Statement of Dissent

Commissioner Scott D. O’Malia

Further Definition of “Swap Dealer,” “Security-Based Swap Dealer,” “Major Swap Participant,” “Major Security-Based Swap Participant,” and “Eligible Contract Participant”¹

April 18, 2012

In General

I respectfully dissent from the Commodity Futures Trading Commission’s (the “Commission” or “CFTC”) approval today of the Entities Rule, which is a joint final and interim final rule with the Securities and Exchange Commission (“SEC”) under the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). ² I have a number of concerns with each definition in the CFTC Entities Rule. However, this dissent focuses on the “swap dealer” definition.

Preliminarily, in its proposal, ³ the Commission ignored basic canons of statutory construction⁴ in defining “swap dealer.”⁵ Specifically, the statutory definition has four clauses, lettered (A) through (D). As discussed below, the Commission defined “swap dealer” as encompassed only within CEA section 1a(49)(A). Thus, the Commission advanced a definition focusing on activities, rather than the entities conducting these activities.⁶ The Commission then minimized the other clauses of the definition. Specifically, the Commission characterized CEA section 1a(49)(C) as an “exception” for certain activities. The Commission also characterized CEA section 1a(49)(B) as only authorizing “limited designation.”⁷

I have always disagreed with the Proposal. By focusing on the activities in CEA section 1a(49)(A), the Commission essentially used the “swap dealer” definition to capture commercial end-users.⁸ Congress clearly precluded this result. As described below, CEA section 1a(49)(C) provides a mandatory exclusion for commercial end-users.⁹ Alternatively, CEA section 1a(49)(B) permits the Commission to exercise its discretion to exclude commercial end-users, so long as the Commission articulates a rational basis for such differential treatment.¹⁰ The Commission has many reasons for exercising its discretion, including certain statutory reasons.

Today, the Commission has erected the CFTC Entities Rule on the infirm scaffold of the Proposal. To be sure, the Commission has performed astonishing contortions to afford greater certainty to commercial end-users.¹¹ However, the Commission could have provided equivalent or superior certainty by properly construing CEA sections 1a(49)(C) and (B), either initially or in a re-proposal. By preserving and furthering the statutory misconstructions in the Proposal, the CFTC Entities Rule may ultimately provide illusory comfort. Therefore, I cannot support the CFTC Entities Rule.

The “Swap Dealer” Definition: Fundamental Misconstruction

CEA section 1a(49)(A): Not the Entire “Swap Dealer” Definition

A statute should be read as a “harmonious whole.”¹² This statement is a basic canon of statutory construction.¹³ The Commission has failed to follow such canon in defining “swap dealer.”

As mentioned above, in the CFTC Entities Rule (as in the Proposal), the Commission insists that CEA section 1a(49)(A) is the entirety of the “swap dealer” definition. According to the Commission, any entity engaged in any activity enumerated in CEA section 1a(49)(A) is a “swap dealer” ¹⁴ (unless otherwise “excepted”).¹⁵ Specifically, the Commission states: “The Dodd-Frank Act definitions of the term ‘swap dealer’…focus on whether a person engages in particular types of activities involving swaps….”¹⁶ Also, the Commission states: “The CEA…[definition] in general encompass persons that engage in any of the [activities in CEA section 1a(49)(A)].”¹⁷ Finally, the Commission characterizes the activities in CEA section 1a(49)(A) as “dealer activities.”¹⁸

CEA section 1a(49)(C): Mandatory Exclusion for Entities

CEA section 1a(49) contradicts in both its language and structure the Commission’s focus on the activities of CEA section 1a(49)(A). Specifically, CEA section 1a(49)(C), when properly construed, sets forth a mandatory exclusion that focuses on the characteristics of an entity, and not exclusively on its activities. CEA section 1a(49)(C) states: “The term ‘swap dealer’ does not include a person that enters into swaps for such person’s own account, either individually or in a fiduciary capacity, but not as part of a regular business.”

First, CEA section 1a(49)(C) is as central to the “swap dealer” definition as CEA section 1a(49)(A). CEA section 1a(49)(C) begins with “The term ‘swap dealer’ does not include…”. In comparison, CEA section 1a(49)(A) begins with “The term ‘swap dealer’ means…”. Therefore, according to their plain language, CEA section 1a(49)(C) and CEA section 1a(49)(A) are equal and opposite of each other. In essence, CEA section 1a(49)(C) sets forth the exclusion criteria for the “swap dealer” definition, whereas CEA section 1a(49)(A) sets forth the inclusion criteria.

Second, CEA section 1a(49)(C) focuses on the characteristics of entities, and not solely on their activities. CEA section 1a(49)(C) states that “[t]he term ‘swap dealer’ does not include a person that enters into swaps…not as part of a regular business.” In contrast, CEA section 1a(49)(A)(iii) states that the “swap dealer” definition encompasses any person that “regularly enters into swaps with counterparties as an ordinary course of business for its own account.” If the Commission is correct in presuming that CEA section 1a(49)(A) focuses on activities, then the phrase “regularly enters into swaps…as an ordinary course of business” must refer to an activity. However, Congress used different words in CEA section 1a(49)(C). According to a basic canon of statutory construction, when Congress uses different words, it intends different meanings. In other words, a court should strive to give effect to every word of a statute. ¹⁹

The Commission could have easily given effect to every word of CEA section 1a(49)(C), while according the same respect to CEA section 1a(49)(A)(iii). Juxtaposing CEA section 1a(49)(C) and CEA section 1a(49)(A)(iii), the following construction emerges: a “person” (i.e., an entity) is not a “swap dealer” if it enters into swaps for “its own account” (i.e., as principal) in the “ordinary course of business” (i.e., normally while conducting business), provided that entering into these swaps is not its “regular business” (i.e., entering into swaps is ancillary to its core business).²⁰

If the Commission had adopted this construction, the Commission would have per se excluded commercial end-users. Such exclusion would have permitted these entities to freely hedge their business risks, whether financial or physical, without fear of becoming a “swap dealer.” Just to provide some context, commercial end-users include Caterpillar, John Deere, and ConAgra Foods. These entities have “a regular business” of supplying energy, food, and other tangible products to America. To these entities, swaps are ancillary tools that they can use to manage risk. These entities suffered from – rather than perpetrated – the 2008 financial crisis. Yet, these entities (either individually or through trade associations) took the time to draft and submit comment letters to the Commission – sometimes multiple letters – because they were afraid of being defined as “swap dealers.”

