After much anticipation, the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) (together, the Commissions) on July 10 adopted joint final rules and interpretations1 further defining the terms "swap," "security based swap," "securitybased swap agreement" (SBSA), and "mixed swap" pursuant to Title VII of the Dodd-Frank Act (DFA).2 The final rules and interpretations will go into effect on October 12, 2012, 60 days after their publication in the Federal Register on August 13, also triggering the compliance dates for a variety of other swap-related regulatory requirements, including the filing of applications for registration with the CFTC as a swap dealer or major swap participant (MSP).3 This article discusses the final rules and interpretations.
Under the DFA, the CFTC has regulatory authority over swaps while the SEC has regulatory authority over security-based swaps.4 In addition, although the CFTC has regulatory authority over SBSAs (which are swaps), the SEC has antifraud authority over and may obtain information from certain CFTC-regulated entities in connection with SBSAs because they are related to securities. Finally, the Commissions are required jointly to make rules affecting mixed swaps. The definitions adopted in the final rules are referred to as the Product Definitions. In addition, those agreements, contracts, or transactions (collectively, Instruments) that are included in the definitions of "swap," "security-based swap," or "mixed swap" are referred to as Title VII Instruments.
Title VII defines a swap to include, in part, any Instrument "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."5 Title VII lists those Instruments that fall within the definition, but also contains a number of exclusions, rules of construction, and other provisions for the interpretation of the definition.
One of the exclusions from the term swap is for a security-based swap, which is defined as an Instrument that is a swap and that also is based on (1) a narrow-based security index, including any interest therein or based on the value thereof; (2) a single security or loan, including any interest therein or based on the value thereof; or (3) the occurrence or nonoccurrence of an event relating to a single issuer of securities in a narrow-based index if that event directly affects the financial condition, obligations, or statements of the issuer.6
Thus, the definition of swap also determines what could be a security-based swap, i.e., if an Instrument is not a swap, it also cannot be a security-based swap.
Whether a Title VII Instrument is a swap, a security-based swap, or a mixed swap should be determined by the time the parties offer to enter into the Instrument. While the Commissions view this determination as rather straightforward, they recognize that some Title VII Instruments raise more complex characterization issues. Moreover, determining whether an Instrument is a Title VII Instrument in the first place can be complicated. Although the Commissions take the view that the detailed statutory definitions do not call for extensive further definition, they also recognize that the statute could be read to include certain types of Instruments that previously had not been considered and were not intended to be considered to be either swaps or security-based swaps. The Adopting Release thus clarifies the types of Instruments that are not Title VII Instruments. These Instruments are discussed in Part II of this article. Parts III and IV discuss the Commissions' treatment of more complex Title VII Instruments. Finally, Part V discusses the Commissions' determinations regarding potential evasion of Title VII and some additional definitional issues.
II. INSTRUMENTS THAT ARE NOT TITLE VII INSTRUMENTS
A. Insurance products
Recognizing that Congress did not intend that insurance products be regulated under Title VII, the final rules provide a non-exclusive insurance safe harbor under which certain Instruments will not be considered Title VII Instruments. Instruments must satisfy both a product (or enumerated product) and a provider test to be able to rely on the insurance safe harbor. The final rules also create an insurance grandfather exclusion from the Product Definitions for certain insurance Instruments entered into on or before the effective date of the Product Definitions. The Adopting Release makes clear, however, that Instruments labeled as insurance or reinsurance but executed as swaps or security-based swaps or otherwise structured to evade Title VII will not qualify for the safe harbor and will be treated as Title VII Instruments.
1. Product Test for Safe Harbor
The final rules create a non-exclusive safe harbor from regulation under Title VII for an Instrument that satisfies all of the following conditions (and also meets the Provider Test below).
The Instrument must:
- Require the beneficiary to have an insurable interest that is the subject of the Instrument and to carry the risk of loss continuously throughout its duration;
Note: Because a credit default swap (CDS) does not require the purchaser of protection to hold any underlying obligation issued by the reference entity on which the CDS is written, a CDS would not satisfy the safe harbor.
- Require the loss to occur and be proven and that any payment or indemnification be limited to the value of the insurable interest;
- Not be traded separately from the insured interest either on an organized market or over-the-counter.
