.3.(b),
above, the Commissions are not adopting a volume based test either as a
replacement or alternative for the public information availability
test. A volume based test would not be readily ascertainable with
respect to certain underlying components which are not exchange traded
or do not satisfy listing standards. The public information
availability test allows for more flexibility with respect to the
components included in indexes underlying index CDS than a volume-based
test. Individual components in an index CDS may not satisfy a volume-
based test but could otherwise satisfy one of the criteria of the
public information availability test. The public information
availability test is similar to the test in the rules for debt security
indexes, which, as noted above, apply in the context of Title VII
Instruments. The public information availability test, accordingly,
provides a consistent set of rules under which index compilers and
market participants can analyze the characterization of index CDS.
---------------------------------------------------------------------------
\1195\ See Markit Letter.
---------------------------------------------------------------------------
In the public information availability test, one commenter proposed
moving the outstanding debt threshold from $1 billion to $100
million.\1196\ As stated above, the CFTC believes that the $1 billion
debt threshold, which is the same amount as the outstanding debt
threshold in the rules for debt security indexes, is set at the
appropriate level to achieve the objective that such entities are
likely to have public information available about them.\1197\ However,
the adopted rules expand on the types of debt that are counted toward
the $1 billion debt threshold to include any indebtedness, including
loans, so long as such indebtedness in not a revolving credit facility.
---------------------------------------------------------------------------
\1196\ Id.
\1197\ See supra part III.G.3(b)(iii); See Securities Offering
Reform, Release No. 33-8591 (Jul. 19, 2005), 70 FR 44722 (Aug. 3,
2005) (discussing economic analysis involved in determining the $1
billion threshold for non-convertible securities in the context of
well-known seasoned issuers).
---------------------------------------------------------------------------
In response to a request for comment by the Commissions, two
commenters believed that the presence of a third-party index provider
would assure that sufficient information is available regarding the
index CDS itself, but neither commenter provided an analysis to explain
how or whether a third-party index provider would be able to provide
information about the underlying securities or issuers of securities in
the index.\1198\ Accordingly, the Commissions are not adopting this
alternative.
---------------------------------------------------------------------------
\1198\ See ISDA Letter and SIFMA Letter.
---------------------------------------------------------------------------
A commenter \1199\ argued that legal uncertainty would present a
burden to market participants absent the Commissions clarifying the
status of swaps on shares of exchange traded funds that reference
broad-based security indices. However, market participants can request
a clarification through the interpretation process established herein
by the Commissions.
---------------------------------------------------------------------------
\1199\ See Anon. Letter.
---------------------------------------------------------------------------
II. Costs and Benefits of Processes To Determine Whether a Title VII
Instrument is a Swap, Security-Based Swap, or Mixed Swap, and To
Determine Regulatory Treatment for Mixed Swaps
(a) Costs
Rule 1.8 under the CEA allows persons to submit a request for a
joint interpretation from the Commissions regarding whether an
agreement, contract or transaction (or a class of agreements,
contracts, or transactions) is a swap, security-based swap, or mixed
swap. The CFTC estimates the cost of submitting a request for a joint
interpretation pursuant to rule 1.8 would be a cost of about $7,700 for
internal company or individual time and associated costs of $12,000 for
the services of outside professionals.\1200\ Once such a joint
interpretation is made, however, other market participants that seek to
transact in the same agreement, contract, or transaction (or class
thereof) would have regulatory clarity about whether it is a swap,
security-based swap, or mixed swap, so the CFTC expects the aggregate
costs of submitting joint interpretations to decrease over time as
joint interpretations are issued and the number of new requests
decrease as a result.
---------------------------------------------------------------------------
\1200\ This estimate is based on information indicating that the
average costs associated with preparing and submitting a no-action
request to the SEC staff in connection with the identification of
whether certain products are securities, which the CFTC believes is
a process similar to the process under rule 1.8. The staff estimates
that costs associated with such a request will cost approximately
$20,000. The CFTC estimates the analysis will require approximately
20 hours of in-house counsel time and 30 hours of outside counsel
time. Based upon data from SIFMA's Management & Professional
Earnings in the Securities Industry 2011 (modified by CFTC staff to
account for an 1800-hour-work-year and multiplied by 5.35 to account
for bonuses, firm size, employee benefits and overhead), staff
estimates that the average national hourly rate for an internal
attorney is $378. The CFTC estimates the costs for outside legal
services to be $400 per hour. Accordingly, the CFTC estimates the
cost to be $20,000 ($7,560 (based on 20 hours of in-house counsel
time x $378) + $12,000 (based on 30 hours of outside counsel x $400)
rounded to two significant digits to $20,000 to submit a joint
request for interpretation.
---------------------------------------------------------------------------
Separately, CFTC rule 1.9 under the CEA allows persons to submit a
request for a joint order from the Commissions regarding an alternative
regulatory treatment for particular mixed swaps. This process applies
except with respect to bilateral, uncleared mixed swaps where one of
the parties to the mixed swap is dually registered with the CFTC as a
swap dealer or major swap participant and with the SEC as a security-
based swap dealer or major security-based swap participant. With
respect to bilateral uncleared mixed swaps where one of the parties is
a dual registrant, the rule provides that such mixed swaps would be
subject to the regulatory scheme set forth in rule 1.9 in order to
provide clarity as to the regulatory treatment of such mixed swaps.
The CFTC estimates that the cost of submitting a request for a
joint order seeking an alternative regulatory treatment for a
particular mixed swap would be approximately $31,000.\1201\ Absent such
a process, though, market participants that desire or intend to enter
into such a mixed swap (or class thereof) would be required pursuant to
[[Page 48325]]
Title VII of the Dodd-Frank Act to comply with all regulatory
requirements applicable to both swaps and security-based swaps. The
CFTC believes that the cost of such dual regulation would likely be at
least as great, if not greater, than the costs of the process set forth
in rule 1.9 to request an alternative regulatory treatment for such the
mixed swap. The rule regarding bilateral uncleared mixed swaps where at
least one party is a dual registrant does not entail any additional
costs, and may reduce costs for dual registrants that enter into such
mixed swaps by eliminating potentially duplicative or inconsistent
regulation.
---------------------------------------------------------------------------
\1201\ This estimate is based on information indicating that the
average costs associated with preparing and submitting a no-action
request to the SEC staff in connection with the identification of
whether certain products are securities, which the CFTC believes is
a process similar to the process under rule 3a68-4(c). The staff
estimates that costs associated with such a request will cost
approximately $31,000. The CFTC estimates the analysis will require
approximately 30 hours of in-house counsel time and 50 hours of
outside counsel time. Based upon data from SIFMA's Management &
Professional Earnings in the Securities Industry 2011 (modified by
CFTC staff to account for an 1800-hour-work-year and multiplied by
5.35 to account for bonuses, firm size, employee benefits and
overhead), staff estimates that the average national hourly rate for
an internal attorney is $378. The CFTC estimates the costs for
outside legal services to be $400 per hour. Accordingly, the CFTC
estimates the cost to be $31,000 ($11,340 (based on 30 hours of in-
house counsel time x $378) + $20,000 (based on 50 hours of outside
counsel x $400) rounded to two significant digits to submit a joint
request for interpretation.
---------------------------------------------------------------------------
(b) Benefits
The CFTC believes that the rules that enable market participants to
submit requests for joint interpretations regarding the nature of
various agreements, contracts, or transactions, and requests for joint
orders regarding the regulatory treatment of mixed swaps will help to
create a more level playing field (since the joint interpretations and
joint orders will be available to all market participants) regarding
which agreements, contracts, or transactions constitute swaps,
security-based swaps, or mixed swaps, and the regulatory treatment
applicable to particular mixed swaps. The joint interpretations and
joint orders will be available to all market participants. The
availability of such joint interpretations and joint orders regarding
the scope of the definitions and the regulatory treatment of mixed
swaps will reduce transaction costs and thereby promote the use of
Title VII instruments for risk management and other purposes.
The product interpretation process established by the Commissions
has a 120-day deadline. This deadline will facilitate new products
coming to market relatively quickly. Further, the process holds the
Commissions accountable because they will have to state why they are
not providing an interpretation when they decline to do so.
(c) Comments and Consideration of Alternatives
A commenter \1202\ recommended that the Commissions require that
market participants disaggregate mixed swaps and enter into separate
simultaneous transactions so that they cannot employ mixed swaps to
obscure the underlying substance of transactions.\1203\ The Commissions
are not adopting any rules or interpretations to require disaggregation
of mixed swaps into their separate components, as the Dodd-Frank Act
specifically contemplated that there would be mixed swaps comprised of
both swaps and security-based swaps. Moreover, the CFTC believes that
requiring market participants to disaggregate their agreements,
contracts, or transactions into swaps and security-based swaps may
limit the freedom of contract or discourage innovation of financial
products and potentially increase transaction costs for swap market
participants.
---------------------------------------------------------------------------
\1202\ See Better Markets Letter.
\1203\ Id.
---------------------------------------------------------------------------
12. Costs and Benefits of SBSA Books and Records, and Data,
Requirements
CFTC rule 1.7 under the CEA would clarify that there would not be
books and records or data requirements regarding SBSAs other than those
that would exist for swaps. The rule alleviates any additional books
and records or information costs to persons who are required to keep
and maintain books and records regarding, or collect and maintain data
regarding, SBSAs because the rule does not require such persons to keep
or maintain any books and records, or collect and maintain any data,
regarding SBSAs that differs from the books, records, and data required
regarding swaps.
Specifically, rule 1.7 would require persons registered as SDRs to:
i) keep and maintain books and records regarding SBSAs only to the
extent that SDRs are required to keep and maintain books and records
regarding swaps; and ii) collect and maintain data regarding SBSAs only
to the extent that SDRs are required to collect and maintain data
regarding swaps. In addition, rule 1.7 would require persons registered
as swap dealers or major swap participants to keep and maintain books
and records, including daily trading records, regarding SBSAs only to
the extent that those persons would be required to keep and maintain
books and records regarding swaps.
Because rule 1.7 imposes no requirements with respect to SBSAs
other than those that exist for swaps, rule 1.7 would impose no costs
other than those that are required with respect to swaps in the absence
of rule 1.7. Rule 1.7 provides clarity by establishing uniform
requirements regarding books and records, and data collection,
requirements for swaps and for SBSAs. No comments were received with
respect to Rule 1.7.
13. Costs and Benefits of the Anti-Evasion Rules and Interpretation
The CFTC is exercising the anti-evasion rulemaking authority
granted to it by the Dodd-Frank Act. Generally, CFTC rule 1.3(xxx)(6)
under the CEA defines as a swap any agreement, contract, or transaction
that is willfully structured to evade the provisions of Title VII
governing the regulation of swaps. Further, CFTC rule 1.6 under the CEA
would prohibit activities conducted outside the United States,
including entering into agreements, contracts, and transactions and
structuring entities, to willfully evade or attempt to evade any
provision of the CEA as enacted by Title VII or the rules and
regulations promulgated thereunder.
As opposed to providing a bright-line test, rule 1.3(xxx)(6) would
apply to agreements, contracts, and transactions that are willfully
structured to evade and rule 1.6 would apply to entering into
agreements, contracts, or transactions to evade (or as an attempt to
evade) and structuring entities to evade (or as an attempt to evade)
subtitle A of Title VII governing the regulation of swaps. Although
this test does not provide a bright line, it helps ensure that would-be
evaders cannot willfully structure their transactions or entities for
the purpose of evading the requirements of subtitle A of Title VII. The
CFTC also is explaining some circumstances that may constitute an
evasion of the requirements of subtitle A of Title VII, while at the
same time preserving the CFTC's ability to determine, on a case-by-case
basis, with consideration given to all the facts and circumstances,
that other types of transactions or actions constitute an evasion of
the requirements of the statute or the regulations promulgated
thereunder.
(a) Costs
Market participants may incur costs when deciding whether a
particular transaction or entity could be construed as being willfully
structured to evade subtitle A of Title VII of the Dodd-Frank Act;
however, the rules and related interpretations explain what constitutes
evasive conduct, which should serve to mitigate such costs.
(b) Benefits
Absent the proposed anti-evasion rules and related interpretations,
price discovery might be impaired because markets would not be informed
about those transactions, since through evasion such transactions would
not comply with Dodd-Frank Act regulatory requirements. Additionally,
certain risks could increase in a manner that the CFTC would not be
able to measure accurately. The anti-evasion rules and related
interpretations will bring the appropriate scope of transactions and
[[Page 48326]]
entities within the regulatory framework established by the Dodd-Frank
Act, which will better allow the CFTC to assure transparency and
protect the U.S. financial system from certain risks that could go
undetected through evasive conduct.
(c) Comments and Consideration of Alternatives
A commenter \1204\ asserted that a market participant should be
able to enter into a transaction or structure an instrument or entity
to avoid higher regulatory burdens and attendant costs as long as the
transaction or entity has an overriding business purpose. Another
commenter \1205\ noted that the CFTC recognized in the Proposing
Release that choosing to do a security-based swap over a swap to lessen
a regulatory burden does not constitute evasion in itself, but
expressed the view that this should not be limited to a choice between
structuring a transaction as a swap and security. In this commenter's
view, parties must be able to legitimately consider all relevant
factors, including the cost and burden of regulation, in making their
structuring choices. Another commenter \1206\ requested that the CFTC
make clear that movements away from swaps towards physical trades that
reduce regulatory burdens will not be considered evasion under the
final rule. A different commenter \1207\ argued that the anti-evasion
proposal is overly broad and unnecessarily limits the ability of market
participants to choose between legitimate structuring alternatives.
Finally, another commenter \1208\ believes that the proposed rules will
create an ``impossible burden'' on the innocent (non-evading) party.
---------------------------------------------------------------------------
\1204\ See CME Letter.
\1205\ See ISDA Letter.
\1206\ See COPE Letter.
\1207\ See SIFMA Letter.
\1208\ See IECA Letter II.
---------------------------------------------------------------------------
Activity conducted solely for a legitimate business purpose, absent
other indicia of evasion, does not constitute evasion as described in
the CFTC's interpretation. The CFTC has clarified that consideration of
regulatory burdens, including evidence of regulatory avoidance, is not
dispositive of whether there has been evasion or not, but should be
considered along with all other relevant facts and circumstances. For
example, activities structured as securities instead of swaps and
transactions that meet the forward exclusion are not evasion per se.
The CFTC has clarified that it will impose appropriate sanctions on the
willful evader for violation of the CEA and CFTC regulations and not on
non-evading parties.
A commenter suggests that an alternative standard for a finding of
evasion should be ``whether the transaction is lawful or not'' under
the CEA, CFTC rules and regulations, orders, or other applicable
federal, state or other laws.\1209\ While the commenter's alternative
standard for evasion may impose lower costs on market participants
because it is a bright-line test, the CFTC is not adopting it. The
commenter's alternative standard would blur the distinction between
whether a transaction (or entity) is lawful and whether it is
structured in a way to evade Dodd-Frank and the CEA. The anti-evasion
rules provided herein are concerned with the latter conduct, not the
former.\1210\ Thus, the CFTC does not believe it is appropriate to
limit the enforcement of its anti-evasion authority to only unlawful
transactions.
---------------------------------------------------------------------------
\1209\ See WGCEF Letter.
\1210\ If a transaction is unlawful, the CFTC (or another
authority) may be able to bring an action alleging a violation of
the applicable rule, regulation, order or law.
---------------------------------------------------------------------------
CEA Section 15(a) Summary:
(1) Protection of Market Participants and the Public
Including certain foreign exchange transactions, forward rate
agreements and certain other transactions in the swap definition
protects the public by subjecting these transactions to Dodd-Frank
regulation. Similarly, the anti-evasion rules protect market
participants against evasive conduct that would take away the
protection afforded to them under Dodd-Frank regulation.
(2) Efficiency, Competitiveness, and the Financial Integrity of Markets
The CFTC believes that the final rules and interpretations can be
consistently applied by substantially all market participants to
determine which agreements, contracts, or transactions are, and which
are not, swaps, security-based swaps, security-based swap agreements,
or mixed swaps. This may improve resource allocation efficiency as
market participant may not have to incur the cost of petitioning the
Commissions or obtaining an opinion of counsel to determine the status
of agreements, contracts or transactions as frequently as would be
necessary without the rules or interpretations.
Moreover, the Commissions' statement that the determination of
whether a Title VII instrument is a swap, a security-based swap, or
both (i.e., a mixed swap), is made prior to the execution of, but no
later than an offer to enter into, the Title VII instrument, and
remains the same throughout the instrument's life (absent amendment of
the instrument), improves resource allocation efficiency because,
without this interpretation, market participants potentially would need
to expend additional resources to continually monitor their swaps to
see if the indexes on which they are based have migrated from broad-
based to narrow-based. The tolerance and grace periods for index CDS
traded on CFTC and SEC-regulated trading platforms should lower the
frequency of index migration and attendant costs, also improving
resource allocation efficiency.
(3) Price Discovery
Not exempting swaps from foreign central banks, foreign sovereigns,
international financial institutions, such as multilateral development
banks, and similar organizations helps improve transparency and price
discovery through disclosure that might otherwise not occur. Market
participants will be informed about the prices of these transactions.
Furthermore, they will be better informed about the risks that these
transactions entail.
The CFTC's interpretation of the term ``swap'' to include
guarantees of swaps that are not security-based swaps or mixed swaps
and the separate CFTC release will enable the CFTC and market
participants to receive more price-forming data about such swaps, which
help improve price discovery for swaps. Without anti-evasion rules,
price discovery might be impaired, since market participants would
otherwise not be informed about relevant but evasive swap transactions.
(4) Sound Risk Management Practices
Properly classifying transactions as swaps or not swaps may lead to
sound risk management practices, because the added clarity provided by
the rules and interpretations herein will enable market participants to
consider whether a particular agreement, contract, or transaction is a
swap, prior to entering into such agreement, contract or transaction.
The business of insurance is already subject to established pre-
Dodd-Frank Act regulatory regimes. Requirements that may work well for
swaps and security-based swaps may not be appropriate for traditional
insurance products. To the extent that the final rules distinguish
insurance from swaps and security-based swaps, the CFTC believes that
the Commissions should be able to tailor rules for specific
[[Page 48327]]
products that are swaps or security-based swaps to achieve Title VII
regulatory objectives. In adopting the Insurance Safe Harbor, the CFTC
believes that the Commissions seek to achieve those net benefits that
may be obtained from not supplanting existing insurance regulation.
Documenting oral book-outs should promote good business practices
and aid the CFTC in preventing evasion through abuse of the forward
exclusion.
Title VII instruments on qualifying foreign futures contracts on
debt securities of one of the 21 enumerated foreign governments is a
swap and not a security-based swap if the Title VII instrument
satisfies certain conditions. The classification may provide cross-
margining benefits when swap contracts and the futures contract are
margined at the same derivatives clearing organization, and thus, may
enhance sound risk management practices.
Other Public Interest Considerations
Documenting oral book-outs should promote good business practices
and aid the CFTC in preventing evasion through abuse of the forward
exclusion.
The product interpretation process established by the Commissions
has a 120-day deadline. This deadline will facilitate new products
coming to market relatively quickly. Further, the process holds the
Commissions accountable, because they will have to state why they are
not providing an interpretation when they decline to do so.
The rule for books and records requirements for SBSAs does not
impose new recordkeeping requirements on SBSAs, but relies on existing
recordkeeping requirements for swaps, which avoids unnecessary
regulation.
Appendix--Rules Effectuated by the Product Definitions
----------------------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------------------
Agricultural Swaps...................... Makes no distinction between agricultural 76 FR 49291, 49297, Aug.
swaps and other swaps. 10, 2011
Commodity Options....................... Exempts subject to conditions certain 77 FR 25320, 25331, Apr.
options on physical commodities where 27, 2012
parties are commercials or ECPs. The
option results in physical delivery of
the underlying.
CPO/CTA compliance obligations.......... Rescinds the exemption from CPO 77 FR 11252, 11275, Feb.
registration; rescinds relief from the 24, 2012
certification requirement for annual
reports provided to operators of certain
pools offered only to qualified eligible
persons (QEPs; modifies the criteria for
claiming relief); and require the annual
filing of notices claiming exemptive
relief under several sections of the
Commission's regulations. Finally, the
adopted amendments include new risk
disclosure requirements for CPOs and
CTAs.
Business Conduct Standards for SDs and Applies to SDs and (except where 77 FR 9734, 9805, Feb. 17,
MSPs With Counterparties. indicated) MSPs and prohibits certain 2012
abusive practices, requires disclosures
of material information to
counterparties and requires SDs/MSPs to
undertake certain due diligence relating
to their dealings with counterparties.
Certain rules do not apply to
transactions initiated on a swap
execution facility (SEF) or designated
contract market (DCM) when the SD/MSP
does not know the identity of the
counterparty prior to execution.
SD and MSP Recordkeeping, Reporting, and Establishes reporting, recordkeeping, and 77 FR 20128, 20166, Apr. 3,
Duties Rules; FCMs and IBs Conflicts of daily trading records requirements for 2012
Interest Rules; and Chief Compliance SDs and MSPs; establishes and governs
Officer Rules for SDs, MSPs, and FCMs. the duties of SDs and MSPs; establishes
conflicts of interest requirements for
SDs, MSPs, FCMs, and IBs; establishes
the designation, qualifications, and
duties of the chief compliance officers
(CCOs) of FCMs, SDs, and MSPs and
describes the required contents of the
annual report detailing a registrant's
compliance policies and activities, to
be prepared by the chief compliance
officer and furnished to the CFTC.
Position Limits for Futures and Swaps... Establishes limits on speculative 76 FR 71626, 71662, Nov.
positions in 28 selected physical 18, 2011
commodity futures and swaps.
Real-Time Public Reporting of Swap Establishes regulations concerning the 77 FR 1182, 1232, Jan. 9,
Transaction Data. real-time public reporting of swap 2012
transactions and pricing data.
Swap Data Recordkeeping and Reporting Establishes swap data recordkeeping and 77 FR 2136, 2176, Jan. 13,
Requirements. reporting requirements for registered 2012
entities and counterparties.
Swap Data Repositories: Registration Establishes regulations concerning the 76 FR 54538, 54572, Sept.
Standards, Duties and Core Principles. registration and regulation of swap data 1, 2011
repositories.
Registration of SDs and MSPs............ Establishes the process for the 77 FR 2613, 2623, Jan. 19,
registration of SDs and MSPs. 2012
----------------------------------------------------------------------------------------------------------------
XI. Administrative Law Matters--Exchange Act Revisions
A. Economic Analysis
1. Overview
The SEC is sensitive to the costs and benefits of its rules. In
adopting the final rules in this release, the SEC has been mindful of
the costs and benefits associated with these rules which provide
fundamental building blocks for the Title VII regulatory regime
established by Congress. In addition, section 3(f) of the Exchange Act
requires the SEC, whenever it engages in rulemaking and is required to
consider or determine whether an action is necessary or appropriate in
the public interest, to consider, in addition to the protection of
investors, whether the action will promote competition, efficiency, and
capital formation.\1211\ Moreover, section 23(a)(2) of the Exchange Act
requires the SEC, when adopting rules under the Exchange Act, to
consider the impact such rules would have on competition. Section
23(a)(2) also prohibits the SEC from adopting any rule that would
impose a burden on competition not necessary or appropriate in
furtherance of the
[[Page 48328]]
purposes of the Exchange Act.\1212\ The SEC requested comment on all
aspects of the costs and benefits of the proposed rules in the
Proposing Release,\1213\ and any effect these rules may have on
competition, efficiency, and capital formation.
---------------------------------------------------------------------------
\1211\ 15 U.S.C. 78c(f).
\1212\ 15 U.S.C. 78w(a)(2).
\1213\ See Proposing Release at 29885.
---------------------------------------------------------------------------
These final rules implement the mandate of Title VII that the CFTC
and the SEC, in consultation with the Federal Reserve Board, jointly
further define the terms ``swap,'' ``security-based swap,'' and
``security-based swap agreement.'' \1214\ The rules adopted in this
release may be divided into three categories:
---------------------------------------------------------------------------
\1214\ See section 712(d)(1) of the Dodd-Frank Act.
---------------------------------------------------------------------------
First, the Commissions are adopting rules that will assist market
participants in determining whether particular agreements, contracts,
and transactions fall within or outside the swap and security-based
swap definitions (i.e., identifying products subject to Title VII). The
final rules provide: (1) An Insurance Safe Harbor for those agreements,
contracts, and transactions that the Commissions believe Congress does
not intend to be Title VII instruments; \1215\ (2) a ``grandfather''
for those insurance agreements, contracts, or transactions (as opposed
to insurance product categories) entered into on or before the
effective date of the Product Definitions provided that, when the
parties entered into such agreement, contract, or transaction, it was
provided in accordance with the Provider Test; \1216\ and (3) further
definition of the term ``swap'' to specifically list certain enumerated
products and not include certain foreign exchange forwards and foreign
exchange swaps.\1217\
---------------------------------------------------------------------------
\1215\ See supra part II.B.1.
\1216\ See supra part II.B.1.c).
\1217\ See supra part II.C.2.
---------------------------------------------------------------------------
Second, the Commissions are adopting rules that will assist market
participants in determining whether a particular Title VII instrument
is a swap subject to CFTC regulation, a security-based swap subject to
SEC regulation, or a mixed swap subject to regulation by the CFTC and
the SEC (i.e., mapping the jurisdictional divide between the CFTC and
the SEC). Specifically, Title VII instruments that are CDS referencing
a security index or a group or index of issuers of securities or
obligations of issuers of securities may be swaps subject to CFTC
regulation or security-based swaps subject to SEC regulation, depending
on whether such Title VII instruments are based on events relating to
``issuers of securities in a narrow-based security index'' or events
relating to securities in a ``narrow-based security index''.\1218\ The
final rules further define the terms ``issuers of securities in a
narrow-based security index'' and ``narrow-based security index'' for
purposes of this analysis.\1219\ Further, the Commissions are adopting
rules that provide tolerance and grace periods for Title VII
instruments based on a security index that are traded on certain
trading platforms where the security index may temporarily move from
being within the ``narrow-based security index'' definition to being
outside (e.g.,. moving from narrow-based to broad-based, or vice
versa.) \1220\ Additionally, the Commissions are providing
clarification that a Title VII instrument based on a qualifying foreign
futures contract on the debt securities of one or more of the 21
enumerated foreign governments is a swap and not a security-based swap,
if certain conditions are met.\1221\
---------------------------------------------------------------------------
\1218\ See section 3(a)(68)(A)(ii)(III) of the Exchange Act, 15
U.S.C. 78c(a)(68)(A)(ii)(III).
\1219\ See supra part III.G.
\1220\ See supra part III.G.5.
\1221\ See supra part III.E.
---------------------------------------------------------------------------
Third, the Commissions are adopting rules that provide: (1) A
regulatory framework for certain mixed swaps and a process for market
participants to request that the Commissions issue a joint order
determining the appropriate regulatory treatment of certain other mixed
swaps \1222\ and (2) a process for market participants to request a
joint interpretation from the Commissions regarding whether a
particular Title VII instrument is a swap, security-based swap, or
mixed swap.\1223\ The final rules also provide that market participants
have no additional books and records requirements for SBSAs other than
those for swaps.\1224\
---------------------------------------------------------------------------
\1222\ See supra part IV.
\1223\ See supra part VI.
\1224\ See supra part V.
---------------------------------------------------------------------------
In considering the economic consequences of the final rules, the
SEC acknowledges the regulatory regime that was in place prior to the
enactment of Title VII. Prior to the enactment of Title VII, swaps and
security-based swaps were by-and-large unregulated. The Commodity
Futures Modernization Act of 2000 (``CFMA'') created a regulatory
regime that prohibited the SEC from regulating security-based swap
agreements,\1225\ though it provided the SEC with limited enforcement
authority over such instruments with respect to fraud, manipulation,
and insider trading.\1226\ Title VII created an entirely new regulatory
regime to regulate swaps, security-based swap agreements and security-
based swaps.
---------------------------------------------------------------------------
\1225\ The CFMA added section 206A to the GLBA, 15 U.S.C. 78c
note, to define the term ``swap agreement'' to mean any agreement,
contract, or transaction between ECPs, the material terms of which
(other than price and quantity) are subject to individual
negotiation, that fall within certain categories of transactions.
Additionally, the CFMA added section 206B to the GLBA, 15 U.S.C. 78c
note, which defined a ``security-based swap agreement'' to mean a
swap agreement (as defined in section 206A of the GLBA) on which a
material term is based on the price, yield, value, or volatility of
any security or any group or index of securities, or any interest
therein. Furthermore, the CFMA added section 206C to the GLBA, 15
U.S.C. 78c note, which defined a ``non-security-based swap
agreement'' to mean any swap agreement (as defined in section 206A
of the GLBA) that is not a security-based swap agreement (as defined
in section 206B of the GLBA). Title VII amended the definition of
the term ``swap agreement'' (discussed in footnote 1284) and
repealed the definition of the terms ``security-based swap
agreement'' and ``non-security-based agreement.'' See sections
762(a) and (b) of the Dodd-Frank Act. However, Title VII also added
a new definition of the term ``security-based swap agreement'' in
section 3(a)(78) of the Exchange Act, 15 U.S.C. 78c(a)(78), that is
generally consistent with the repealed definition, except that the
new definition excludes security-based swaps. Accordingly, Title VII
provides jurisdiction to the CFTC for security-based swap
agreements, such as Title VII Instruments based on broad-based
securities indexes, and also retains the SEC's jurisdiction over
such instruments in instances of fraud, manipulation, or insider
trading.
\1226\ The CFMA excluded from the definition of the term
``security'' the term ``security-based swap agreement'' as well as
the term ``non-security based swap agreement'' (as those terms are
defined in section 206B and 206C (respectively) of the GLBA, 15
U.S.C. 78c note). See sections 2A(a) and (b)(1) of the Securities
Act, 15 U.S.C. 77b-1(a) and (b)(1), and sections 3A(a) and (b)(1) of
the Exchange Act, 15 U.S.C. 78c-1(a) and (b)(1). Furthermore, the
CFMA explicitly prohibited the SEC from registering, or requiring,
recommending, or suggesting the registration under the Securities
Act and the Exchange Act of any security-based swap agreement (as
defined in section 206B of the GLBA). See section 2A(b)(2) of the
Securities Act, 15 U.S.C. 77b-1(b)(2), and section 3A(b)(2) of the
Exchange Act, 15 U.S.C. 78c-1(b)(2). The CFMA also made explicit
that the SEC is prohibited from either (1) promulgating,
interpreting, or enforcing rules or (2) issuing orders of general
applicability under the Securities Act or Exchange Act in a manner
that imposes or specifies reporting or recordkeeping requirements,
procedures, or standards as prophylactic measures against fraud,
manipulation, or insider trading with respect to any security-based
swap agreement (as defined in section 206B of the GLBA). However,
the CFMA did provide the SEC with limited enforcement authority
under section 10(b) of the Exchange Act, 15 U.S.C. 78j(b), and the
rules promulgated thereunder that prohibit fraud, manipulation, or
insider trading (but not rules imposing or specifying reporting or
record-keeping requirements, procedures, or standards as
prophylactic measures against fraud, manipulation, or insider
trading). Furthermore, the CFMA applies judicial precedents under
sections 9, 10(b), 15, 16, 20, and 21A of the Exchange Act, 15
U.S.C. 78i, 78j(b), 78o, 78p, 78t, and 78u-1, as well as section
17(a) of the Securities Act, 15 U.S.C. 77q(a), to security-based
swap agreements (as defined in section 206B of the GLBA) to the same
extent as they apply to securities.
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2. Economic Analysis Considerations
The rules adopted in this release implicate different types of
potential costs and benefits. First, there are costs,
[[Page 48329]]
as well as benefits, arising from subjecting certain agreements,
contracts, or transactions to the regulatory regime of Title VII. The
SEC refers to these costs and benefits as ``programmatic'' costs and
benefits. Additionally, there are costs that parties will incur to
assess whether certain agreements, contracts, or transactions are
indeed subject to the Title VII regulatory regime, and, if so, costs to
assess whether such Title VII instrument is subject to the regulatory
regime of the SEC or the CFTC. The SEC refers to these costs as
``assessment'' costs.\1227\
---------------------------------------------------------------------------
\1227\ The SEC expects that the benefits resulting from further
defining the terms ``swap,'' ``security-based swap,'' and ``mixed
swap'' will likely accrue primarily at the programmatic level. To
the extent appropriate, given the purposes of Title VII, the
Commissions have sought to mitigate the costs persons will incur in
connection with determining whether the instrument is a swap,
security-based swap, or mixed swap.
---------------------------------------------------------------------------
The programmatic costs and benefits and the assessment costs raise
distinct analytic issues. First, the SEC recognizes that the Product
Definitions, while integral to the regulatory requirements that will be
imposed on the swap and security-based swap markets pursuant to Title
VII, do not themselves establish the scope or nature of those
substantive requirements or their related costs and benefits. The SEC
anticipates that the rules implementing the substantive requirements
under Title VII will be subject to their own economic analysis, but
final rules have not yet been adopted that would subject agreements,
contracts, or transactions, or entities that act as intermediaries
(such as security-based swap dealers (``SBS dealers'') or major
security-based swap participants (``MSBSPs'')) or provide market
infrastructures (such as clearing agencies, trade repositories and
trade execution facilities), to such substantive requirements. The
costs and benefits described below are therefore those that may arise
in connection with: (1) Determining whether certain agreements,
contracts, or transactions are Title VII instruments (i.e., the
assessment costs) and (2) subjecting those agreements, contracts, or
transactions that are Title VII instruments, determined based on the
statutory definitional lines that the Commissions are further defining,
to a complete and fully effective complement of Title VII statutory and
regulatory requirements. In addition, the discussion below addresses
the costs and benefits arising from security-based swaps being within
the definition of security under the Securities Act and the Exchange
Act. Once a Title VII Instrument is determined to be a security-based
swap, the security-based swap will be a security subject to the full
panoply of the Federal securities laws. Such treatment will give rise
to costs and benefits, including those that apply to securities
generally. Security-based swaps may be subject to additional costs to
the extent that there are overlapping regulatory requirements arising
from the Title VII regulatory requirements and those Federal securities
laws requirements that apply to securities generally. The SEC has
already taken action to address some of such overlapping or
inconsistent requirements \1228\ and will continue to evaluate other
needed actions, if any, to minimize any such overlapping regulatory
implications.
---------------------------------------------------------------------------
\1228\ See Order Pursuant to Sections 15F(b)(6) and 36 of the
Securities Exchange Act of 1934 Granting Temporary Exemptions and
Other Temporary Relief, Together With Information on Compliance
Dates for New Provisions of the Securities Exchange Act of 1934
Applicable to Security-Based Swaps, and Request for Comment, Release
No. 34-64678 (June 15, 2011), 76 FR 36287 (June 22, 2011); Exchange
Act Exemptive Order; and SB Swaps Interim Final Rules.
---------------------------------------------------------------------------
Second, in determining the appropriate scope of these rules, the
SEC considers the types of agreements, contracts, or transactions that
should be regulated as swaps, security-based swaps, or mixed swaps
under Title VII in light of the purposes of the Dodd-Frank Act, the
overall regulatory framework, the historical treatment of the
instruments and other regulatory frameworks, and the data currently
available to the SEC. The SEC has sought to further define the terms
``swap,'' ``security-based swap,'' and ``mixed swap'' to address the
status of agreements, contracts, and transactions that are appropriate
to regulate as swaps, security-based swaps and mixed swaps within the
purposes of Title VII and not to include those agreements, contracts,
and transactions that historically have not been considered to be swaps
or security-based swaps thereby not imposing unnecessary or
inappropriate Title VII costs and burdens on parties engaging in
agreements, contracts, and transactions. In addition, the SEC
recognizes that these rules may have effects on competition,
efficiency, and capital formation as a result of certain agreements,
contracts, and transactions being determined to fall under or outside
the Title VII regulatory regime, or as a result of the jurisdictional
divide between the SEC and CFTC as mandated by the statute.