If the Commission had any doubt regarding the above construction, the Commission could have referred to various letters from members of Congress. Such letters explicitly state that Congress intended to exclude commercial end-users. For example, former Chairman Christopher Dodd and Chairwoman Blanche Lincoln circulated a joint letter stating: “Congress does not intend to regulate end-users as Major Swap Participants or Swap Dealers just because they use swaps to hedge or manage the commercial risks associated with their business.”²¹ Both senators Dodd and Lincoln were instrumental in shaping the legislation that became the Dodd-Frank Act.

Recently, Chairwoman Debbie Stabenow and Chairman Frank Lucas reiterated this point:

[I]t is important for the Commission to finalize the swap dealer definition in a manner that is not overly broad, and that will not impose significant new regulations on entities that Congress did not intend to be regulated as swap dealers. The Commission’s final rulemaking further defining ‘swap dealing’ should clearly distinguish swap activities that end-users engage in to hedge or mitigate the commercial risks associated with their businesses, including swaps entered into by end-users to hedge physical commodity price risk, from swap dealing.²²

It is important to note that Chairwoman Stabenow and Chairman Lucas lead the Congressional committees charged with overseeing the Commission.

CEA section 1a(49)(B): Discretionary Exclusion for Entities

In the alternative (assuming that the Commission rejects the above construction), CEA section 1a(49)(B) also contradicts the Commission’s focus on the activities in CEA section 1a(49)(A). Specifically, CEA section 1a(49)(B), when properly construed, sets forth a permissive exclusion focused on entities, with respect to either their activities or their swaps. CEA section 1a(49)(B) states: “A person may be designated as a swap dealer for a single type or single class or category of swap or activities and considered not to be a swap dealer for other types, classes, or categories of swaps or activities.”

First, CEA section 1a(49)(B) references “[a] person.” CEA section 1a(38) defines “person” as “import[ing] the plural or singular.” Read together, the sections indicate that CEA section 1a(49)(B) focuses on either (i) an entity or (ii) multiple entities.

Second, CEA section 1a(49)(B) states that “[a] person” (or “persons”) could be “considered not to be” a “swap dealer” for “types, classes, or categories of swaps.” So, an entity could be excluded from the “swap dealer” definition with respect to, e.g., physical commodity swaps, regardless of its activity with respect to such swaps. That indicates that the “swap dealer” definition does not solely focus on activity, as the Commission maintains. Instead, the characteristics of the entity and the underlying swaps are also relevant.

Third, CEA section 1a(49)(B) states that “[a] person” (or “persons”) could be “considered not to be” a “swap dealer” for certain “activities.” So, even if an entity engages in “activities” in CEA section 1a(49)(A), that entity may nevertheless not be a “swap dealer.” That indicates that the “swap dealer” definition may not even predominantly focus on activity.

Finally, CEA section 1a(49)(B) permits the Commission to include one “person” (or a group of “persons”) engaging in certain activities in the “swap dealer” definition, but to exclude another “person” (or group of “persons”) engaging in the same activities. Of course, the Commission has to articulate a rational basis for differential treatment. As discussed below, there may be certain statutory bases for differentiation (including the reference to “financial entity” in the end-user exception). Nothing in CEA section 1a(49)(B) prevents the Commission from so differentiating through rulemaking (rather than individual determinations).

o Unnecessary Statutory Contortions

Instead of following the canons of statutory construction and properly interpreting CEA section 1a(49)(C) and CEA section 1a(49)(B), the Commission engages in a series of contortions with seemingly opposing purposes. Upon review, these contortions appear to stem from a desire of the Commission to provide a measure of certainty to commercial end-users in the CFTC Entities Rule, without explicitly contradicting the Proposal.

Preliminarily, the Commission appears to broadly define “swap dealer” to capture commercial end-users. For example, both the Proposal and the CFTC Entities Rule obfuscate the application of CEA section 1a(49)(C) to entities (rather than solely to activities) by collapsing CEA section 1a(49)(C) into CEA section 1a(49)(A)(iii).²³ In performing such collapse, the Commission states that it “continue[s] to believe, as stated in the [Proposal], that the phrases ‘ordinary course of business’ and ‘a regular business’ are, for purposes of the definition of ‘swap dealer’ essentially synonymous.”²⁴ Neither the Proposal nor the CFTC Entities Rule fully supports collapsing CEA section 1a(49)(C) – one of four clauses in the statutory “swap dealer” definition – into CEA section 1a(49)(A)(iii) – a subparagraph of one clause. Further, neither the Proposal nor the CFTC Entities Rule fully supports interpreting two separate phrases (i.e., “ordinary course of business” and “regular business”) as meaning the same thing. The Commission similarly minimizes CEA section 1a(49)(B) as providing for “limited designation” only, rather than an alternate source of authority for the Commission to exclude certain entities from the “swap dealer” definition.²⁵

However, after appearing to broadly define “swap dealer”, the Commission then cobbles together various measures that aim – with differing levels of success – to provide a measure of certainty to commercial end-users. The most important (and successful) of these measures is a higher de minimis threshold. Two other important measures are: (i) referencing the dealer-trader distinction and (ii) incorporating an explicit hedging exception.