Note: Assignments of insurance contracts as permitted or required by state law, or the purchase or assignment of an insurance contract on an "insurance exchange," do not constitute trading separately from the related insurable interest; and
- With respect only to financial guaranty insurance (i.e., bond insurance or bond wraps), in the event of payment default or insolvency of the obligor, acceleration of payment under the policy must be at the sole discretion of the insurer;7
Note: While financial guaranty insurance products can be economically similar to swaps and security-based swap (e.g., CDS), the acceleration limitation is a key distinction.8
2. Provider Test for Safe Harbor
In addition to meeting the Product Test, the Instrument must be:
- (i) Provided by a person subject to supervision by an appropriate insurance regulator and (ii) regulated as insurance under applicable law (the provider does not have to be an insurance company); or
- Provided directly or indirectly by the US, a state or state agency or instrumentality, or pursuant to a statutorily-authorized program of one of these entities; or
- In the case of reinsurance (i.e., the assumption by an insurer of all or part of a risk undertaken originally by another insurer) and retrocession (i.e., reinsurance of reinsurance) transactions, (i) provided to someone that meets the above provider conditions unless the person providing the reinsurance is not permitted to do so by applicable law; (ii) the Instrument to be reinsured satisfies either the Product Test above or the Enumerated Products Test below; and (iii) except as may be permitted by applicable state law, the total amount reimbursable by all reinsurers for the Instrument is no more than the claims or losses paid by the person writing the risk that was transferred; or
- In the case of "non-admitted insurance," provided by certain persons located outside of the US or that meet certain eligibility criteria under applicable state law.
3. Enumerated Products Test for Safe Harbor
If an Instrument satisfies the Provider Test, it need not also satisfy the Product Test as long as it is one of the following types of products: a surety or fidelity bond; life, health, title, long-term care, title, disability, or property and casualty insurance; an annuity; insurance against default on individual residential mortgages; or reinsurance of any of these types of products.
4. Insurance Grandfather
The Insurance Grandfather will apply to any product that meets the Provider Test when it is entered into, as long as that occurs on or before the effective date of the Product Definitions.
5. Further Analysis Required
The safe harbor is not intended to define insurance or to create a presumption that an Instrument failing to meet the above requirements will necessarily be a Title VII Instrument. Rather, any such Instrument will require a facts-and-circumstances analysis that will look to the form and substance of the Instrument to determine whether it is insurance. Instruments that would require further analysis include, for example, a surety bond or title insurance sold by a person that does not satisfy the Provider Test or in a state that does not regulate the product as insurance. Conversely, circumstances (e.g., market conditions) may change that would prompt the Commissions to reconsider (through formal rulemaking) whether any Instrument that satisfies the safe harbor should no longer do so.
7. Guarantees of Title VII Instruments
The CFTC has determined that a guarantee or insurance of an Instrument that is a swap (and is not a security-based swap or mixed swap) is functionally or economically similar to a swap and will be treated the same way as all other guarantees of swaps (that are not security-based swaps or mixed swaps). Thus, guarantees of swaps are swaps, to the extent that a counterparty to a swap position would have recourse to the guarantor in connection with the position. The CFTC plans to issue further guidance on guarantees of swaps.
The SEC for its part will not treat a guarantee of a security-based swap as a separate securitybased swap or as part of a security-based swap. Instead, it will consider requiring additional reporting of information about guarantees. A guarantee of a security is also a security, however, and, therefore, a guarantee of a security-based swap is a security.
B. Forward Contract Exclusion from Swap and Security-Based Swap Definition
Under the DFA, Title VII Instruments do not include "any sale of a nonfinancial commodity or security for deferred shipment or delivery, so long as the transaction is intended to be physically settled."9 The Commissions have provided guidance on the scope of the exclusion of forward contracts for nonfinancial commodities and securities.
SEC Guidance. The SEC's final guidance is unchanged from the proposed guidance10 and makes clear that sales of securities on a fixed or contingent basis or for deferred delivery when intended to be physically delivered (i.e., an agreement to purchase one or more securities or groups or indexes of securities at a future date at a certain price), which includes security forwards, are not security-based swaps. The guidance also provides that forward sales of mortgage-backed securities (MBS) guaranteed or sold by Fannie Mae, Freddie Mac, or Ginnie Mae11 in a "To-Be-Announced" market also are not swaps or security-based swaps even if the precise MBS are not in existence at the time the forward is entered into.