In the sections below, the SEC begins by recognizing that the Title
VII regulatory regime has programmatic benefits and costs, as well as
assessment costs. These costs and benefits have informed the decisions
and the actions taken that are described throughout the release.
Accordingly, the analysis below includes references to the discussions
of the decisions and actions taken by the Commissions set forth above
in other parts of this release. Finally the SEC discusses the effects
of these rules on competition, efficiency, and capital formation.
3. Programmatic Benefits and Costs
By enacting Title VII, Congress created a regulatory regime for
swaps and security-based swaps that previously did not exist.\1229\
Title VII amendments to the Exchange Act impose, among other
requirements, the following: (1) Registration and comprehensive
oversight of SBS dealers and MSBSPs; \1230\ (2) reporting of security-
based swaps to a registered security-based swap data repository (``SB
SDR''), or to the SEC (if the security-based swap is uncleared and no
SB SDR will accept the security-based swap for reporting), and
dissemination of the security-based swap market data to the public;
\1231\ (3) clearing of security-based swaps at a registered clearing
agency (or a clearing agency that is exempt from registration) if the
SEC makes a determination that such security-based swaps are required
to be cleared, unless an exception from the mandatory clearing
requirement applies; \1232\ and (4) if a security-based
[[Page 48330]]
swap is subject to the clearing requirement, execution of the security-
based swap transaction on an exchange, on a security-based swap
execution facility (``SB SEF'') registered under the Exchange
Act,\1233\ or on an SB SEF that has been exempted from registration by
the SEC under the Exchange Act,\1234\ unless no SB SEF or exchange
makes such security-based swap available for trading.\1235\ In
addition, Title VII amends the Securities Act and the Exchange Act to
include security-based swaps in the definition of ``security'' for the
purposes of those statutes.\1236\ As a result, security-based swaps are
subject to the full panoply of the Federal securities laws. Title VII
also added specific provisions to the Securities Act and Exchange Act
affecting how security-based swaps may be sold. For example, Title VII
amended section 5 of the Securities Act to require that a registration
statement meeting the requirements of the Securities Act be in effect
before there can be an offer to sell, offer to buy, purchase or sale of
a security-based swap from or to any person who is not an ECP.\1237\ In
addition, Title VII added section 6(l) to the Exchange Act to require
that any security-based swap transaction with or for a person that is
not an ECP must be effected on a national securities exchange.\1238\
---------------------------------------------------------------------------
\1229\ See supra part XI.A.1.
\1230\ See section 15F of the Exchange Act, 15 U.S.C. 78o-10.
\1231\ See section 3(a)(75) of the Exchange Act, 15 U.S.C.
78c(a)(75) (defining the term ``security-based swap data
repository''); section 13(m) of the Exchange Act, 15 U.S.C. 78m(m)
(regarding public availability of security-based swap data); section
13(n) of the Exchange Act, 15 U.S.C. 78m(n) (regarding requirements
related to SB SDRs); and section 13A of the Exchange Act, 15 U.S.C.
78m-1 (regarding reporting and recordkeeping requirements for
certain security-based swaps). See also Security-Based Swap Data
Repository Registration, Duties, and Core Principles, Release No.
34-63347 (Nov. 19, 2010), 75 FR 77306 (Dec. 10, 2010); corrected at
75 FR 79320 (Dec. 20, 2010) and 76 FR 2287 (Jan. 13, 2011) (``SDR
Proposing Release''); and Regulation SBSR--Reporting and
Dissemination of Security-Based Swap Information, Release No. 34-
63346 (Nov. 19, 2010), 75 FR 75208 (Dec. 2, 2010) (``Regulation SBSR
Proposing Release''). In each proposing release the SEC invited
comment with respects to the costs and benefits of each of the
proposed rules. The costs associated with these and other
substantive rules, along with any comments received by the SEC
addressing the costs of the proposed rules, are being addressed in
more detail in connection with the applicable rulemakings.
\1232\ See section 3C(a)(1) of the Exchange Act, 15 U.S.C. 78c-
3(a)(1). See also Process for Submissions for Review of Security-
Based Swaps for Mandatory Clearing and Notice Filing Requirements
for Clearing Agencies; Technical Amendments to Rule 19b-4 and Form
19b-4 Applicable to All Self-Regulatory Organizations, 75 FR 82490
(Dec. 30, 2010) (``Clearing Procedures Proposing Release''). In the
Clearing Procedures Proposing Release the SEC invited comment with
respects to the costs and benefits of each of the proposed rules.
The costs associated with these and other substantive rules, along
with any comments received by the SEC addressing the costs of the
proposed rules, are being addressed in more detail in connection
with the applicable rulemakings.
\1233\ See section 3D of the Exchange Act, 15 U.S.C. 78c-4.
\1234\ See section 3D(e) of the Exchange Act, 15 U.S.C. 78c-
4(e).
\1235\ See sections 3C(g) and (h) of the Exchange Act, 15 U.S.C.
78c-3(g) and (h). See also section 3(a)(77) of the Exchange Act, 15
U.S.C. 78c(77) (defining the term ``security-based swap execution
facility''). See also Registration and Regulation of Security-Based
Swap Execution Facilities, Release No. 34-63825 (Feb. 2, 2011), 76
FR 10948 (Feb. 28, 2011) (``SB SEF Proposing Release''). In the SB
SEF Proposing Release each proposing release the SEC invited comment
with respects to the costs and benefits of each of the proposed
rules. The costs associated with these and other substantive rules,
along with any comments received by the SEC addressing the costs of
the proposed rules, are being addressed in more detail in connection
with the applicable rulemakings.
\1236\ See sections 761(a)(2) and 768(a)(1) of the Dodd-Frank
Act (amending sections 3(a)(10) of the Exchange Act, 15 U.S.C.
78c(a)(10), and 2(a)(1) of the Securities Act, 15 U.S.C. 77b(a)(1),
respectively). The Dodd-Frank Act also amended the Securities Act to
provide that any offer or sale of a security-based swap by or on
behalf of the issuer of the securities upon which such security-
based swap is based or is referenced, an affiliate of the issuer, or
an underwriter, shall constitute a contract for sale of, sale of,
offer for sale, or offer to sell such securities. See section 768(a)
of the Dodd-Frank Act (amending section 2(a)(3) of the Securities
Act, 15 U.S.C. 77b(a)(3)).
\1237\ 15 U.S.C. 77e.
\1238\ See section 6(l) of the Exchange Act, 15 U.S.C. 78f(l).
---------------------------------------------------------------------------
The creation of regulatory regimes for agreements, contracts, or
transactions that are defined as a swap or security-based swap will
result in an array of programmatic benefits. However, if an agreement,
contract or transaction falls within the swap or security-based swap
definition, the parties to the agreement, contract, or transaction also
may incur a number of upfront and ongoing costs associated with the
regulation of Title VII instruments and transactions. These
programmatic benefits and costs, discussed in more detail below, relate
to Title VII registration; business conduct standards, compliance,
operation and governance; clearing, trade execution, and reporting and
processing; investor protection provisions of Title VII and the
application of the Federal securities laws.\1239\
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\1239\ For example, dealers and major participants will be
subject to business conduct requirements of section 15F of the
Exchange Act, and thus will be required, among other things, to
determine that their counterparty meets certain eligibility
standards before entering into security-based swaps with them and to
disclose information about material risks and characteristics,
material incentives, conflicts of interest, the daily mark, and
clearing rights. See Business Conduct Standards for Security-Based
Swaps Dealer and Major Security-Based Swap Participants, Release No.
34-64766 (June 29, 2011), 76 FR 42396, 42406, 42410 (July 18, 2011)
(``Business Conduct Standards Proposing Release''). Also, for
example, in connection with registration requirements the SEC
expects security-based swap dealers and major security-based swap
participants to incur costs in connection with completing and filing
forms, providing related certifications, addressing additional
requirements in connection with associated persons, as well as
certain additional costs. See Registration of Security-Based Swap
Dealers and Major Security-Based Swap Participants, Release No. 34-
65543 (Oct. 12, 2011), 76 FR 65784, 65813-18 (Oct. 24, 2011) (``SB
Swap Participant Registration Proposing Release''). In each
proposing release the SEC invited comment with respects to the costs
and benefits of each of the proposed rules. The costs associated
with these and other substantive rules, along with any comments
received by the SEC addressing the costs of the proposed rules, are
being addressed in more detail in connection with the applicable
rulemakings.
---------------------------------------------------------------------------
(a) Title VII Registration of Entities Involved in Security-Based Swaps
As a result of Title VII imposing a new regulatory regime on
security-based swaps, in addition to making such security-based swaps
securities under the Securities Act and the Exchange Act, Title VII
will require the registration of entirely new types of registrants with
the SEC, including SBS dealers and MSBSPs,\1240\ SB SEFs,\1241\ SB
SDRs,\1242\ and clearing agencies registered to clear security-based
swaps.\1243\ The SEC expects that registrants will incur costs in
gathering information, accurately completing forms and filing these
forms with the SEC.\1244\ Registration will provide the SEC with
information regarding registrants which will enable the SEC to oversee
the SEC's security-based swap registrants.
---------------------------------------------------------------------------
\1240\ See section 15F(b)(5) of the Exchange Act, 15 U.S.C. 78o-
10(b)(5).
\1241\ See section 3D(a) of the Exchange Act, 15 U.S.C. 78c-4.
\1242\ See section 13(n)(1) of the Exchange Act, 15 U.S.C.
78m(n)(1).
\1243\ See section 17A(g) of the Exchange Act, 15 U.S.C. 78q-
1(g).
\1244\ The SEC has proposed rules related to the registration
requirements for each of these new registrants. See SB Swap
Participant Registration Proposing Release; SB SEF Proposing
Release; SDR Proposing Release; and Clearing Agency Standards for
Operation and Governance, Release No. 34-64017 (Mar. 3, 2011), 76 FR
14472 (Mar. 16, 2011) (``Clearing Agency Standards Proposing
Release''). In each proposing release the SEC invited comment with
respects to the costs and benefits of each of the proposed rules.
The costs associated with these and other substantive rules, along
with any comments received by the SEC addressing the costs of the
proposed rules, are being addressed in more detail in connection
with the applicable rulemakings.
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(b) Business Conduct Standards, Compliance, Operation, and Governance
Title VII imposes requirements on registrants that did not exist
prior to the adoption of Title VII, including core principles, duties
and/or standards that are related to the type of registrant and its
function.\1245\ For example, Title VII includes core principles for SB
SEFs, many of which require SB SEFs to establish and enforce rules
specific to the trading of security-based swaps.\1246\ Similarly, Title
VII assigns duties (in addition to core principles) that are specific
to the nature of SB SDRs, e.g. the acceptance and maintenance of data
related to security-based swaps.\1247\ The
[[Page 48331]]
provisions of Title VII related to SB SEFs and SB SDRs are designed to
provide transparency in the security-based swap market.
---------------------------------------------------------------------------
\1245\ See sections 3D(d), 13(n)(5) and (7), and 15F(h) and (j)
of the Exchange Act, 15 U.S.C. 78c-4(d), 78m(n)(5) and (7), and 78o-
10(h) and (j).
\1246\ See sections 3D(d)(2), (3), (4), (6), and (8) of the
Exchange Act, 15 U.S.C. 78c-4(d)(2), (3), (4), (6), and (8). See
also SB SEF Proposing Release. In the SB SEF Proposing Release the
SEC invited comment with respects to the costs and benefits of each
of the proposed rules. The costs associated with these and other
substantive rules, along with any comments received by the SEC
addressing the costs of the proposed rules, are being addressed in
more detail in connection with the applicable rulemakings.
\1247\ See section 13(n)(5) of the Exchange Act, 15 U.S.C.
78m(n)(5). See also SDR Proposing Release. In the SDR Proposing
Release the SEC invited comment with respects to the costs and
benefits of each of the proposed rules. The costs associated with
these and other substantive rules, along with any comments received
by the SEC addressing the costs of the proposed rules, are being
addressed in more detail in connection with the applicable
rulemakings.
---------------------------------------------------------------------------
Title VII also imposes a number of requirements on registered SBS
dealers and MSBSPs, such as external business conduct
requirements.\1248\ Specifically, section 15F(h)(3)(B) of the Exchange
Act establishes certain disclosure requirements for SBS dealers and
MSBSPs,\1249\ and section 15F(h)(3)(C) of the Act requires that
communications by these entities meet certain standards of fairness and
balance.\1250\ The level of protection becomes higher for special
entities \1251\ to whom dealers offer security-based swaps.\1252\ For
example, an SBS dealer that acts as an advisor to a special entity has
a duty to act in the best interest of the special entity and is
required to make reasonable efforts to obtain such information as is
necessary for the SBS dealer to make a reasonable determination that
any security-based swap recommended by the SBS dealer is in the best
interests of the special entity.\1253\ In addition, section 15F(j)(5)
of the Exchange Act imposes requirements intended to address potential
conflicts of interest that may arise in transactions between a SBS
dealer or MSBSP and its counterparty.\1254\ Title VII also imposes upon
SBS dealers and MSBSPs requirements to implement risk management
policies and procedures that are designed to prevent them from taking
on excessive risk and to enable them to better deal with market
fluctuations that might otherwise endanger their financial
health.\1255\
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\1248\ The SEC has proposed rules regarding business conduct
standards for security-based swap dealers and major security-based
swap participants. See Business Conduct Standards Proposing Release.
In the Business Conduct Standards Proposing Release the SEC invited
comment regarding the costs and benefits associated with the
proposed rules. The costs associated with these and other
substantive rules, along with any comments received by the SEC
addressing the costs of the proposed rules, are being addressed in
more detail in connection with the applicable rulemakings.
\1249\ See section 15F(h)(3)(B) of the Exchange Act, 15 U.S.C.
78o-10(h)(3)(B).
\1250\ See section 15F(h)(3)(C) of the Exchange Act, 15 U.S.C.
78o-10(h)(3)(C).
\1251\ Title VII amends the Exchange Act to define a special
entity as: (1) A Federal agency; (2) a State, State agency, city,
county, municipality, or other political subdivision of a State; (3)
any employee benefit planned, as defined in section 3 of the
Employee Retirement Income Security Act of 1974; or (4) any
governmental plan, as denied in section 3 of the Employee Retirement
Income Security Act of 1974; or any endowment, including an
endowment that is an organization in section 501(c)(3) of the
Internal Revenue Code of 1986. See section 15F(h)(2)(C) of the
Exchange Act, 15 U.S.C. 78o-10(h)(2)(C).
\1252\ See sections 15F(h)(2), (h)(4), and (h)(5) of the
Exchange Act, 15 U.S.C. 78o-10(h)(2), (h)(4), and (h)(5).
\1253\ See section 15F(h)(4)(B) and (C) of the Exchange Act, 15
U.S.C. 78o-10(h)(4)(B) and (C).
\1254\ See section 15F(j)(5) of the Exchange Act, 15 U.S.C. 78o-
10(j)(5).
\1255\ See section 15F(j)(2) of the Exchange Act, 15 U.S.C. 78o-
10(j)(2).
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Section 15F(e) of the Exchange Act as added by section 764(a) of
the Dodd Frank Act, imposes capital and margin requirements on dealers
and major participants,\1256\ which are designed to reduce the
financial risks of these institutions and contribute to the stability
of the security-based swap market in particular and the U.S. financial
system more generally.\1257\ With respect to a security-based swap
submitted for clearing, counterparties will be required to post initial
margin and maintenance margin to secure its obligations under the
trade.
---------------------------------------------------------------------------
\1256\ See section 15F(e) of the Exchange Act, 15 U.S.C. 78o-
10(e).
\1257\ See Entity Definitions Release at 30723, supra note 12.
---------------------------------------------------------------------------
Section 3E of the Exchange Act, among other things, requires
registered brokers, dealers and SBS dealers that collect initial and
variation margin from counterparties to cleared security-based swap
transactions to maintain that collateral in segregated accounts.\1258\
With respect to uncleared swaps, section 3E gives a counterparty to a
SBS dealer or MSBSP that collects collateral the right to request
segregation of initial margins and maintenance of such initial margins
in accordance with rules promulgated by the SEC.\1259\ These
protections provide market participants who enter into transactions
with these entities confidence that their collateral accounts will
remain separate from the SBS dealer or MSBSP's assets in the event of
bankruptcy.\1260\
---------------------------------------------------------------------------
\1258\ See 15 U.S.C. 78c-5.
\1259\ Id.
\1260\ Id.
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(c) Clearing, Trade Execution, Reporting and Processing
Section 763 of the Dodd-Frank Act adds section 3C to the Exchange
Act, which deals with clearing for security-based swaps.\1261\ Prior to
the enactment of Title VII, swaps which traded on a bilateral basis
were subject to counterparty credit risk, which may not have been fully
mitigated by the posting of collateral.\1262\ Section 3C of the
Exchange Act requires that security-based swaps, with some exceptions,
be cleared through a central counterparty (``CCP'') registered with the
SEC.\1263\ Clearing a security-based swap places a CCP between the
parties to a trade and reduces the counterparty risk.
---------------------------------------------------------------------------
\1261\ See 15 U.S.C. 78c-3. See also Clearing Procedures
Proposing Release; Clearing Agency Standards Proposing Release; End-
User Exception of Mandatory Clearing of Security-Based Swaps,
Release No. 34-63556 (Dec. 15, 2010), 75 FR 79992 (Dec. 21, 2010)
(``End-User Exception Proposing Release''); and Ownership
Limitations and Governance Requirements for Security-Based Swap
Clearing Agencies, Security-Based Swap Execution Facilities, and
National Securities Exchanges with Respect to Security-Based Swaps
under Regulation MC, Release No. 34-63107, (Oct. 14, 2010), 75 FR
65882 (Oct. 26, 2010) (``Proposed Regulation MC''). In each
proposing release the SEC invited comment with respects to the costs
and benefits of each of the proposed rules. The SEC has received
comments on the cost and benefits of these proposed rules. The costs
associated with these and other substantive rules are being
addressed in more detail in connection with the applicable
rulemakings.
\1262\ See U.S. Gov't Accountability Office, Systemic Risk:
Regulatory Oversight and Recent Initiatives to Address Risk Posed by
Credit Default Swaps, GAO-09-397T, at 13 (Mar. 5, 2009).
\1263\ 15 U.S.C. 78c-3. Such clearing agencies also are required
to register. See section 17A(g) of the Exchange Act, 15 U.S.C. 78q-
1(g).
---------------------------------------------------------------------------
Title VII also requires the execution of clearable security-based
swaps on exchanges or SB SEFs if such security-based swaps are
available to trade and the reporting of trades to an SB SDR and
dissemination of trading data to the public.\1264\ Title VII also
imposes requirements relating to the operations of the SB SEFs and
SDRs.\1265\ Section 15F(i) of the Exchange Act establishes regulatory
standards for certain [registered security-based swap entities] related
to the confirmation, processing, netting, documentation, and valuation
of security-based swaps, which should enhance the efficiency of the
trade execution and processing of security-based swaps.\1266\
---------------------------------------------------------------------------
\1264\ See sections 3C(h) and 13(m) of the Exchange Act, 15
U.S.C. and 13m(m). See also Regulation SBSR Proposing Release; and
SDR Proposing Release.
\1265\ See SDR Proposing Release; and SB SEF Proposing Release.
In each proposing release the SEC invited comment with respects to
the costs and benefits of each of the proposed rules. The costs
associated with these and other substantive rules, along with any
comments received by the SEC addressing the costs of the proposed
rules, are being addressed in more detail in connection with the
applicable rulemakings.
\1266\ See section 15F(i) of the Exchange Act, 15 U.S.C. 78o-
10(i). See also Trade Acknowledgment and Verification on Security-
Based Swap Transactions, Release No. 34-63727 (Jan. 14, 2011), 76 FR
3859 (Jan. 21, 2011) (``Trade Documentation Proposing Release''). In
the Trade Documentation Proposing Release the SEC invited comment
with respects to the costs and benefits of each of the proposed
rules. The costs associated with these and other substantive rules,
along with any comments received by the SEC addressing the costs of
the proposed rules, are being addressed in more detail in connection
with the applicable rulemakings.
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Furthermore, sections 15F(f), (g), and (j)(3) of the Exchange Act
impose certain reporting, recordkeeping, and regulatory disclosure
requirements on SBS dealers
[[Page 48332]]
and MSBSPs.\1267\ Specifically, Title VII imposes on parties to a
security-based swap the responsibility to ``report security-based swap
transaction information to the appropriate registered entity in a
timely manner as may be prescribed by the [SEC].'' \1268\ Title VII's
reporting, recordkeeping, and disclosure requirements should enhance
the volume and quality of information available in the market and
facilitate effective oversight by the SEC.
---------------------------------------------------------------------------
\1267\ See section 15F(f) of the Exchange Act, 15 U.S.C. 78o-
10(f) (reporting and recordkeeping requirements); section 15F(g) of
the Exchange Act, 15 U.S.C. 78o-10(g) (daily trading records
requirements); section 15F(j)(3) of the Exchange Act, 15 U.S.C. 78o-
10(j)(3) (requirements related to the disclosure of information to
regulators). See also Regulation SBSR Proposing Release. In the
Regulation SBSR Proposing Release the SEC invited comment with
respects to the costs and benefits of each of the rules proposed in
the release. The costs associated with these and other substantive
rules, along with any comments received by the SEC addressing the
costs of the proposed rules, are being addressed in more detail in
connection with the applicable rulemakings.
\1268\ See section 13(m)(1)(F) of the Exchange Act, 15 U.S.C.
13m(m)(1)(F). See also Regulation SBSR Proposing Release. In the
Regulation SBSR Proposing Release the SEC invited comment with
respects to the costs and benefits of each of the proposed rules.
The costs associated with these and other substantive rules, along
with any comments received by the SEC addressing the costs of the
proposed rules, are being addressed in more detail in connection
with the applicable rulemakings.
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(d) Investor Protection Provisions of Title VII and the Application of
the Federal Securities Laws
Prior to the enactment of Title VII, the SEC had the ability to
bring actions based on fraud, manipulation or insider trading relating
to security-based swap agreements (as defined in section 206B of the
GLBA \1269\) but did not have any other regulatory authority over
swaps, security-based swaps or market participants involved in
security-based swap transactions.\1270\ Title VII provides the SEC with
antifraud enforcement authority over SBSAs under Title VII and gives
the SEC the authority to regulate security-based swap transactions and
the security-based swaps market, including the authority to prevent or
deter fraud, manipulation or deceptive conduct and take other
actions.\1271\
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\1269\ 15 U.S.C. 78c note.
\1270\ See supra part XI.A.1, notes 1225 and 1226.
\1271\ See supra part XI.A.1, notes 1225 and 1226 and part I.
See also Prohibition Against Fraud, Manipulation, and Deception in
Connection with Security-Based Swaps, Release No. 34-63236 (Nov. 3,
2010), 75 FR 68560 (Nov. 8, 2010) (``SB Swap Antifraud Proposing
Release''). In the SB Swap Antifraud Proposing Release the SEC
invited comment with respects to the costs and benefits of each of
the proposed rules. The costs associated with these and other
substantive rules, along with any comments received by the SEC
addressing the costs of the proposed rules, are being addressed in
more detail in connection with the applicable rulemakings.
---------------------------------------------------------------------------
By including security-based swaps in the definition of security
under the Securities Act and the Exchange Act and repealing the
restrictions on regulating security-based swap agreements as
securities, Title VII extended the investor protections under the
Federal securities laws to security-based swaps. In particular, Title
VII amends the Exchange Act and the Securities Act to include security-
based swaps within the definition of the term ``security.'' \1272\
Accordingly, security-based swaps are securities and benefit from the
investor protections provided by the Federal securities laws.\1273\ In
addition to the antifraud and anti-manipulation provisions, these
protections include the registration, disclosure and civil liability
provisions of the Securities Act and the disclosure provisions of the
Exchange Act. Title VII specifically provides protections to non-ECPs
by adding section 5(e) to the Securities Act, which requires that a
registration statement must be in effect before a person can offer to
sell, offer to purchase from, or otherwise enter into security-based
swaps with non-ECPs.\1274\ Any security-based swap with or for a person
that is not an ECP must be effected on a national securities
exchange.\1275\ Furthermore, Title VII ensures that a security-based
swap cannot be used to avoid registration or investor protection under
the Securities Act by providing that if a security-based swap is
entered into by an issuer's affiliate or underwriter, the offer and
sale of the underlying security must comply with the Securities
Act.\1276\
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\1272\ See section 2(a)(1) of the Securities Act and section
3(a)(10) of the Exchange Act, 15 U.S.C. 77b(a)(1) and 15 U.S.C.
78c(a)(10).
\1273\ See, e.g., Order Granting Temporary Exemptions under the
Securities Exchange Act of 1934 in Connection with the Pending
Revision of the Definition of ``Security'' to Encompass Security-
Based Swaps, and Request for Comment, 76 FR 39927 (July 7, 2011)
(discussing the effect of the amendment to the definition of the
term ``security'' to include security-based swaps under the Exchange
Act and granting certain temporary relief and providing interpretive
guidance).
\1274\ See section 768(b) of the Dodd Frank Act (adding section
5(e) of the Securities Act, 15 U.S.C. 77e(d)).
\1275\ See section 6(l) of the Exchange Act, 15 U.S.C. 78f(l).
\1276\ See section 768(a) of the Dodd-Frank Act (amending
section 2(a)(3) of the Securities Act, 15 U.S.C. 77b(a)(3)).
---------------------------------------------------------------------------
The programmatic benefits related to investor protection under the
Federal securities laws have corresponding costs including costs
associated with compliance with the registration and disclosure regime
of the Securities Act if an exemption from such registration provisions
is not available.\1277\
---------------------------------------------------------------------------
\1277\ For offers and sales to non-ECPs, the statute requires
registration of the security-based swap transaction.
---------------------------------------------------------------------------
The above programmatic benefits and costs that will flow from
regulation of the security-based swap market mandated by Title VII will
be significant, although very difficult to quantify and measure.\1278\
Moreover, the benefits can be expected to manifest themselves over the
long run and be distributed over the market as a whole. The
programmatic costs and benefits associated with substantive rules
applicable to security-based swaps under Title VII are being addressed
in more detail in connection with the applicable rulemakings
implementing Title VII. There are programmatic costs that may arise
from the application of other provisions of the Federal securities laws
to security-based swaps, security-based swap transactions and market
participants involved in such security-based swap transactions,
including costs arising from potential overlapping regulatory
requirements. The SEC already has taken interim actions to mitigate
such overlapping and potentially conflicting regulatory requirements
and will be carefully evaluating any future actions that may be
necessary and appropriate to address such overlapping or conflicting
requirements.
---------------------------------------------------------------------------
\1278\ One commenter suggested that the best measure of the
benefits of the Dodd-Frank Act is the cost of the 2008 financial
crisis. This commenter provided, as an example, an estimate from the
Bank of England that the cost of the 2008 financial crisis in terms
of lost output was between $60 trillion and $200 trillion. See
Letter from Dennis Kelleher, Better Markets to the CFTC, June 3,
2011, regarding the reopening and extension of comment periods for
rulemaking implementing the Dodd-Frank Wall Street Reform and
Consumer Protection Act. The SEC recognizes that this estimate
addresses the aggregate cost of the financial crisis. It is also
recognized that others have expressed concern regarding the
potential cost of the requirements of Dodd-Frank. See, e.g., letters
from SIFMA, the American Bankers Association, the Financial Services
Roundtable and the Clearing House Association, dated February 13,
2012 (commenting on Prohibitions and Restrictions on Proprietary
Trading and Certain Interests in, and Relationships With, Hedge
Funds and Private Equity Funds, 76 FR 68846 (Nov. 7, 2011)) and The
Financial Services Roundtable, dated October 17, 2011 (commenting on
Further Definition of ``Swap Dealer,'' ``Security-Based Swap
Dealer,'' ``Major Swap Participant,'' ``Major Security-Based Swap
Participant'' and ``Eligible Contract Participant,'' 75 FR 80174
(Dec. 21, 2010)).
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[[Page 48333]]
4. Costs and Benefits Associated With Specific Rules
(a) Insurance Safe Harbor and Grandfather for Insurance Products (Rules
3a69-1 Under the Exchange Act)
(i) Programmatic Benefits and Costs
The Commissions are adopting rules that establish an Insurance Safe
Harbor and an Insurance Grandfather for certain agreements, contracts,
and transactions that meet the conditions and tests set forth in rule
3a69-1 under the Exchange Act.\1279\ The agreements, contracts, and
transactions that satisfy the Insurance Safe Harbor or Insurance
Grandfather under the Exchange Act will fall outside the statutory swap
and security-based swap definitions.\1280\ The SEC believes that the
conditions and tests set forth in the Insurance Safe Harbor represent
the characteristics of many types of traditional insurance
products.\1281\ As stated above, the Commissions are not aware of
anything in the legislative history or Title VII itself to suggest that
Congress intended for traditional insurance products to be regulated as
swaps or security-based swaps.\1282\
---------------------------------------------------------------------------
\1279\ See supra part II.B.1.
\1280\ Id.
\1281\ Id.
\1282\ Id.
---------------------------------------------------------------------------
Typically, insurance has not been regulated under the Federal
securities laws; although variable life insurance and annuities are
securities and are regulated under the Federal securities laws.\1283\
Although a broad reading of the swap definition could encompass
traditional insurance, the SEC does not believe that such a reading is
consistent with Congressional intent.\1284\ To include products that
meet the Insurance Safe Harbor or Insurance Grandfather in the swap or
security-based swap definition would subject traditional insurance
products to the Title VII regime which the SEC does not believe is
intended by Congress. Imposing programmatic costs on the insurance
industry, such as those associated with compliance with the
registration, compliance, and operation and governance requirements as
described above, in addition to the Securities Act and Exchange Act
requirements applicable to security-based swap transactions involving
non-ECPs, would increase the business costs of insurance providers,
which costs could be passed on to the consumers who need such
insurance. In addition, because of the above costs as well as the
Securities Act and Exchange Act restrictions applicable to offers and
sales of security-based swaps to non-ECPs, including products that meet
the Insurance Safe Harbor in the swap or security-based swap definition
could potentially affect the ability of insurance providers to continue
to offer insurance products and disrupt contracts that satisfy the
Insurance Grandfather that are used every day in the American economy.
For example, if Title VII applied to traditional insurance products,
people who purchased insurance to protect their property or families
against accidental hazards or risks would need to be qualified as ECPs
\1285\ or the offer and sale of the insurance products that were
security-based swaps would need to be registered with the SEC \1286\
and traded on an exchange; \1287\ and for swaps that are under the CFTC
jurisdiction would only be able to be sold on or subject to the rules
of a board of trade. In addition, insurance providers that offer
insurance products exceeding the de minimis threshold (as adopted in
the Entities Release) applicable to swap dealers and security-based
swap dealers would be required to register as swap dealers or SBS
dealers \1288\ and be subject to the substantive requirements that
result from such registration.
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\1283\ See generally section 3(a)(8) of the Securities Act, 15
U.S.C. 77c(a)(8), and section 12(g) of the Exchange Act, 15 U.S.C.
78l(g). The SEC has previously stated its view that Congress
intended any insurance contract falling within section 3(a)(8) to be
excluded from all provisions of the Securities Act notwithstanding
the language of the Securities Act indicating that section 3(a)(8)
is an exemption from the registration but not the antifraud
provisions. See Definition of ``Annuity Contract or Optional Annuity
Contract'', 49 FR 46750, 46753 (Nov. 28, 1984). See also Tcherepnin
v. Knight, 389 U.S. 332, 342 n.30 (1967) (Congress specifically
stated that ``insurance policies are not to be regarded as
securities subject to the provisions of the [Securities] act,''
(quoting H.R. Rep. 85, 73rd Cong., 1st Sess. 15 (1933)). See also
supra note 42.
\1284\ Section 206A of the GLBA, 15 U.S.C. 78c note defined the
term ``swap agreement'' and the CFMA had two requirements in
addition to the definition of ``swap'' itself: (1) The transaction
is between ECPs (as defined prior to enactment of the Dodd-Frank
Act); and (2) the material terms of the swap agreement (other than
price and quantity) are subject to individual negotiation. Section
762 of the Dodd-Frank Act removed these requirements from the
definition of swap agreement. See supra part XI.A.1, notes 1225 and
1226. The definition of swap in Title VII of the Dodd-Frank Act is
not conditioned on the existence of either of the two requirements,
although swap or security-based swap transactions with non-ECPs are
subject to additional restrictions under the Federal securities laws
and the Commodity Exchange Act. See CEA section 1a(47), 7 U.S.C.
1a(47). Insurance policies are typically not subject to individual
negotiation. Additionally, the average insurance purchaser may not
qualify as an ECP. See CEA section 1a(18)(A)(xi), 7 U.S.C.
1a(18)(A)(xi).
\1285\ An individual is considered an ECP if the individual
``has amounts invested on a discretionary basis, the aggregate of
which is in excess of--(i) $10,000,000; or (ii) $5,000,000 and who
enters into the agreement, contract, or transaction in order to
manage the risk associated with an asset owned or liability
incurred, or reasonable likely to be owned or incurred, by the
individual.'' CEA section 1a(18)(A)(xi), 7 U.S.C. 1a(18)(A)(xi).
\1286\ See section 5(e) of the Securities Act, 15 U.S.C. 77e(d).
\1287\ See CEA section 2(e), 7 U.S.C. 2(e), and section 6(l) of
the Exchange Act, 15 U.S.C. 78f(l).
\1288\ See Registration of Swap Dealers and Major Swap
Participants, 77 FR 2613, corrected at 77 FR 3590 (regarding swap
dealers and major swap participants); SB Swap Participant Proposing
Release, supra note 1239, (regarding SBS dealers and MSBSPs).
---------------------------------------------------------------------------
The rules adopted in this release provide continuity in the
regulatory treatment of agreements, contracts, and transactions that
are insurance and fall outside the swap and security-based swap
definitions. Market participants will be able to continue to rely on
their existing understanding of insurance laws and regulations to
engage in business activities relating to the insurance agreements,
contracts, and transactions that satisfy the Insurance Safe Harbor or
Insurance Grandfather.
(ii) Assessment Costs
Market participants will need to assess whether a particular
agreement, contract, or transaction satisfies the Insurance Safe Harbor
or Insurance Grandfather, prior to execution, but no later than when
the parties offer to enter into the agreement, contract, or
transaction. If such agreement, contract, or transaction satisfies
rules 3a69-1 under the Exchange Act, it would fall outside the swap and
security-based swap definitions. If such agreement, contract, or
transaction does not satisfy the Insurance Safe Harbor or Insurance
Grandfather, it would need to be analyzed based upon its own facts and
circumstances in order to determine whether it falls within or outside
the swap or security-based swap definition. For agreements, contracts,
or transactions entered into subsequent to the effective date of such
rule, this analysis will have to be performed prior to execution but no
later than when the parties offer to enter into the agreement,
contract, or transaction to customers to ensure compliance with Title
VII. Incurring these assessment costs with respect to these agreements,
contracts, or transactions would not have been required in most cases
prior to Title VII for two primary reasons. First, as security-based
swaps were not regulated prior to Title VII, there was no need to
determine whether an agreement, contract or transaction fell within or
outside the definition of security-based swap agreement in the CFMA.
Second, the need for parties to assess individual types of insurance
for purposes of determining whether the Federal securities laws apply
would be limited because, as previously stated, typically,
[[Page 48334]]
insurance has not been regulated under the Federal securities laws,
although variable life insurance and annuities are securities and are
regulated under the Federal securities laws.\1289\
---------------------------------------------------------------------------
\1289\ See supra note 1283.