Although these measures reflect positive policy choices, they also reflect various compromises that may ultimately diminish the certainty that they seek to provide. As mentioned above, the Commission could have provided equivalent or superior certainty by properly construing CEA sections 1a(49)(C) and (B), either initially or in a re-proposal.

o Reference to the Dealer-Trader Distinction

In the CFTC Entities Rule, the Commission states that it “believe[s] that the dealer-trader distinction – which already forms a basis for identifying which persons fall within the longstanding Exchange Act definition of ‘dealer’ – in general provides an appropriate framework for interpreting the statutory definition of the term ‘swap dealer.’”²⁶ In so recognizing, the Commission departs from the Proposal.²⁷ I have always argued that differences exist among (i) dealing, (ii) trading, and (iii) hedging. I have also recommended that the Commission provide guidance to clearly distinguish among the three categories. Such guidance would aid market participants in determining whether to register as a “swap dealer.” Although the CFTC Entities Rule contains (i) an interim final hedging exception²⁸ and (ii) a final “floor trader” exclusion, ²⁹ both provisions are limited in scope. Therefore, market participants will still need clear guidance on Commission interpretation of the dealer-trader distinction, in order to determine whether their trading or hedging transactions may cause them to be deemed “swap dealers.”

Unfortunately, the Commission has missed its opportunity in the CFTC Entities Rule. After reading the relevant portions of the rulemaking multiple times, it is still unclear to me exactly how the Commission intends to distinguish among (i) dealing, (ii) trading (outside of the limited “floor trader” exclusion), and (iii) hedging (outside of the specific hedging exception, which I discuss below). For example, the Commission states: “[t]he principles embedded within the ‘dealer trader distinction’ are also applicable to distinguishing dealers from non-dealers such as hedgers or investors.”³⁰ I agree with this statement. The Commission also cites to more support from the SEC Entities Rule – specifically the fact that “[t]he ‘dealer-trader’ nomenclature has been used for decades.”³¹ I also agree with this statement. However, the Commission then states: “These same principles, though instructive, may be inapplicable to swaps in certain circumstances or may be applied differently in the context of dealing activities involving commodity, interest rate, or other types of swaps.”³² I do not know whether to agree or disagree with this statement, given its ambiguity. Thus, for all of its girth, the CFTC Entities Rule fails to answer a basic question – namely, under which circumstances would an entity be deemed a dealer (rather than a trader or hedger) with respect to specific swap transactions?³³

The Commission appears to argue that inherent differences between the swaps markets and securities markets (other than security-based swaps) justify its selective incorporation of dealer-trader elements (which elements, in themselves, apparently vary according to unknown facts and circumstances). For example, the Commission states that an entity need not engage in two-way transactions in order to fall within the “swap dealer” definition. One justification that the Commission advances is that “swaps thus far are not significantly traded on exchanges or other trading systems” and that this “[attribute] – along with the lack of ‘buying and selling’ language in the swap dealer definition…-- suggest that concepts of what it means to make a market need to be construed flexibly in the contexts of the swap market.”³⁴ However, in the same section of the CFTC Entities Rule, the Commission states: “many cash market securities also are not significantly traded on those systems.”³⁵ Therefore, the Commission advances a justification for selective incorporation of dealer-trader elements and then contradicts its justification in the same paragraph. Thus, even if market participants wished to understand Commission reasoning to determine whether they need to register as “swap dealers”, they may not be able to do so.

Finally, the Commission and the SEC appear to emphasize different dealer-trader elements. For example, the Commission tends to emphasize “accommodating demand or facilitating interest in the instrument.”³⁶ In contrast, the SEC tends to emphasize “a business model that seeks to profit by providing liquidity.”³⁷ The Commission fails to provide a rationale for its difference in focus.³⁸ On its face, “accommodating demand or facilitating interest” seems to capture more traders and hedgers than having “a business model that seeks to profit by providing liquidity.”

o Interim Final Rule on Hedging

In the CFTC Entities Rule, the Commission has included an interim final rule excepting certain hedging transactions from the “swap dealer” definition (i.e., Regulation 1.3(ppp)(6)(iii)).³⁹ I agree that hedging is not dealing. However, I find the interim final rule excessively narrow. First, the interim final rule only applies to a limited set of physical commodity hedges. I am not sure why the Commission does not wish to allow commercial end-users to hedge financial risks (e.g., through interest rate swaps) without fearing that they could be deemed “swap dealers.”⁴⁰ Permitting such hedging would be consonant with Congressional intent, as expressed in the letters from members of Congress.⁴¹ Conversely, I am not sure why the Commission wants to encourage, e.g., banking entities – like Barclays – to own physical commodities and claim the hedge exception.

Second, there are four other hedging definitions that are either (i) currently effective or (ii) the subject of a Dodd-Frank Act proposal.⁴² Given the call by President Obama to simplify regulation,⁴³ I would have expected the Commission to refrain from proposing a fifth hedging definition, unless strictly necessary. In the CFTC Entities Rule, the Commission does not cogently explain the necessity for a fifth hedging exception. For example, the Commission spends a considerable amount of effort to differentiate the interim final rule from bona fide hedging in Regulations 1.3(z) and 151.5(a)(1). The Commission’s rationale may be distilled into one circular sentence: the Commission believes that certain bona fide hedging transactions may constitute swap dealing, due to reasons that the Commission declines to fully explain.⁴⁴ Additionally, the Commission spends one paragraph attempting to differentiate between the interim final rule and the “major swap participant” definition (which contains a hedging or mitigating commercial risk exception). In that paragraph, the central argument appears to be that the “swap dealer” definition determines the parameters of the “major swap participant” definition – but not also vice versa.⁴⁵ Preliminarily, the Commission declines to cite where exactly the Dodd-Frank Act states that the “swap dealer” definition is determinative. Secondarily, even assuming that the Commission is correct in characterizing the interconnection, the Commission does not clearly explain why it thinks that those transactions (i) falling outside the interim final rule but (ii) falling within hedging or mitigating commercial risk are more likely to constitute swap dealing.

Finally, the Commission is silent on the manner in which the interim final rule interacts with the proposed Regulation 39.6 (detailing hedging or mitigating commercial risk for the end-user exception). If an entity is a “swap dealer,” then it cannot rely on the end-user exception to clearing.⁴⁶ Therefore, if the Commission overreaches in defining “swap dealer,” it may narrow the end-user exception in a way not congruent with Congressional intent.⁴⁷

Other Provisions of the Dodd-Frank Act and the CEA: Further Misconstructions

As mentioned above, the Commission fails to properly construe the various clauses of CEA section 1a(49). As detailed in this section, the Commission also fails to consider other provisions of the CEA or the Dodd-Frank Act in determining the parameters of “swap dealer.” The Commission appears to assume that the “swap dealer” definition is determinative for all such provisions, rather than also vice versa. The Commission does not provide much (if any) rationale for this assumption. Removing this assumption, it becomes clear that other provisions of the CEA or the Dodd-Frank Act may suggest further limitations on “swap dealer.”⁴⁸

o End-User Exemption: Who can take advantage of it?

CEA section 2(h)(7) sets forth what is commonly known as the “end-user clearing exception.” As mentioned above, the “swap dealer” definition is crucial to determining which entities could use the end-user clearing exception. That is because CEA section 2(h)(7) only applies if one counterparty to a swap is not a “financial entity.”⁴⁹ CEA section 2(h)(7)(C) defines “financial entity” as including a “swap dealer.”⁵⁰ Therefore, if the Commission defines “swap dealer” expansively, then the Commission will limit the number and types of end-users that may use the clearing exception.

Given the importance of the interconnections between the “swap dealer” definition and the end-user clearing exception, I would have expected the Commission to discuss such interconnections in great detail. Surprisingly, in that portion of the CFTC Entities Rule defining “swap dealer”, the Commission only discusses the end-user clearing in a footnote.⁵¹

Footnote 213 illustrates in a particularly poignant manner the Commission’s failure to properly consider the interaction between the “swap dealer” definition and the end-user exception. In that footnote, the Commission attempts to dismiss the argument that the “swap dealer” definition should only apply to financial entities. The Commission states:

Similarly, the absence of any limitation in the statutory definition of the term “swap dealer” to financial entities, when such limitation is included elsewhere in Title VII, indicates that no such limitation applies to the swap dealer definition.  CEA section 2(h)(7), 7 U.S.C. 2(h)(7), specifically limits the application of the clearing mandate, in certain circumstances, to only “financial entities.”  That section also provides a detailed definition of the term “financial entity.”  See CEA section 2(h)(7)(C), 7 U.S.C. 2(h)(7)(C).  That such a limitation is included in this section, but not in the swap dealer definition, does not support the view that the statutory definition of the term “swap dealer” should encompass only financial entities.

In actuality, Footnote 213 raises more questions than it answers. In Footnote 213, the Commission presumes that the interaction between the “swap dealer” definition and the end-user exception only goes one way – namely, that the “swap dealer” definition fixes the scope of the end-user exception, but not also vice versa. The Commission provides no basis for this presumption, especially since a basic canon of statutory is that the Commission should construe a statute as a “harmonious whole.” From that perspective, it becomes clear that Footnote 213 raises a series of fundamental questions. Why did Congress use the term “financial entity” in CEA section 2(h)(7)(C)? Does use of this term imply in any way that Congress presumed that the “swap dealer” definition would exclude commercial entities? Why or why not? Surely, Congress need not have specified financial entity in CEA section 2(h)(7)(C) if it had intended to permit the Commission to vitiate the reference to financial by simply defining “swap dealers” to include commercial entities. If Congress intended to so permit, then Congress could have simply used the term “entity” in CEA section 2(h)(7)(C).

o Employee Benefit Plans: “Swap Dealers?”

In Section II(A)(2)(f) of the CFTC Entities Rule, the Commission describes comments requesting categorical exclusions from the “swap dealer” definition. One such comment was from American Benefits Council (“ABC”) and the Committee on the Investment of Employee Benefit Assets (“CIEBA”).⁵² In their comments, ABC/CIEBA requested that the Commission exclude (or interpret CEA section 1a(49) to exclude) certain employee benefit plans from the “swap dealer” definition. In Section II(A)(6) of the CFTC Entities Rule, the Commission denies this request, mainly on the basis of its misguided construction of CEA section 1a(49).

In so denying, the Commission fails to consider CEA section 4s(h). Specifically, CEA sections 4s(h)(2), (4), and (5) prescribe heightened business conduct standards for “swap dealers” interacting with “special entities.” In fact, the Commission recently promulgated a final rulemaking on these standards.⁵³ CEA section 4s(h)(2)(C) defines “special entity” as, among other things, “any employee benefit plan, as defined in section 3 of the Employee Retirement Income Security Act of 1974 (29 U.S.C. 1002).” CEA section 4s(h) raises another series of fundamental questions. Did Congress presume that employee benefit plans would not constitute “swap dealers”?⁵⁴ Why or why not? Indeed, how does the Commission reconcile its denial of the ABC/CIEBA request with its own de minimis requirement, which seems to recognize a per se difference between a “special entity” and a “swap dealer”?⁵⁵

o Internal Business Conduct Standards: Indication of the Scope of “Swap Dealer?”

In addition to failing to account for external business conduct standards, the Commission fails to account for certain internal business conduct standards in defining “swap dealer.” For example, CEA section 4s(j)(5) requires “swap dealers” to have systems and procedures to mitigate conflicts of interest resulting from interactions between (i)(A) any person engaged in “research or analysis of the price or market for any commodity or swap” or (B) any person “acting in a role of providing clearing activities or making determinations as to accepting clearing customers” and (ii) certain persons involved in “pricing, trading, or clearing activities.” The Commission recently promulgated a final rulemaking on this requirement.⁵⁶ CEA section 4s(j)(5) raises another fundamental question. Did Congress presume that “swap dealers” generally engage in either “research or analysis” or “providing clearing activities or making determinations” and “pricing, trading, or clearing activities”? Why or why not?

o Volcker: How does the CFTC Entities Rule Fit?