---------------------------------------------------------------------------
The SEC believes that rule 3a69-1 under the Exchange Act reduces
the assessment costs that would otherwise exist without these rules.
Without rule 3a69-1 under the Exchange Act, market participants would
still need to assess whether or not the agreement, contract, or
transaction they are offering falls within the swap or security-based
swap definition. More time and effort would likely be spent on the
assessment because of lack of any safe harbor or grandfather to rely
on. Without rule 3a69-1 under the Exchange Act, market participants may
feel the need to request joint interpretations from the Commissions
before they invest resources in insurance business, even with respect
to agreements, contracts, or transactions that would otherwise meet the
Insurance Safe Harbor or Insurance Grandfather.
The SEC recognizes that the assessment costs associated with rule
3a69-1 under the Exchange Act may include costs related to obtaining
legal advice on whether an agreement, contract, or transaction meets
the requirements of the Insurance Safe Harbor or Insurance Grandfather.
The SEC has sought to minimize the costs of this analysis by adopting
an approach that incorporates the characteristics of traditional
insurance into the straightforward Product Test and Provider Test, as
described in the discussions of relevant rules above.
The SEC believes there will be minimal assessment costs for parties
to determine whether an agreement, contract, or transaction is among
those specifically enumerated in rule 3a69-1 under the Exchange Act
\1290\ or that falls within the Insurance Grandfather.\1291\
---------------------------------------------------------------------------
\1290\ See supra part II.B.1.
\1291\ See supra part II.B.1.c).
---------------------------------------------------------------------------
With respect to rule 3a69-1 under the Exchange Act, the SEC
believes that at least some market participants are likely to seek
legal counsel for interpretation of various aspects of the rule,
particularly when structuring new or novel insurance products. The
costs associated with obtaining such legal counsel would vary depending
on the relevant facts and circumstances, including the complexity of
the agreement, contract, or transaction and whether an interpretation
from the Commissions is requested. The SEC believes that the range of
costs to undertake the legal analysis required to determine whether the
Insurance Safe Harbor or Insurance Grandfather applies to an agreement,
contract, or transaction will range from $378 to $27,000, with $27,000
representing a reasonable estimate of the upper end of the range of the
costs.\1292\
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\1292\ The average cost incurred by market participants in
connection with assessing whether an agreement, contract, or
transaction is a swap or security-based swap is based on the
estimated amount of time that staff believes will be required for
both in-house counsel and outside counsel to apply rule 3a69-1.
Staff estimates that some agreements, contracts, or transactions
will clearly satisfy the Insurance Safe Harbor, Insurance
Grandfather and an in-house attorney, without the assistance of
outside counsel, will be able to make a determination in one hour.
Based upon data from SIFMA's Management & Professional Earnings in
the Securities Industry 2011 (modified by SEC staff to account for
an 1800-hour-work-year and multiplied by 5.35 to account for
bonuses, firm size, employee benefits and overhead), staff estimates
that the average national hourly rate for an in-house counsel is
$378. If an agreement, contract, or transaction is more complex, the
SEC estimates the analysis will require approximately 30 hours of
in-house counsel time and 40 hours of outside counsel time. The SEC
estimates the costs for outside legal services to be $400 per hour.
This is based on an estimated $400 per hour cost for outside legal
services. This is the same estimate used by the SEC for these
services in the release involving Exemptions for Security-Based
Swaps Issued By Certain Clearing Agencies, Release No. 33-9308 (Mar.
30, 2012), 77 FR 20536 (Apr. 5, 2012). Accordingly, on the high end
of the range the SEC estimates the cost to be $27,340 ($11,340
(based on 30 hours of in-house counsel time x $378) + $16,000 (based
on 40 hours of outside counsel x $400). This estimate is rounded by
two significant digits to avoid the impression of false precision of
the estimate.
---------------------------------------------------------------------------
(iii) Alternatives
The SEC could have determined to not further define the terms
``swap'' and ``security-based swap'' to address the status of
traditional insurance products. If the Commissions did not further
define the terms ``swap'' and ``security-based swap'' to address the
status of traditional insurance products by adopting the Insurance Safe
Harbor or the Insurance Grandfather certain insurance providers would
have treated their insurance products as swaps or security-based swap,
thereby incurring programmatic costs that would otherwise be avoidable.
Other insurance providers could misinterpret the application of the
definition of swap to certain agreements, contracts, or transactions to
determine that they fall outside such definition of swap or security-
based swap, in which case the amount of Title VII programmatic benefits
and costs with respect to such products may potentially decrease. As
stated above, without rule 3a69-1 under the Exchange Act, there also
would be higher assessment costs to determine whether an agreement,
contract, or transaction falls within or outside the swap or security-
based swap definition.\1293\
---------------------------------------------------------------------------
\1293\ See supra part XI.A.4(a)(ii).
---------------------------------------------------------------------------
The Commissions received several comments in support of
alternatives to rule 3a69-1 under the Exchange Act as proposed.\1294\
The alternatives suggested by commenters include:
---------------------------------------------------------------------------
\1294\ See supra part II.B.1.d), for a discussion of each of the
proposed alternatives.
---------------------------------------------------------------------------
A test based on whether the agreement, contract, or
transaction is subject to regulation as insurance by the insurance
commissioner of the applicable state(s).\1295\
---------------------------------------------------------------------------
\1295\ See ACLI Letter; AFGI Letter; AIA Letter; MetLife Letter
and Travelers Letter.
---------------------------------------------------------------------------
A test based on the application of section 3(a)(8) of the
Securities Act \1296\ to the agreement, contract, or transaction.\1297\
---------------------------------------------------------------------------
\1296\ 15 U.S.C. 77c(a)(8).
\1297\ See ACLI Letter at 7; AFGI Letter at 3; CAI Letter at 21-
25 and Nationwide Letter at 4.
---------------------------------------------------------------------------
Various alternative tests that add (or exclude)
requirements to the Product Test and the Provider Test.\1298\
---------------------------------------------------------------------------
\1298\ See ACLI Letter; AIA Letter; Nationwide Letter and NAIC
Letter.
---------------------------------------------------------------------------
The Commissions have considered each of these alternatives proposed
by commenters and are adopting the final rule as discussed above.\1299\
The Commissions are not adopting the specific alternative tests as
proposed by commenters. In considering each of these alternatives, the
SEC has taken into account the costs and benefits associated with each
alternative.
---------------------------------------------------------------------------
\1299\ See supra part II.B.1.
---------------------------------------------------------------------------
In the SEC's view, as discussed above,\1300\ because these
alternative tests do not adequately distinguish traditional insurance
products from Title VII instruments, they could result in an over-
inclusive Insurance Safe Harbor or Insurance Grandfather and fail to
include in the Title VII regulatory regime agreements, contracts, and
transactions that Congress intended to be regulated as swaps or
security-based swaps.\1301\ Therefore, the programmatic benefits of the
Title VII regime would not be fully realized if any of the alternatives
were adopted.
---------------------------------------------------------------------------
\1300\ See supra part II.B.1.d).
\1301\ For a more detailed discussion of the comments, including
those that suggested alternatives, and the Commissions' response,
see supra part II.B.1.d).
---------------------------------------------------------------------------
(b) Narrow-Based Security Index Rules (Rules 3a68-1a, 3a68-1b, and
3a68-3(a) Under the Exchange Act)
(i) Programmatic Costs and Benefits
As previously stated, Title VII created a jurisdictional division
between the CFTC and the SEC. The CFTC has jurisdiction over swaps,
whereas the SEC has jurisdiction over security-based
[[Page 48335]]
swaps. In most instances it is clear based on a plain reading of the
statute whether a Title VII instrument is a swap or security-based swap
(e.g., a CDS referencing a single security or issuer is a security-
based swap).\1302\ In other instances, such as index CDS, whether a
Title VII instrument is a swap or security-based swap depends on
whether such instrument is based on a ``narrow-based security index''
or events relating to ``issuers of securities in a narrow-based
security index''.\1303\ The Commissions are adopting rules 3a68-1a and
3a68-1b under the Exchange Act to further define the terms ``issuers of
securities in a narrow-based security index'' and ``narrow-based
security index'' for purposes of analyzing CDS.\1304\ Additionally, the
Commissions are adopting rule 3a68-3(a) under the Exchange Act to
define narrow-based security index, except as otherwise provided in
rules 3a68-1a and 3a68-1b, consistent with the statutory definition set
forth in section 3(a)(55) of the Exchange Act and the rules,
regulations and orders of the SEC thereunder.
---------------------------------------------------------------------------
\1302\ See section 3(a)(68)(A)(II) of the Exchange Act, 15
U.S.C. 78c(a)(68)(A)(II).
\1303\ See section 3(a)(68)(A)(I) and (III) of the Exchange Act,
15 U.S.C. 78c(a)(68)(A)(I) and (III).
\1304\ See supra part III.G.3.b).
---------------------------------------------------------------------------
As discussed above, there are programmatic costs and benefits that
flow from being a Title VII instrument.\1305\ The overall programmatic
costs and benefits flowing from an agreement, contract, or transaction
being a swap or a security-based swap may be impacted by the
similarities and differences in the Commissions' regulatory programs
for swaps and security-based swaps. Generally, the Title VII regulatory
regimes of the CFTC and SEC are expected to be broadly similar and
complementary. Title VII requires the SEC and the CFTC to consult and
coordinate for the purposes of assuring regulatory consistency and
comparability with respect to rules adopted and orders issued pursuant
to Title VII to the extent possible.\1306\ Title VII provides that the
Commissions should treat functionally or economically similar products
or entities in a similar manner in such rules or orders, but does not
require identical rules.\1307\ The Commissions may, therefore, diverge
substantively on certain rulemakings. In certain areas, the SEC
believes it may be appropriate for Title VII's application to security-
based swaps to be different from its application to the swaps that will
be regulated by the CFTC, as the relevant products, entities and market
themselves are different, or because the relevant statutory provisions
are different. The SEC believes, however, that the programmatic costs
and benefits (which will be discussed in subsequent releases adopting
substantive rules) that will flow from the application of rules under
either jurisdiction as a result of applying rules 3a68-1a, 3a68-1b, and
3a68-3(a) under the Exchange Act are expected to be broadly similar and
complementary.
---------------------------------------------------------------------------
\1305\ See supra part XI.A.3.
\1306\ See section 712(a)(1) and (a)(2) of the Dodd-Frank Act.
\1307\ See section 712(a)(7)(A) and (B) of the Dodd-Frank Act.
---------------------------------------------------------------------------
In addition, since Title VII specifically provides that security-
based swaps are securities and grants the SEC the exclusive authority
to regulate security-based swaps (other than as to mixed swaps for
which the SEC shares jurisdiction with the CFTC), in adopting rules
3a68-1a, 3a68-1b, and 3a68-3(a) under the Exchange Act to further
define the terms ``narrow-based security index,'' and ``issuers of
securities in a narrow-based security index'', the SEC is mindful of
the programmatic costs and benefits specifically associated with
security-based swaps falling under the Federal securities laws regime
and being regulated by the SEC. These programmatic benefits include,
for example, the applicability of the Securities Act registration,
disclosure, and civil liability scheme, as well as the SEC's authority
to take action to protect investors and prevent fraud and market
manipulation. These benefits could in some cases have corresponding
costs associated with the application of the Securities Act related to
registration, disclosure and civil liability scheme and the
registration, disclosure and liability provisions of the Exchange Act.
For example, if an issuer of an underlying security enters into a
security-based swap it will have to comply with the Securities Act
registration requirements both for the security-based swap and the
underlying security unless an exemption from registration is available.
As another example, if market participants wish to sell security-based
swaps to non-ECPs they will have to comply with the registration
requirements of the Securities Act. Any person that would be required
to comply with the registration requirements of the Securities Act with
respect to security-based swaps will incur the costs of such
registration, including legal and accounting costs. Additionally, such
person will become subject to the periodic reporting requirements of
the Exchange Act, unless already subject to such requirements, and
incur the costs associated with such Exchange Act periodic reporting.
(ii) Assessment Costs
Market participants will need to ascertain whether an agreement,
contract or transaction based on an index is a swap or a security-based
swap, prior to execution, but no later than when the parties offer to
enter into it, according to the criteria set forth in the definitions
of the terms ``narrow-based security index'' and ``issuers of
securities in a narrow-based security index.'' The SEC expects that
this assessment will be made each time an index is considered to be
used or created for purposes of transactions based on such index, and
each time the material terms of the index on which the agreement,
contract, or transaction is based are amended or modified.\1308\ These
assessment costs with respect to agreements, contracts, or transactions
based on indexes did not arise prior to the enactment of Title VII. The
SEC believes that such assessment costs may vary depending on the
composition of the index that may underlie agreement, contract, or
transaction. For example, the number of components in an index may
impact the assessment costs because of the need to determine whether
the index's components satisfy the various tests within the rule.
However, once such assessment is performed and the narrow-based or
broad-based characteristics have been established with respect to an
index, unless the characteristic of such index changes, any market
participants engaging in agreements, contracts, or transactions
referencing such index would not need to incur any material assessment
costs, other than to confirm that the index has not changed in a way
that would change its classification from narrow-based to broad-based
or vice versa.
---------------------------------------------------------------------------
\1308\ See generally supra part III.G.
---------------------------------------------------------------------------
Although the assessment cost associated with rules 3a68-1a, 3a68-
1b, and 3a68-3(a) under the Exchange Act may vary, the SEC estimates
that costs associated with undertaking the determination of whether an
agreement, contract or transaction based on an index is a swap or
security-based swap will range from $378 to $20,000.\1309\ The
[[Page 48336]]
SEC believes that some agreements, contracts, or transactions based on
an established index would not need the assistance of outside counsel,
and a determination can be made in one hour. If an agreement, contract,
or transaction is more complex, the SEC estimates the analysis will
require approximately 20 hours of in-house counsel time and 30 hours of
outside counsel time. Accordingly, if an agreement, contract or
transaction is based on a newly structured customized index or basket
to suit a particular investment or hedging need, the SEC estimates that
the assessment may be at or close to the upper end of the estimated
range, as part of the structuring of such customized index or
basket.\1310\
---------------------------------------------------------------------------
\1309\ The average cost incurred by market participants in
connection with assessing whether an agreement, contract, or
transaction is a swap or security-based swap is based on the
estimated amount of time that staff believes will be required for
both in-house counsel and outside counsel to apply the definition.
Staff estimates that the average national hourly rate for an in-
house counsel is $378 based on data from SIFMA's Management &
Professional Earnings in the Securities Industry 2011 (modified by
SEC staff to account for an 1800-hour-work-year and multiplied by
5.35 to account for bonuses, firm size, employee benefits and
overhead). The SEC estimates the costs for outside legal services to
be $400 per hour. This is the same estimate used by the SEC for
these services in the release involving Exemptions for Security-
Based Swaps Issued By Certain Clearing Agencies, Release No. 33-9308
(Mar. 30, 2012), 77 FR 20536 (Apr. 5, 2012). Accordingly, on the
high end of the range the SEC estimates the cost to be $19,560
($7,560 (based on 20 hours of in-house counsel time x $378) +
$12,000 (based on 30 hours of outside counsel x $400). This estimate
is rounded by two significant digits to avoid the impression of
false precision of the estimate.
\1310\ For example, the legal costs associated with the analysis
of whether an index or basket CDS is a swap or security-based swap
will include, among other things, analysis of the weighting of each
index or basket component, the aggregate weighting of any five non-
affiliated reference entities included in the index or basket,
whether a predominant percentage (by weighting) of the issuers
included in the index or basket satisfy the public information
availability test and whether any issuer included in the index or
basket with 5% or more weighting satisfies the public information
availability test.
---------------------------------------------------------------------------
(iii) Alternatives
The Commissions received many comments on proposed rules 3a68-1a
and 3a68-1b and have incorporated many of the suggested alternatives
into the final rules and rejected, after careful consideration, other
suggested alternatives, as fully discussed in section III.G.3.b. The
policy choices made with respect to accepting or rejecting the
alternatives suggested by the commenters have been informed by the cost
and benefit considerations. In particular, as stated above, the SEC is
mindful of the programmatic costs and benefits specifically associated
with security-based swaps falling under the Federal securities laws
regime.\1311\
---------------------------------------------------------------------------
\1311\ See supra part XI.4.(b)(i).
---------------------------------------------------------------------------
One alternative to rules 3a68-1a and 3a68-1b is for the Commissions
to not further define the terms ``issuers of securities in a narrow-
based security index'' or ``narrow-based security index.'' The SEC
believes the assessment cost associated with determining whether an
index CDS is a swap or security-based swap would be greater in the
absence of rules 3a68-1a and 3a68-1b. Without these rules, market
participants would still need to analyze index components and it would
be difficult to apply the statutory language of ``issuer of securities
in a narrow-based security index'' in section 3(a)(68)(A)(ii)(III) of
the Exchange Act to index CDS, given that the existing statutory
definition of ``narrow-based security index'' and the past guidance are
focused on equity security indexes, volatility indexes and debt
security indexes, none of which are specifically tailored for index
CDS.\1312\ Absent rules 3a68-1a and 3a68-1b, it is very likely that
market participants would need to request interpretations from the
Commissions. Rules 3a68-1a and 3a68-1b provide tailored and objective
criteria, similar to the criteria used in the context of futures
contracts on volatility indexes and debt security indexes, to assist
market participants in determining whether an index CDS is based on
issuers of securities in a narrow-based security index.\1313\ These
rules will allow market participants to make determinations without
requesting interpretations from the Commissions and, therefore, should
reduce the assessment costs.
---------------------------------------------------------------------------
\1312\ See supra part III.G.3.
\1313\ Id.
---------------------------------------------------------------------------
Commenters expressed concern associated with the public information
availability test and suggested that the public information
availability test not be incorporated into the final rule for various
reasons.\1314\ As discussed above \1315\, the Commissions are adopting
the public information availability test with some modifications.
---------------------------------------------------------------------------
\1314\ See LSTA Letter (with respect to loans), Markit Letter,
ISDA Letter and SIFMA Letter.
\1315\ See supra part III.G.3.b(iii).
---------------------------------------------------------------------------
The SEC believes there are many programmatic benefits associated
with the public information availability test. As noted above, the
public information availability test is intended as the substitute test
for the ADTV provision in the statutory narrow-based security index
definition.\1316\ The ADTV test is designed to take into account the
trading of equity securities and, because the listing standards for
equity securities require that the security be registered under the
Exchange Act, the issuer of the equity security will be subject to the
periodic reporting requirements of the Exchange Act. Due to the
specific provisions of the statutory ADTV test, the Commissions have
determined that the ADTV test is not a useful test for purposes of
determining whether an index of reference entities or debt securities
is a ``narrow-based security index'' because the components of the
index are either reference entities, which do not ``trade,'' or debt
instruments, which commonly are not listed, and, therefore, do not have
a significant trading volume.\1317\ Applying the ADTV test in the
existing statutory narrow-based security index definition would not
serve any purposes. However, the basis for such provision, that there
is sufficient trading in the securities, public information about, and
therefore market following of, the issuer of the securities, applies to
index CDS. As a substitute for such ADTV test, the SEC believes that
there should be public information available about a predominant
percentage of the reference entities included in the index, or, in the
case of an index CDS on an index of securities, about the issuers of
the securities or the securities underlying the index. The SEC believes
that this should reduce the likelihood that non-narrow-based indexes
referenced in index CDS, or the component securities, or the named
issuers of securities in that index would be used as a surrogate for
the reference entities securities without complying with the Federal
securities laws. In particular, the SEC believes that the public
information availability test should reduce the likelihood that the
index CDS could be used to circumvent the registration provisions of
the Securities Act and provisions of the Exchange Act through the use
of CDS based on such indexes, manipulate the reference entities
securities or the securities in the index and reduce the potential for
misuse of material non-public information through the use of CDS based
on such indexes.\1318\ If a CDS is based on an index that does not
satisfy the public information availability test,\1319\ such index CDS
will be a security-based swap and thus
[[Page 48337]]
subject to the Federal securities laws and the SEC's oversight.\1320\
---------------------------------------------------------------------------
\1316\ Id.
\1317\ Id.
\1318\ Id.
\1319\ So long as the effective notional amounts allocated to
reference entities or securities included in the index that satisfy
the public information availability test comprise at least 80
percent of the index's weighting, failure by a reference entity or
security included in the index to satisfy the public information
availability test would be disregarded if the effective notional
amounts allocated to that reference entity or security comprise less
than 5 percent of the index's weighting. See paragraph (b) of rules
1.3(zzz) and 1.3(aaaa) under the CEA and rule 3a68-1a and 3a68-1b
under the Exchange Act.
\1320\ See id.
---------------------------------------------------------------------------
Some commenters indicated that the determinations of public
availability of information would be costly but did not quantify such
costs or explain the difficulty in making an assessment of whether
information was publicly available.\1321\ The SEC recognizes that there
will be assessment costs associated with application of the public
information availability test. The SEC notes that the public
information availability test applies only for purposes of determining
whether an index is a ``narrow-based security index.'' The SEC would
expect that market participants would look to the index provider to
make the assessment or, if the index or basket is customized by the
market participant that the creator of the index would take into
account the public information availability of the index components in
creating the custom index or basket. As a result, while the SEC
recognizes that there will be costs in evaluating whether the index
components satisfy the tests, including the public information
availability test, the SEC believes that the index provider (or the
creator of the custom index or basket) would already be evaluating the
index components to determine whether the provider's index criteria
were satisfied and, as part of such evaluation, would be able to
ascertain whether the public information availability test is
satisfied.
---------------------------------------------------------------------------
\1321\ See LSTA Letter (with respect to loans); and SIFMA Letter
---------------------------------------------------------------------------
One commenter raised a specific concern about the assessment cost
relating to applying the public information availability test to
indexes of loans or borrowers and stated that unlike index of
securities, which are generally subject to national or exchange-based
reporting and disclosure regimes, a higher proportion of the components
of an index of loans or borrowers may not be registered securities or
reporting companies under the Exchange Act and therefore, this
commenter stated that it would be more difficult or costly to determine
whether an index of loans or borrowers meets the public information
availability test.\1322\ The SEC has modified the public information
availability test to expand the categories of instrument to be
aggregated for purposes of the outstanding indebtedness criterion and
to change the method of calculating affiliation for purposes of the
public information availability test. The SEC believes that these
modifications will mitigate the assessment costs that the commenter is
concerned about.\1323\
---------------------------------------------------------------------------
\1322\ See July LSTA Letter. See also supra part
III.G.3(b)(iii).
\1323\ See supra part III.G.3.b)iii).
---------------------------------------------------------------------------
The SEC believes that the overall assessment costs of including a
public information availability test are justified in light of its
benefits of preventing the index CDS from being used as a surrogate for
the underlying securities or securities of the referenced issuer of
securities. This should, in turn, prevent circumvention of the
application of the Securities Act to index CDS transactions, and
prevent fraud, manipulation and misuse of material non-public
information.
One commenter suggested replacing the public information
availability test with a volume trading test.\1324\ The Commissions are
not adopting a volume-trading test based on the CDS components of the
index or on the index itself, either as a replacement for the public
information availability test or as an alternative means of satisfying
it. A volume trading test based on CDS is not practicable to use to
determine the character of such index CDS because the character of the
index CDS would have to be determined prior to any transaction in the
Title VII Instrument. Given that there would be no trading volume at
the time such determination is made, the index CDS would fail a volume-
trading test in all cases \1325\ and the assessment costs incurred in
connection with such test would not serve any purpose. There also would
be assessment costs in determining how many transactions in the CDS
index or each CDS component of the index existed, and it is not
apparent that any such trade information is either publicly available
or verifiable at this time. In addition, the SEC also believes that a
volume test based either on the CDS components of the index or the CDS
index itself would not be an appropriate substitute for or an
alternative to a public information availability test with respect to
the referenced entity, issuer of securities, or underlying security
because such a volume-based test would not provide transparency on such
underlying entities, issuers of securities or securities.\1326\ The
volume of transactions in a particular CDS or the CDS index does not
relate to whether there is public information about the reference
entity or reference security underlying the CDS or CDS index.
Therefore, a volume-trading test would not achieve the programmatic
benefits described above with respect to the public information
availability test.
---------------------------------------------------------------------------
\1324\ See Markit Letter.
\1325\ See supra part III.G.3.b)iii).
\1326\ Id.
---------------------------------------------------------------------------
Similarly, the Commissions also rejected commenters' suggestion
that the presence of a third-party index provider would assure that
sufficient information is available regarding the index CDS itself
without the need for a public information availability test.\1327\ As
stated above, the public information availability test is intended to
assure the availability of information about the components of the
index, the underlying securities and issuers of the securities.\1328\
The existence of a third-party index provider does not imply any
greater likelihood that such public information is available.\1329\
Although the existence of a third-party index provider as a substitute
for the public information availability test would reduce assessment
costs of the market participants using such an index (other than the
index provider who must evaluate compliance with index criteria), the
SEC does not believe that the existence of the third party index
provider is a substitute for the public information availability test.
The SEC believes that the information a third-party index provider
makes available about the construction of an index, index rules,
components, and predetermined adjustments provides information only
about the index and is not a substitute for the public availability of
information about the issuers of the securities or the securities in
the index.\1330\ In addition, the SEC does not believe that the
existence of a third-party index provider indicates any likelihood that
such public information is available about the components of the index,
which the SEC believes is important to reduce the potential for
manipulation of the component securities of an index, or the named
issuers of securities in an index, the misuse of non-public information
about such an index, the component securities or the reference entities
and circumvention of other provisions of the Federal securities laws
through the use of CDS based on such an index.\1331\ Further, the SEC
notes that a third-party index provider may create customized indexes
at the behest of market participants, including as part of its regular
business and be paid by such market participants for its index
[[Page 48338]]
customization and creation services.\1332\ Accordingly, the SEC does
not believe that a third party index test is an appropriate alternative
for the public information availability test and the costs to market
participants is justified by the programmatic benefits such test
provides.\1333\
---------------------------------------------------------------------------
\1327\ See ISDA Letter; and SIFMA Letter. Neither commenter
provided any analysis to explain how or whether a third-party index
provider would be able to provide information about the underlying
securities or issuers of securities in the index.
\1328\ See supra part III.G.3.b)iii).
\1329\ Id.
\1330\ Id.
\1331\ Id.
\1332\ Id. See also Proposing Release at 29852.
\1333\ Id.
---------------------------------------------------------------------------
As more fully discussed above in section III.G.3.b.iii, in
considering other alternatives, including whether to revise or maintain
the public information availability test, the SEC has consistently
considered the programmatic benefits described above and the importance
of assuring that there is information available with respect to the
issuers of securities constituting a predominant percentage of an index
on which a CDS is based if such index is not going to be considered a
``narrow-based security index.''
(c) Swaps on Certain Futures Contracts on Foreign Sovereign Debt (Rule
3a68-5 Under the Exchange Act)
(i) Programmatic Benefits and Costs
Rule 3a68-5 provides that a Title VII instrument that is based on
qualifying foreign futures contracts on debt securities of one of the
21 enumerated foreign governments is a swap and not a security-based
swap if the Title VII instrument satisfies certain conditions.\1334\
This rule is intended to prevent such Title VII instruments from being
used to circumvent both the conditions of rule 3a12-8 and the Federal
securities laws protections underlying such conditions.\1335\ The
conditions provided in rule 3a68-5 are intended to address these
concerns. As discussed above, certain of the qualifying foreign futures
contracts on the debt securities of one of the 21 enumerated foreign
governments that satisfy the conditions of rule 3a12-8 trade with
significant volume through foreign trading venues.\1336\ Treating Title
VII Instruments on such qualifying foreign futures contracts, subject
to the conditions provided in rule 3a68-5, as swaps and not security-
based swaps would not raise the concerns that such swaps could be used
to circumvent rule 3a12-8, the Federal securities laws concerns that
such conditions are intended to protect, or allow circumvention of the
provisions of the Securities Act applicable to security-based swaps
(including those applicable to security-based swaps entered into by
issuer of securities underlie such security-based swaps, their
affiliates, or underwriters of their securities).\1337\ There are
certain programmatic costs associated with the rule that market
participants will need to be cognizant of. For example, although rule
3a12-8 allows qualifying foreign futures to be physically settled
outside the United States, the conditions of rule 3a68-5 require that
the swap be cash settled in order to be a swap and not a security-based
swap. This has the potential cost of not permitting settlement on the
same terms as the qualifying foreign future. However, the SEC believes
that, as with other Title VII Instruments, if the Title VII Instrument
can be physically settled with securities, it will be a security-based
swap. The other condition in rule 3a68-5 that may impact the
characterization of the Title VII Instrument is that the Title VII
Instrument cannot be entered into by the foreign government, its
affiliates, or an underwriter of its securities. This condition is
intended to preserve the programmatic benefit of the application of the
Securities Act to transactions in Title VII Instruments entered into by
issuers of securities, their affiliates and underwriters. Moreover, the
final rule provides consistent treatment of qualifying foreign futures
contracts on the debt securities of the 21 enumerated foreign
governments and Title VII instruments based on such futures contracts
on the debt securities of the 21 enumerated foreign governments, which
will allow instruments to trade through designated contract markets.
---------------------------------------------------------------------------
\1334\ See supra part III.E.
\1335\ See supra note 717 and accompanying text.
\1336\ Id.
\1337\ Id.
---------------------------------------------------------------------------
(ii) Assessment Costs
The SEC believes that the assessment cost associated with
determining whether a swap on certain futures contracts on foreign
government securities constitute a swap or security-based swap under
rule 3a68-5 should be minimal. Currently, qualifying foreign futures
contracts on debt securities of the 21 enumerated foreign governments
are traded on exchanges or boards of trade. Market participants may
look at the exchange or board of trade listing to determine what they
are. Therefore, the assessment, in accordance with the rule, would
primarily focus on whether such swap itself is traded on or through a
board of trade; whether the swap is cash-settled; whether the futures
is traded on a board of trade; whether any security used to determine
the cash settlement amount are not registered under the Securities Act
or the subject of any American depositary receipt registered under the
Securities Act; and whether the swap is entered into by the foreign
government issuing the debt securities upon which the qualifying
futures contract is based or referenced, an affiliate of such foreign
government or an underwriter of such foreign government securities. All
of these determinations may be readily ascertained by the parties
entering into the agreement, contract, or transaction. Therefore, the
assessment costs associated with rule 3a68-5 under the Exchange Act
should be nominal because parties should be able to make assessments
under rule 3a68-5 in less than an hour.
(d) Tolerance and Grace Period for Swaps and Security-Based Swaps
Traded on Regulated Trading Platforms (Rule 3a68-3 Under the Exchange
Act)
(i) Programmatic Benefits and Costs
In addition to defining narrow-based security index consistent with
the statutory definition set forth in section 3(a)(55) of the Exchange
Act and the rules, regulations and orders of the SEC thereunder, Rule
3a68-3 under the Exchange Act establishes a tolerance and grace period
for swaps and security-based swaps to address the treatment of indexes
that migrate from broad-based to narrow-based or narrow-based to broad-
based, so that market participants will know which regulatory
jurisdiction will apply to such Title VII instruments.\1338\
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\1338\ See supra part III.G.5.
---------------------------------------------------------------------------
There are programmatic costs and benefits associated with tolerance
and grace periods. Because swaps may only trade on designated contract
markets (``DCM''), swap execution facilities (``SEF''), and foreign
boards of trade (``FBOT''), and security-based swaps may trade only on
registered national securities exchanges (``NSE'') and SB SEFs, a
tolerance and grace period creates the benefit of permitting the index
provider to substitute certain index components in order to maintain
the characteristic of such index being narrow-based or broad-based and
allow market participants to continue to enter into the Title VII
instrument on which such index is based.\1339\ The associated
programmatic costs are primarily related to the monitoring of index
migrations performed by various trading platforms. Such monitoring
costs would be part of the operation costs that a trading platform
would incur in connection with implementing Title VII regardless of
whether rule 3a68-3 under the Exchange Act is adopted. Absent rule
3a68-3 under the Exchange Act, trading platforms still need to have the
[[Page 48339]]
technology necessary to monitor and conduct surveillance for index
migration, as well as create internal policies and procedures relating
to such migration. On the other hand, without a tolerance and grace
period, if a market participant wishes to offset a security-based swap
to hedge its index CDS position on an SEC-regulated trading platform
where the underlying security index has migrated from narrow-based to
broad-based, the participant would be prohibited from doing so because
a Title VII instrument based on the index would be a swap, and is
ineligible for trading on an NSE or SB SEF.
---------------------------------------------------------------------------
\1339\ Id.
---------------------------------------------------------------------------
(ii) Assessment Costs
Rule 3a68-3 under the Exchange Act provides a tolerance and grace
period and does not require any determination to be made beyond the
programmatic cost to monitor for migration as described above. The SEC
believes that the assessment costs associated with rule 3a68-3 under
the Exchange Act should be nominal on the parties entering into an
agreement, contract, or transaction.
(iii) Alternatives
One commenter stated its view that extending the ``grace period''
from three months to six months would ease any disruption or
dislocation associated with the delisting process with respect to an
index that has migrated from broad-based to narrow-based, or narrow-
based to broad-based, and such migration is not reversed during the
tolerance period.\1340\ The commenter did not provide any data,
evidence, or other justification for its request. The Commissions are
adopting the three-month grace period as proposed, which was the time
frame used by Congress in the context of migration of indexes
underlying security futures to address the same issue caused by index
migration.\1341\ The SEC believes that the three-month grace period
gives parties to a swap or security-based swap on an index that has
migrated sufficient time to execute offsetting positions and believes
that it is appropriate to maintain the three-month period that is the
applicable grace period for security futures.
---------------------------------------------------------------------------
\1340\ See MarketAxess Letter. See also supra part III.G.5.b).
\1341\ See section 3(a)(55)(C)(iii)(II) of the Exchange Act, 15
U.S.C. 77c(a)(55)(C)(iii)(II).
---------------------------------------------------------------------------
(e) Request for Interpretation Process (Rule 3a68-2 Under the
Exchange Act)
(i) Programmatic Benefits and Costs
Rule 3a68-2 under the Exchange Act allows persons to submit a
request for a joint interpretation from the Commissions regarding
whether an agreement, contract or transaction (or a class of
agreements, contracts, or transactions) is a swap, security-based swap,
or mixed swap. As stated above,\1342\ if an agreement, contract, or
transaction is a swap or a security-based swap the overall programmatic
costs and benefits that may arise from the Commissions' regulatory
programs are expected to be broadly similar and complementary.\1343\
However, in implementing Title VII the Commissions may diverge on rules
and requirements stemming from the Title VII regulatory regime.
Accordingly, a party to an agreement, contract, or transaction will
need to know the appropriate classification, e.g. whether it is a swap
or security-based swap, in order to know which regulatory regime and
corresponding requirements is applicable. The Dodd-Frank Act requires
that, with respect to the definitions of swaps, security-based swaps,
and mixed swaps, the Commissions must jointly interpret such
definitions. This rule, by providing a mechanism for the Commissions to
provide such joint interpretations, allows parties to understand the
timing and process for seeing such joint interpretation. Regardless of
this rule, the programmatic costs and benefits that flow from being a
swap or security-based swap remain the same for parties requesting a
joint interpretation. But, the rule allows for parties to the
agreement, contract, or transaction to request through a joint
interpretation from the Commissions, what regulatory regime would apply
or whether the agreement, contract, or transaction is within the
definition of swap or security-based swap.
---------------------------------------------------------------------------
\1342\ See supra part X.4(b)(i).
\1343\ Id.