As I have noted previously, the “Volcker Rule”⁵⁷ sets forth detailed metrics to differentiate between (i) market-making and (ii) proprietary trading. To say that the CFTC Entities Rule does not replicate such detail would be an understatement. Worse, the CFTC Entities Rule does not even attempt to explain why the metrics in the Volcker Rule are inapplicable to the “swap dealer” definition. In fact, the Commission addresses the interaction between the Volcker Rule and the CFTC Entities Rule only in one footnote. This footnote states in relevant part:

The Commissions have proposed an approach to the Volcker Rule under which a person could seek to avoid the Volcker Rule in connection with swap activities by asserting the availability of that market making exception…Under this approach, such a person would likely also be required to register as a swap dealer (unless the person is excluded from the swap dealer definition, such as by the exclusion of certain swaps entered into in connection with the origination of a loan).⁵⁸

Of course, this footnote provides no useful clarification, since the operative question is whether an entity engaging in activities that would not be “market-making” under the Volcker Rule could nonetheless be engaging in “market-making” under the CFTC Entities Rule (and, solely by virtue of such characterization, be required to register as a “swap dealer”).

Conclusion

In the CFTC Entities Rule, the Commission has made many positive policy changes. To enable these changes, however, the Commission engages in a series of statutory contortions. Moreover, the Commission ignores a number of important questions. Witnessing these statutory gymnastics, I am reminded of the Robert Frost poem, “The Road Not Taken.” In its eagerness to adopt the CFTC Entities Rule, the Commission opted for one road. Specifically, the Commission opted for providing more relief to market participants, without contradicting the fundamental premises of its proposal. However, once market participants have examined the rulemaking, will the Commission have wished that it had properly construed CEA section 1a(49) instead? Given the Proposal and the final CFTC Entities Rule (and their respective differences), the Commission may well conclude that “…it took the one less traveled by…And that has made all the difference.” ⁵⁹

¹ Further Definition of “Swap Dealer”, “Security-Based Swap Dealer”, “Major Swap Participant”, “Major Security-Based Swap Participant”, and “Eligible Contract Participant” (to be codified at 17 CFR pt. 1), available at: [___________]. As stated below, this final rule and interim final rule is joint between the Commission and the SEC. Therefore, within this dissent, (i) the term “Entities Rule” refers to the entire rule, (ii) the term “CFTC Entities Rule” refers to only the CFTC portion of such rule, and (iii) the term “SEC Entities Rule” refers to the SEC portion of such rule.

² Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. 111–203, 124 Stat. 1376 (2010).

³ See Further Definition of “Swap Dealer”, “Security-Based Swap Dealer”, “Major Swap Participant”, “Major Security-Based Swap Participant”, and “Eligible Contract Participant”, 75 Fed. Reg. 80174 (proposed Dec. 21, 2010) (to be codified at 17 CFR pt. 1) (the “Proposal”).

⁴ The canons of statutory construction are “important rules and conventions” that the judiciary applies to determine the meaning of statutory provisions. Congressional Research Service, Report for Congress, Statutory Interpretation: General Principles and Recent Trends, updated August 31, 2008 (the “CRS Report”) (Summary). In general, it behooves agencies (such as the Commission) to adhere to such canons so that its regulations, if subject to legal challenge, would be more likely to survive judicial scrutiny. In the CFTC Entities Rule, the Commission acknowledges the importance of canons of statutory construction, since it cites to certain canons in determining the application of its “eligible contract participant” definition. See Section III(B)(4) of the CFTC Entities Rule.

⁵ The statutory definition of “swap dealer” can be found in section 1a(49) of the Commodity Exchange Act (the “CEA”), 7 U.S.C. 1a(49). For purposes of reference, the text of CEA section 1a(49) is as follows:

‘‘(49) SWAP DEALER.—

‘‘(A) IN GENERAL.—The term ‘swap dealer’ means any person who—

‘‘(i) holds itself out as a dealer in swaps;

‘‘(ii) makes a market in swaps;

‘‘(iii) regularly enters into swaps with counterparties as an ordinary course of business for its own account; or

‘‘(iv) engages in any activity causing the person to be commonly known in the trade as a dealer or market maker in swaps,

provided however, in no event shall an insured depository institution be considered to be a swap dealer to the extent

it offers to enter into a swap with a customer in connection with originating a loan with that customer.

‘‘(B) INCLUSION.—A person may be designated as a swap dealer for a single type or single class or category

of swap or activities and considered not to be a swap dealer for other types, classes, or categories of swaps or activities.

‘‘(C) EXCEPTION.—The term ‘swap dealer’ does not include a person that enters into swaps for such person’s own account, either individually or in a fiduciary capacity, but not as a part of a regular business.

‘‘(D) DE MINIMIS EXCEPTION.—The Commission shall exempt from designation as a swap dealer an entity that engages in a de minimis quantity of swap dealing in connection with transactions with or on behalf of its customers.

The Commission shall promulgate regulations to establish factors with respect to the making of this determination

to exempt.”

⁶ See 75 Fed. Reg. at 80175, 80179 (stating that “The Dodd-Frank Act defines the terms ‘swap dealer’…in terms of whether a person engages in certain types of activities involving swaps or security-based swaps… Based on the plain meaning of the statutory definition, so long as a person engages in dealing activity that is not de minimis, as discussed below, the person is a swap dealer...”).

⁷ The following example illustrates the difference between (i) an “exception” and (ii) an “exclusion.” Imagine a circle entitled “swap dealer.” “Exceptions” are circles within the “swap dealer” circle. In essence, entities within those circles are subcategories of “swap dealer” permitted special treatment. “Exclusions” are circles entirely separate from the “swap dealer” circle. In essence, entities within those circles are not “swap dealers” in the first instance. As described below, CEA section 1a(49)(C) provides a mandatory “exclusion” from the “swap dealer” definition for – at a minimum – non-financial entities that do not have “a regular business” of entering into swap transactions. To be clear, this “exclusion” applies to entities, and not solely to their activities. Similarly, CEA section 1a(49)(B) provides a discretionary “exclusion” from the “swap dealer” definition (rather than just “limited designation,” as the Commission contends).