---------------------------------------------------------------------------
(ii) Assessment Costs
The SEC estimates the costs of submitting a request for a joint
interpretation pursuant to rule 3a68-2 under the Exchange Act would be
approximately $20,000.\1344\ The use of inside counsel in lieu of
outside counsel would reduce this estimate. Once such a joint
interpretation is made, however, other market participants that seek to
transact in the same agreement, contract, or transaction (or class
thereof) would be able to rely on such interpretation in determining
whether their agreement, contract, or transaction is a swap, security-
based swap, or mixed swap. Accordingly, assessment costs may be
affected by the number of parties seeing an interpretation or whether
prior interpretations with respect to the same or similar agreements,
contracts, or transactions have been sought.
---------------------------------------------------------------------------
\1344\ As stated in the Proposing Release at 29878, n. 354, this
estimate is based on information indicating that the average costs
associated with preparing and submitting a no action request to the
SEC staff, which the SEC believes is a process similar to the
process under rule 3a68-2 under the Exchange Act. The staff
estimates that costs associated with a request pursuant to rule
3a68-2 will cost approximately $19,560. The SEC estimates the
analysis will require approximately 20 hours of in-house counsel
time and 30 hours of outside counsel time. Based upon data from
SIFMA's Management & Professional Earnings in the Securities
Industry 2011 (modified by SEC staff to account for an 1800-hour-
work-year and multiplied by 5.35 to account for bonuses, firm size,
employee benefits, and overhead), staff estimates that the average
national hourly rate for an in-house attorney is $378. The SEC
estimates the costs for outside legal services to be $400 per hour.
This is the same estimate used by the SEC for these services in the
release involving Exemptions for Security-Based Swaps Issued By
Certain Clearing Agencies, Release No. 33-9308 (Mar. 30, 2012), 77
FR 20536 (Apr. 5, 2012). Accordingly, the SEC estimates the cost to
be $19,560 ($7,560 (based on 20 hours of in-house counsel time x
$378) + $12,000 (based on 30 hours of outside counsel x $400)) to
submit a joint request for interpretation. This estimate is rounded
by two significant digits to avoid the impression of false precision
of the estimate.
---------------------------------------------------------------------------
(f) Definition of Swap (Rule 3a69-2 Under the Exchange Act)
(i) Programmatic Benefits and Costs
Rule 3a69-2(a) under the Exchange Act states that the term swap has
the meaning set forth in section 3(a)(69) of the Exchange Act.\1345\
Rule 3a69-2(b) under the Exchange Act explicitly defines the term
``swap'' to include an agreement, contract, or transaction that is a
cross-currency swap, currency option, foreign currency option, foreign
exchange option, foreign exchange rate option, foreign exchange
forward, foreign exchange swap, forward rate agreement, or non-
deliverable forward involving foreign exchange, unless such agreement,
contract, or transaction is otherwise excluded by section 1a(47)(B) of
the CEA.\1346\ Rule 3a69-2(c) under the Exchange Act provides that: (1)
A foreign exchange forward or a foreign exchange swap shall not be
considered a swap if the Secretary of the Treasury makes the
determination described in section 1a(47)(E)(i) of the CEA; \1347\ and
(2) notwithstanding any such determination, certain provisions of the
CEA will apply to such a foreign exchange forward or foreign exchange
swap (specifically, the reporting requirements in section 4r of the CEA
\1348\ and regulations thereunder
[[Page 48340]]
and, in the case of a swap dealer or major swap participant that is a
party to a foreign exchange swap or foreign exchange forward, the
business conduct standards in section 4s of the CEA \1349\ and
regulations thereunder). Rule 3a69-2(c) under the Exchange Act further
clarifies that a currency swap, cross-currency swap, currency option,
foreign currency option, foreign exchange option, foreign exchange rate
option, or non-deliverable forward involving foreign exchange is not a
foreign exchange forward or foreign exchange swap subject to a
determination by the Secretary of the Treasury as described in the
preamble.
---------------------------------------------------------------------------
\1345\ 15 U.S.C. 78c(a)(69).
\1346\ 7 U.S.C. 1a(47)(B).
\1347\ 7 U.S.C. 1a(47)(E)(i).
\1348\ 7 U.S.C. 6r.
\1349\ 7 U.S.C. 6s.
---------------------------------------------------------------------------
Rule 3a69-2 is parallel to rule 1.3(xxx)(2) under the CEA. In order
to determine whether an agreement, contract, or transaction is a
``swap'' or ``security-based swap'', it is necessary for the
Commissions to adopt parallel rules that will apply to a Title VII
instrument. Therefore, rule 3a69-2 is included under the Exchange Act.
The definition of swap is the starting point for determining the status
of a Title VII Instrument as a swap, security-based swap, or mixed
swap. To the extent that the specific agreements, contracts, and
transactions listed in section 1a(47)(B) of the CEA are swaps, the
programmatic costs and benefits that flow from such agreements,
contracts or transactions being a Title VII instrument under rule 3a69-
2 will be determined by the substantive rules adopted by the CFTC
mandated by Title VII. If any such agreements, contracts, or
transactions are security-based swaps, the programmatic costs and
benefits will be the same as with other security-based swaps.
(ii) Assessment Costs
Since this rule lists some of the types of agreements, contracts or
transactions already listed in section 1a(47)(B) of the CEA \1350\ and
the determination made by the Secretary of the Treasury, the SEC does
not believe there would be assessment costs in addition to those
incurred by market participants in determining whether an agreement,
contract or transaction falls within the definition of swap.
---------------------------------------------------------------------------
\1350\ 7 U.S.C. 1a(47)(B).
---------------------------------------------------------------------------
(g) Mixed Swaps (Rule 3a68-4 Under the Exchange Act)
(i) Programmatic Benefits and Costs
Rule 3a68-4(a) under the Exchange Act defines a ``mixed swap'' in
the same manner as the term is defined in both the CEA and Exchange
Act. Furthermore, rule 3a68-4(b) under the Exchange Act establishes the
regulatory framework for mixed swaps with which parties to bilateral
uncleared mixed swaps (i.e., mixed swaps that are neither executed on
or subject to the rules of a DCM, NSE, SEF, SB SEF, or FBOT nor cleared
through a DCO or clearing agency), as to which at least one of the
parties is dually registered with both the CFTC and the SEC, will need
to comply. The SEC believes that paragraph (b) of rule 3a68-4 under the
Exchange Act will augment the programmatic benefits of the Title VII
regulatory regime. The rule addresses potentially duplicative
regulatory requirements for dually-registered dealers and major
participants that are subject to regulation by both the CFTC and the
SEC, while requiring dual registrants to comply with the regulatory
requirements the Commissions believe are necessary to provide
sufficient regulatory oversight for mixed swaps transactions entered
into by such dual registrants. It eliminates potentially duplicative
regulation and reduces the programmatic costs associated with
regulatory implementation and compliance in the context of mixed swaps
by providing that a bilateral uncleared mixed swap would be subject to
all applicable provisions of the Federal securities laws (and the SEC
rules and regulations promulgated thereunder) but would be subject only
to certain CEA provisions (and the CFTC rules and regulations
promulgated thereunder).
Rule 3a68-4(c) under the Exchange Act establishes a process for
persons to request that the Commissions issue a joint order, with
respect to parallel provisions \1351\ applicable to mixed swaps, to
permit such persons (and any other person or persons that subsequently
lists, trades, or clears that class of mixed swap) to comply with the
parallel provisions of either the CEA or the Exchange Act and related
rules and regulations (collectively ``specified parallel provisions''),
instead of being required to comply with parallel provisions in both
the CEA and the Exchange Act. This process applies except with respect
to bilateral, uncleared mixed swaps where one of the parties to the
mixed swap is dually registered with the CFTC as a swap dealer or major
swap participant and with the SEC as a security-based swap dealer or
major security-based swap participant, for which the regulatory
framework is established under rule 3a68-4(c). The SEC has recognized
the programmatic benefits associated with rule 3a68-4(c) and believes
that in the mixed swap area, the process established by rule 3a68-4(c)
would eliminate potentially duplicative regulatory requirements and
reduce the compliance costs associated with mixed swaps.
---------------------------------------------------------------------------
\1351\ For purposes of paragraph (c) of rule 3a68-4 under the
Exchange Act, ``parallel provisions'' means comparable provisions of
the CEA and the Exchange Act that were added or amended by Title VII
with respect to security-based swaps and swaps, and the rules and
regulations thereunder.
---------------------------------------------------------------------------
(ii) Assessment Costs
With respect to rule 3a68-4(b) under the Exchange Act, one cost is
that parties to a mixed swap would need to determine whether they
satisfy the conditions set forth in such rule in order to ascertain the
regulatory treatment of the mixed swap. Such assessment includes
determining whether the mixed swap is neither executed on nor subject
to the rules of a DCM, NSE, SEF, SB SEF, or FBOT, whether the mixed
swap will not be submitted for clearing, and whether one party to the
mixed swap is a dually registered dealer or major participant. The SEC
believes that the above determinations would be based on readily
ascertainable facts and the assessment costs associated with such
determinations should be minimal.
With respect to rule 3a68-4(c) under the Exchange Act, parties to
mixed swaps have the option to decide whether to submit a request for
issuing a joint order, weighing the benefits realized from the joint
order against the cost of submitting such request. If parties to mixed
swaps decide to submit a request, the SEC estimates the total costs of
preparing and submitting a party's request to the Commissions pursuant
to rule 3a68-4(c) under the Exchange Act will be $31,000 per request
for mixed swaps for which a request for a joint interpretation pursuant
to rule 3a68-4(c) was not previously made.\1352\ The use of inside
[[Page 48341]]
counsel in lieu of outside counsel would reduce this estimate. Absent
such a process, though, market participants that desire or intend to
offer or enter into such a mixed swap (or class thereof) would not have
the option to request for the Commissions' joint interpretation and
absent a joint interpretation, they would be required pursuant to Title
VII to comply with all regulatory requirements applicable to both swaps
and security-based swaps.
---------------------------------------------------------------------------
\1352\ As discussed in the Proposing Release at 29878, note 356,
this estimate is based on information indicating that the average
costs associated with preparing and submitting a no-action request
to the SEC staff, which the SEC believes is a process similar to the
process under rule 3a68-4(c). The staff estimates that costs
associated with such a request will cost approximately $31,340. The
SEC estimates the analysis will require approximately 30 hours of
in-house counsel time and 50 hours of outside counsel time. Based
upon data from SIFMA's Management & Professional Earnings in the
Securities Industry 2011 (modified by SEC staff to account for an
1800-hour-work-year and multiplied by 5.35 to account for bonuses,
firm size, employee benefits, and overhead), staff estimates that
the average national hourly rate for an in-house attorney is $378.
The SEC estimates the costs for outside legal services to be $400
per hour. This is the same estimate used by the SEC for these
services in the release involving Exemptions for Security-Based
Swaps Issued By Certain Clearing Agencies, Release No. 33-9308 (Mar.
30, 2012), 77 FR 20536 (Apr. 5, 2012). Accordingly, the SEC
estimates the cost to be $31,340 ($11,340 (based on 30 hours of in-
house counsel time x $378) + $20,000 (based on 50 hours of outside
counsel x $400)) to submit a joint request for interpretation. This
estimate is rounded by two significant digits to avoid the
impression of false precision of the estimate.
---------------------------------------------------------------------------
(iii) Alternatives
One commenter recommended that the Commissions require that market
participants disaggregate mixed swaps and enter into separate
simultaneous transactions so that they cannot employ mixed swaps to
obscure the underlying substance of transactions.\1353\ This commenter
stated that ``the regulatory complexity of dealing with a mixed swap
far outweighs the legitimate benefits to counterparties from
documenting the transactions as mixed swaps.'' \1354\ This commenter
asserted that some benefits of requiring disaggregation include more
useful price reporting; increased transparency; regulatory reporting
and monitoring that will align with the transaction database of the
counterparties; and the thwarting of illegitimate motivations, such as
obfuscation of prices and fees. Regardless of the benefits of
disaggregation raised by the commenter, Title VII specifically
contemplates that there would be mixed swaps comprised of both swaps
and security-based swaps. The SEC believes that requiring parties to
disaggregate mixed swaps into separate components is not consistent
with congressional intent and may result in certain programmatic costs,
such as limiting the types of derivatives products and transactions
market participants may offer and enter into and increasing transaction
costs (such as documentation costs) by disaggregating a mixed swap into
multiple separate transactions.
---------------------------------------------------------------------------
\1353\ See Better Markets Letter.
\1354\ Id.
---------------------------------------------------------------------------
(h) Books and Records Requirement for SBSAs (Rule 3a69-3 Under the
Exchange Act)
(i) Programmatic Benefits and Costs
Rule 3a69-3 under the Exchange Act provides that there are no
additional books and records, or data, requirements regarding SBSAs
beyond those required for swaps. The SEC recognized the following
programmatic benefits and costs in adopting this rule.
As discussed above, SBSAs are swaps over which the CFTC has primary
regulatory authority, but for which the SEC has antifraud, anti-
manipulation, and certain other authority.\1355\ There will be
programmatic benefits and costs as a result of the SDRs, swap dealers,
and major swap participants implementing and complying with the books
and records requirements provided in sections 21 and 4s of the
CEA.\1356\ The programmatic benefits and costs will flow from the
substantive rules adopted by the CFTC regarding record keeping
requirements for swaps. SBSAs are swaps and will be subject to these
books and records requirements. The SEC believes that the rules
proposed by the CFTC would provide sufficient books and records
regarding SBSAs,\1357\ and that additional books and records
requirements for SBSAs may be duplicative and would not produce
corresponding benefits warranting such additional costs. Rule 3a69-3
under the Exchange Act avoids any additional programmatic costs,
especially the additional compliance and operation costs that would be
incurred by SDRs, swap dealers, and major swap participants in the area
of data maintenance and recordkeeping, beyond those which have already
been prescribed by the CFTC's rules.
---------------------------------------------------------------------------
\1355\ See supra part V.
\1356\ 7 U.S.C. 24a and 6s. Pursuant to sections 21(b)(2) and
4s(f)(1)(B)(ii) of the CEA, the CFTC has adopted rules with respect
to data collection and maintenance by SDR and books and records
requirements for swap dealers and major swap participants. See Swap
Dealer and Major Swap Participant Recordkeeping, Reporting, and
Duties Rules; Futures Commission Merchant and Introducing Broker
Conflicts of Interest Rules; and Chief Compliance Officer Rules for
Swap Dealers, Major Swap Participants, and Futures Commission
Merchants, 77 FR 20128 (April 3, 2012); and Swap Data Recordkeeping
and Reporting Requirements, 77 FR 2136 (January 13, 2012).
\1357\ See Proposing Release at 29863. See also supra part V.
---------------------------------------------------------------------------
(ii) Assessment Costs
The SEC does not believe that any assessment costs associated with
rule 3a69-3 under the Exchange Act would be material.
5. Effects on Competition, Efficiency, and Capital Formation
Section 3(f) of the Exchange Act requires the SEC, whenever it
engages in rulemaking and is required to consider or determine whether
an action is necessary or appropriate in the public interest, to
consider, in addition to the protection of investors, whether the
action would promote efficiency, competition, and capital
formation.\1358\ In addition, section 23(a)(2) of the Exchange Act
\1359\ requires the SEC, when adopting rules under the Exchange Act, to
consider the impact such rules would have on competition. Section
23(a)(2) of the Exchange Act also prohibits the SEC from adopting any
rule that would impose a burden on competition not necessary or
appropriate in furtherance of the purposes of the Exchange Act.
---------------------------------------------------------------------------
\1358\ 15 U.S.C. 78c(f).
\1359\ 15 U.S.C. 78w(a)(2).
---------------------------------------------------------------------------
The Commissions are further defining ``swap'' and ``security-based
swap'' pursuant to section 712(d)(1) of the Dodd-Frank Act.\1360\ In
the Proposing Release, the SEC stated that the SEC preliminarily
believed that the proposed Exchange Act rules would not impose
significant burden on competition, that they would create efficient
processes, and that they would not have adverse effects on capital
formation.\1361\ In the Proposing Release, the SEC requested comment on
each of these issues,\1362\ and no commenters responded to specifically
address these issues.
---------------------------------------------------------------------------
\1360\ The SEC is also acting pursuant to its rulemaking
authority provided by sections 3 and 23(a) of the Exchange Act.
\1361\ See Proposing Release at 29885-87.
\1362\ Id. at 29887.
---------------------------------------------------------------------------
The SEC recognizes that the most significant impact of the swap and
security-based swap definitions will derive from these definitions
serving as the foundation for implementing the Title VII regulatory
regime, particularly given the significant impacts that Title VII will
have on the security-based swap market. In adopting these definitional
rules, the SEC has sought to fairly reflect the statutory definitions
and their underlying intent to implement the regulatory framework
Congress intended to impose on the derivatives markets by enacting
Title VII.
The scope of the definitions will affect the ultimate regulatory
effects on competition, efficiency, and capital formation that will
accompany the full implementation of Title VII. The SEC anticipates
analyzing these effects in the adopting releases for the particular
regulations. Below is a general discussion of the impacts on
competition, efficiency, and capital formation as a result of the rules
being adopted in this release.
The final rules being adopted relate primarily to further defining
the terms ``swap,'' ``security-based swap,'' and ``mixed swap'' to
determine (i) the instruments that will be subject to the Title VII
regulatory regime and (ii) the jurisdictional line between Title VII
[[Page 48342]]
instruments regulated by the SEC and those regulated by the CFTC. There
also are procedural rules regarding interpretive requests and joint
orders from the Commissions, and recordkeeping relating to SBSAs. The
SEC believes that these procedural rules are related to the status of a
product and the regulatory treatment of a mixed swaps, and therefore,
the effects of these rules on competition, efficiency, and capital
formation are subsumed in the overall impact of the rules defining the
perimeter of the Title VII regulatory regime, and those of the rules
relating to the jurisdictional line between the SEC and CFTC.
(a) The Status of Products
The status of products as inside the Title VII regulatory perimeter
(i.e., swaps and security-based swaps) or outside the regulatory
perimeter will have impacts on market participants. These rules will
impact the status of certain market participants currently acting as
intermediaries in the security-based swap market, subjecting them to
regulatory oversight and registration. As the SEC has noted, the market
among intermediaries for security-based swaps is highly concentrated.
The concentration in large part appears to reflect the fact that larger
entities possess competitive advantages in engaging in over-the-counter
security-based swap dealing activities, particularly with respect to
having sufficient financial resources to provide potential
counterparties with adequate assurances of financial performance.\1363\
At the same time, as noted by commenters to the Entities Definition
Release, some entities engage in smaller volumes of security-based swap
dealing activity.\1364\ Some small and mid-size banks, for example,
routinely provide such services involving relatively small notional
amounts to their customers.\1365\ Although these relatively small
dealers in general may not compete directly with the largest dealers
(because they service a different segment of the market), they may be
expected to play a role in helping certain types of customers (such as
customers with a relatively small need for security-based swaps) enter
into security-based swaps, thus promoting the availability of these
products.\1366\ This availability may assist market participants (as
end users), as discussed below, in engaging security-based swap
activities that may be related to their businesses or financing needs.
---------------------------------------------------------------------------
\1363\ See Entity Definitions Release, at 30740.
\1364\ Id.
\1365\ Id.
\1366\ Id.
---------------------------------------------------------------------------
As the SEC has noted before, persons who fall within the
definitions of ``security-based swap dealer'' and ``major security-
based swap participant'' will incur a range of programmatic costs by
virtue of their status as a registered dealer or major participant and
certain assessment costs regarding their security-based swap
activities. To the extent the costs associated with these statutorily
mandated requirements are relatively fixed or large enough, they may
negatively affect competition within the security-based swap
market.\1367\ This may, for example, lead smaller dealers or entities
for whom dealing is not a core business to keep their security-based
swap dealing activity below the volume threshold required to be
registered with the SEC or exit the market if the profit from the
security-based swap dealing activity cannot justify the cost incurred
to comply with the Title VII requirements; both scenarios could cause
customers to have less access to the market or to incur higher costs in
accessing the market. Such costs might also deter the entry of new
firms into the market. If sufficiently high, these costs of compliance
may increase concentration among dealers.\1368\
---------------------------------------------------------------------------
\1367\ Id.
\1368\ Id.
---------------------------------------------------------------------------
Certain aspects of the regulation of products defined as security-
based swaps may enhance competition in the market for security-based
swaps. For example, the proposed business conduct standards, if adopted
as proposed, including those for disclosure of material risks and for
fair and balanced communications, may reduce information asymmetries
between security-based swap dealers, major security based swap
participants, and their counterparties. The reduction of information
asymmetries should promote price efficiency, promote more informed
decision-making, and reduce the incidence of fraudulent or misleading
representations.\1369\
---------------------------------------------------------------------------
\1369\ See Business Conduct Standards Proposing Release, 76 FR
42396-42459, at 42452. See also supra part XI.A.3.
---------------------------------------------------------------------------
In addition, as the SEC noted in the Entity Definitions Release,
the current security-based swap market is subject to the potential for
risk spillovers and systemic risk, which can occur when the financial
sector as a whole (or certain key segments) is exposed to a significant
amount of concentrated financial risk, either through direct
counterparty relationships or the deterioration of asset values, and
such exposure gives rise to the systemic chain effect of one firm's
financial distress or losses leading to financial distress or losses of
the entire financial sector as a whole.\1370\ With respect to
transactions involving security-based swaps, security-based swap
dealers and major security-based swap participants will be regulated
and, as noted in the Entity Definitions Release, such regulation and
requirements are expected to increase market participants' confidence
in the dealers' and major participants' ability to perform their
obligations.\1371\
---------------------------------------------------------------------------
\1370\ See Entity Definitions Release, at 30740.
\1371\ Id. at 30723-30724.
---------------------------------------------------------------------------
The effect of the definitions on efficiency and capital formation
is linked to their effect on competition. Markets that are competitive,
with fair and transparent pricing and equal access to security-based
swaps, may be expected to promote the efficient allocation of capital.
Similarly, definitions that promote, or do not unduly restrict,
competition can be accompanied by regulatory benefits that minimize the
risk of market failure and thus promote efficiency and capital
formation within the market.\1372\
---------------------------------------------------------------------------
\1372\ See Entity Definitions Release, at 30742.
---------------------------------------------------------------------------
As discussed above, certain Title VII requirements and rules
relating to intermediaries, such as internal and external business
conduct standards, if adopted as proposed, are expected to reduce
information asymmetries and promote price efficiency. These business
conduct standards, if adopted as proposed, would also help regulators
perform their functions in an effective manner. The resulting increase
in market integrity could affect capital formation in U.S. capital
markets positively.\1373\
---------------------------------------------------------------------------
\1373\ See Business Conduct Standards Proposing Release, at
42452; SDR Proposing Release, at 77365.
---------------------------------------------------------------------------
Other entities also will be affected by the scope of the security-
based swap definition, including clearing agencies that currently, and
in the future will, clear security-based swaps, the security-based swap
data repositories that collect security-based swap data, and the SB
SEFs and exchanges that are transaction venues for security-based
swaps, subjecting these entities to regulation and oversight by the
SEC.\1374\ For example, The SEC has noted that the intent of the
proposed rules concerning standards for clearing agency operations and
governance standards of clearing agencies is to promote the prompt and
accurate clearance and settlement of securities transactions, including
security-based swap transactions, by
[[Page 48343]]
requiring certain minimum standards at clearing agencies.\1375\ The SEC
stated that it preliminarily believes that these requirements would
ensure resilient and cost-effective clearing agency operations as well
as promote transparent and effective clearing agency governance that
would consequently support confidence among market participants in
clearing agencies' ability to serve as efficient mechanisms for
clearance and settlement and to facilitate capital formation.\1376\
---------------------------------------------------------------------------
\1374\ See supra part XI.A.3.
\1375\ See Clearing Agency Standards Proposing Release, at
14535.
\1376\ Id.
---------------------------------------------------------------------------
Similarly, the SEC has previously stated that the core principles,
duties, and requirements imposed by Title VII and the proposed rules on
SB SEFs will foster innovation in the security-based swap market by
allowing entities that seek to become SB SEFs to structure diverse
platforms for the trading of security-based swaps,\1377\ increase pre-
trade price transparency, and establish fair, objective, and not
unreasonably discriminatory standards for granting impartial access to
trading on the SB SEFs,\1378\ thereby furthering higher efficiency,
promoting competition, and encouraging capital formation.\1379\ The SEC
also noted that any resulting increase in market integrity proceeding
from the rules intended to support the statutorily-mandated regulatory
obligations of SB SEFs would likely increase market participants'
confidence in the soundness and fairness of the security-based swap
market.\1380\ Such increased confidence likely would stimulate
financial investment in SB swaps by corporate entities and others that
may find that more transparent venues for the trading of SB swaps would
allow them to purchase SB swaps to offset business risks and to meet
hedging objectives.\1381\ Further, to the extent that market
participants utilize SB swaps to better manage portfolio risks with
respect to positions in underlying securities, the extent that they are
willing to participate in the SB swap market may impact their
willingness to participate in the underlying asset's market.\1382\
Therefore, the Commission stated its preliminary belief that the
proposed rules would help encourage capital formation.\1383\
---------------------------------------------------------------------------
\1377\ See SB SEF Proposing Release, at 11049.
\1378\ Id.
\1379\ Id. at 11049-50.
\1380\ Id. at 11049.
\1381\ Id.
\1382\ Id. at 11050.
\1383\ Id.
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Furthermore, in the proposing release regarding SDRs, \1384\ the
SEC noted that, by allowing multiple SDRs to provide data collection,
maintenance, and recordkeeping services, the rules are intended to
promote competition among SDRs. The SEC also stated that the proposed
rules promote data collection, maintenance, and recordkeeping according
to existing best practices that are used in similar capital market
institutions and are likely to positively affect transparency in credit
markets and would help capital formation in the broader capital markets
whose participants rely on security-based swap markets to meet their
hedging objectives.\1385\
---------------------------------------------------------------------------
\1384\ See SDR Proposing Release, at 77365.
\1385\ Id.
---------------------------------------------------------------------------
Other parties to security-based swap transactions may be affected
by the definitions as well. Title VII amends the Exchange Act and the
Securities Act to include security-based swap within the definition of
the term ``security.'' \1386\ End-users will have the benefit and
protection of the existing Federal securities laws, including the
Exchange Act and Securities Act provisions added by Title VII. As a
result of the amendment to the Securities Act regarding security-based
swap transactions entered into by issuers of the securities underlying
the security-based swap, and their affiliates and underwriters,\1387\
such issuers, affiliates, and underwriters cannot use security-based
swaps without also complying with the Securities Act provisions with
respect to the underlying securities. Furthermore, Title VII provides
protections to non-ECPs by adding provisions to both the Securities Act
and the Exchange Act that require security-based swap transactions with
such non-ECPs to be covered by an effective registration statement
under the Securities Act and traded on a national securities exchange,
and for brokers and dealers engaging in transactions with non-ECPs to
be registered as such under section 15 of the Exchange Act. To the
extent counterparties, including issuers of the underlying securities,
or their affiliates or underwriters, determine to engage in such
transactions, other counterparties may have a greater willingness to
engage in such transactions because of the protections afforded by the
Securities Act registration, disclosure, and civil liability scheme. An
increased interest by end-users may create effects on competition.
---------------------------------------------------------------------------
\1386\ See section 2(a)(1) of the Securities Act and section
3(a)(10) of the Exchange Act, 15 U.S.C. 77b(a)(1) and 15 U.S.C.
78c(a)(10).
\1387\ See supra part XI.A.3.
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While other securities-related derivatives have the same
limitations on issuers, affiliates, and underwriters using the
derivative to avoid the Securities Act application to the underlying
securities at the time the transaction is entered into, these other
derivatives, such as security options and security futures, do not
contain the same limitation on transactions with non-ECPs. Although
security options and security futures must be traded on a national
securities exchange as one condition to avail themselves of an
exemption from registration under the Securities Act,\1388\ other
exemptions from registration under the Securities Act may be available
for transactions in security options sold to non-ECPs that are not
available to security-based swap transactions with non-ECPs.
---------------------------------------------------------------------------
\1388\ See section 3(a)(14) of the Securities Act and Rule 238
under the Securities Act.
---------------------------------------------------------------------------
There also may be effects on efficiency and capital formation by
facilitating end-users' use of security-based swaps for investment or
hedging of risks relating to investments or business operations,
thereby affecting liquidity and costs in connection with the issuance
of equity and debt securities. The further definitions may promote
capital formation by facilitating these hedging and investment
activities. For example, in the context of CDS, as credit risk is
correlated, lenders who made loans and investors in debt securities may
find it desirable to hedge credit risks on their loan or securities
portfolios by purchasing protection through single-name or index
CDS.\1389\ Although basis risk may exist in this type of trade, it
should be effective at reducing counterparty exposure.\1390\
---------------------------------------------------------------------------
\1389\ See Entity Definitions Release, at 30742.
\1390\ Id.
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(b) Jurisdictional Divide Impacts
There may be competitive impacts that arise due to the
jurisdictional divide between the CFTC and the SEC that Congress
imposed in Title VII. While the competitive impacts of the substantive
rules will be addressed as part of each substantive rulemaking, the SEC
acknowledges that such competitive effects may exist as a consequence
of the statutory jurisdictional divide. These competitive impacts may
arise due to capital and margin treatment, for example, which may
affect demand for security-based swaps as compared to other types of
security instruments. In addition, to the extent there are differences
in regulatory treatment between security-based swaps
[[Page 48344]]
and other securities-based or securities-related instruments, there
will be competition across the markets affecting all market
participants.
As one example of the possible competitive effects of the
jurisdictional divide, section 3E(a) of the Exchange Act provides that
only a registered broker, dealer, or security-based swap dealer may
accept margin from customers to secure cleared security-based swap
transactions,\1391\ and that the broker, dealer, or security-based swap
dealer shall treat and deal with all margin received from a customer as
belonging to the customer.\1392\ Similarly, section 4d(f) of the
Commodity Exchange Act requires that only a registered futures
commission merchant may accept margin from customers to secure cleared
swap transactions \1393\ and that the futures commissions merchant
shall treat and deal with margin received from a customer as belonging
to the customer.\1394\ The SEC understands that many members of
clearing agencies are dually-registered broker-dealers and futures
commission merchants and that much of the clearing of security-based
swaps may occur through such dually-registered entities.\1395\ Because
collateral for swaps and security-based swaps are required under
applicable statutory requirements to be maintained in two separate
accounts under the CEA and Exchange Act, respectively, the derivatives
portfolio of a customer will be separated into a swap portfolio and a
security-based swap portfolio, with two separate margin accounts and
without the benefits of netting swaps against security-based swaps for
purposes of calculating margin requirements. Absent the adoption of a
margin and segregation approach that would permit a customer to hold
both swaps and security-based swaps in a single customer account, a
customer who clears swaps and security-based swaps through a clearing
member who is dually-registered as a futures commission merchant with
the CFTC and a broker-dealer with the SEC may have to deliver
collateral to the clearing member with respect to the customer's
cleared swap portfolio and also deliver collateral as margin to the
clearing member with respect to its security-based swap portfolio even
if the positions in the swap portfolio offset the risk arising from the
positions in the security-based swap portfolio. This will impact
customers' liquidity, as opposed to holding swap and security-based
swap positions in one single account,\1396\ and increase customers'
transaction costs. Such an increase will affect customers' ability to
use security-based swaps and may drive them to seek less expensive
alternatives. Decrease in demand for security-based swaps may increase
dealer competition in the security-based swap market for the remaining
business, or result in dealers exiting the market.
---------------------------------------------------------------------------
\1391\ See section 3E(a) of the Exchange Act, 15 U.S.C. 78c-
5(a).
\1392\ See section 3E(b)(1) of the Exchange Act, 15 U.S.C. 78c-
5(b)(1).
\1393\ See section 4d(f)(1) of the CEA, 7 U.S.C. 6d(f)(1).
\1394\ See section 4d(f)(2)(A) of the CEA, 7 U.S.C. 6d(f)(2)(A).
\1395\ See, e.g., letter to the SEC from ICE Clear Credit LLC,
dated November 7, 2011 (``ICE Clear Credit Letter''), available at
http://www.sec.gov/rules/petitions/2011/petn4-641.pdf (requesting
exemptive relief from the application of section 15(c)(3) of the
Exchange Act and Rule 15c3-3 thereunder to allow ICE Clear Credit,
and its members that are dually-registered broker-dealers and
futures commission merchants, to, among other things: (1) Hold
customer assets used to margin, secure, or guarantee customer
positions consisting of cleared credit default swaps that include
swaps and security-based swaps in a commingled customer omnibus
account subject to section 4d(f) of the CEA; and (2) calculate
margin for this commingled customer account on a portfolio margin
basis); see also section 4d(F)(1) of the CEA (making it unlawful for
any person to, among other things, accept money and securities from
a swaps customer for a cleared swap unless such person has
registered with the CFTC as a futures commission merchant).
\1396\ See ICE Clear Credit Letter at 6, 13-14. See also
Statement of General Policy on the Sequencing of the Compliance
Dates for Final Rules Applicable to Security-Based Swaps Adopted
Pursuant to the Securities Exchange Act of 1934 and the Dodd-Frank
Wall Street Reform and Consumer Protection Act, 77 FR 35625 n.138
(June 14, 2012).
---------------------------------------------------------------------------
In addition, there may be competitive impacts on security-based
swap dealers, major security-based swap participants, clearing
agencies, security-based swap data repositories and security-based swap
execution facilities (or national securities exchanges) if they provide
services for both security-based swaps and swaps, as their businesses
will be divided based on the jurisdictional line between swaps and
security-based swaps. For registered entities whose derivatives
activities involve products that reference indexes or baskets, they
will incur assessment costs \1397\ and, to the extent that SEC and CFTC
regulations diverge, they will incur additional regulatory compliance
costs \1398\ to implement two sets of regulations that would not
otherwise be incurred if the jurisdictional divide did not exist. The
SEC recognizes that these costs may affect existing market
participants' considerations whether to continue to operate their
business, and new entrants' desire to enter into new business, across
two separate regulatory regimes and if they determine that the
incremental costs of operating the derivatives business under two
separate regulatory regimes would outweigh potential revenues, they may
exit certain products to limit the application of regulatory
requirements to solely those of the CFTC or the SEC. This could result
in a redistribution of the swaps or security-based swaps dealing
activity in the derivatives market and lead to further concentration of
security-based swap dealing activity.
---------------------------------------------------------------------------
\1397\ See the discussion of assessment costs of various rules
and interpretations, supra part XI.A.4.
\1398\ See supra parts XI.A.3and XI.A.4.
---------------------------------------------------------------------------
The SEC understands that Congress intended to create two parallel
regulatory regimes for the derivatives market that complement each
other. Each regulatory regime will have the benefit of the regulatory
expertise of the respective agency. The rules further defining swap,
security-based swap, and mixed swap do not by themselves create
negative competitive impacts other than those which potentially could
be imposed if the Commissions' substantive requirements differ
substantially.
Finally, the rules being adopted may have effects on efficiency and
capital formation. For example, the rules defining the terms ``issuers
of securities in a narrow-based security index'' and ``narrow-based
security index'' for purposes of the jurisdictional divide are intended
to, among other things, minimize the likelihood that an index on which
a CDS is based that is outside of the SEC's jurisdiction can be used as
a surrogate or substitute for the underlying security, or with respect
to securities of the referenced issuer, or to manipulate the market for
such securities. Such provisions will provide greater protection to the
reference issuers or the issuers of the securities in the index that
the index CDS cannot be used in a manner that will adversely affect
such issuers and their ability to raise capital.
In conclusion, the SEC believes the rules and interpretations
adopted here would not have overall adverse effects on efficiency,
competition, or capital formation.