⁸ See, e.g., Opening Statement, Sixth Series of Proposed Rulemakings under the Dodd-Frank Act, Dec. 1, 2010, available at http://www.cftc.gov/PressRoom/SpeechesTestimony/omaliastatement120110; and Jobs on Main Street vs. Wall Street: The Choice Should be Clear, 2011 Futures Industry Association Energy Forum, New York, Keynote Address, Sept. 14, 2011, available at http://www.cftc.gov/PressRoom/SpeechesTestimony/opaomalia-8.

⁹ See supra note 5 for the exact text of CEA section 1a(49)(C). See also supra note 7 for an explanation of the difference between (i) an “exception” and (ii) an “exclusion.” The collapse of CEA section 1a(49)(C) (referencing “a regular business” into CEA section 1a(49)(A)(iii) (referencing “an ordinary course of business”) illustrates that the Commission still considers entities within CEA section 1a(49)(C) as subcategories of “swap dealers,” absent Commission largesse.

¹⁰ Id. for the exact text of CEA section 1a(49)(B).

¹¹ In the CFTC Entities Rule, the Commission departs from the Proposal in the following ways, among others: (i) acknowledging that there is a difference between dealing, trading, and hedging, (ii) setting forth an explicit exception for swaps that an entity enters into in its capacity as a floor trader (as defined in CEA section 1a(23)), (iii) providing another explicit exception for certain hedging activities, (iv) providing an exception for swaps between majority-owned affiliates, and (iv) setting forth a phase-in period with a higher de minimis threshold.

¹² See, e.g., Congressional Research Service, Report for Congress, Statutory Interpretation: General Principles and Recent Trends, updated August 31, 2008 (the “CRS Report”), p. CRS-2.

¹³ Id.

¹⁴ As mentioned above, CEA section 1a(49)(A) states that the term “swap dealer” means “any person who – (i) holds itself out as a dealer in swaps; (ii) makes a market in swaps; (iii) regularly enters into swaps with counterparties as an ordinary course of business for its own account; or (iv) engages in any activity causing the person to be commonly known in the trade as a dealer or market maker in swaps.”

¹⁵ See supra note 9.

¹⁶ Section II of the CFTC Entities Rule.

¹⁷ Id.

¹⁸ Id.

¹⁹ The CRS Report, p. CRS-14 (stating that “A basic principle of statutory construction is that courts should ‘give effect, if possible to every clause and word of a statute, avoiding, if it may be, any construction which implies that the legislature was ignorant of the meaning of the language it employed.” (quoting Montclair v. Ramsdell, 107 U.S. 147, 152 (1883)). See also the CRS Report, CRS-12, footnote 62 (discussing the “modern variant” of this canon).

²⁰ As mentioned below, certain financial entities may also satisfy these criteria, such as “special entities” (as defined in CEA section 4s(h)(2)(C) (e.g., certain employee benefit plans covered by the Employee Retirement Income Security Act of 1974 (“ERISA”)). If the Commission wanted to prevent other financial entities from abusing CEA section 1a(49)(C), the Commission could have preliminarily limited the exclusion to commercial end-users (or other entities that the Commission determines could be excluded based on a holistic reading of the Dodd-Frank Act and the CEA, including small financial institutions as delineated in CEA section 2(h)(7)(C)). Additionally, if the Commission wanted to prevent commercial end-users (or such other entities) from abusing CEA section 1a(49)(C) (by, e.g., entering into non-ancillary transactions in swaps), the Commission has anti-evasion authority under CEA 721(c).

The regulations that the Commission promulgates under the Dodd-Frank Act will irrevocably change the structure of the swap markets. Such changes have benefits and costs. To properly weigh the benefits and costs of its regulations under CEA section 15(a), it would have behooved the Commission to have discussed (i) categorically excluding certain entities from the “swap dealer” definition within the phase-in period, and (ii) exercising anti-evasion authority, if the Commission found it necessary based on its surveillance of the swaps market.

²¹ Letter from Chairman Christopher Dodd, Committee on Banking, Housing, and Urban Affairs, United States Senate, and Chairman Blanche Lincoln, Committee on Agriculture, Nutrition, and Forestry, United States Senate, to Chairman Barney Frank, Financial Services Committee, United States House of Representatives, and Chairman Colin Peterson, Committee on Agriculture, United States House of Representatives (June 30, 2010) (the “Dodd-Lincoln Letter”).

The Dodd-Lincoln Letter (as well as the Stabenow-Lucas Letter (as defined below)) appears to have embraced a broader conception of “commercial risk” than the Commission. See infra note 41.

²² Letter from Chairwoman Debbie Stabenow, Committee on Agriculture, Nutrition, and Forestry, U.S. Senate, and Chairman Frank D. Lucas, Committee on Agriculture, United States House of Representatives to Chairman Gary Gensler, United States Commodity Futures Trading Commission (March 29, 2012) (the “Stabenow-Lucas Letter”).

²³ In Section II(A)(4)(d) of CFTC Entities Rule, the Commission states: “We recognize, as noted by one commenter (see letter from ISDA dated February 22, 2011), that the ‘regular business’ exclusion is not limited solely to the ‘ordinary course of business’ test of the swap dealer definition. Our interpretations of the other three tests are, and should be read to be, consistent with the exclusion of activities that are not part of a regular business.”

Preliminarily, I would note that more than one commenter observed the collapse.

Secondarily, as noted above, CEA section 1a(49)(C) applies to entities (and not solely to activities). Therefore, the Commission does not (and really cannot) argue that the collapse of CEA section 1a(49)(C) into CEA section 1a(49)(A)(iii) has little to no impact on its construction of CEA sections 1a(49)(A)(i), (ii), and (iv).