B. Paperwork Reduction Act
1. Background
Rules 3a68-2 and 3a68-4(c) under the Exchange Act contain new
``collection of information'' requirements within the meaning of the
Paperwork Reduction Act of 1995.\1399\ The SEC has submitted them to
the Office of Management and Budget (``OMB'') for review in accordance
with the PRA.\1400\ The titles
[[Page 48345]]
for the collections of information are: (1) Interpretation of Swaps,
Security-Based Swaps, and Mixed Swaps and (2) Regulation of Mixed
Swaps: Process for determining regulatory treatment for mixed swaps
(OMB Control No. 3235-0685). An agency may not conduct or sponsor, and
a person is not required to respond to, a collection of information
unless it displays a currently valid OMB control number.
---------------------------------------------------------------------------
\1399\ 44 U.S.C. 3501 et seq.
\1400\ 44 U.S.C. 3507(d) and 5 CFR 1320.11.
---------------------------------------------------------------------------
The rules containing these two collections of information are being
adopted pursuant to the Exchange Act. The rules establish a process
through which a person can submit a request to the Commissions that the
Commissions provide a joint interpretation of whether an agreement,
contract, or transaction (or class thereof) is a swap, security-based
swap, or both (i.e., a mixed swap). The rules also establish a process
with respect to mixed swaps through which a person can submit a request
to the Commissions that the Commissions issue a joint order permitting
the requesting 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 specified parallel
provisions, instead of being required to comply with parallel
provisions of both the CEA and the Exchange Act. The hours and costs
associated with preparing and sending these requests will constitute
reporting and cost burdens imposed by each collection of information.
In the Proposing Release, the SEC requested comment on the
collection of information requirements.\1401\ As discussed in
connection with rules 3a68-2 and 3a68-4(c) under the Exchange Act,
under the Exchange Act the final rules require the same information to
be collected as proposed.\1402\ As noted above, the Commissions
received approximately 86 comment letters on the Proposing
Release.\1403\ The SEC did not receive any comments that directly
address its Paperwork Reduction Act analysis or its burden estimates.
However, the SEC did receive comments regarding confidentiality of
information submitted as a result of the collection of information
requirements. These comments do not directly address the SEC's
Paperwork Reduction Act analysis, but they do implicate those aspects
of the analysis regarding confidentiality. These comments are discussed
below.\1404\
---------------------------------------------------------------------------
\1401\ See Proposing Release at 29877, 29879.
\1402\ See discussion of rules 3a68-2 and 3a68-4(c) supra parts
VI and IV.B.3.
\1403\ See supra part I.
\1404\ See infra part XI.B.3.
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2. Summary of Collection of Information Under Rules 3a68-2 and 3a68-
4(c) Under the Exchange Act
First, the SEC is adopting new rule 3a68-2 under the Exchange Act,
which will allow persons to submit a request for a joint interpretation
from the Commissions regarding whether an agreement, contract, or
transaction (or a class thereof) is a swap, security-based swap, or
both (i.e., a mixed swap). Under rule 3a68-2 under the Exchange Act, a
person will provide to the Commissions all material information
regarding the terms of, and a statement of the economic characteristics
and purpose of, each relevant agreement, contract, or transaction (or
class thereof), along with that person's determination as to whether
each such agreement, contract, or transaction (or class thereof) should
be characterized as a swap, security-based swap, or both (i.e., a mixed
swap), including the basis for such a determination. The Commissions
also may request the submitting person to provide additional
information.
The Commissions may issue in response a joint interpretation or
joint notice of proposed rulemaking regarding the status of that
agreement, contract, or transaction (or class thereof) as a swap,
security-based swap, or both (i.e., a mixed swap). Any joint
interpretation, like any joint notice of proposed rulemaking, will be
public and may discuss the material information regarding the terms of
the relevant agreement, contract, or transaction (or class thereof), as
well as any other information the Commissions deem material to the
interpretation. Requesting persons also will be permitted to withdraw a
request made pursuant to rule 3a68-2 under the Exchange Act at any time
before the Commissions have issued a joint interpretation or joint
notice of proposed rulemaking in response to the request.
Persons will submit requests pursuant to rule 3a68-2 under the
Exchange Act on a voluntary basis. However, if a person submits a
request, all of the information required under the rule, including any
additional information requested by the Commissions, must be submitted
to the Commissions, except to the extent a person withdraws the request
pursuant to the rule.
Second, the SEC is adopting rule 3a68-4(c) under the Exchange Act,
which will allow persons to submit requests to the Commissions for
joint orders regarding the regulation of a particular mixed swap (or
class thereof). Under rule 3a68-4(c) under the Exchange Act, a person
will provide to the Commissions all material information regarding the
terms of, and the economic characteristics and purpose of, the
specified (or specified class of) mixed swap. In addition, a person
will provide the specified parallel provisions, the reasons the person
believes such specified parallel provisions are appropriate for the
mixed swap (or class thereof), and an analysis of: (1) The nature and
purposes of the parallel provisions that are the subject of the
request; (2) the comparability of such parallel provisions; and (3) the
extent of any conflicts or differences between such parallel
provisions. The Commissions also may request the submitting person to
provide additional information.
The Commissions may issue in response a joint order, after public
notice and opportunity for comment, permitting the requesting 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 provisions (or another subset of the
parallel provisions that are the subject of the request, as the
Commissions determine is appropriate), instead of being required to
comply with parallel provisions of both the CEA and the Exchange Act.
Any joint order will be public and may discuss the material information
regarding the terms of the relevant agreement, contract, or transaction
(or class thereof), as well as any other information the Commissions
deem material to the interpretation. Requesting persons also will be
permitted to withdraw a request made pursuant to rule 3a68-4(c) under
the Exchange Act at any time before the Commissions have issued a joint
order in response to the request.
Persons will submit requests pursuant to rule 3a68-4(c) under the
Exchange Act on a voluntary basis. However, if a person submits a
request, all of the information required under the rule, including any
additional information requested by the Commissions, must be submitted
to the Commissions, except to the extent a person withdraws the request
pursuant to the rule.
3. Reasons for and Use of Information
The SEC will use the information collected pursuant to rule 3a68-2
under the Exchange Act to evaluate agreements, contracts, or
transactions (or classes thereof) in order to provide joint
interpretations or joint notices of
[[Page 48346]]
proposed rulemaking with the CFTC regarding whether these agreements,
contracts, or transactions (or classes thereof) are swaps, security-
based swaps, or both (i.e., mixed swaps) as defined in the Dodd-Frank
Act. The SEC will use the information collected pursuant to rule 3a68-
4(c) under the Exchange Act to evaluate a specified, or a specified
class of, mixed swap in order to provide joint orders or joint notices
of proposed rulemaking with the CFTC regarding the regulation of that
particular mixed swap or class of mixed swap. The information provided
to the SEC pursuant to rules 3a68-2 and 3a68-4(c) under the Exchange
Act also will allow the SEC to monitor the development of new OTC
derivatives products in the marketplace and determine whether
additional rulemaking or interpretive guidance is necessary or
appropriate.
As discussed above, some commenters expressed concern about the
public availability of information regarding the joint interpretive
process and asked that the parties be able to seek confidential
treatment of their submissions.\1405\ As stated above, under existing
rules of both Commissions, 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.\1406\ Also as stated above, even if
confidential treatment has been requested, all joint interpretive
requests, as well 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.\1407\
---------------------------------------------------------------------------
\1405\ See supra part VI.
\1406\ See 17 CFR 200.81 and 17 CFR 140.98. See also supra part
VI.
\1407\ See supra part VI.
---------------------------------------------------------------------------
4. Respondents
As discussed in the Proposing Release, the SEC believes that the
relevant categories of persons that will submit requests under rule
3a68-2 under the Exchange Act will be swap dealers, security-based swap
dealers, major swap participants, and major security-based swap
participants; SEFs, security-based SEFs and DCMs trading swaps; and
SDRs, SBSDRs, DCOs clearing swaps, and clearing agencies clearing
security-based swaps.\1408\ The SEC estimates that the total number of
such persons will be 475.\1409\ Similarly, the SEC believes that the
relevant categories of persons that will submit a request under rule
3a68-4(c) under the Exchange Act will be SEFs, security-based SEFs, and
DCMs trading swaps and estimates that the total number of such persons
will be 72.\1410\
---------------------------------------------------------------------------
\1408\ See Proposing Release at 29876.
\1409\ This total number includes an estimated 250 swap dealers,
50 major swap participants, 50 security-based swap dealers, 10 major
security-based swap participants, 35 SEFs, 20 security-based SEFs,
12 DCOs, 17 DCMs, 15 SDRs, 10 SBSDRs, and 6 clearing agencies, as
set forth by the CFTC and SEC, respectively, in their other Dodd-
Frank Act rulemaking proposals. See Entity Definitions Release,
supra note 12 (regarding security-based swap dealers and major
security-based swap participants); Registration of Swap Dealers and
Major Swap Participants, supra note 1288 (regarding swap dealers and
major security-based swap participants); SDR Proposing Release,
supra note 1231 (regarding SBSDRs); Swap Data Repositories, supra
note 6 (regarding SDRs); Core Principles and Other Requirements for
Swap Execution Facilities, 76 FR 1214, Jan. 7, 2011 (regarding
SEFs); Registration and Regulation of Security-Based Swap Execution
Facilities, 76 FR 10948, Feb. 28, 2011 (regarding security-based
SEFs); Derivatives Clearing Organization General Provisions and Core
Principles, 76 FR 69334 (Nov. 8, 2011); Core Principles and Other
Requirements for Designated Contract Markets, 75 FR 80572, Dec. 22,
2010 (regarding DCMs); Clearing Agency Standards for Operation and
Governance, 76 FR 14472, Mar. 16, 2011 (regarding clearing
agencies).
\1410\ Id.
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However, based on the SEC's experience and information received
from commenters to the ANPR \1411\ and during meetings with the public
to discuss the Product Definitions generally, and taking into
consideration the certainty provided by the rules and interpretive
guidance in this release, the SEC believes that the number of requests
for a joint interpretation to the Commissions pursuant to rule 3a68-2
under the Exchange Act will be small.\1412\ With respect to proposed
rule 3a68-4(c) under the Exchange Act, the SEC also estimates the
number of requests for joint orders will be small.\1413\ Pursuant to
the Commissions' rules and interpretive guidance, a number of persons
that engage in agreements, contracts, or transactions that are swaps,
security-based swaps, or both (i.e., a mixed swap) will be certain that
their agreements, contracts, or transactions are, indeed, swaps,
security-based swaps, or both, (i.e., mixed swaps) and will not request
an interpretation pursuant to rule 3a68-2 under the Exchange Act. Also,
as the Commissions provide joint interpretations regarding whether
agreements, contracts, or transactions (or classes thereof) are or are
not swaps, security-based swaps, or both (i.e., mixed swaps), the SEC
expects that the number of requests for interpretation will decrease
over time. The SEC believes that the rules and interpretive guidance
regarding swaps, security-based swaps, and mixed swaps the Commissions
are adopting, as well as the additional guidance issued pursuant to
joint interpretations and orders under rules 3a68-2 and 3a68-4(c) under
the Exchange Act, will result in a narrow pool of potential
respondents, approximately 50,\1414\ to the collection of information
requirements of proposed rule 3a68-2 under the Exchange Act. Although
the SEC does not have precise figures for the number of requests that
persons will submit after the first year, the SEC believes it is
reasonable to estimate that there likely will be fewer than 10 requests
on average in each ensuing year.
---------------------------------------------------------------------------
\1411\ See supra note 12 and accompanying text.
\1412\ See infra note 1414 and accompanying text.
\1413\ See infra note 1415 and accompanying text.
\1414\ The SEC believes that there will be approximately 50
requests in the first year. See discussion infra part XI.B.5. The
SEC recognizes that one person might submit more than one request
but for purposes of the PRA is considering the submitter of each
such request as a separate person.
---------------------------------------------------------------------------
Similarly, because the SEC believes that both the category of mixed
swap transactions and the number of market participants that engage in
mixed swap transactions are small, the SEC believes that the pool of
potential persons requesting a joint order regarding the regulation of
a specified, or specified class of, mixed swap pursuant to proposed
rule 3a68-4(c) under the Exchange Act will be small. In addition,
depending on the characteristics of a mixed swap (or class thereof), a
person may choose not to submit a request pursuant to rule 3a68-4(c)
under the Exchange Act. The SEC also notes that any joint order issued
by the Commissions will apply to any person that subsequently lists,
trades, or clears that specified, or specified class of, mixed swap, so
that requests for joint orders could diminish over time. Also, persons
may submit requests for an interpretation under rule 3a68-4(c) under
the Exchange Act that do not result in an interpretation that the
agreement, contract, or transaction (or class thereof) is a mixed
swap.\1415\ Also, those requests submitted pursuant to rule 3a68-2
under the Exchange Act that result in an interpretation that the
agreement, contract, or transaction (or class thereof) is not a mixed
swap will reduce the pool of possible persons submitting a request
regarding the regulation of particular mixed swaps (or class thereof)
pursuant to rule 3a68-4(c) under the Exchange Act.
---------------------------------------------------------------------------
\1415\ The SEC believes it is reasonable to estimate that it
will receive 20 requests in the first year and, as with rule 3a68-2
under the Exchange Act, it will count the submitter of each request
as a separate person. See id.
---------------------------------------------------------------------------
Furthermore, although certain requests made pursuant to rule 3a68-
[[Page 48347]]
4(c) under the Exchange Act may be made without a previous request for
a joint interpretation pursuant to rule 3a68-2 under the Exchange Act,
the SEC believes that most requests under rule 3a68-2 under the
Exchange Act that result in the interpretation that an agreement,
contract, or transaction (or class thereof) is a mixed swap will result
in a subsequent request for alternative regulatory treatment pursuant
to rule 3a68-4(c) under the Exchange Act. The SEC believes that 90
percent, or 18 of the estimated 20 requests pursuant to rule 3a68-4(c)
under the Exchange Act in the first year would be such ``follow-on''
requests.
In addition, not only the requesting party, but also any other
person that subsequently lists, trades, or clears that mixed swap, will
be subject to, and must comply with, the joint order regarding the
regulation of the specified, or specified class of, mixed swap, as
issued by the Commissions. Therefore, the SEC believes that the number
of requests for a joint order regarding the regulation of mixed swaps,
particularly involving specified classes of mixed swaps, will decrease
over time. As discussed above, the SEC believes that as the Commissions
provide joint orders regarding alternative regulatory treatment, the
number of requests received will decrease over time. The SEC believes
it is reasonable to estimate that there likely will be five requests on
average in each ensuing year.
5. Paperwork Reduction Act Burden Estimates
Rules 3a68-2 and 3a68-4(c) under the Exchange Act require
submission of certain information to the Commissions to the extent
persons elect to request an interpretation and/or alternative
regulatory treatment. Rules 3a68-2 and 3a68-4(c) under the Exchange Act
each require certain information that a requesting party must include
in its request to the Commissions in order to receive a joint
interpretation or order, as applicable.
(a) Rule 3a68-2 Under the Exchange Act
Rule 3a68-2 will apply only to requests made by persons that desire
an interpretation from the Commissions. For each agreement, contract,
or transaction (or class thereof) for which a person requests the
Commissions' joint interpretation under rule 3a68-2 under the Exchange
Act, the requesting person will be required to provide certain
information, as discussed above.\1416\
---------------------------------------------------------------------------
\1416\ See discussion supra part VI.
---------------------------------------------------------------------------
As discussed above, the SEC believes it is reasonable to estimate
that 50 requests will be received in the first year. For purposes of
the PRA, the SEC estimates the total paperwork burden associated with
preparing and submitting a person's request to the Commissions pursuant
to rule 3a68-2 under the Exchange Act will be 20 hours per request and
associated costs of $12,000 for outside professionals, which the SEC
believes will consist of services provided by attorneys.\1417\ These
total costs include all collection burdens associated with the rule,
including burdens related to the initial determination requirements.
---------------------------------------------------------------------------
\1417\ See discussion supra part XI.A.4.e(ii). This estimate is
based on information indicating that the average burden associated
with preparing and submitting a no-action request to the SEC staff
in connection with the identification of whether certain products
are securities, which the SEC believes is a process similar to the
process under rule 3a68-2 under the Exchange Act, is approximately
20 hours and associated costs of $12,000. Assuming these costs
correspond to legal fees, which the SEC estimates at an hourly cost
of $400, the SEC estimates that this cost is equivalent to
approximately 30 hours ($12,000/$400). The estimated internal or
company time burden for rule 3a68-2 under the Exchange Act has not
changed from that included in the Proposing Release, but the
estimated burden of the cost for outside professionals for rule
3a68-2 under the Exchange Act has been revised from that included in
the Proposing Release to reflect updated data regarding hourly costs
for the services of outside professionals. The estimate of the
dollar burden for rule 3a68-2 under the Exchange Act in the
Proposing Release was based on data from SIFMA's ``Management &
Professional Earnings in the Securities Industry 2009.'' See
Proposing Release at 29876, note 345. The hourly rate used to
estimate the PRA burdens is discussed above. See supra note 1344.
---------------------------------------------------------------------------
Assuming 50 requests in the first year, the SEC estimates that this
will result in an aggregate burden for the first year of 1000 hours of
company time (50 requests x 20 hours/request) and $600,000 for the
services of outside professionals (e.g., attorneys) (50 requests x 30
hours/request x $400). The estimated internal or company time burden
for rule 3a68-2 under the Exchange Act has not changed from that
included in the Proposing Release.\1418\ However, the estimated burden
of the cost for outside professionals for rule 3a68-2 under the
Exchange Act has been revised from that included in the Proposing
Release to reflect updated data regarding the hourly cost for an
attorney.\1419\
---------------------------------------------------------------------------
\1418\ See Proposing Release at 29876, 29877-78.
\1419\ See id.
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As discussed above, the SEC believes that there will be 10 requests
on average in each ensuing year, which results in an aggregate burden
in each ensuing year of 200 hours of company time (10 requests x 20
hours/request) and $120,000 for the services of outside professionals
(e.g., attorneys) (10 requests x 30 hours/request x $400).\1420\
---------------------------------------------------------------------------
\1420\ See discussion supra part XI.B.4.
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(b) Rule 3a68-4(c) Under the Exchange Act
Rule 3a68-4(c) under the Exchange Act will require any party
requesting a joint order regarding the regulation of a specified, or
specified class of, mixed swap under the rule to include certain
information about the agreement, contract, or transaction (or class
thereof) that is a mixed swap, including the specified parallel
provisions that the person believes should apply to the mixed swap (or
class thereof), the reasons the person believes the specified parallel
provisions will be appropriate for the mixed swap.\1421\
---------------------------------------------------------------------------
\1421\ See discussion supra part IV.B.3.
---------------------------------------------------------------------------
As discussed above, the SEC believes the number of requests that
persons will submit pursuant to rule 3a68-4(c) under the Exchange Act
is quite small given the limited types of agreements, contracts, and
transactions (or classes thereof) the Commissions believe will
constitute mixed swaps and that it will receive 20 requests in the
first year.\1422\ For purposes of the PRA, the SEC estimates the total
paperwork burden associated with preparing and submitting a party's
request to the Commissions pursuant to rule 3a68-4(c) under the
Exchange Act will be 30 hours and associated costs of $20,000 for the
services of outside professionals, which the SEC believes will consist
of services provided by attorneys,\1423\ per request for mixed swaps
for which a request for a joint interpretation pursuant to rule 3a68-
4(c) under the Exchange Act was not previously made.\1424\ These total
costs include all collection burdens associated with the rule,
including burdens related to the initial determination requirements.
[[Page 48348]]
Assuming 20 requests in the first year, the SEC estimates that this
will result in an aggregate burden for the first year of 600 hours of
company time (20 requests x 30 hours/request) and $400,000 for the
services of outside professionals (20 requests x 50 hours/request x
$400).\1425\
---------------------------------------------------------------------------
\1422\ See supra note 1415 and accompanying text.
\1423\ See supra note 1352.
\1424\ This estimate is based on information indicating that the
average burden associated with preparing and submitting a no-action
request to the SEC staff in connection with the regulatory treatment
of certain securities products, which the SEC believes is a process
similar to the process under rule 3a68-4(c) under the Exchange Act,
is approximately 30 hours and associated costs of $20,000. Assuming
these costs correspond to legal fees, which the SEC estimates at an
hourly cost of $400 as discussed above, the SEC estimates that this
cost is equivalent to approximately 50 hours ($20,000/$400). As with
rule 3a68-2 under the Exchange Act, the estimated internal or
company time burdens for rule 3a68-4(c) under the Exchange Act have
not changed from those included in the Proposing Release, but the
estimated burdens of the cost for outside professionals for rule
3a68-4(c) under the Exchange Act have been revised from those
included in the Proposing Release to reflect updated data regarding
hourly costs for the services of outside professionals.
\1425\ See supra note 1415 and accompanying text.
---------------------------------------------------------------------------
As discussed above, the SEC believes that most requests under rule
3a68-2 under the Exchange Act that result in the interpretation that an
agreement, contract, or transaction (or class thereof) is a mixed swap
will result in a subsequent request for alternative regulatory
treatment pursuant to rule 3a68-4(c) under the Exchange Act.
Also as discussed above, the SEC believes that 90 percent, or 18 of
the estimated 20 requests pursuant to rule 3a68-4(c) under the Exchange
Act in the first year, as discussed above will be ``follow-on''
requests. For mixed swaps for which a request for a joint
interpretation pursuant to rule 3a68-2 under the Exchange Act was
previously made, the SEC estimates the total paperwork burden under the
PRA associated with preparing and submitting a party's request to the
Commissions pursuant to rule 3a68-4(c) under the Exchange Act will be
10 hours fewer and $6,000 less per request than for mixed swaps for
which a request for a joint interpretation pursuant to rule 3a68-2
under the Exchange Act was not previously made because certain,
although not all, of the information required to be submitted and
necessary to prepare pursuant to rule 3a68-4(c) under the Exchange Act
will have been required to be submitted and necessary to prepare
pursuant to rule 3a68-2 under the Exchange Act.\1426\ The SEC estimates
that this will result in an aggregate burden for such ``follow-on''
requests in the first year of 360 hours of company time (18 requests x
20 hours/request) and $252,000 for the services of outside
professionals (18 requests x 35 hours/request x $400) and an aggregate
burden for all requests in the first year of 420 hours of company time
(2 requests x 30 hours/request and 18 requests x 20 hours/request) and
$292,000 for the services of outside professionals (2 requests x 50
hours/request x $400 and 18 requests x 35 hours/request x $400).
---------------------------------------------------------------------------
\1426\ This estimate takes into account that certain information
regarding the mixed swap (or class thereof), namely the material
terms and the economic purpose, will have already been gathered and
prepared as part of the request submitted pursuant to proposed rule
3a68-2 under the Exchange Act. The SEC estimates that these items
constitute approximately 10 hours fewer and a reduction in
associated costs of $6,000. Assuming these costs correspond to legal
fees, which the SEC estimates at an hourly cost of $400, the SEC
estimates that this cost is equivalent to approximately 15 hours
($6,000/$400). As noted above, these amounts are revised from those
included in the Proposing Release to reflect updated data regarding
the hourly costs for the services of outside professionals.
---------------------------------------------------------------------------
The estimated internal or company time burden for rule 3a68-4(c)
under the Exchange Act has not changed from that included in the
Proposing Release.\1427\ However, the estimated burden of the cost for
outside professionals for rule 3a68-4(c) has been revised from that
included in the Proposing Release to reflect updated data regarding the
hourly cost for an attorney.\1428\
---------------------------------------------------------------------------
\1427\ See Proposing Release at 29876, 29878-79.
\1428\ See id.
---------------------------------------------------------------------------
As discussed above, the SEC believes that there will be five
requests on average in each ensuing year. Assuming five requests in
each ensuing year, the SEC estimates that this will result in an
aggregate burden in each ensuing year of 150 hours of company time (5
requests x 30 hours/request) and $100,000 for the services of outside
professionals (5 requests x 50 hours/request x $400). As discussed
above, however, assuming that approximately 90 percent, or 4 of the
estimated 5 requests pursuant to rule 3a68-4(c) under the Exchange Act
in each ensuing year are ``follow-on'' requests to requests for joint
interpretation from the Commissions under rule 3a68-4(c) under the
Exchange Act, the SEC estimates that this will result in an aggregate
burden for such ``follow-on'' requests in each ensuing year of 80 hours
of company time (4 requests x 20 hours/request) and $56,000 for the
services of outside professionals (4 requests x 35 hours/request x
$400) and an aggregate burden for all requests in each ensuing year of
110 hours of company time (1 request x 30 hours/request and 4 requests
x 20 hours/request) and $76,000 for the services of outside
professionals (1 request x 50 hours/request x $40] and 4 requests x 35
hours/request x $400).
C. Regulatory Flexibility Act Certification
The Regulatory Flexibility Act (``RFA'') \1429\ requires Federal
agencies, in promulgating rules, to consider the impact of those rules
on small entities. Section 603(a) \1430\ of the Administrative
Procedure Act,\1431\ as amended by the RFA, generally requires the SEC
to undertake a regulatory flexibility analysis of all proposed rules,
or proposed rule amendments, to determine the impact of such rulemaking
on ``small entities.'' \1432\ Section 605(b) of the RFA provides that
this requirement shall not apply to any proposed rule or proposed rule
amendment, which if adopted, would not have a significant economic
impact on a substantial number of small entities.\1433\
---------------------------------------------------------------------------
\1429\ 5 U.S.C. 601 et seq.
\1430\ 5 U.S.C. 603(a).
\1431\ 5 U.S.C. 551 et seq.
\1432\ Although section 601(b) of the RFA defines the term
``small entity,'' the statute permits the Commissions to formulate
their own definitions. The SEC has adopted definitions for the term
small entity for the purposes of SEC rulemaking in accordance with
the RFA. Those definitions, as relevant to this proposed rulemaking,
are set forth in Rule 0-10, 17 CFR 240.0-10. See Statement of
Management on Internal Accounting Control, 47 FR 5215, Feb. 4, 1982.
\1433\ See 5 U.S.C. 605(b).
---------------------------------------------------------------------------
For purposes of SEC rulemaking in connection with the RFA, a small
entity includes: (1) When used with reference to an ``issuer'' or a
``person,'' other than an investment company, an ``issuer'' or
``person'' that, on the last day of its most recent fiscal year, had
total assets of $5 million or less \1434\ and (2) a broker-dealer with
total capital (net worth plus subordinated liabilities) of less than
$500,000 on the date in the prior fiscal year as of which its audited
financial statements were prepared pursuant to rule 17a-5(d) under the
Exchange Act,\1435\ or, if not required to file such statements, a
broker-dealer with total capital (net worth plus subordinated
liabilities) of less than $500,000 on the last day of the preceding
fiscal year (or in the time that it has been in business, if shorter);
and is not affiliated with any person (other than a natural person)
that is not a small entity.\1436\ Under the standards adopted by the
Small Business Administration, small entities in the finance and
insurance industry include the following: (1) For entities engaged in
credit intermediation and related activities, entities with $175
million or less in assets; \1437\ (2) for entities engaged in non-
depository credit intermediation and certain other activities, entities
with $7 million or less in annual receipts; \1438\ (3) for entities
engaged in financial investments and related activities, entities with
$7 million or less in annual receipts; \1439\ (4) for insurance
carriers and entities engaged in related activities, entities with $7
million or less in annual receipts; \1440\ and (5) for funds, trusts,
and other financial
[[Page 48349]]
vehicles, entities with $7 million or less in annual receipts.\1441\
---------------------------------------------------------------------------
\1434\ See 17 CFR 240.0-10(a).
\1435\ See 17 CFR 240.17a-5(d).
\1436\ See 17 CFR 240.0-10(c).
\1437\ See 13 CFR 121.201 (Subsector 522).
\1438\ See id. at Subsector 522.
\1439\ See id. at Subsector 523.
\1440\ See id. at Subsector 524.
\1441\ See id. at Subsector 525.
---------------------------------------------------------------------------
The Proposing Release stated that, based on the SEC's existing
information about the swap markets, the SEC believed that the swap
markets, while broad in scope, are largely dominated by entities such
as those that would qualify as swap dealers, security-based swap
dealers, major swap participants, and major security-based swap
participants (collectively, ``swap market dealers and major
participants'') and that the SEC believed that such entities exceed the
thresholds defining ``small entities'' set out above.\1442\
---------------------------------------------------------------------------
\1442\ See Proposing Release at 29887.
---------------------------------------------------------------------------
The Proposing Release also stated that, although it is possible
that other persons may engage in swap and security-based swap
transactions, the SEC did not believe that any of these entities would
be ``small entities'' as defined in rule 0-10 under the Exchange Act
\1443\ and that feedback from industry participants about the swap
markets indicates that only persons or entities with assets
significantly in excess of $5 million (or with annual receipts
significantly in excess of $7 million) participate in the swap
markets.\1444\
---------------------------------------------------------------------------
\1443\ See 17 CFR 240.0-10(a).
\1444\ See Proposing Release at 29887.
---------------------------------------------------------------------------
The Proposing Release further stated that, to the extent that a
small number of transactions did have a counterparty that was defined
as a ``small entity'' under SEC rule 0-10, the SEC believed it is
unlikely that the proposed rules and interpretive guidance would have a
significant economic impact on that entity because the proposed rules
and interpretive guidance simply would address whether certain products
fall within the swap definition, address whether certain products are
swaps, security-based swaps, SBSAs, or mixed swaps, provide a process
for requesting interpretations of whether agreements, contracts, and
transactions are swaps, security-based swaps, and mixed swaps, provide
a process for requesting alternative regulatory treatment for mixed
swaps, and specify that the books and records for SBSAs are those that
are applicable to all entities.\1445\
---------------------------------------------------------------------------
\1445\ See Proposing Release at 29887-88.
---------------------------------------------------------------------------
As a result, the SEC certified that the proposed rules and
interpretive guidance would not have a significant economic impact on a
substantial number of small entities for purposes of the RFA, and
requested written comments regarding this certification.\1446\
---------------------------------------------------------------------------
\1446\ See Proposing Release at 29888.
---------------------------------------------------------------------------
In response to the Proposing Release, one commenter, representing a
number of market participants, submitted a comment to the CFTC related
to the RFA.\1447\ The commenter did not address the letter to the SEC
or provide comments regarding the SEC's RFA analysis.\1448\
---------------------------------------------------------------------------
\1447\ See Letter from the National Rural Electric Cooperative
Association, the American Public Power Association, the Large Public
Power Council, the Edison Electric Institute, and the Electric Power
Supply Association (July 22, 2011).
\1448\ See id.
---------------------------------------------------------------------------
The SEC continues to believe that the types of entities that would
participate in the swap markets--which generally would be swap market
dealers and major participants--would not be ``small entities'' for
purposes of the RFA. The final rules and interpretive guidance do not
themselves impose any compliance obligations. Instead they describe the
categories of agreements, contracts, and transactions that are outside
the scope of the Product Definitions and delineate the jurisdictional
divide between the SEC's and the CFTC's regulatory regime. Accordingly,
the SEC certifies that the final rules and interpretive guidance would
not have a significant economic impact on a substantial number of small
entities for purposes of the RFA.
XII. Statutory Basis and Rule Text
List of Subjects
17 CFR Part 1
Definitions, General swap provisions.
17 CFR Parts 230 and 240
Reporting and recordkeeping requirements, Securities.
17 CFR Part 241
Securities.
Commodity Futures Trading Commission
Pursuant to the Commodity Exchange Act, 7 U.S.C. 1 et seq., as
amended by Title VII of the Dodd-Frank Wall Street Reform and Consumer
Protection Act, Public Law 111-203, 124 Stat. 1376 (2010) (``Dodd-Frank
Act''), and sections 712(a)(8), 712(d), 721(a), 721(b), 721(c), 722(d),
and 725(g) of the Dodd-Frank Act, the CFTC is adopting rules 1.3(xxx)
through 1.3(bbbb) and 1.6 through 1.9 under the Commodity Exchange Act.
Text of Final Rules
For the reasons stated in the preamble, the CFTC is amending Title
17, Chapter I, of the Code of Federal Regulations, as follows:
PART 1--GENERAL REGULATIONS UNDER THE COMMODITY EXCHANGE ACT
0
1. The authority citation for part 1 is revised to read as follows:
Authority: 7 U.S.C. 1a, 2, 5, 6, 6a, 6b, 6c, 6e, 6f, 6g, 6h,
6i, 6j, 6k, 6l, 6m, 6n, 6o, 6p, 6r, 7, 7a, 7b, 8, 9, 10, 12, 12a,
12c, 13a, 13a-1, 16, 16a, 21, 23, and 24.
0
2. Amend Sec. 1.3 by:
0
a. Adding and reserving paragraphs (nnn) through (www); and
0
b. Adding paragraphs (xxx), (yyy), (zzz), (aaaa) and (bbbb).
The additions read as follows:
Sec. 1.3 Definitions.
* * * * *
(nnn)-(www) [Reserved]
(xxx) Swap. (1) In general. The term swap has the meaning set forth
in section 1a(47) of the Commodity Exchange Act.
(2) Inclusion of particular products. (i) The term swap includes,
without limiting the meaning set forth in section 1a(47) of the
Commodity Exchange Act, the following agreements, contracts, and
transactions:
(A) A cross-currency swap;
(B) A currency option, foreign currency option, foreign exchange
option and foreign exchange rate option;
(C) A foreign exchange forward;
(D) A foreign exchange swap;
(E) A forward rate agreement; and
(F) A non-deliverable forward involving foreign exchange.
(ii) The term swap does not include an agreement, contract, or
transaction described in paragraph (xxx)(2)(i) of this section that is
otherwise excluded by section 1a(47)(B) of the Commodity Exchange Act.
(3) Foreign exchange forwards and foreign exchange swaps.
Notwithstanding paragraph (xxx)(2) of this section:
(i) A foreign exchange forward or a foreign exchange swap shall not
be considered a swap if the Secretary of the Treasury makes a
determination described in section 1a(47)(E)(i) of the Commodity
Exchange Act.
(ii) Notwithstanding paragraph (xxx)(3)(i) of this section:
(A) The reporting requirements set forth in section 4r of the
Commodity Exchange Act and regulations promulgated thereunder shall
apply to a foreign exchange forward or foreign exchange swap; and
(B) The business conduct standards set forth in section 4s(h) of
the Commodity Exchange Act and regulations promulgated thereunder shall
apply to a swap dealer or major
[[Page 48350]]
swap participant that is a party to a foreign exchange forward or
foreign exchange swap.
(iii) For purposes of section 1a(47)(E) of the Commodity Exchange
Act and this paragraph (xxx), the term foreign exchange forward has the
meaning set forth in section 1a(24) of the Commodity Exchange Act.
(iv) For purposes of section 1a(47)(E) of the Commodity Exchange
Act and this paragraph (xxx), the term foreign exchange swap has the
meaning set forth in section 1a(25) of the Commodity Exchange Act.
(v) For purposes of sections 1a(24) and 1a(25) of the Commodity
Exchange Act and this paragraph (xxx), the following transactions are
not foreign exchange forwards or foreign exchange swaps:
(A) A currency swap or a cross-currency swap;
(B) A currency option, foreign currency option, foreign exchange
option, or foreign exchange rate option; and
(C) A non-deliverable forward involving foreign exchange.
(4) Insurance. (i) This paragraph is a non-exclusive safe harbor.
The terms swap as used in section 1a(47) of the Commodity Exchange Act
and security-based swap as used in section 1a(42) of the Commodity
Exchange Act do not include an agreement, contract, or transaction
that:
(A) By its terms or by law, as a condition of performance on the
agreement, contract, or transaction:
(1) Requires the beneficiary of the agreement, contract, or
transaction to have an insurable interest that is the subject of the
agreement, contract, or transaction and thereby carry the risk of loss
with respect to that interest continuously throughout the duration of
the agreement, contract, or transaction;
(2) Requires that loss to occur and to be proved, and that any
payment or indemnification therefor be limited to the value of the
insurable interest;
(3) Is not traded, separately from the insured interest, on an
organized market or over-the-counter; and
(4) With respect to financial guaranty insurance only, in the event
of payment default or insolvency of the obligor, any acceleration of
payments under the policy is at the sole discretion of the insurer; and
(B) Is provided:
(1)(i) By a person 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
(ii) Such agreement, contract, or transaction is regulated as
insurance under applicable State law or the laws of the United States;
(2)(i) Directly or indirectly by the United States, any State or
any of their respective agencies or instrumentalities; or
(ii) Pursuant to a statutorily authorized program thereof; or
(3) In the case of reinsurance only, by a person to another person
that satisfies the conditions set forth in paragraph (xxx)(4)(i)(B) of
this section, provided that:
(i) Such person is not prohibited by applicable State law or the
laws of the United States from offering such agreement, contract, or
transaction to such person that satisfies the conditions set forth in
paragraph (xxx)(4)(i)(B) of this section;
(ii) The agreement, contract, or transaction to be reinsured
satisfies the conditions set forth in paragraph (xxx)(4)(i)(A) or
paragraph (xxx)(4)(i)(C) of this section; and
(iii) Except as otherwise permitted under applicable State law, the
total amount reimbursable by all reinsurers for such agreement,
contract, or transaction may not exceed the claims or losses paid by
the person writing the risk being ceded or transferred by such person;
or
(4) In the case of non-admitted insurance, 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; or
(C) Is provided in accordance with the conditions set forth in
paragraph (xxx)(4)(i)(B) of this section and is one of the following
types of products:
(1) Surety bond;
(2) Fidelity bond;
(3) Life insurance;
(4) Health insurance;
(5) Long term care insurance;
(6) Title insurance;
(7) Property and casualty insurance;
(8) Annuity;
(9) Disability insurance;
(10) Insurance against default on individual residential mortgages;
and
(11) Reinsurance of any of the foregoing products identified in
paragraphs (xxx)(4)(i)(C)(1) through (10) of this section; or
(ii) The terms swap as used in section 1a(47) of the Commodity
Exchange Act and security-based swap as used in section 1a(42) of the
Commodity Exchange Act do not include an agreement, contract, or
transaction that was entered into on or before the effective date of
paragraph (xxx)(4) of this section, and that, at such time that it was
entered into, was provided in accordance with the conditions set forth
in paragraph (xxx)(4)(i)(B) of this section.
(5) State. For purposes of paragraph (xxx)(4) of this section, the
term State means any state of the United States, the District of
Columbia, Puerto Rico, the U.S. Virgin Islands, or any other possession
of the United States.
(6) Anti-Evasion:
(i) An agreement, contract, or transaction that is willfully
structured to evade any provision of Subtitle A of the Wall Street
Transparency and Accountability Act of 2010, including any amendments
made to the Commodity Exchange Act thereby (Subtitle A), shall be
deemed a swap for purposes of Subtitle A and the rules, regulations,
and orders of the Commission promulgated thereunder.
(ii) An interest rate swap or currency swap, including but not
limited to a transaction identified in paragraph (xxx)(3)(v) of this
section, that is willfully structured as a foreign exchange forward or
foreign exchange swap to evade any provision of Subtitle A shall be
deemed a swap for purposes of Subtitle A and the rules, regulations,
and orders of the Commission promulgated thereunder.
(iii) An agreement, contract, or transaction of a bank that is not
under the regulatory jurisdiction of an appropriate Federal banking
agency (as defined in section 1a(2) of the Commodity Exchange Act),
where the agreement, contract, or transaction is willfully structured
as an identified banking product (as defined in section 402 of the
Legal Certainty for Bank Products Act of 2000) to evade the provisions
of the Commodity Exchange Act, shall be deemed a swap for purposes of
the Commodity Exchange Act and the rules, regulations, and orders of
the Commission promulgated thereunder.
(iv) The form, label, and written documentation of an agreement,
contract, or transaction shall not be dispositive in determining
whether the agreement, contract, or transaction has been willfully
structured to evade as provided in paragraphs (xxx)(6)(i) through
(xxx)(6)(iii) of this section.
(v) An agreement, contract, or transaction that has been willfully
structured to evade as provided in paragraphs (xxx)(6)(i) through
(xxx)(6)(iii) of this section shall be considered in determining
whether a
[[Page 48351]]
person that so willfully structured to evade is a swap dealer or major
swap participant.
(vi) Notwithstanding the foregoing, no agreement, contract, or
transaction structured as a security (including a security-based swap)
under the securities laws (as defined in section 3(a)(47) of the
Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(47))) shall be deemed
a swap pursuant to this paragraph (xxx)(6) or shall be considered for
purposes of paragraph (xxx)(6)(v) of this section.
(yyy) Narrow-based security index as used in the definition of
``security-based swap.''
(1) In general. Except as otherwise provided in paragraphs (zzz)
and (aaaa) of this section, for purposes of section 1a(42) of the
Commodity Exchange Act, the term narrow-based security index has the
meaning set forth in section 1a(35) of the Commodity Exchange Act, and
the rules, regulations and orders of the Commission thereunder.
(2) Tolerance period for swaps traded on designated contract
markets, swap execution facilities, and foreign boards of trade.
Notwithstanding paragraph (yyy)(1) of this section, solely for purposes
of swaps traded on or subject to the rules of a designated contract
market, swap execution facility, or foreign board of trade, a security
index underlying such swaps shall not be considered a narrow-based
security index if:
(i)(A) A swap on the index is traded on or subject to the rules of
a designated contract market, swap execution facility, or foreign board
of trade for at least 30 days as a swap on an index that was not a
narrow-based security index; or
(B) Such index was not a narrow-based security index during every
trading day of the six full calendar months preceding a date no earlier
than 30 days prior to the commencement of trading of a swap on such
index on a market described in paragraph (yyy)(2)(i)(A) of this
section; and
(ii) The index has been a narrow-based security index for no more
than 45 business days over three consecutive calendar months.
(3) Tolerance period for security-based swaps traded on national
securities exchanges or security-based swap execution facilities.
Notwithstanding paragraph (yyy)(1) of this section, solely for purposes
of security-based swaps traded on a national securities exchange or
security-based swap execution facility, a security index underlying
such security-based swaps shall be considered a narrow-based security
index if:
(i)(A) A security-based swap on the index is traded on a national
securities exchange or security-based swap execution facility for at
least 30 days as a security-based swap on a narrow-based security
index; or
(B) Such index was a narrow-based security index during every
trading day of the six full calendar months preceding a date no earlier
than 30 days prior to the commencement of trading of a security-based
swap on such index on a market described in paragraph (yyy)(3)(i)(A) of
this section; and
(ii) The index has been a security index that is not a narrow-based
security index for no more than 45 business days over three consecutive
calendar months.
(4) Grace period.
(i) Solely with respect to a swap that is traded on or subject to
the rules of a designated contract market, swap execution facility, or
foreign board of trade, an index that becomes a narrow-based security
index under paragraph (yyy)(2) of this section solely because it was a
narrow-based security index for more than 45 business days over three
consecutive calendar months shall not be a narrow-based security index
for the following three calendar months.
(ii) Solely with respect to a security-based swap that is traded on
a national securities exchange or security-based swap execution
facility, an index that becomes a security index that is not a narrow-
based security index under paragraph (yyy)(3) of this section solely
because it was not a narrow-based security index for more than 45
business days over three consecutive calendar months shall be a narrow-
based security index for the following three calendar months.
(zzz) Meaning of ``issuers of securities in a narrow-based security
index'' as used in the definition of ``security-based swap'' as applied
to index credit default swaps.
(1) Notwithstanding paragraph (yyy)(1) of this section, and solely
for purposes of determining whether a credit default swap is a
security-based swap under the definition of ``security-based swap'' in
section 3(a)(68)(A)(ii)(III) of the Securities Exchange Act of 1934 (15
U.S.C. 78c(a)(68)(A)(ii)(III), as incorporated in section 1a(42) of the
Commodity Exchange Act, the term issuers of securities in a narrow-
based security index means issuers of securities included in an index
(including an index referencing loan borrowers or loans of such
borrowers) in which:
(i)(A) There are nine or fewer non-affiliated issuers of securities
that are reference entities included in the index, provided that an
issuer of securities shall not be deemed a reference entity included in
the index for purposes of this section unless:
(1) A credit event with respect to such reference entity would
result in a payment by the credit protection seller to the credit
protection buyer under the credit default swap based on the related
notional amount allocated to such reference entity; or
(2) The fact of such credit event or the calculation in accordance
with paragraph (zzz)(1)(i)(A)(1) of this section of the amount owed
with respect to such credit event is taken into account in determining
whether to make any future payments under the credit default swap with
respect to any future credit events;
(B) The effective notional amount allocated to any reference entity
included in the index comprises more than 30 percent of the index's
weighting;
(C) The effective notional amount allocated to any five non-
affiliated reference entities included in the index comprises more than
60 percent of the index's weighting; or
(D) Except as provided in paragraph (zzz)(2) of this section, for
each reference entity included in the index, none of the criteria in
paragraphs (zzz)(1)(i)(D)(1) through (8) of this section is satisfied:
(1) The reference entity included in the index is required to file
reports pursuant to section 13 or section 15(d) of the Securities
Exchange Act of 1934 (15 U.S.C. 78m or 78o(d));
(2) The reference entity included in the index is eligible to rely
on the exemption provided in rule 12g3-2(b) under the Securities
Exchange Act of 1934 (17 CFR 240.12g3-2(b));
(3) The reference entity included in the index has a worldwide
market value of its outstanding common equity held by non-affiliates of
$700 million or more;
(4) The reference entity included in the index (other than a
reference entity included in the index that is an issuing entity of an
asset-backed security as defined in section 3(a)(77) of the Securities
Exchange Act of 1934 (15 U.S.C. 78c(a)(77)) has outstanding notes,
bonds, debentures, loans, or evidences of indebtedness (other than
revolving credit facilities) having a total remaining principal amount
of at least $1 billion;
(5) The reference entity included in the index is the issuer of an
exempted security as defined in section 3(a)(12) of the Securities
Exchange Act of 1934 (15 U.S.C. 78c(a)(12)) (other than any municipal
security as defined in section
[[Page 48352]]
3(a)(29) of the Securities Exchange Act of 1934 (15 U.S.C.
78c(a)(29)));
(6) The reference entity included in the index is a government of a
foreign country or a political subdivision of a foreign country;
(7) If the reference entity included in the index is an issuing
entity of an asset-backed security as defined in section 3(a)(77) of
the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(77)), such asset-
backed security was issued in a transaction registered under the
Securities Act of 1933 (15 U.S.C. 77a et seq.) and has publicly
available distribution reports; and
(8) For a credit default swap entered into solely between eligible
contract participants as defined in section 1a(18) of the Commodity
Exchange Act:
(i) The reference entity included in the index (other than a
reference entity included in the index that is an issuing entity of an
asset-backed security as defined in section 3(a)(77) of the Securities
Exchange Act of 1934 (15 U.S.C. 78c(a)(77))) makes available to the
public or otherwise makes available to such eligible contract
participant information about the reference entity included in the
index pursuant to rule 144A(d)(4) under the Securities Act of 1933 (17
CFR 230.144A(d)(4));
(ii) Financial information about the reference entity included in
the index (other than a reference entity included in the index that is
an issuing entity of an asset-backed security as defined in section
3(a)(77) of the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(77)))
is otherwise publicly available; or
(iii) In the case of a reference entity included in the index that
is an issuing entity of an asset-backed security as defined in section
3(a)(77) of the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(77)),
information of the type and level included in publicly available
distribution reports for similar asset-backed securities is publicly
available about both the reference entity included in the index and
such asset-backed security; and
(ii)(A) The index is not composed solely of reference entities that
are issuers of exempted securities as defined in section 3(a)(12) of
the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(12)), as in
effect on the date of enactment of the Futures Trading Act of 1982
(other than any municipal security as defined in section 3(a)(29) of
the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(29))), as in
effect on the date of enactment of the Futures Trading Act of 1982; and
(B) Without taking into account any portion of the index composed
of reference entities that are issuers of exempted securities as
defined in section 3(a)(12) of the Securities Exchange Act of 1934 (15
U.S.C. 78c(a)(12)), as in effect on the date of enactment of the
Futures Trading Act of 1982 (other than any municipal security as
defined in section 3(a)(29) of the Securities Exchange Act of 1934 (15
U.S.C. 78c(a)(29))), the remaining portion of the index would be within
the term ``issuer of securities in a narrow-based security index''
under paragraph (zzz)(1)(i) of this section.
(2) Paragraph (zzz)(1)(i)(D) of this section will not apply with
respect to a reference entity included in the index if:
(i) The effective notional amounts allocated to such reference
entity comprise less than five percent of the index's weighting; and
(ii) The effective notional amounts allocated to reference entities
included in the index that satisfy paragraph (zzz)(1)(i)(D) of this
section comprise at least 80 percent of the index's weighting.
(3) For purposes of this paragraph (zzz):
(i) A reference entity included in the index is affiliated with
another reference entity included in the index (for purposes of
paragraph (zzz)(3)(iv) of this section) or another entity (for purposes
of paragraph (zzz)(3)(v) of this section) if it controls, is controlled
by, or is under common control with, that other reference entity
included in the index or other entity, as applicable; provided that
each reference entity included in the index that is an issuing entity
of an asset-backed security as defined in section 3(a)(77) of the
Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(77)) will not be
considered affiliated with any other reference entity included in the
index or any other entity that is an issuing entity of an asset-backed
security.
(ii) Control for purposes of this section means ownership of more
than 50 percent of the equity of a reference entity included in the
index (for purposes of paragraph (zzz)(3)(iv) of this section) or
another entity (for purposes of paragraph (zzz)(3)(v) of this section),
or the ability to direct the voting of more than 50 percent of the
voting equity of a reference entity included in the index (for purposes
of paragraph (zzz)(3)(iv) of this section) or another entity (for
purposes of paragraph (zzz)(3)(v) of this section).
(iii) In identifying a reference entity included in the index for
purposes of this section, the term reference entity includes:
(A) An issuer of securities;
(B) An issuer of securities that is an issuing entity of an asset-
backed security as defined in section 3(a)(77) of the Securities
Exchange Act of 1934 (15 U.S.C. 78c(a)(77)); and
(C) An issuer of securities that is a borrower with respect to any
loan identified in an index of borrowers or loans.
(iv) For purposes of calculating the thresholds in paragraphs
(zzz)(1)(i)(A) through (1)(i)(C) of this section, the term reference
entity included in the index includes a single reference entity
included in the index or a group of affiliated reference entities
included in the index as determined in accordance with paragraph
(zzz)(3)(i) of this section (with each reference entity included in the
index that is an issuing entity of an asset-backed security as defined
in section 3(a)(77) of the Act (15 U.S.C. 78c(a)(77)) being considered
a separate reference entity included in the index).
(v) For purposes of determining whether one of the criterion in
either paragraphs (zzz)(1)(i)(D)(1) through (zzz)(1)(i)(D)(4) of this
section or paragraphs (zzz)(1)(iv)(D)(8)(i) and (a)(1)(iv)(D)(8)(ii) of
this section is met, the term reference entity included in the index
includes a single reference entity included in the index or a group of
affiliated entities as determined in accordance with paragraph
(zzz)(3)(i) of this section (with each issuing entity of an asset-
backed security as defined in section 3(a)(77) of the Act (15 U.S.C.
78c(a)(77)) being considered a separate entity).
(aaaa) Meaning of ``narrow-based security index'' as used in the
definition of ``security-based swap'' as applied to index credit
default swaps.
(1) Notwithstanding paragraph (yyy)(1) of this section, and solely
for purposes of determining whether a credit default swap is a
security-based swap under the definition of ``security-based swap'' in
section 3(a)(68)(A)(ii)(I) of the Securities Exchange Act of 1934 (15
U.S.C. 78c(a)(68)(A)(ii)(I), as incorporated in section 1a(42) of the
Commodity Exchange Act, the term narrow-based security index means an
index in which:
(i)(A) The index is composed of nine or fewer securities or
securities that are issued by nine or fewer non-affiliated issuers,
provided that a security shall not be deemed a component of the index
for purposes of this section unless:
(1) A credit event with respect to the issuer of such security or a
credit event with respect to such security would result in a payment by
the credit protection seller to the credit protection buyer under the
credit default swap
[[Page 48353]]
based on the related notional amount allocated to such security; or
(2) The fact of such credit event or the calculation in accordance
with paragraph (aaaa)(1)(i)(A)(1) of this section of the amount owed
with respect to such credit event is taken into account in determining
whether to make any future payments under the credit default swap with
respect to any future credit events;
(B) The effective notional amount allocated to the securities of
any issuer included in the index comprises more than 30 percent of the
index's weighting;
(C) The effective notional amount allocated to the securities of
any five non-affiliated issuers included in the index comprises more
than 60 percent of the index's weighting; or
(D) Except as provided in paragraph (aaaa)(2) of this section, for
each security included in the index, none of the criteria in paragraphs
(aaaa)(1)(i)(D)(1) through (8) is satisfied:
(1) The issuer of the security included in the index is required to
file reports pursuant to section 13 or section 15(d) of the Securities
Exchange Act of 1934 (15 U.S.C. 78m or 78o(d));
(2) The issuer of the security included in the index is eligible to
rely on the exemption provided in rule 12g3-2(b) under the Securities
Exchange Act of 1934 (17 CFR 240.12g3-2(b));
(3) The issuer of the security included in the index has a
worldwide market value of its outstanding common equity held by non-
affiliates of $700 million or more;
(4) The issuer of the security included in the index (other than an
issuer of the security that is an issuing entity of an asset-backed
security as defined in section 3(a)(77) of the Securities Exchange Act
of 1934 (15 U.S.C. 78c(a)(77))) has outstanding notes, bonds,
debentures, loans or evidences of indebtedness (other than revolving
credit facilities) having a total remaining principal amount of at
least $1 billion;
(5) The security included in the index is an exempted security as
defined in section 3(a)(12) of the Securities Exchange Act of 1934 (15
U.S.C. 78c(a)(12)) (other than any municipal security as defined in
section 3(a)(29) of the Securities Exchange Act of 1934 (15 U.S.C.
78c(a)(29)));
(6) The issuer of the security included in the index is a
government of a foreign country or a political subdivision of a foreign
country;
(7) If the security included in the index is an asset-backed
security as defined in section 3(a)(77) of the Securities Exchange Act
of 1934 (15 U.S.C. 78c(a)(77)), the security was issued in a
transaction registered under the Securities Act of 1933 (15 U.S.C. 77a
et seq.) and has publicly available distribution reports; and
(8) For a credit default swap entered into solely between eligible
contract participants as defined in section 1a(18) of the Commodity
Exchange Act:
(i) The issuer of the security included in the index (other than an
issuer of the security that is an issuing entity of an asset-backed
security as defined in section 3(a)(77) of the Securities Exchange Act
of 1934 (15 U.S.C. 78c(a)(77))) makes available to the public or
otherwise makes available to such eligible contract participant
information about such issuer pursuant to rule 144A(d)(4) of the
Securities Act of 1933 (17 CFR 230.144A(d)(4));
(ii) Financial information about the issuer of the security
included in the index (other than an issuer of the security that is an
issuing entity of an asset-backed security as defined in section
3(a)(77) of the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(77)))
is otherwise publicly available; or
(iii) In the case of an asset-backed security as defined in section
3(a)(77) of the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(77)),
information of the type and level included in public distribution
reports for similar asset-backed securities is publicly available about
both the issuing entity and such asset-backed security; and
(ii)(A) The index is not composed solely of exempted securities as
defined in section 3(a)(12) of the Securities Exchange Act of 1934 (15
U.S.C. 78c(a)(12)), as in effect on the date of enactment of the
Futures Trading Act of 1982 (other than any municipal security as
defined in section 3(a)(29) of the Securities Exchange Act of 1934 (15
U.S.C. 78c(a)(29))), as in effect on the date of enactment of the
Futures Trading Act of 1982; and
(B) Without taking into account any portion of the index composed
of exempted securities as defined in section 3(a)(12) of the Securities
Exchange Act of 1934 (15 U.S.C. 78c(a)(12)), as in effect on the date
of enactment of the Futures Trading Act of 1982 (other than any
municipal security as defined in section 3(a)(29) of the Securities
Exchange Act of 1934 (15 U.S.C. 78c(a)(29))), the remaining portion of
the index would be within the term ``narrow-based security index''
under paragraph (aaaa)(1)(i) of this section.
(2) Paragraph (aaaa)(1)(i)(D) of this section will not apply with
respect to securities of an issuer included in the index if:
(i) The effective notional amounts allocated to all securities of
such issuer included in the index comprise less than five percent of
the index's weighting; and
(ii) The securities that satisfy paragraph (aaaa)(1)(i)(D) of this
section comprise at least 80 percent of the index's weighting.
(3) For purposes of this paragraph (aaaa):
(i) An issuer of securities included in the index is affiliated
with another issuer of securities included in the index (for purposes
of paragraph (aaaa)(3)(iv) of this section) or another entity (for
purposes of paragraph (aaaa)(3)(v) of this section) if it controls, is
controlled by, or is under common control with, that other issuer or
other entity, as applicable; provided that each issuer of securities
included in the index that is an issuing entity of an asset-backed
security as defined in section 3(a)(77) of the Securities Exchange Act
of 1934 (15 U.S.C. 78c(a)(77)) will not be considered affiliated with
any other issuer of securities included in the index or any other
entity that is an issuing entity of an asset-backed security.
(ii) Control for purposes of this section means ownership of more
than 50 percent of the equity of an issuer of securities included in
the index (for purposes of paragraph (aaaa)(3)(iv) of this section) or
another entity (for purposes of paragraph (aaaa)(3)(v) of this
section), or the ability to direct the voting of more than 50 percent
of the voting equity an issuer of securities included in the index (for
purposes of paragraph (aaaa)(3)(iv) of this section) or another entity
(for purposes of paragraph (aaaa)(3)(v) of this section).
(iii) In identifying an issuer of securities included in the index
for purposes of this section, the term issuer includes:
(A) An issuer of securities; and
(B) An issuer of securities that is an issuing entity of an asset-
backed security as defined in section 3(a)(77) of the Securities
Exchange Act of 1934 (15 U.S.C. 78c(a)(77)).
(iv) For purposes of calculating the thresholds in paragraphs
(zzz)(1)(i)(A) through (1)(i)(C) of this section, the term issuer of
the security included in the index includes a single issuer of
securities included in the index or a group of affiliated issuers of
securities included in the index as determined in accordance with
paragraph (aaaa)(3)(i) of this section (with each issuer of securities
included in the index that is an issuing entity of an asset-backed
security as defined in section 3(a)(77) of the Securities Exchange Act
of 1934 (15
[[Page 48354]]
U.S.C. 78c(a)(77)) being considered a separate issuer of securities
included in the index).
(v) For purposes of determining whether one of the criterion in
either paragraphs (aaaa)(1)(i)(D)(1) through (aaaa)(1)(i)(D)(4) of this
section or paragraphs (aaaa)(1)(iv)(D)(8)(i) and
(aaaa)(1)(iv)(D)(8)(ii) of this section is met, the term issuer of the
security included in the index includes a single issuer of securities
included in the index or a group of affiliated entities as determined
in accordance with paragraph (aaaa)(3)(i) of this section (with each
issuing entity of an asset-backed security as defined in section
3(a)(77) of the Act (15 U.S.C. 78c(a)(77)) being considered a separate
entity).
(bbbb) Futures contracts on certain foreign sovereign debt. The
term security-based swap as used in section 3(a)(68) of the Securities
Exchange Act of 1934 (15 U.S.C. 78c(a)(68)), as incorporated in section
1a(42) of the Commodity Exchange Act, does not include an agreement,
contract, or transaction that is based on or references a qualifying
foreign futures contract (as defined in rule 3a12-8 under the
Securities Exchange Act of 1934 (17 CFR 240.3a12-8)) on the debt
securities of any one or more of the foreign governments enumerated in
rule 3a12-8 under the Securities Exchange Act of 1934 (17 CFR 240.3a12-
8), provided that such agreement, contract, or transaction satisfies
the following conditions:
(1) The futures contract that the agreement, contract, or
transaction references or upon which the agreement, contract, or
transaction is based is a qualifying foreign futures contract that
satisfies the conditions of rule 3a12-8 under the Securities Exchange
Act of 1934 (17 CFR 240.3a12-8) applicable to qualifying foreign
futures contracts;
(2) The agreement, contract, or transaction is traded on or through
a board of trade (as defined in the Commodity Exchange Act);
(3) The debt securities upon which the qualifying foreign futures
contract is based or referenced and any security used to determine the
cash settlement amount pursuant to paragraph (bbbb)(4) of this section
were not registered under the Securities Act of 1933 (15 U.S.C. 77 et
seq.) or the subject of any American depositary receipt registered
under the Securities Act of 1933;
(4) The agreement, contract, or transaction may only be cash
settled; and
(5) The agreement, contract or transaction is not entered into by
the issuer of the debt securities upon which the qualifying foreign
futures contract is based or referenced (including any security used to
determine the cash payment due on settlement of such agreement,
contract or transaction), an affiliate (as defined in the Securities
Act of 1933 (15 U.S.C. 77 et seq.) and the rules and regulations
thereunder) of the issuer, or an underwriter of such issuer's debt
securities.
0
3. Add Sec. Sec. 1.6 through 1.9 to read as follows:
Sec.
1.6 Anti-evasion.
1.7 Books and records requirements for security-based swap
agreements.
1.8 Requests for interpretation of swaps, security-based swaps, and
mixed swaps.
1.9 Regulation of mixed swaps.
* * * * *
Sec. 1.6 Anti-evasion.
(a) It shall be unlawful to conduct activities outside the United
States, including entering into agreements, contracts, and transactions
and structuring entities, to willfully evade or attempt to evade any
provision of the Commodity Exchange Act as enacted by Subtitle A of the
Wall Street Transparency and Accountability Act of 2010 or the rules,
regulations, and orders of the Commission promulgated thereunder
(Subtitle A).
(b) The form, label, and written documentation of an agreement,
contract, or transaction, or an entity, shall not be dispositive in
determining whether the agreement, contract, or transaction, or entity,
has been entered into or structured to willfully evade as provided in
paragraph (a) of this section.
(c) An activity conducted outside the United States to evade as
provided in paragraph (a) of this section shall be subject to the
provisions of Subtitle A.
(d) Notwithstanding the foregoing, no agreement, contract, or
transaction structured as a security (including a security-based swap)
under the securities laws (as defined in section 3(a)(47) of the
Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(47))) shall be deemed
a swap pursuant to this section.
Sec. 1.7 Books and records requirements for security-based swap
agreements.
(a) A person registered as a swap data repository under section 21
of the Commodity Exchange Act and the rules and regulations thereunder:
(1) Shall not be required to keep and maintain additional books and
records regarding security-based swap agreements other than the books
and records regarding swaps required to be kept and maintained pursuant
to section 21 of the Commodity Exchange Act and the rules and
regulations thereunder; and
(2) Shall not be required to collect and maintain additional data
regarding security-based swap agreements other than the data regarding
swaps required to be collected and maintained by such persons pursuant
to section 21 of the Commodity Exchange Act and the rules and
regulations thereunder.
(b) A person shall not be required to keep and maintain additional
books and records, including daily trading records, regarding security-
based swap agreements other than the books and records regarding swaps
required to be kept and maintained by such persons pursuant to section
4s of the Commodity Exchange Act and the rules and regulations
thereunder if such person is registered as:
(1) A swap dealer under section 4s(a)(1) of the Commodity Exchange
Act and the rules and regulations thereunder;
(2) A major swap participant under section 4s(a)(2) of the
Commodity Exchange Act and the rules and regulations thereunder;
(3) A security-based swap dealer under section 15F(a)(1) of the
Securities Exchange Act of 1934 (15 U.S.C. 78o-10(a)(1)) and the rules
and regulations thereunder; or
(4) a major security-based swap participant under section 15F(a)(2)
of the Securities Exchange Act of 1934 (15 U.S.C. 78o-10(a)(2)) and the
rules and regulations thereunder.
(c) The term security-based swap agreement has the meaning set
forth in section 1a(47)(A)(v) of the Commodity Exchange Act.
Sec. 1.8 Requests for interpretation of swaps, security-based swaps,
and mixed swaps.
(a) In general. Any person may submit a request to the Commission
and the Securities and Exchange Commission to provide a joint
interpretation of whether a particular agreement, contract, or
transaction (or class thereof) is:
(1) A swap, as that term is defined in section 1a(47) of the
Commodity Exchange Act and the rules and regulations promulgated
thereunder;
(2) A security-based swap, as that term is defined in section
1a(42) of the Commodity Exchange Act and the rules and regulations
promulgated thereunder; or
(3) A mixed swap, as that term is defined in section 1a(47)(D) of
the Commodity Exchange Act and the rules and regulations promulgated
thereunder.
(b) Request process. In making a request pursuant to paragraph (a)
of this section, the requesting person must
[[Page 48355]]
provide the Commission and the Securities and Exchange Commission with
the following:
(1) All material information regarding the terms of the agreement,
contract, or transaction (or class thereof);
(2) A statement of the economic characteristics and purpose of the
agreement, contract, or transaction (or class thereof);
(3) The requesting person's determination as to whether the
agreement, contract, or transaction (or class thereof) should be
characterized as a swap, a security-based swap, or both, (i.e., a mixed
swap), including the basis for such determination; and
(4) Such other information as may be requested by the Commission or
the Securities and Exchange Commission.
(c) Request withdrawal. A person may withdraw a request made
pursuant to paragraph (a) of this section at any time prior to the
issuance of a joint interpretation or joint proposed rule by the
Commission and the Securities and Exchange Commission in response to
the request; provided, however, that notwithstanding such withdrawal,
the Commission and the Securities and Exchange Commission may provide a
joint interpretation of whether the agreement, contract, or transaction
(or class thereof) is a swap, a security-based swap, or both (i.e., a
mixed swap).
(d) Request by the Commission or the Securities and Exchange
Commission. In the absence of a request for a joint interpretation
under paragraph (a) of this section:
(1) If the Commission or the Securities and Exchange Commission
receives a proposal to list, trade, or clear an agreement, contract, or
transaction (or class thereof) that raises questions as to the
appropriate characterization of such agreement, contract, or
transaction (or class thereof) as a swap, a security-based swap, or
both (i.e., a mixed swap), the Commission or the Securities and
Exchange Commission, as applicable, promptly shall notify the other of
the agreement, contract, or transaction (or class thereof); and
(2) The Commission or the Securities and Exchange Commission, or
their Chairmen jointly, may submit a request for a joint interpretation
as described in paragraph (a) of this section; such submission shall be
made pursuant to paragraph (b) of this section, and may be withdrawn
pursuant to paragraph (c) of this section.
(e) Timeframe for joint interpretation. (1) If the Commission and
the Securities and Exchange Commission determine to issue a joint
interpretation as described in paragraph (a) of this section, such
joint interpretation shall be issued within 120 days after receipt of a
complete submission requesting a joint interpretation under paragraph
(a) or (d) of this section.
(2) The Commission and the Securities and Exchange Commission shall
consult with the Board of Governors of the Federal Reserve System prior
to issuing any joint interpretation as described in paragraph (a) of
this section.
(3) If the Commission and the Securities and Exchange Commission
seek public comment with respect to a joint interpretation regarding an
agreement, contract, or transaction (or class thereof), the 120-day
period described in paragraph (e)(1) of this section shall be stayed
during the pendency of the comment period, but shall recommence with
the business day after the public comment period ends.
(4) Nothing in this section shall require the Commission and the
Securities and Exchange Commission to issue any joint interpretation.
(5) If the Commission and the Securities and Exchange Commission do
not issue a joint interpretation within the time period described in
paragraph (e)(1) or (e)(3) of this section, each of the Commission and
the Securities and Exchange Commission shall publicly provide the
reasons for not issuing such a joint interpretation within the
applicable timeframes.
(f) Joint proposed rule. (1) Rather than issue a joint
interpretation pursuant to paragraph (a) of this section, the
Commission and the Securities and Exchange Commission may issue a joint
proposed rule, in consultation with the Board of Governors of the
Federal Reserve System, to further define one or more of the terms
swap, security-based swap, or mixed swap.
(2) A joint proposed rule described in paragraph (f)(1) of this
section shall be issued within the timeframe for issuing a joint
interpretation set forth in paragraph (e) of this section.
Sec. 1.9 Regulation of mixed swaps.
(a) In general. The term mixed swap has the meaning set forth in
section 1a(47)(D) of the Commodity Exchange Act.
(b) Regulation of bilateral uncleared mixed swaps entered into by
dually-registered dealers or major participants. A mixed swap that is
neither executed on nor subject to the rules of a designated contract
market, national securities exchange, swap execution facility,
security-based swap execution facility, or foreign board of trade; that
will not be submitted to a derivatives clearing organization or
registered or exempt clearing agency to be cleared; and where at least
one party is registered with the Commission as a swap dealer or major
swap participant and also with the Securities and Exchange Commission
as a security-based swap dealer or major security-based swap
participant, shall be subject to:
(1) The following provisions of the Commodity Exchange Act, and the
rules and regulations promulgated thereunder:
(i) Examinations and information sharing: sections 4s(f) and 8 of
the Commodity Exchange Act;
(ii) Enforcement: sections 2(a)(1)(B), 4(b), 4b, 4c, 4s(h)(1)(A),
4s(h)(4)(A), 6(c), 6(d), 6c, 6d, 9, 13(a), 13(b), and 23 of the
Commodity Exchange Act;
(iii) Reporting to a swap data repository: section 4r of the
Commodity Exchange Act;
(iv) Real-time reporting: section 2(a)(13) of the Commodity
Exchange Act;
(v) Capital: section 4s(e) of the Commodity Exchange Act; and
(vi) Position Limits: section 4a of the Commodity Exchange Act; and
(2) The provisions of the Federal securities laws, as defined in
section 3(a)(47) of the Securities Exchange Act of 1934 (15 U.S.C.
78c(a)(47)), and the rules and regulations promulgated thereunder.
(c) Process for determining regulatory treatment for other mixed
swaps--(1) In general. Any person who desires or intends to list,
trade, or clear a mixed swap (or class thereof) that is not subject to
paragraph (b) of this section may request the Commission and the
Securities and Exchange Commission to issue a joint order permitting
the requesting person (and any other person or persons that
subsequently lists, trades, or clears that mixed swap) to comply, as to
parallel provisions only, with specified parallel provisions of either
the Commodity Exchange Act or the Securities Exchange Act of 1934 (15
U.S.C. 78a et seq.), and the rules and regulations thereunder
(collectively, specified parallel provisions), instead of being
required to comply with parallel provisions of both the Commodity
Exchange Act and the Securities Exchange Act of 1934. For purposes of
this paragraph (c), parallel provisions means comparable provisions of
the Commodity Exchange Act and the Securities Exchange Act of 1934 that
were added or amended by the Wall Street Transparency and
Accountability Act of 2010 with respect to swaps and security-based
swaps, and the rules and regulations thereunder.