Finally, although it is ambiguous in the CFTC Entities Rule (and not contemplated in the Proposal), it seems like the Commission may be indirectly relying on its reference to the dealer-trader distinction to justify its collapse of CEA section 1a(49)(C) and 1a(49)(A)(iii). Interestingly, the SEC does not state that “regular business” in Exchange Act section 3(a)(71)(C)) (parallel to CEA section 1a(49)(C)) is “synonymous” with “ordinary course of business” in Exchange Act section 3(a)(71)(A)(iii) (parallel to CEA section 1a(49)(A)(iii)). Of course, it may have been understood that the SEC would hew more closely to the dealer-trader distinction, as historically applicable to securities, and thus would focus on activities and not entities. See Section II(A)(3) of the Entities Rule. However, one wonders that of all the distinctions that the Commission makes or attempts to preserve between the swaps and securities-based swaps markets, the Commission does not acknowledge (i) the “high degree of concentration” of dealing in the securities-based swaps markets among the largest financial entities and (ii) the lack of similar concentration in the swaps markets (particularly with respect to markets that commercial end-users frequent, such as the physical commodity swaps markets). Compare generally Section II(D)(5) of the SEC Entities Rule (which repeatedly references “high degree of concentration”) with Section II(D)(4) of the CFTC Entities Rule (which does not contain such references). See also Section II(A)(2)(e)(iii) of the CFTC Entities Rule (describing comments with respect to electricity swaps). The Commission should have accorded greater consideration to differences in market structure before dismissing a construction of CEA section 1a(49)(C) as focusing on entities (and as independent of CEA section 1a(49)(A)(iii)).

²⁴ Section II(A)(4)(d) of the CFTC Entities Rule.

²⁵ The Commission characterizes CEA section 1a(49)(B) as “limited designation” based on a series of misconstructions. First, as noted above, the Commission insists that CEA section 1a(49)(A) is the entirety of the “swap dealer” definition. Second, the Commission then interprets CEA section 1a(49)(B) to apply to the registration of an entity as a “swap dealer”, and not to the “swap dealer” definition. Third, because CEA section 1a(49)(B) applies to registration, the Commission concludes that it would be appropriate to apply an individualized, facts-and-circumstances analysis.

In actuality, CEA section 1a(49)(B) does more than provide for “limited designation.” First, as discussed above, CEA section 1a(49)(A) sets forth general parameters for defining “swap dealer.” The entirety of the “swap dealer” definition is actually CEA sections 1a(49)(A), (B), (C), and (D). Second, CEA section 1a(49)(B) is in the definition of “swap dealer.” It is not in CEA section 4s(a), which pertains to registration of “swap dealers.” Therefore, the Commission should have considered the effect of CEA section 1a(49)(B) in delineating the universe of entities that need to seek registration with the Commission, and not solely the effect of CEA section 1a(49)(B) in determining the scope of registration that the Commission would afford such entities. Third, because CEA section 1a(49)(B) relates to the definition and not the registration of “swap dealers”, the Commission articulates no basis for an individualized, facts-and-circumstances determination.

²⁶ Section II(A)(4)(a) of the CFTC Entities Rule.

²⁷ The Commission acknowledges such departure, but attempts to mitigate its legal effect by emphasizing that (i) the dealer-trader framework overlaps with the functional approach in the Proposal, and (ii) the Commission has changed its interpretative approach to the “swap dealer” definition in response to comments. See Section II(A)(4)(a) of the CFTC Entities Rule.

²⁸ As described below, this exception only applies to physical commodity swaps. Therefore, commercial end-users would not be able to rely on this exception for swaps to hedge financial risks. Moreover, small financial institutions would not be able to rely on this exception (as they most likely would be hedging financial risk), even if the Commission were to permit them to use the end-user exception. Finally, even financial entities (such as “special entities”) may engage in “hedging” without “dealing.” The CFTC Entities Rule does not provide much clarity on how such financial entities could demonstrate that they are not “dealing” (other than the amorphous distinction between “purpose” and “consequences”).

²⁹ The final “floor trader” exclusion has many limitations. For example, an entity cannot rely on this exclusion if it participates in a market-making program offered by a designated contract market (“DCM”) or swap execution facility. One wonders what would happen if an entity participates in a DCM market-making program for futures, and then the Commission requires such futures to be converted to swaps in a forthcoming rulemaking. See, e.g., Core Principles and Other Requirements for Designated Contract Markets, 75 Fed. Reg. 80572 (Dec. 22, 2010).

³⁰ Section II(A)(4)(a) of the CFTC Entities Rule.

³¹ Section II(A)(5)(a) of the SEC Entities Rule.

³² Section II(A)(3) of the Entities Rule.

³³ For example, in Section II(A)(4)(a) of the CFTC Entities Rule, the Commission sets forth a list of indicia that are either “particularly similar to” or “generally consistent with…the dealer-trader distinction as it will be applied to determine whether a person is a security-based swap dealer.” However, the Commission immediately undermines any comfort that such list could provide by stating “[t]o clarify, the activities listed in the text are indicative of acting as a swap dealer. Engaging in one or more of these activities is not a prerequisite to a person being covered by the swap dealer definition.”

³⁴ Section II(A)(4)(a) of the CFTC Entities Rule.

³⁵ Id.

³⁶ See generally Section II(A)(4) of the CFTC Entities Rule.

³⁷ See generally Section II(A)(5) of the SEC Entities Rule.

The CFTC Entities Rule does acknowledge that seeking to profit from providing liquidity is one indicia of dealing. However, the CFTC Entities Rule limits its discussion of this indicia to CEA section 1a(49)(A)(ii), which emphasizes market-making. The Commission appears to rely more heavily on “accommodating or facilitating interest” (without necessarily emphasizing a “business model that seeks to profit from providing liquidity”) in its interpretation of the remainder of CEA section 1a(49)(A). Therefore, a dissonance still exists between the CFTC Entities Rule and the SEC Entities Rule.

³⁸ See supra note 23. The Commission could have focused on differences in market composition. Unfortunately, such focus could have raised other issues with Commission construction of CEA section 1a(49).