(2) Request Process. A person submitting a request pursuant to
[[Page 48356]]
paragraph (c)(1) of this section must provide the Commission and the
Securities and Exchange Commission with the following:
(i) All material information regarding the terms of the specified,
or specified class of, mixed swap;
(ii) The economic characteristics and purpose of the specified, or
specified class of, mixed swap;
(iii) The specified parallel provisions, and the reasons the person
believes such specified parallel provisions would be appropriate for
the mixed swap (or class thereof); and
(iv) An analysis of:
(A) The nature and purposes of the parallel provisions that are the
subject of the request;
(B) The comparability of such parallel provisions;
(C) The extent of any conflicts or differences between such
parallel provisions; and
(D) Such other information as may be requested by the Commission or
the Securities and Exchange Commission.
(3) Request withdrawal. A person may withdraw a request made
pursuant to paragraph (c)(1) of this section at any time prior to the
issuance of a joint order under paragraph (c)(4) of this section by the
Commission and the Securities and Exchange Commission in response to
the request.
(4) Issuance of orders. In response to a request under paragraph
(c)(1) of this section, the Commission and the Securities and Exchange
Commission, as necessary to carry out the purposes of the Wall Street
Transparency and Accountability Act of 2010, may issue a joint order,
after notice and opportunity for comment, permitting the requesting
person (and any other person or persons that subsequently lists,
trades, or clears that mixed swap) to comply, as to parallel provisions
only, with the specified parallel provisions (or another subset of the
parallel provisions that are the subject of the request, as the
Commissions determine is appropriate), instead of being required to
comply with parallel provisions of both the Commodity Exchange Act and
the Securities Exchange Act of 1934. In determining the contents of
such joint order, the Commission and the Securities and Exchange
Commission may consider, among other things:
(i) The nature and purposes of the parallel provisions that are the
subject of the request;
(ii) The comparability of such parallel provisions; and
(iii) The extent of any conflicts or differences between such
parallel provisions.
(5) Timeframe. (i) If the Commission and the Securities and
Exchange Commission determine to issue a joint order as described in
paragraph (c)(4) of this section, such joint order shall be issued
within 120 days after receipt of a complete request for a joint order
under paragraph (c)(1) of this section, which time period shall be
stayed during the pendency of the public comment period provided for in
paragraph (c)(4) of this section and shall recommence with the business
day after the public comment period ends.
(ii) Nothing in this section shall require the Commission and the
Securities and Exchange Commission to issue any joint order.
(iii) If the Commission and the Securities and Exchange Commission
do not issue a joint order within the time period described in
paragraph (c)(5)(i) of this section, each of the Commission and the
Securities and Exchange Commission shall publicly provide the reasons
for not issuing such a joint order within that timeframe.
Securities and Exchange Commission
Pursuant to the Securities Act, 15 U.S.C. 77a et seq., and
particularly, sections 19 and 28 thereof, and the Exchange Act, 15
U.S.C. 78a et seq., and particularly, sections 3 and 23 thereof, and
sections 712(a)(8), 712(d), 721(a), 761(a) of the Dodd-Frank Act, the
SEC is adopting rule 194 under the Securities Act and rules 3a68-1a
through 3a68-5 and 3a69-1 through 3a69-3 under the Exchange Act.
Text of Final Rules
For the reasons stated in the preamble, the SEC is amending Title
17, Chapter II of the Code of the Federal Regulations as follows:
PART 230--GENERAL RULES AND REGULATIONS, SECURITIES ACT OF 1933
0
1. The authority citation for Part 230 continues to read, in part, as
follows:
Authority: 15 U.S.C. 77b, 77b note, 77c, 77d, 77f, 77g, 77h,
77j, 77r, 77s, 77z-3, 77sss, 78c, 78d, 78j, 78l, 78m, 78n, 78o, 78o-
7 note, 78t, 78w, 78ll(d), 78mm, 80a-8, 80a-24, 80a-28, 80a-29, 80a-
30, 80a-37, and Pub. L. 111-203, Sec. 712, 124 Stat. 1376 (2010)
unless otherwise noted.
* * * * *
0
2. Section 230.194 is added to read as follows:
Sec. 230.194 Definitions of the terms ``swap'' and ``security-based
swap'' as used in the Act.
(a) The term swap as used in section 2(a)(17) of the Act (15 U.S.C.
77b(a)(17)) has the same meaning as provided in section 3(a)(69) of the
Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(69)) and 17 CFR
240.3a69-1 through 240.3a69-3.
(b) The term security-based swap as used in section 2(a)(17) of the
Act (15 U.S.C. 77b(a)(17)) has the same meaning as provided in section
3(a)(68) of the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(68))
and 17 CFR 240.3a68-1a through 240.3a68-5.
PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF
1934
0
3. The general authority citation for Part 240 is revised to read as
follows:
Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77z-3,
77eee, 77ggg, 77nnn, 77jjj, 77kkk, 77sss, 77ttt, 78c, 78d, 78e, 78f,
78g, 78i, 78j, 78j-1, 78k, 78k-1, 78l, 78m, 78n, 78n-1, 78o, 78o-4,
78o-8, 78p, 78q, 78s, 78u-5, 78w, 78x, 78dd(b), 78dd(c), 78ll, 78mm,
80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4, 80b-11, 7201 et seq.,
and 8302; 18 U.S.C. 1350; 12 U.S.C. 5221(e)(3), and Pub. L. 111-203,
Sec. 712, 124 Stat. 1376 (2010), unless otherwise noted.
* * * * *
0
4. Add an undesignated center heading and Sec. Sec. 240.3a68-1a
through 240.3a68-5 and Sec. Sec. 240.3a69-1 through 240.3a69-3 to read
as follows:
Further Definition of Swap, Security-Based Swap, and Security-Based
Swap Agreement; Mixed Swaps; Security-Based Swap Agreement
Recordkeeping
240.3a68-1a Meaning of ``issuers of securities in a narrow-based
security index'' as used in section 3(a)(68)(A)(ii)(III) of the Act.
240.3a68-1b Meaning of ``narrow-based security index'' as used in
section 3(a)(68)(A)(ii)(I) of the Act.
240.3a68-2 Requests for interpretation of swaps, security-based
swaps, and mixed swaps.
240.3a68-3 Meaning of ``narrow-based security index'' as used in the
definition of ``security-based swap.''
240.3a68-4 Regulation of mixed swaps.
240.3a68-5 Regulation of certain futures contracts on foreign
sovereign debt.
240.3a69-1 Safe Harbor Definition of ``security-based swap'' and
``swap'' as used in sections 3(a)(68) and 3(a)(69) of the Act--
insurance.
240.3a69-2 Definition of ``swap'' as used in section 3(a)(69) of the
Act--additional products.
240.3a69-3 Books and records requirements for security-based swap
agreements.
* * * * *
Sec. 240.3a68-1a Meaning of ``issuers of securities in a narrow-based
security index'' as used in section 3(a)(68)(A)(ii)(III) of the Act.
(a) Notwithstanding Sec. 240.3a68-3(a), and solely for purposes of
determining
[[Page 48357]]
whether a credit default swap is a security-based swap under section
3(a)(68)(A)(ii)(III) of the Act (15 U.S.C. 78c(a)(68)(A)(ii)(III)), the
term issuers of securities in a narrow-based security index as used in
section 3(a)(68)(A)(ii)(III) of the Act means issuers of securities
included in an index (including an index referencing loan borrowers or
loans of such borrowers) in which:
(1)(i) There are nine or fewer non-affiliated issuers of securities
that are reference entities included in the index, provided that an
issuer of securities shall not be deemed a reference entity included in
the index for purposes of this section unless:
(A) A credit event with respect to such reference entity would
result in a payment by the credit protection seller to the credit
protection buyer under the credit default swap based on the related
notional amount allocated to such reference entity; or
(B) The fact of such credit event or the calculation in accordance
with paragraph (a)(1)(i)(A) of this section of the amount owed with
respect to such credit event is taken into account in determining
whether to make any future payments under the credit default swap with
respect to any future credit events;
(ii) The effective notional amount allocated to any reference
entity included in the index comprises more than 30 percent of the
index's weighting;
(iii) The effective notional amount allocated to any five non-
affiliated reference entities included in the index comprises more than
60 percent of the index's weighting; or
(iv) Except as provided in paragraph (b) of this section, for each
reference entity included in the index, none of the criteria in
paragraphs (a)(1)(iv)(A) through (a)(1)(iv)(H) of this section is
satisfied:
(A) The reference entity included in the index is required to file
reports pursuant to section 13 or section 15(d) of the Act (15 U.S.C.
78m or 78o(d));
(B) The reference entity included in the index is eligible to rely
on the exemption provided in Sec. 240.12g3-2(b);
(C) The reference entity included in the index has a worldwide
market value of its outstanding common equity held by non-affiliates of
$700 million or more;
(D) The reference entity included in the index (other than a
reference entity included in the index that is an issuing entity of an
asset-backed security as defined in section 3(a)(77) of the Act (15
U.S.C. 78c(a)(77))) has outstanding notes, bonds, debentures, loans, or
evidences of indebtedness (other than revolving credit facilities)
having a total remaining principal amount of at least $1 billion;
(E) The reference entity included in the index is the issuer of an
exempted security as defined in section 3(a)(12) of the Act (15 U.S.C.
78c(a)(12)) (other than any municipal security as defined in section
3(a)(29) of the Act (15 U.S.C. 78c(a)(29)));
(F) The reference entity included in the index is a government of a
foreign country or a political subdivision of a foreign country;
(G) If the reference entity included in the index is an issuing
entity of an asset-backed security as defined in section 3(a)(77) of
the Act (15 U.S.C. 78c(a)(77)), such asset-backed security was issued
in a transaction registered under the Securities Act of 1933 (15 U.S.C.
77a et seq.) and has publicly available distribution reports; and
(H) For a credit default swap entered into solely between eligible
contract participants as defined in section 3(a)(65) of the Act (15
U.S.C. 78c(a)(65)):
(1) The reference entity included in the index (other than a
reference entity included in the index that is an issuing entity of an
asset-backed security as defined in section 3(a)(77) of the Act (15
U.S.C. 78c(a)(77))) makes available to the public or otherwise makes
available to such eligible contract participant information about the
reference entity included in the index pursuant to Sec.
230.144A(d)(4)) of this chapter;
(2) Financial information about the reference entity included in
the index (other than a reference entity included in the index that is
an issuing entity of an asset-backed security as defined in section
3(a)(77) of the Act (15 U.S.C. 78c(a)(77))) is otherwise publicly
available; or
(3) In the case of a reference entity included in the index that is
an issuing entity of an asset-backed security as defined in section
3(a)(77) of the Act (15 U.S.C. 78c(a)(77)), information of the type and
level included in publicly available distribution reports for similar
asset-backed securities is publicly available about both the reference
entity included in the index and such asset-backed security; and
(2)(i) The index is not composed solely of reference entities that
are issuers of exempted securities as defined in section 3(a)(12) of
the Act (15 U.S.C. 78c(a)(12)), as in effect on the date of enactment
of the Futures Trading Act of 1982 (other than any municipal security
as defined in section 3(a)(29) of the Act (15 U.S.C. 78c(a)(29))), as
in effect on the date of enactment of the Futures Trading Act of 1982);
and
(ii) Without taking into account any portion of the index composed
of reference entities that are issuers of exempted securities as
defined in section 3(a)(12) of the Act (15 U.S.C. 78c(a)(12)), as in
effect on the date of enactment of the Futures Trading Act of 1982
(other than any municipal security as defined in section 3(a)(29) of
the Act (15 U.S.C. 78c(a)(29))), the remaining portion of the index
would be within the term ``issuer of securities in a narrow-based
security index'' under paragraph (a)(1) of this section.
(b) Paragraph (a)(1)(iv) of this section will not apply with
respect to a reference entity included in the index if:
(1) The effective notional amounts allocated to such reference
entity comprise less than five percent of the index's weighting; and
(2) The effective notional amounts allocated to reference entities
included in the index that satisfy paragraph (a)(1)(iv) of this section
comprise at least 80 percent of the index's weighting.
(c) For purposes of this section:
(1) A reference entity included in the index is affiliated with
another reference entity included in the index (for purposes of
paragraph (c)(4) of this section) or another entity (for purposes of
paragraph (c)(5) of this section) if it controls, is controlled by, or
is under common control with, that other reference entity included in
the index or other entity, as applicable; provided that each reference
entity included in the index that is an issuing entity of an asset-
backed security as defined in section 3(a)(77) of the Act (15 U.S.C.
78c(a)(77)) will not be considered affiliated with any other reference
entity included in the index or any other entity that is an issuing
entity of an asset-backed security.
(2) Control for purposes of this section means ownership of more
than 50 percent of the equity of a reference entity included in the
index (for purposes of paragraph (c)(4) of this section) or another
entity (for purposes of paragraph (c)(5) of this section), or the
ability to direct the voting of more than 50 percent of the voting
equity of a reference entity included in the index (for purposes of
paragraph (c)(4) of this section) or another entity (for purposes of
paragraph (c)(5) of this section).
(3) In identifying a reference entity included in the index for
purposes of this section, the term reference entity includes:
(i) An issuer of securities;
(ii) An issuer of securities that is an issuing entity of an asset-
backed security as defined in section 3(a)(77) of the Act (15 U.S.C.
78c(a)(77)); and
[[Page 48358]]
(iii) An issuer of securities that is a borrower with respect to
any loan identified in an index of borrowers or loans.
(4) For purposes of calculating the thresholds in paragraphs
(a)(1)(i) through (a)(1)(iii) of this section, the term reference
entity included in the index includes a single reference entity
included in the index or a group of affiliated reference entities
included in the index as determined in accordance with paragraph (c)(1)
of this section (with each reference entity included in the index that
is an issuing entity of an asset-backed security as defined in section
3(a)(77) of the Act (15 U.S.C. 78c(a)(77)) being considered a separate
reference entity included in the index).
(5) For purposes of determining whether one of the criterion in
either paragraphs (a)(1)(iv)(A) through (a)(1)(iv)(D) of this section
or paragraphs (a)(1)(iv)(H)(1) and (a)(1)(iv)(H)(2) of this section is
met, the term reference entity included in the index includes a single
reference entity included in the index or a group of affiliated
entities as determined in accordance with paragraph (c)(1) of this
section (with each issuing entity of an asset-backed security as
defined in section 3(a)(77) of the Act (15 U.S.C. 78c(a)(77)) being
considered a separate entity).
Sec. 240.3a68-1b Meaning of ``narrow-based security index'' as used
in section 3(a)(68)(A)(ii)(I) of the Act.
(a) Notwithstanding Sec. 240.3a68-3(a), and solely for purposes of
determining whether a credit default swap is a security-based swap
under section 3(a)(68)(A)(ii)(I) of the Act (15 U.S.C.
78c(a)(68)(A)(ii)(I)), the term narrow-based security index as used in
section 3(a)(68)(A)(ii)(I) of the Act means an index in which:
(1)(i) The index is composed of nine or fewer securities or
securities that are issued by nine or fewer non-affiliated issuers,
provided that a security shall not be deemed a component of the index
for purposes of this section unless:
(A) A credit event with respect to the issuer of such security or a
credit event with respect to such security would result in a payment by
the credit protection seller to the credit protection buyer under the
credit default swap based on the related notional amount allocated to
such security; or
(B) The fact of such credit event or the calculation in accordance
with paragraph (a)(1)(i)(A) of this section of the amount owed with
respect to such credit event is taken into account in determining
whether to make any future payments under the credit default swap with
respect to any future credit events;
(ii) The effective notional amount allocated to the securities of
any issuer included in the index comprises more than 30 percent of the
index's weighting;
(iii) The effective notional amount allocated to the securities of
any five non-affiliated issuers included in the index comprises more
than 60 percent of the index's weighting; or
(iv) Except as provided in paragraph (b) of this section, for each
security included in the index none of the criteria in paragraphs
(a)(1)(iv)(A) through (a)(1)(iv)(H) of this section is satisfied:
(A) The issuer of the security included in the index is required to
file reports pursuant to section 13 or section 15(d) of the Act (15
U.S.C. 78m or 78o(d));
(B) The issuer of the security included in the index is eligible to
rely on the exemption provided in Sec. 240.12g3-2(b);
(C) The issuer of the security included in the index has a
worldwide market value of its outstanding common equity held by non-
affiliates of $700 million or more;
(D) The issuer of the security included in the index (other than an
issuer of the security that is an issuing entity of an asset-backed
security as defined in section 3(a)(77) of the Act (15 U.S.C.
78c(a)(77))) has outstanding notes, bonds, debentures, loans, or
evidences of indebtedness (other than revolving credit facilities)
having a total remaining principal amount of at least $1 billion;
(E) The security included in the index is an exempted security as
defined in section 3(a)(12) of the Act (15 U.S.C. 78c(a)(12)) (other
than any municipal security as defined in section 3(a)(29) of the Act
(15 U.S.C. 78c(a)(29)));
(F) The issuer of the security included in the index is a
government of a foreign country or a political subdivision of a foreign
country;
(G) If the security included in the index is an asset-backed
security as defined in section 3(a)(77) of the Act (15 U.S.C.
78c(a)(77)), the security was issued in a transaction registered under
the Securities Act of 1933 (15 U.S.C. 77a et seq.) and has publicly
available distribution reports; and
(H) For a credit default swap entered into solely between eligible
contract participants as defined in section 3(a)(65) of the Act (15
U.S.C. 78c(a)(65)):
(1) The issuer of the security included in the index (other than an
issuer of the security that is an issuing entity of an asset-backed
security as defined in section 3(a)(77) of the Act (15 U.S.C.
78c(a)(77))) makes available to the public or otherwise makes available
to such eligible contract participant information about such issuer
pursuant to Sec. 230.144A(d)(4)) of this chapter;
(2) Financial information about the issuer of the security included
in the index (other than an issuer of the security that is an issuing
entity of an asset-backed security as defined in section 3(a)(77) of
the Act (15 U.S.C. 78c(a)(77))) is otherwise publicly available; or
(3) In the case of an asset-backed security as defined in section
3(a)(77) of the Act (15 U.S.C. 78c(a)(77)), information of the type and
level included in public distribution reports for similar asset-backed
securities is publicly available about both the issuing entity and such
asset-backed security; and
(2)(i) The index is not composed solely of exempted securities as
defined in section 3(a)(12) of the Act (15 U.S.C. 78c(a)(12)), as in
effect on the date of enactment of the Futures Trading Act of 1982
(other than any municipal security as defined in section 3(a)(29) of
the Act (15 U.S.C. 78c(a)(29))), as in effect on the date of enactment
of the Futures Trading Act of 1982); and
(ii) Without taking into account any portion of the index composed
of exempted securities as defined in section 3(a)(12) of the Act (15
U.S.C. 78c(a)(12)), as in effect on the date of enactment of the
Futures Trading Act of 1982 (other than any municipal security as
defined in section 3(a)(29) of the Act (15 U.S.C. 78c(a)(29))), the
remaining portion of the index would be within the term ``narrow-based
security index'' under paragraph (a)(1) of this section.
(b) Paragraph (a)(1)(iv) of this section will not apply with
respect to securities of an issuer included in the index if:
(1) The effective notional amounts allocated to all securities of
such issuer included in the index comprise less than five percent of
the index's weighting; and
(2) The securities that satisfy paragraph (a)(1)(iv) of this
section comprise at least 80 percent of the index's weighting.
(c) For purposes of this section:
(1) An issuer of securities included in the index is affiliated
with another issuer of securities included in the index (for purposes
of paragraph (c)(4) of this section) or another entity (for purposes of
paragraph (c)(5) of this section) if it controls, is controlled by, or
is under common control with, that other issuer or other entity, as
applicable; provided that each issuer of securities included in the
index that is an issuing entity of an asset-backed security as defined
in section 3(a)(77) of
[[Page 48359]]
the Act (15 U.S.C. 78c(a)(77)) will not be considered affiliated with
any other issuer of securities included in the index or any other
entity that is an issuing entity of an asset-backed security.
(2) Control for purposes of this section means ownership of more
than 50 percent of the equity of an issuer of securities included in
the index (for purposes of paragraph (c)(4) of this section) or another
entity (for purposes of paragraph (c)(5) of this section), or the
ability to direct the voting of more than 50 percent of the voting
equity an issuer of securities included in the index (for purposes of
paragraph (c)(4) of this section) or another entity (for purposes of
paragraph (c)(5) of this section).
(3) In identifying an issuer of securities included in the index
for purposes of this section, the term issuer includes:
(i) An issuer of securities; and
(ii) An issuer of securities that is an issuing entity of an asset-
backed security as defined in section 3(a)(77) of the Act (15 U.S.C.
78c(a)(77)).
(4) For purposes of calculating the thresholds in paragraphs
(a)(1)(i) through (a)(1)(iii) of this section, the term issuer of the
security included in the index includes a single issuer of securities
included in the index or a group of affiliated issuers of securities
included in the index as determined in accordance with paragraph (c)(1)
of this section (with each issuer of securities included in the index
that is an issuing entity of an asset-backed security as defined in
section 3(a)(77) of the Act (15 U.S.C. 78c(a)(77)) being considered a
separate issuer of securities included in the index).
(5) For purposes of determining whether one of the criterion in
either paragraphs (a)(1)(iv)(A) through (a)(1))(iv)(D) of this section
or paragraphs (a)(1)(iv)(H)(1) and (a)(1)(iv)(H)(2) of this section is
met, the term issuer of the security included in the index includes a
single issuer of securities included in the index or a group affiliated
entities as determined in accordance with paragraph (c)(1) of this
section (with each issuing entity of an asset-backed security as
defined in section 3(a)(77) of the Act (15 U.S.C. 78c(a)(77)) being
considered a separate entity).
Sec. 240.3a68-2 Requests for interpretation of swaps, security-based
swaps, and mixed swaps.
(a) In general. Any person may submit a request to the Commission
and the Commodity Futures Trading Commission to provide a joint
interpretation of whether a particular agreement, contract, or
transaction (or class thereof) is:
(1) A swap, as that term is defined in section 3(a)(69) of the Act
(15 U.S.C. 78c(a)(69)) and the rules and regulations promulgated
thereunder;
(2) A security-based swap, as that term is defined in section
3(a)(68) of the Act (15 U.S.C. 78c(a)(68)) and the rules and
regulations promulgated thereunder; or
(3) A mixed swap, as that term is defined in section 3(a)(68)(D) of
the Act and the rules and regulations promulgated thereunder.
(b) Request process. In making a request pursuant to paragraph (a)
of this section, the requesting person must provide the Commission and
the Commodity Futures Trading Commission with the following:
(1) All material information regarding the terms of the agreement,
contract, or transaction (or class thereof);
(2) A statement of the economic characteristics and purpose of the
agreement, contract, or transaction (or class thereof);
(3) The requesting person's determination as to whether the
agreement, contract, or transaction (or class thereof) should be
characterized as a swap, a security-based swap, or both (i.e., a mixed
swap), including the basis for such determination; and
(4) Such other information as may be requested by the Commission or
the Commodity Futures Trading Commission.
(c) Request withdrawal. A person may withdraw a request made
pursuant to paragraph (a) of this section at any time prior to the
issuance of a joint interpretation or joint proposed rule by the
Commission and the Commodity Futures Trading Commission in response to
the request; provided, however, that notwithstanding such withdrawal,
the Commission and the Commodity Futures Trading Commission may provide
a joint interpretation of whether the agreement, contract, or
transaction (or class thereof) is a swap, a security-based swap, or
both (i.e., a mixed swap).
(d) Request by the Commission or the Commodity Futures Trading
Commission. In the absence of a request for a joint interpretation
under paragraph (a) of this section:
(1) If the Commission or the Commodity Futures Trading Commission
receives a proposal to list, trade, or clear an agreement, contract, or
transaction (or class thereof) that raises questions as to the
appropriate characterization of such agreement, contract, or
transaction (or class thereof) as a swap, a security-based swap, or
both (i.e., a mixed swap), the Commission or the Commodity Futures
Trading Commission, as applicable, promptly shall notify the other of
the agreement, contract, or transaction (or class thereof); and
(2) The Commission or the Commodity Futures Trading Commission, or
their Chairmen jointly, may submit a request for a joint interpretation
as described in paragraph (a) of this section; such submission shall be
made pursuant to paragraph (b) of this section, and may be withdrawn
pursuant to paragraph (c) of this section.
(e) Timeframe for joint interpretation. (1) If the Commission and
the Commodity Futures Trading Commission determine to issue a joint
interpretation as described in paragraph (a) of this section, such
joint interpretation shall be issued within 120 days after receipt of a
complete submission requesting a joint interpretation under paragraph
(a) or (d) of this section.
(2) The Commission and the Commodity Futures Trading Commission
shall consult with the Board of Governors of the Federal Reserve System
prior to issuing any joint interpretation as described in paragraph (a)
of this section.
(3) If the Commission and the Commodity Futures Trading Commission
seek public comment with respect to a joint interpretation regarding an
agreement, contract, or transaction (or class thereof), the 120-day
period described in paragraph (e)(1) of this section shall be stayed
during the pendency of the comment period, but shall recommence with
the business day after the public comment period ends.
(4) Nothing in this section shall require the Commission and the
Commodity Futures Trading Commission to issue any joint interpretation.
(5) If the Commission and the Commodity Futures Trading Commission
do not issue a joint interpretation within the time period described in
paragraph (e)(1) or (e)(3) of this section, each of the Commission and
the Commodity Futures Trading Commission shall publicly provide the
reasons for not issuing such a joint interpretation within the
applicable timeframes.
(f) Joint proposed rule. (1) Rather than issue a joint
interpretation pursuant to paragraph (a) of this section, the
Commission and the Commodity Futures Trading Commission may issue a
joint proposed rule, in consultation with the Board of Governors of the
Federal Reserve System, to further
[[Page 48360]]
define one or more of the terms swap, security-based swap, or mixed
swap.
(2) A joint proposed rule described in paragraph (f)(1) of this
section shall be issued within the timeframe for issuing a joint
interpretation set forth in paragraph (e) of this section.
Sec. 240.3a68-3 Meaning of ``narrow-based security index'' as used in
the definition of ``security-based swap.''
(a) In general. Except as otherwise provided in Sec. 240.3a68-1a
and Sec. 240.3a68-1b, for purposes of section 3(a)(68) of the Act (15
U.S.C. 78c(a)(68)), the term narrow-based security index has the
meaning set forth in section 3(a)(55) of the Act (15 U.S.C.
78c(a)(55)), and the rules, regulations, and orders of the Commission
thereunder.
(b) Tolerance period for swaps traded on designated contract
markets, swap execution facilities and foreign boards of trade.
Notwithstanding paragraph (a) of this section, solely for purposes of
swaps traded on or subject to the rules of a designated contract
market, swap execution facility, or foreign board of trade pursuant to
the Commodity Exchange Act (7 U.S.C. 1 et seq.), a security index
underlying such swaps shall not be considered a narrow-based security
index if:
(1)(i) A swap on the index is traded on or subject to the rules of
a designated contract market, swap execution facility, or foreign board
of trade pursuant to the Commodity Exchange Act (7 U.S.C. 1 et seq.)
for at least 30 days as a swap on an index that was not a narrow-based
security index; or
(ii) Such index was not a narrow-based security index during every
trading day of the six full calendar months preceding a date no earlier
than 30 days prior to the commencement of trading of a swap on such
index on a market described in paragraph (b)(1)(i) of this section; and
(2) The index has been a narrow-based security index for no more
than 45 business days over three consecutive calendar months.
(c) Tolerance period for security-based swaps traded on national
securities exchanges or security-based swap execution facilities.
Notwithstanding paragraph (a) of this section, solely for purposes of
security-based swaps traded on a national securities exchange or
security-based swap execution facility, a security index underlying
such security-based swaps shall be considered a narrow-based security
index if:
(1)(i) A security-based swap on the index is traded on a national
securities exchange or security-based swap execution facility for at
least 30 days as a security-based swap on a narrow-based security
index; or
(ii) Such index was a narrow-based security index during every
trading day of the six full calendar months preceding a date no earlier
than 30 days prior to the commencement of trading of a security-based
swap on such index on a market described in paragraph (c)(1)(i) of this
section; and
(2) The index has been a security index that is not a narrow-based
security index for no more than 45 business days over three consecutive
calendar months.
(d) Grace period. (1) Solely with respect to a swap that is traded
on or subject to the rules of a designated contract market, swap
execution facility or foreign board of trade pursuant to the Commodity
Exchange Act (7 U.S.C. 1 et seq.), an index that becomes a narrow-based
security index under paragraph (b) of this section solely because it
was a narrow-based security index for more than 45 business days over
three consecutive calendar months shall not be a narrow-based security
index for the following three calendar months.
(2) Solely with respect to a security-based swap that is traded on
a national securities exchange or security-based swap execution
facility, an index that becomes a security index that is not a narrow-
based security index under paragraph (c) of this section solely because
it was not a narrow-based security index for more than 45 business days
over three consecutive calendar months shall be a narrow-based security
index for the following three calendar months.
Sec. 240.3a68-4 Regulation of mixed swaps.
(a) In general. The term mixed swap has the meaning set forth in
section 3(a)(68)(D) of the Act (15 U.S.C. 78c(a)(68)(D)).
(b) Regulation of bilateral uncleared mixed swaps entered into by
dually-registered dealers or major participants. A mixed swap:
(1) That is neither executed on nor subject to the rules of a
designated contract market, national securities exchange, swap
execution facility, security-based swap execution facility, or foreign
board of trade;
(2) That will not be submitted to a derivatives clearing
organization or registered or exempt clearing agency to be cleared; and
(3) Where at least one party is registered with the Commission as a
security-based swap dealer or major security-based swap participant and
also with the Commodity Futures Trading Commission as a swap dealer or
major swap participant, shall be subject to:
(i) The following provisions of the Commodity Exchange Act (7
U.S.C. 1 et seq.), and the rules and regulations promulgated
thereunder, set forth in the rules and regulations of the Commodity
Futures Trading Commission:
(A) Examinations and information sharing: 7 U.S.C. 6s(f) and 12;
(B) Enforcement: 7 U.S.C. 2(a)(1)(B), 6(b), 6b, 6c, 6s(h)(1)(A),
6s(h)(4)(A), 9, 13b, 13a-1, 13a-2, 13, 13c(a), 13c(b), 15 and 26;
(C) Reporting to a swap data repository: 7 U.S.C. 6r;
(D) Real-time reporting: 7 U.S.C. 2(a)(13);
(E) Capital: 7 U.S.C. 6s(e); and
(F) Position Limits: 7 U.S.C. 6a; and
(ii) The provisions of the Federal securities laws, as defined in
section 3(a)(47) of the Act (15 U.S.C. 78c(a)(47)), and the rules and
regulations promulgated thereunder.
(c) Process for determining regulatory treatment for other mixed
swaps--(1) In general. Any person who desires or intends to list,
trade, or clear a mixed swap (or class thereof) that is not subject to
paragraph (b) of this section may request the Commission and the
Commodity Futures Trading Commission to issue a joint order permitting
the requesting person (and any other person or persons that
subsequently lists, trades, or clears that mixed swap) to comply, as to
parallel provisions only, with specified parallel provisions of either
the Act (15 U.S.C. 78a et seq.) or the Commodity Exchange Act (7 U.S.C.
1 et seq.), and the rules and regulations thereunder (collectively,
specified parallel provisions), instead of being required to comply
with parallel provisions of both the Act and the Commodity Exchange
Act. For purposes of this paragraph (c), parallel provisions means
comparable provisions of the Act and the Commodity Exchange Act that
were added or amended by the Wall Street Transparency and
Accountability Act of 2010 with respect to security-based swaps and
swaps, and the rules and regulations thereunder.
(2) Request process. A person submitting a request pursuant to
paragraph (c)(1) of this section must provide the Commission and the
Commodity Futures Trading Commission with the following:
(i) All material information regarding the terms of the specified,
or specified class of, mixed swap;
(ii) The economic characteristics and purpose of the specified, or
specified class of, mixed swap;
(iii) The specified parallel provisions, and the reasons the person
believes
[[Page 48361]]
such specified parallel provisions would be appropriate for the mixed
swap (or class thereof); and
(iv) An analysis of:
(A) The nature and purposes of the parallel provisions that are the
subject of the request;
(B) The comparability of such parallel provisions;
(C) The extent of any conflicts or differences between such
parallel provisions; and
(D) Such other information as may be requested by the Commission or
the Commodity Futures Trading Commission.
(3) Request withdrawal. A person may withdraw a request made
pursuant to paragraph (c)(1) of this section at any time prior to the
issuance of a joint order under paragraph (c)(4) of this section by the
Commission and the Commodity Futures Trading Commission in response to
the request.
(4) Issuance of orders. In response to a request under paragraph
(c)(1) of this section, the Commission and the Commodity Futures
Trading Commission, as necessary to carry out the purposes of the Wall
Street Transparency and Accountability Act of 2010, may issue a joint
order, after notice and opportunity for comment, permitting the
requesting person (and any other person or persons that subsequently
lists, trades, or clears that mixed swap) to comply, as to parallel
provisions only, with the specified parallel provisions (or another
subset of the parallel provisions that are the subject of the request,
as the Commissions determine is appropriate), instead of being required
to comply with parallel provisions of both the Act (15 U.S.C. 78a et
seq.) and the Commodity Exchange Act (7 U.S.C. 1 et seq.). In
determining the contents of such joint order, the Commission and the
Commodity Futures Trading Commission may consider, among other things:
(i) The nature and purposes of the parallel provisions that are the
subject of the request;
(ii) The comparability of such parallel provisions; and
(iii) The extent of any conflicts or differences between such
parallel provisions.
(5) Timeframe. (i) If the Commission and the Commodity Futures
Trading Commission determine to issue a joint order as described in
paragraph (c)(4) of this section, such joint order shall be issued
within 120 days after receipt of a complete request for a joint order
under paragraph (c)(1) of this section, which time period shall be
stayed during the pendency of the public comment period provided for in
paragraph (c)(4) of this section and shall recommence with the business
day after the public comment period ends.
(ii) Nothing in this section shall require the Commission and the
Commodity Futures Trading Commission to issue any joint order.
(iii) If the Commission and the Commodity Futures Trading
Commission do not issue a joint order within the time period described
in paragraph (c)(5)(i) of this section, each of the Commission and the
Commodity Futures Trading Commission shall publicly provide the reasons
for not issuing such a joint order within that timeframe.
Sec. 240.3a68-5 Regulation of certain futures contracts on foreign
sovereign debt.
The term security-based swap as used in section 3(a)(68) of the Act
(15 U.S.C. 78c(a)(68)) does not include an agreement, contract, or
transaction that is based on or references a qualifying foreign futures
contract (as defined in Sec. 240.3a12-8 on the debt securities of any
one or more of the foreign governments enumerated in Sec. 240.3a12-8,
provided that such agreement, contract, or transaction satisfies the
following conditions:
(a) The futures contract that the agreement, contract, or
transaction references or upon which the agreement, contract, or
transaction is based is a qualifying foreign futures contract that
satisfies the conditions of Sec. 240.3a12-8 applicable to qualifying
foreign futures contracts;
(b) The agreement, contract, or transaction is traded on or through
a board of trade (as defined in 7 U.S.C. 2);
(c) The debt securities upon which the qualifying foreign futures
contract is based or referenced and any security used to determine the
cash settlement amount pursuant to paragraph (d) of this section were
not registered under the Securities Act of 1933 (15 U.S.C. 77 et seq.)
or the subject of any American depositary receipt registered under the
Securities Act of 1933;
(d) The agreement, contract, or transaction may only be cash
settled; and
(e) The agreement, contract or transaction is not entered into by
the issuer of the debt securities upon which the qualifying foreign
futures contract is based or referenced (including any security used to
determine the cash payment due on settlement of such agreement,
contract or transaction), an affiliate (as defined in the Securities
Act of 1933 (15 U.S.C. 77 et seq.) and the rules and regulations
thereunder) of the issuer, or an underwriter of such issuer's debt
securities.
Sec. 240.3a69-1 Safe Harbor Definition of ``security-based swap'' and
``swap'' as used in sections 3(a)(68) and 3(a)(69) of the Act--
insurance.
(a) This paragraph is a non-exclusive safe harbor. The terms
security-based swap as used in section 3(a)(68) of the Act (15 U.S.C.
78c(a)(68)) and swap as used in section 3(a)(69) of the Act (15 U.S.C.
78c(a)(69)) do not include an agreement, contract, or transaction that:
(1) By its terms or by law, as a condition of performance on the
agreement, contract, or transaction:
(i) Requires the beneficiary of the agreement, contract, or
transaction to have an insurable interest that is the subject of the
agreement, contract, or transaction and thereby carry the risk of loss
with respect to that interest continuously throughout the duration of
the agreement, contract, or transaction;
(ii) Requires that loss to occur and to be proved, and that any
payment or indemnification therefor be limited to the value of the
insurable interest;
(iii) Is not traded, separately from the insured interest, on an
organized market or over the counter; and
(iv) With respect to financial guaranty insurance only, in the
event of payment default or insolvency of the obligor, any acceleration
of payments under the policy is at the sole discretion of the insurer;
and
(2) Is provided:
(i)(A) By a person that is subject to supervision by the insurance
commissioner (or similar official or agency) of any State, as defined
in section 3(a)(16) of the Act (15 U.S.C. 78c(a)(16)), or by the United
States or an agency or instrumentality thereof; and
(B) Such agreement, contract, or transaction is regulated as
insurance under applicable State law or the laws of the United States;
(ii)(A) Directly or indirectly by the United States, any State or
any of their respective agencies or instrumentalities; or
(B) Pursuant to a statutorily authorized program thereof; or
(iii) In the case of reinsurance only by a person to another person
that satisfies the conditions set forth in paragraph (a)(2) of this
section, provided that:
(A) Such person is not prohibited by applicable State law or the
laws of the United States from offering such agreement, contract, or
transaction to such person that satisfies the conditions set forth in
paragraph (a)(2) of this section;
(B) The agreement, contract, or transaction to be reinsured
satisfies the
[[Page 48362]]
conditions set forth in paragraph (a)(1) or (3) of this section; and
(C) Except as otherwise permitted under applicable State law, the
total amount reimbursable by all reinsurers for such agreement,
contract, or transaction may not exceed the claims or losses paid by
the person writing the risk being ceded or transferred by such person;
or
(iv) In the case of non-admitted insurance by a person who:
(A) 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
(B) Meets the eligibility criteria for non-admitted insurers under
applicable State law; or
(3) Is provided in accordance with the conditions set forth in
paragraph (a)(2) of this section and is one of the following types of
products:
(i) Surety bond;
(ii) Fidelity bond;
(iii) Life insurance;
(iv) Health insurance;
(v) Long term care insurance;
(vi) Title insurance;
(vii) Property and casualty insurance;
(viii) Annuity;
(ix) Disability insurance;
(x) Insurance against default on individual residential mortgages;
and
(xi) Reinsurance of any of the foregoing products identified in
paragraphs (i) through (x) of this section.
(b) The terms security-based swap as used in section 3(a)(68) of
the Act (15 U.S.C. 78c(a)(68)) and swap as used in section 3(a)(69) of
the Act (15 U.S.C. 78c(a)(69)) do not include an agreement, contract,
or transaction that was entered into on or before the effective date of
this section and that, at such time that it was entered into, was
provided in accordance with the conditions set forth in paragraph
(a)(2) of this section.
Sec. 240.3a69-2 Definition of ``swap'' as used in section 3(a)(69) of
the Act--additional products.
(a) In general. The term swap has the meaning set forth in section
3(a)(69) of the Act (15 U.S.C. 78c(a)(69)).
(b) Inclusion of particular products. (1) The term swap includes,
without limiting the meaning set forth in section 3(a)(69) of the Act
(15 U.S.C. 78c(a)(69)), the following agreements, contracts, and
transactions:
(i) A cross-currency swap;
(ii) A currency option, foreign currency option, foreign exchange
option and foreign exchange rate option;
(iii) A foreign exchange forward;
(iv) A foreign exchange swap;
(v) A forward rate agreement; and
(vi) A non-deliverable forward involving foreign exchange.
(2) The term swap does not include an agreement, contract, or
transaction described in paragraph (b)(1) of this section that is
otherwise excluded by section 1a(47)(B) of the Commodity Exchange Act
(7 U.S.C. 1a(47)(B)).
(c) Foreign exchange forwards and foreign exchange swaps.
Notwithstanding paragraph (b)(2) of this section:
(1) A foreign exchange forward or a foreign exchange swap shall not
be considered a swap if the Secretary of the Treasury makes a
determination described in section 1a(47)(E)(i) of the Commodity
Exchange Act (7 U.S.C. 1a(47)(E)(i)).
(2) Notwithstanding paragraph (c)(1) of this section:
(i) The reporting requirements set forth in section 4r of the
Commodity Exchange Act (7 U.S.C. 6r) and regulations promulgated
thereunder shall apply to a foreign exchange forward or foreign
exchange swap; and
(ii) The business conduct standards set forth in section 4s(h) of
the Commodity Exchange Act (7 U.S.C. 6s) and regulations promulgated
thereunder shall apply to a swap dealer or major swap participant that
is a party to a foreign exchange forward or foreign exchange swap.
(3) For purposes of section 1a(47)(E) of the Commodity Exchange Act
(7 U.S.C. 1a(47)(E)) and this section, the term foreign exchange
forward has the meaning set forth in section 1a(24) of the Commodity
Exchange Act (7 U.S.C. 1a(24)).
(4) For purposes of section 1a(47)(E) of the Commodity Exchange Act
(7 U.S.C. 1a(47)(E)) and this section, the term foreign exchange swap
has the meaning set forth in section 1a(25) of the Commodity Exchange
Act (7 U.S.C. 1a(25)).
(5) For purposes of sections 1a(24) and 1a(25) of the Commodity
Exchange Act (7 U.S.C. 1a(24) and (25)) and this section, the following
transactions are not foreign exchange forwards or foreign exchange
swaps:
(i) A currency swap or a cross-currency swap;
(ii) A currency option, foreign currency option, foreign exchange
option, or foreign exchange rate option; and
(iii) A non-deliverable forward involving foreign exchange.
Sec. 240.3a69-3 Books and records requirements for security-based
swap agreements.
(a) A person registered as a swap data repository under section 21
of the Commodity Exchange Act (7 U.S.C. 24a) and the rules and
regulations thereunder:
(1) Shall not be required to keep and maintain additional books and
records regarding security-based swap agreements other than the books
and records regarding swaps required to be kept and maintained pursuant
to section 21 of the Commodity Exchange Act (7 U.S.C. 24a) and the
rules and regulations thereunder; and
(2) Shall not be required to collect and maintain additional data
regarding security-based swap agreements other than the data regarding
swaps required to be collected and maintained by such persons pursuant
to section 21 of the Commodity Exchange Act (7 U.S.C. 24a) and the
rules and regulations thereunder.
(b) A person shall not be required to keep and maintain additional
books and records, including daily trading records, regarding security-
based swap agreements other than the books and records regarding swaps
required to be kept and maintained by such persons pursuant to section
4s of the Commodity Exchange Act (7 U.S.C. 6s) and the rules and
regulations thereunder if such person is registered as:
(1) A swap dealer under section 4s(a)(1) of the Commodity Exchange
Act (7 U.S.C. 6s(a)(1)) and the rules and regulations thereunder;
(2) A major swap participant under section 4s(a)(2) of the
Commodity Exchange Act (7 U.S.C. 6s(a)(2)) and the rules and
regulations thereunder;
(3) A security-based swap dealer under section 15F(a)(1) of the Act
(15 U.S.C. 78o-10(a)(1)) and the rules and regulations thereunder; or
(4) A major security-based swap participant under section 15F(a)(2)
of the Act (15 U.S.C. 78o-10(a)(2)) and the rules and regulations
thereunder.
(c) The term security-based swap agreement has the meaning set
forth in section 3(a)(78) of the Act (15 U.S.C. 78c(a)(78)).
PART 241--INTERPRETATIVE RELEASES RELATING TO THE SECURITIES
EXCHANGE ACT OF 1934 AND GENERAL RULES AND REGULATIONS THEREUNDER
0
5. Part 241 is amended by adding Release No. 34-67453 and the release
date of July 18, 2012, to the list of interpretative releases.
Dated: July 18, 2012.
[[Page 48363]]
By the Commodity Futures Trading Commission.
David A. Stawick,
Secretary.
By the Securities and Exchange Commission.
Dated: July 18, 2012.
Elizabeth M. Murphy,
Secretary.
Product Definitions Contained in Title VII of the Dodd-Frank Wall
Street Reform and Consumer Protection Act--CFTC Voting Summary and
Statements of CFTC Commissioners
Note: The following appendices will not appear in the Code of
Federal Regulations.
CFTC Voting Summary
On this matter, Chairman Gensler and Commissioners Sommers,
O'Malia and Wetjen voted in the affirmative; Commissioner Chilton
voted in the negative.
Statement of CFTC Chairman Gary Gensler
I support the final rulemaking to implement the Dodd-Frank Wall
Street Reform and Consumer Protection Act (Dodd-Frank Act)
requirement to further define ``swap'' and other products that come
under swaps market reform. The Commodity Futures Trading Commission
(CFTC) worked closely with the Securities and Exchange Commission
(SEC), in consultation with the Federal Reserve, on the final rules
and interpretations to further define ``swaps,'' ``security-based
swaps,'' ``mixed swaps'' and ``security-based swap agreements.''
The statutory definition as laid out by Congress of swap is very
detailed. These final rules and interpretations are consistent with
that detailed definition and Congressional intent. For example,
interest rate swaps, currency swaps, commodity swaps, including
energy, metals and agricultural swaps, and broad-based index swaps,
such as index credit default swaps, are all swaps. Consistent with
Congress's definition of swaps, the rule also defines options as
swaps.
In preparing this final rulemaking, staff worked to address the
more than 140 comments that were submitted by the public in response
to the product further definition proposal. Many of the commenters
asked the Commissions to specifically provide guidance on what is
not a swap or security-based swap.
For example, under the Commodity Exchange Act, the CFTC does not
regulate forward contracts. Over the decades, there have been a
series of orders, interpretations and cases that market participants
have come to rely upon regarding the exception from futures
regulation for forwards and forwards with embedded options.
Consistent with that history, the Dodd-Frank Act excluded from the
definition of a swap ``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 Commission
is interpreting that exclusion in a manner that is consistent with
Commission precedent and, in response to commenters, is providing
increased clarity on the forward exclusion from futures regulation.
The final release provides guidance regarding forwards with embedded
volumetric options, like those used within the electricity markets,
and is requesting comment on this interpretation.
Further, consistent with the Dodd-Frank Act, insurance products
will not be regulated as swaps. Similarly, this final rulemaking
clarifies that certain consumer and commercial arrangements that
historically have not been considered swaps, such as consumer
mortgage rate locks, contracts to lock in the price of home heating
oil and contracts relating to inventory or equipment, also will not
be regulated as swaps.
The rule provides clarity on the dividing line between ``swaps''
and ``security-based swaps'' or both, i.e. mixed swaps. The rule
also provides a process for requesting joint interpretations in
circumstances where there are questions. These dividing lines and
the process will benefit market participants, as they will provide
greater clarity as to what regulatory requirements apply when they
transact in the derivatives markets.
Lastly, the final release includes specific provisions that
guard against transactions that are willfully structured to evade
Dodd-Frank Act swaps market reforms.
I'd like to express my appreciation for their dedication to
completing this rule to Chairman Mary Schapiro and her fellow
Commissioners at the SEC, as well as the staff, including Robert
Cook, Brian Bussey, Amy Starr, Donna Chambers, Christie March, Andy
Schoeffler, Wenchi Hu, John Guidroz and Sarah Otte.
I'd also like to thank the CFTC's hardworking staff: Julian
Hammar, Lee Ann Duffy, David Aron, Terry Arbit, Eric Juzenas and
Stephen Kane.
Dissent of CFTC Commissioner Chilton on Further Definition of ``Swap,''
``Security-Based Swap,'' and ``Security-Based Swap Agreement;'' Mixed
Swaps; Security-Based Swap Agreement Recordkeeping
I respectfully dissent from this joint final rule and
interpretive guidance because I have reservations about certain
aspects of the Commodity Futures Trading Commission's
(``Commission'') interpretive guidance on forward contracts. Apart
from this specific area, I agree with the joint release and would
support its adoption.
I am dissenting from the interpretive guidance for two chief
reasons. First, I believe that the Commission should make stronger
efforts to ensure market participants claim the forward contract
exclusion only under appropriate circumstances, consistent with its
interpretive guidance. The Commission should apply a rebuttable
presumption that contracts do not have as their predominant feature
actual delivery in instances where market participants often do not
follow the delivery settlement term in a contract. The Commission
should set forth the conditions for a safe harbor, consistent with
its interpretation of the forward contract exclusion, for market
participants that often do not terminate ``forward'' contracts
through physical delivery that includes some affirmative statement
to the Commission explaining the circumstances leading to non-
delivery. This safe harbor, in my view, would encourage market
participants to submit information that would vastly improve the
ability of the Commission to ensure that market participants
claiming the forward contract exclusion are doing so appropriately,
consistent with the law and Commission and staff interpretation of
the law.
Second, the Commission has failed to provide adequate legal
certainty to market participants engaging in contracts with embedded
volumetric commodity options, particularly those that can terminate
without physical delivery. Contracts with embedded commodity options
that can negate the physical delivery term have optionality that
targets the delivery term of the contract and therefore cannot be
seen as having as a predominant feature actual delivery, a necessary
element in any forward contract under applicable Commission
precedent. The Commission has failed to perform an analysis of these
types of contracts in an excess of caution that may invite
confusion, at best, and evasion, at worst.
The Dodd-Frank Wall Street Reform and Consumer Protection Act
(``Dodd-Frank Act'') \1\ imposes new safeguards on hitherto
unregulated markets. These safeguards increase the integrity of the
markets by, e.g., improving market transparency and thereby
deterring abuses of the sorts seen in recent decades. These
safeguards inevitably increase compliance costs, particularly in the
initial phase of implementation. As I can predict with absolute
certainty, bad actors ([agrave] la Amaranth) will be drawn to dark
markets in search of spoils. Less ill-intentioned or ``grey'' actors
may follow them in search of lower compliance costs. The Commission
should not cede swaths of jurisdiction because such markets have not
hitherto given rise to concerns.\2\
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\1\ See Dodd-Frank Wall Street Reform and Consumer Protection
Act, Public Law 111-203, 124 Stat. 1376 (2010). The text of the
Dodd-Frank Act may be accessed at http://www.cftc.gov/LawRegulation/OTCDERIVATIVES/index.htm.
\2\ See Financial Crisis Inquiry Commission, ``The Financial
Crisis Inquiry Report: Final Report of the National Commission on
the Causes of the Financial and Economic Crisis in the United
States,'' Jan. 2011, at 25, available at http://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf (``concluding that ``enactment of * *
* [the Commodity Futures Modernization Act of 2000 (``CFMA'')] to
ban the regulation by both the Federal and State governments of
over-the-counter (OTC) derivatives was a key turning point in the
march toward the financial crisis.'').
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The Commission proposed \3\ and is now adopting an approach to
the forward contract exclusion that draws on ``the principles
underlying'' the Brent Interpretation.\4\ I agree
[[Page 48364]]
generally with this approach (I voted in the affirmative on
releasing the proposal). In addition, the Commission recognizes that
the underlying purpose of a transaction is a critical factor in
determining whether a given transaction is more appropriately
classified as a forward or swap (or commodity option).\5\ I commend
this clarification and hope it is applied or further clarified in a
way that affirms the principles underlying the Brent Interpretation
without endorsing the outcome of the Brent Interpretation.
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\3\ See Further Definition of ``Swap,'' ``Security-Based Swap,''
and ``Security-Based Swap Agreement''; Mixed Swaps; Security-Based
Swap Agreement Recordkeeping, 76 FR 29818, 29829, May 23, 2011.
\4\ Further Definition of ``Swap,'' ``Security-Based Swap,'' and
``Security-Based Swap Agreement''; Mixed Swaps; Security-Based Swap
Agreement Recordkeeping, 77 FR ------, ------ (``Adopting
Release''); Statutory Interpretation Concerning Forward
Transactions, 55 FR 39188, Sept. 25, 1990 (``Brent
Interpretation''). I note that the Commission did not endorse the
outcome of the Brent Interpretation.
\5\ I recognize (and perhaps the Commission has quietly
recognized as well) the merit in the dissent of former Commissioner
Fowler West to the Brent Interpretation and am heartened to find
elements of his analytical approach in this release. Commissioner
West, among other things, emphasized the importance of the
underlying purpose of a transaction in a forward contract analysis.
Id., Dissent of Commissioner Fowler West, available at http://www.cftc.gov/ucm/groups/public/@aboutcftc/documents/file/fwestdissent092090.pdf (because, among other things, 15-day Brent
contracts are entered into for the purpose of hedging or speculation
rather than for the purpose of transferring ownership in crude oil
they do not sufficiently resemble forward contracts to be excluded
from the CEA) citing CFTC v. Co. Petro Marketing Group, Inc., 680
F.2d 573, 580 (9th Cir. 1982). Commissioner West's dissent presaged
the Brent market aberrations of the 1990s and early 2000s that some
tied to squeezes of the Brent delivery complex through a hoarding of
``forwards'' that made leveraged cash-settled contract positions
designed to benefit from such aberrations very profitable. While I
endorse the Commission's approach to affirming the principles
contained in the Brent Interpretation, I believe future interpretive
guidance should apply the lessons of the past two-plus decades of
market and regulatory history and apply the Brent Interpretation
principles in that light. In this dissent, however, I do not need to
go so far as to reinterpret the principles underlying the Brent
Interpretation: even based on a conservative review of our precedent
I feel we did not provide the market adequate clarity.
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1. Safe Harbor for ``Forwards'' That Often Do Not Terminate With Actual
Delivery
I believe that the Commission should make stronger efforts to
ensure market participants claim the forward contract exclusion only
under appropriate circumstances. I am concerned that the forward
contract exclusion may be abused if not intentionally evaded by the
lack of safeguards to ensure its appropriate application.\6\ This
concern is exacerbated by the fact that actors claiming the forward
contract exclusion are not subject to any reporting requirements,
nor have we even provided for a safe harbor that encourages such
reporting. In light of the transparency the CEA now provides for
futures, options, and swaps markets, the regulatory differential
between these regulated markets and unregulated markets, like
forward markets, is going to encourage regulatory arbitrage. Despite
substantial progress in improving the Commission's visibility into
regulated markets, the Commission has failed to set forth
interpretive guidance that ensures that, at the minimum, it can see
and understand the transactions that market participants claim as
being subject to the forward contract exclusion. I believe the
Commission should be more active when it comes to ensuring that the
forward contract exclusion is properly applied, particularly in
instances where an ostensible ``forward'' closely resembles, in
form, purpose, or economic substance regulated products.
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\6\ See Adopting Release.
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The Commission has endorsed the purpose of a transaction as a
factor in determining a contract's eligibility for the forward
contract exclusion.\7\ The Brent Interpretation or the Commission's
re-interpretation of it notwithstanding, I believe that when few
``forward'' contracts for a given market participant result in
delivery, then there is sufficient ground for the Commission to have
doubt about the appropriateness of the forward contract exclusion
claim. Moreover, under such circumstances the Commission should have
doubt about the underlying purpose of the claimed ``forwards.''
Therefore, the Commission should apply a rebuttable presumption that
the market participant may not be engaging in transactions that have
as their predominant feature actual delivery.
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\7\ See Adopting Release.
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At the same time, the Commission should specify the means by
which this presumption may be rebutted. I believe that the
Commission provide for a safe harbor for market participants that
regularly engage in transactions they believe to qualify for the
forward contract exclusion that, nonetheless, often do not terminate
with delivery (e.g., in less than 20% of instances as measured by
number of ``forward'' contracts or by potential total quantity under
all ``forward'' contracts). This non-delivery could be of the result
of, for example, exercised embedded volumetric optionality or
through book-outs. Market participants claiming this safe harbor
should include a brief, periodic statement that explains the reason
why their forward transactions, in general terms or with more
specificity as is necessary for the Commission to determine whether
the presumption that the market participant is inappropriately
claiming the forward contract exclusion is rebutted.
I request comment on my proposed safe harbor concept. I
encourage the Commission to adopt some version of this safe harbor
in order to allay the very real concerns I and, indeed, many market
participants and many in the public have expressed to me that
unregulated forwards markets could become a refuge for those that
thrive in opacity. Our regulations implementing the Dodd-Frank Act
will vastly improve transparency in regulated futures, options, and
swaps markets. Unfortunately, our interpretive guidance today does
little to ensure even any visibility for regulators in how players
in the physical commodity markets, so critical to the Commission's
mission, are claiming the forward contract exclusion: the unwatched
back door out of the transparency-related requirements of the CEA.
2. Legal Certainty for Certain Commodity Options
Section 4c(b) of the CEA provides:
No person shall offer to enter into, enter into or confirm the
execution of, any transaction involving any commodity regulated
under this chapter which is of the character of, or is commonly
known to the trade as, an ``option'', ``privilege''', ``indemnity'',
``bid'', ``offer'', ``put'', ``call'', ``advance guaranty'', or
``decline guaranty'', contrary to any rule, regulation, or order of
the Commission prohibiting any such transaction or allowing any such
transaction under such terms and conditions as the Commission shall
prescribe. Any such order, rule, or regulation may be made only
after notice and opportunity for hearing, and the Commission may set
different terms and conditions for different markets.\8\
\8\ CEA section 4c(b), 7 U.S.C. 6c(b).
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Through this decades-old provision, Congress gave the Commission
jurisdiction and plenary rulemaking authority over physical
commodity option transactions.\9\ The Dodd-Frank Act not only
preserved this plenary authority over commodity options, but also
reaffirmed the reach of the CEA over commodity options. Section 721
of the Dodd-Frank Act added section 1a(47) to the CEA, defining
``swap'' to include not only ``any agreement, contract, or
transaction commonly known as,'' among other things, ``a commodity
swap,'' \10\ but also ``[an] option of any kind that is for the
purchase or sale, or based on the value, of 1 or more * * *
commodities * * *,''\11\ i.e. commodity options.\12\ While commodity
options are subject to the Commission's plenary jurisdiction, the
Commission has limited jurisdiction over forward contracts.\13\
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\9\ CEA section 4c(b) has been in the Act in substantially the
same form since it was added by the Commodity Futures Trading
Commission Act of 1974. See Public Law 93-463, October 23, 1974.
\10\ See CEA section 1a(47)(A)(iii), 7 U.S.C. 1a(47)(A)(iii).
\11\ See CEA section 1a(47)(A)(i), 7 U.S.C. 1a(47)(A)(i). Note
that the swap definition excludes options on futures (which must be
traded on a DCM pursuant to part 33 of the Commission's regulations)
(see CEA section 1a(47)(B)(i), 7 U.S.C. 1a(47)(B)(i)), but it
includes options on physical commodities (whether or not traded on a
DCM) (see CEA section 1a(47)(A)(i), 7 U.S.C. 1a(47)(A)(i)).
\12\ The Commission's regulations define a commodity option
transaction or commodity option as ``any transaction or agreement in
interstate commerce which is or is held out to be of the character
of, or is commonly known to the trade as, an `option,' `privilege,'
`indemnity,' `bid,' `offer,' `call,' `put,' `advance guaranty' or
`decline guaranty'.'' 17 CFR 1.3(hh).
\13\ See CEA section 1a(47)(B)(ii), 7 U.S.C. 1a(47)(B)(ii)
(excluding from the definition of ``swap'' contracts involving ``any
sale of a nonfinancial commodity or security for deferred shipment
or delivery, so long as the transaction is intended to be physically
settled.''). See also CEA section 8(d), 7 U.S.C. 12(d), which
directs the CFTC to investigate the marketing conditions of
commodities and commodity products and byproducts, including supply
and demand for these commodities, cost to the consumer, and handling
and transportation charges; CEA sections 6(c), 6(d) and 9(a)(2), 7
U.S.C. 9, 13b, and 13(a)(2), which proscribe any manipulation or
attempt to manipulate the price of any commodity in interstate
commerce; and CEA section 6(c) as amended by section 753 of the
Dodd-Frank Act, which contains prohibitions regarding manipulation
and false reporting with respect to any commodity in interstate
commerce, including prohibiting any person to (i) ``use or employ,
or attempt to use or employ * * * any manipulative or deceptive
device or contrivance'' (section 6(c)(1)); (ii) ``to make any false
or misleading statement of material fact'' to the CFTC or ``omit to
state in any such statement any material fact that is necessary to
make any statement of material fact made not misleading in any
material respect'' (section 6(c)(2)); and (iii) ``manipulate or
attempt to manipulate the price of any swap, or of any commodity in
interstate commerce * * *'' (section 6(c)(3)). See also Rule
180.1(a) under the CEA, 17 CFR 180.1(a) (broadly prohibiting in
connection with a commodity in interstate commerce manipulation,
false or misleading statements or omissions of material fact to the
Commission, fraud or deceptive practices or courses of business, and
false reporting).
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[[Page 48365]]
In the Brent Interpretation, the Commission found certain Brent
oil contracts to be eligible for the forward contract exclusion,
notwithstanding the fact that such transactions ``may ultimately
result in performance through the payment of cash as an alternative
to actual physical transfer or delivery of the commodity.'' The
Commission found that when delivery obligations under a forward were
terminated pursuant to a separate and individually negotiated
``book-out'' agreement, the parties escaped the physical delivery
obligation traditionally required to claim the forward contract
exclusion. The Commission also emphasized two features (among
others) of the Brent oil contracts at issue: (1) The absence of a
contractual right to offset (or to terminate without delivery) the
transaction ``by the terms of the contracts as initially entered
into'' and (2) the counterparties had to incur ``substantial
economic risks of a commercial nature'' relating to actual delivery
in order to claim the exclusion. Underlying the Brent
Interpretation, other CFTC precedent, and the Commission's approach
to the interpretive guidance on the forward contract exclusion is
the essential feature of forward contracts: actual delivery (and not
potential delivery).\14\
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\14\ See Adopting Release.
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The Commission has failed to provide adequate legal certainty to
market participants engaging in contracts with embedded volumetric
commodity options, particularly those that can terminate without
physical delivery. Contracts that are composed of a forward delivery
obligation component combined with an embedded commodity option that
can render delivery optional (``zero-delivery'' embedded volumetric
options) are not forwards because the predominant feature of the
contract cannot be actual delivery under these circumstances (more
literally, the predominant feature is potential delivery which is an
essential characteristic of commodity options). Such contracts
include a contractual right to offset through the exercise of the
volumetric option that can extinguish the delivery obligation.
Because such contracts have a commodity option component that
mitigates the risk incurred from an underlying forward delivery
obligation, these contracts may fail to meet the incurring
``economic risks of a commercial nature'' element. Moreover, the
purpose of the delivery optionality in these types of contracts
shares a common purpose with commodity options: To provide market
participants a means to hedge commodity quantity risk of a
commercial nature. The Commission should therefore clarify, in any
future interpretive guidance, that zero-delivery embedded volumetric
options are generally commodity options because the delivery
obligation is not obligatory.
The confluence of these features, as analyzed under a
conservative reading of the Brent Interpretation, leads me to
conclude that contracts with embedded zero-delivery option
components cannot be said to have actual delivery as their essential
feature. Other relevant Commission precedent is consistent with this
analysis. Most recently, in In re Wright, a forward contract
containing pricing optionality was found to be a forward contract
because the optionality:
(i) May be used to adjust the forward contract price, but do not
undermine the overall nature of the contract as a forward contract;
(ii) do not target the delivery term, so that the predominant
feature of the contract is actual delivery; and (iii) cannot be
severed and marketed separately from the overall forward contract in
which they are embedded.\15\
\15\ See In re Wright, CFTC Docket No. 97-02, 2010 WL 4388247
(Oct. 25, 2010) (emphasis added). See also Characteristics
Distinguishing Cash and Forward Contracts and ``Trade'' Options, 50
FR 39656 (Sept. 30, 1985) (finding that hedge-to-arrive contracts
with pricing optionality could be categorized as forwards so long as
it created a binding delivery obligation that could only be annulled
in the event of a crop failure, in which case liquidated damages may
apply).
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In re Wright is distinguishable because it involves pricing
optionality, not volumetric optionality-the latter a feature the
Commission has not hitherto opined on in the context of the forward
contract exclusion. As the emphasized section of the block quote
immediately above discusses, the interpretation there turned on the
fact that the optionality in the In re Wright options did ``not
target the delivery term.'' Optionality that can result in zero
delivery ``targets the delivery term,'' in direct contrast to the In
re Wright options. I commend the Commission for not overextending
(to put it charitably) In re Wright to cover zero-delivery
volumetric optionality, as argued by some commenters. Nonetheless,
the Commission did not clarify that a contract that provides for
optionality that can render delivery optional cannot therefore have
as its predominant feature actual delivery because the optionality
``targets the delivery term.''\16\
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\16\ In re Wright, CFTC Docket No. 97-02, 2010 WL 4388247 (Oct.
25, 2010).
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Instead of, in my opinion, a proper application of the statute
and precedent, the Commission has adopted a seven-element
interpretation that applies to contracts with embedded volumetric
optionality. This interpretative approach would potentially allow
contracts with zero-delivery option components to nonetheless claim
the forward contract exclusion when:
1. The embedded optionality does not undermine the overall
nature of the agreement, contract, or transaction as a forward
contract;
2. The predominant feature of the agreement, contract, or
transaction is actual delivery;
3. The embedded optionality cannot be severed and marketed
separately from the overall agreement, contract, or transaction in
which it is embedded;
4. The seller of a nonfinancial commodity underlying the
agreement, contract, or transaction with embedded volumetric
optionality intends, at the time it enters into the agreement,
contract, or transaction, to deliver the underlying nonfinancial
commodity if the optionality is exercised;
5. The buyer of a nonfinancial commodity underlying the
agreement, contract or transaction with embedded volumetric
optionality intends, at the time it enters into the agreement,
contract, or transaction, to take delivery of the underlying
nonfinancial commodity if it exercises the embedded volumetric
optionality;
6. Both parties are commercial parties; and
7. 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 first two elements, in particular, invoke the Brent
Interpretation and related precedent.\17\ The seventh and most
problematic element seems to imply that supply and demand, i.e.,
economic factors, could be a primary factor in the exercise or non-
exercise of an embedded volumetric option. I fear how broadly this
element could be interpreted by those predisposed to interpret the
CEA in an opportunistic light. When can supply and demand factors
not be correlated with physical factors? Does this mean that if
delivery renders such a contract unprofitable for a party to such a
contract that they can elect not to deliver? If that is the case,
then the contract is a commodity option.\18\
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\17\ See Adopting Release.
\18\ See, e.g., 50 FR 39656, 39660.
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I would amend the seventh element by making it clear the
exercise or non-exercise for physical factors that influence demand
and supply can negate the delivery obligation only in exceptional
circumstances. If delivery renders a contract merely unprofitable
and the contract permits a party to elect not to deliver, such a
contract is not a forward and is a commodity option.
In addition, I would require, consistent with the third,
``severability,'' element, that in order to claim the forward
contract exclusion where the contract at issue contains a zero-
delivery embedded volumetric option, the parties must sever the
forward contract component, which has as its purpose the delivery of
commodities, from the remaining commodity option component, which
has as its purpose the management of the commodity quantity risk
associated with operating a commercial enterprise.\19\ The
[[Page 48366]]
commodity option component of these transactions could be eligible
for a trade option exemption \20\ that exempts (and importantly,
does not exclude) them from many CEA requirements.\21\
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\19\ These forward contract and commodity option hybrid
contracts can, as I understand it, generally be severed into two
separate forward and commodity option contracts. Some commenters
suggested that many ``peaking'' contracts involve volumetric
optionality that cannot be severed, but I have yet to be convinced
that the same party that is the ``seller'' under these contracts
cannot simply become the appropriate counterparty when such
contracts are severed into a forward contract component and a
commodity option component that can offset or book-out the buyer's
obligation to take delivery.
\20\ Commodity Options, 77 FR 25320, Apr. 27, 2012, codified at
17 CFR 32.3.
\21\ As of July 10, 2012, the Commission has received 12
comments on the interim final rule setting forth the trade option
exemption.
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Moreover, while the Adopting Release's guidance is the first of
its kind and therefore an incremental step toward more legal
certainty, it doesn't directly address embedded zero-delivery
volumetric optionality specifically or any of the conceivable
specific variations of such contracts. I believe this to be a flaw;
a flaw that did not exist in a previous version of this document.
The Commission should affirm in any relevant future interpretive
guidance the formal features in the Brent Interpretation's forward
contract exclusion, e.g., that the delivery obligation cannot be
offset based on terms contained in the contract, that any delivery
obligation be appropriately booked-out (in a separate transaction),
or that the contract involve incurring ``substantial economic risks
of a commercial nature.'' \22\ In the absence of the Commission's
courage to provide for more legal certainty on these kinds of
transactions, I stress the application of the third, severability,
element in the Commission's seven-element interpretation and note
that as long as a market participant can decompose a pre-Dodd-Frank
Act transaction into components, such action would not be in
violation of the CEA if the resulting agreements, contracts, or
transactions (1) neatly fall into forward, commodity option, or
other swap contract buckets and (2) are dealt with as such.\23\
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\22\ The Commission's inclusion of the underlying purpose of a
transaction as a factor in determining its classification as a
forward, commodity option, or other form of swap. The Commission
will, under the interpretive guidance, consider the ``purpose of the
claimed forward'' and whether its purpose is to sell physical
commodities, hedge risk, or speculate. See Adopting Release.
\23\ See Adopting Release, fn 337 (``When a forward contract
includes an embedded option that is severable from the forward
contract, the forward can remain subject to the forward contract
exclusion, if the parties document the severance of the embedded
option component and the resulting transactions, i.e. a forward and
an option. Such an option would be subject to the CFTC's regulations
applicable to commodity options.'').
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I look forward to receiving and reviewing comments on the
Commission's interpretation, in particular those submitted in
response to Question Seven.\24\ I also welcome comments on this
statement too, of course, particularly as it relates to zero-
delivery embedded volumetric options. I am particularly interested
in understanding under what circumstances such embedded option
contracts and other contracts can be structured to evade Dodd-Frank
Act requirements in a way that creates plausible deniability for one
or both counterparties that they did not ``willfully'' intend to
structure a transaction in a manner intended to evade. Should the
Commission, instead of my proposed approach, follow a rebuttable
presumption approach with respect to zero-delivery embedded option
contracts whereby the presumption can be rebutted by a certification
of facts that indicate a true commercial purpose for the
transaction?
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\24\ Id. (``Do the agreements, contracts, and transactions
listed in question no. 6 above have embedded optionality in the
first instance? Based on descriptions by commenters, it appears that
they may have a binding obligation for delivery, but have no set
amount specified for delivery. Instead, delivery (including the
possibility of nominal or zero delivery) is determined by the terms
and conditions contained within the agreement, contract, or
transaction (including, for example, the satisfaction of a condition
precedent to delivery, such as a commodity price or temperature
reaching a level specified in the agreement, contract, or
transaction). That is, the variation in delivery is not driven by
the exercise of embedded optionality by the parties. Do the
agreements, contracts, and transactions listed in question no. 6
exhibit these kinds of characteristics? If so, should the CFTC
consider them in some manner other than its forward interpretation?
Why or why not?'').
[FR Doc. 2012-18003 Filed 8-10-12; 8:45 am]
BILLING CODE 8011-01- 6351-01-P