³⁹ See Section II(A)(4)(e) of the CFTC Entities Rule.

⁴⁰ The Commission relies on its misconstruction of the statutory “swap dealer” definition to justify such a narrow exclusion. In Section II(A)(4)(e) of the CFTC Entities Rule, the Commission states: “In terms of the statutory definition of the term ‘swap dealer,’ the CFTC notes as an initial matter that there is no specific provision addressing hedging activity. Thus, the statutory definition leaves the treatment of hedging swaps to the CFTC’s discretion; it neither precludes consideration of a swap’s hedging purpose, nor does it require an absolute exclusion of all swaps used for hedging.” As noted above, whereas CEA section 1a(49) does not specifically refer to “hedging”, CEA section 1a(49)(C) (as well as CEA section 1a(49)(B)) – as properly construed – would have excluded commercial end-users that engage in swaps for purposes of hedging. It is interesting that the SEC did not endorse these specific sentences.

⁴¹ As mentioned above, the Commission contorts itself in the CFTC Entities Rule to provide an interim hedging exception that applies only to physical commodity risks. This approach runs contrary to the Dodd-Lincoln Letter (as well as the Stabenow-Lucas Letter (as defined below)). Both letters emphasize exclusions for entities – such as commercial end-users – so that they could freely hedge their risks – whether financial or physical.

The Dodd-Lincoln Letter begins by referencing hedging of interest rate risk. It specifically states: “Whether swaps are used by an airline hedging its fuel costs or a global manufacturing company hedging interest rate risk, derivatives are an important tool businesses use to manage costs and market volatility. This legislation will preserve that tool.” Moreover, the Dodd-Lincoln Letter states: “The end user exemption may also apply to our smaller financial entities – credit unions, community banks, and farm credit institutions.” If such institutions could be categorized as “swap dealers,” then they would be prohibited from relying on the end-user exception. Such institutions would likely seek to hedge financial risk.

As mentioned above, the Stabenow-Lucas Letter states: “The Commission’s final rulemaking further defining ‘swap dealing’ should clearly distinguish swap activities that end-users engage in to hedge or mitigate the commercial risks associated with their businesses, including swaps entered into by end-users to hedge physical commodity price risk, from swap dealing.” In using the term “including,” the Stabenow-Lucas Letter acknowledges that end-users may use swaps to hedge or mitigate risks – such as financial risks – other than those related to physical commodities.

Bu focusing only physical commodity risks, therefore, the interim hedging exception fails to fully satisfy Congressional intent.

⁴² See Regulation 1.3(z), 17 C.F.R. 1.3(z); (ii) Regulation 151.5(a)(1) (in Position Limits in Futures and Swaps, 76 Fed. Reg. 71626, 71688 (Nov. 18, 2011) (to be codified at 17 C.F.R. pts. 1, 150, and 151)); (iii) Regulation 1.3(ttt) (as set forth in the CFTC Entities Rule); and (iv) Regulation 39.6(c) (in End-User Exception to Mandatory Clearing of Swaps, 75 Fed. Reg. 80747, 80757 (proposed Dec. 23, 2010) (to be codified at 17 C.F.R. pt. 39)).

⁴³ See Exec. Order No. 13563, 76 FR 3821, Jan. 21, 2011; see also Exec. Order No. 13579, 76 FR 41587, July 14, 2011.

⁴⁴ In Section II(A)(4)(e) of the CFTC Entities Rule, the Commission attempts to distinguish between “purpose” and “effect.” Market participants may find such an attempt to be less than clear.

⁴⁵ Section II(A)(4)(e) of the CFTC Entities Rule (stating “…The definition of the term “major swap participant,” which applies only to persons who are not swap dealers, is premised on the prior identification, by the swap dealer definition, of persons who accommodate demand for swaps, make a market in swaps, or otherwise engage in swap dealing activity. The major swap participant definition performs the subsequent function of identifying persons that are not swap dealers, but hold swap positions that create an especially high level of risk that could significantly impact the U.S. financial system.”).

⁴⁶ See CEA section 2(h)(7).

⁴⁷ See supra note 41.

⁴⁸ As mentioned above, the Commission has authority to discretionarily exclude certain entities pursuant to CEA section 1a(49)(B).

⁴⁹ CEA section 2(h)(7)(A) states: “In General. – The requirements of paragraph (1)(A) shall not apply to a swap if 1 of the counterparties to the swap – (i) is not a financial entity; (ii) is using swaps to hedge or mitigate commercial risk; and (iii) notifies the Commission, in a manner set forth by the Commission, how it generally meets its financial obligations associated with entering into non-cleared swaps.”

⁵⁰ Notably, CEA section 2(h)(7)(C)(i) also lists commodity pools, certain private funds, certain employee benefit plans, and certain banking and financial entities separately from “swap dealer.” Does this separate listing imply that those entities are not “swap dealers”? Why or why not?

⁵¹ The Commission discusses the end-user clearing exception more fully in that portion of the CFTC Entities Rule defining “major swap participant.”

⁵² Comment from ABC/CIEBA, dated February 22, 2011, available at: http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=27944&SearchText=American%20Benefits%20Council.

⁵³ Business Conduct Standards for Swap Dealers and Major Swap Participants with Counterparties, 77 Fed. Reg. 9734 (Feb. 17, 2012).

⁵⁴ See supra note 50.

⁵⁵ See Section II(D) of the CFTC Entities Rule.

⁵⁶ 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 Fed. Reg. 20128 (Apr. 3, 2012).

⁵⁷ Prohibitions and Restrictions on Proprietary Trading and Certain Interests in, and Relationships With,

Hedge Funds and Covered Funds, 77 Fed. Reg. 8332 (Feb. 14, 2012).

⁵⁸ Section II(A)(4)(c) of the CFTC Entities Rule.

⁵⁹ Generally, because the vast body of administrative law provides guideposts to the road more traveled.

Last Updated: April 18, 2012