CFTC Guidance. The CFTC has made a number of modifications in response to comments. These are discussed below.
1. Nonfinancial Commodities
Under the CEA, an exempt commodity is any commodity other than an excluded commodity or an agricultural commodity. Examples of exempt commodities include energy commodities and metals. An excluded commodity is generally any financial instrument such as a security, currency, interest rate, debt instrument, or credit rating; any economic or commercial index other than a narrow-based commodity index; or any other value that is out of the control of participants and is associated with an economic consequence.12 A nonfinancial commodity is an exempt or agricultural commodity that can be physically delivered. An intangible commodity (that is not an excluded commodity) that can be physically delivered qualifies as a nonfinancial commodity if ownership can be conveyed in some way and the commodity can be consumed, e.g., an environmental commodity such as an emission allowance. In appropriate circumstances, these types of commodities (environmental and others) could qualify as forwards.
2. Forward Contracts in Nonfinancial Commodities
The forward exclusion for nonfinancial commodities will be interpreted consistently with the CFTC's historical interpretation of the existing forward exclusion with respect to futures contracts and with the entire body of CFTC precedent regarding forwards.
a) Historical Interpretation of Forwards
The primary purpose of a forward contract is to transfer ownership of the commodity itself and not solely price risk. Therefore, the CFTC's historical interpretation has been that forward contracts (as opposed to futures) with respect to nonfinancial commodities are "commercial merchandising transactions" generally not subject to the CFTC's jurisdiction under the CEA. Intent to deliver, determined by a facts and-circumstances test, has historically been a key element of the analysis of whether a contract is a forward or a future and will similarly be a part of the analysis of whether a contract is a forward or a swap.
b) Brent Interpretation
The CFTC's "Brent Interpretation" excluded certain forward contracts from regulation by the CFTC as futures contracts.13 Even though the CFTC has declined to codify the principles underpinning the Brent Interpretation, it has made clear that those principles will apply to the forward exclusion from the swap definition. In addition, while the Brent Interpretation applied only to oil, the CFTC's interpretive guidance will apply to all nonfinancial commodities, both with respect to the term "swap," and the definition of "future delivery" under the CEA. These transactions and the persons engaging in them are not wholly outside of the CEA's reach, however, and will be subject to the agency's investigative and enforcement authority.
Separate, individually-negotiated cancellation agreements between "commercial participants in connection with their business" that "book out" the contract, rather than make or take delivery, do not extinguish the original intent to make or take delivery. That intent may be inferred from a binding delivery obligation for the referenced commodity as well as the past conduct of the parties to the contract, i.e., whether they in fact regularly make or take delivery of the referenced commodity in the ordinary course of their business.
The CFTC has not imposed a minimum contract size for a transaction to qualify as a forward contract under the Brent Interpretation, but size may be considered as a "contextual factor" in determining whether a particular contract is a forward. In addition, other factors may be considered as well, consistent with the CFTC's historical facts-and-circumstances approach, such as whether there is a demonstrable need for the product, the underlying purpose of the contract, the regular practices of the commercial entity with respect to its commercial business, or whether the absence of physical settlement is based on a change in commercial circumstances.
To prevent abuse, the CFTC will now require that any oral book-out transaction be confirmed electronically or in writing in a "commercially reasonable timeframe" following the oral agreement.
Pre-transaction netting agreements that result in offsetting physical delivery obligations (provided that the parties had a bona fide intent to make or take delivery), bona fide termination rights (e.g., termination triggered by counterparty insolvency or other inability to perform that was not expected at the time the contract was entered into), or certain settlement methods used by parties to energy contracts, will not disqualify a transaction from the Brent Interpretation safe harbor. The CFTC intends to scrutinize these transactions carefully for abuse or evasion, however.
Consistent with the Brent Interpretation, "commercial" means "related to the business of a producer, processor, fabricator, refiner or merchandiser."14 The participant need not be solely engaged in commercial activities to be a "commercial market participant" as long as the business activity in which it makes or takes delivery is commercial activity.
Examples. An investment vehicle taking delivery of gold as part of its investment strategy would not be engaged in commercial activity. However, if the investment vehicle owns a gold mine and sells the output for forward delivery or owns a chain of jewelry stores that produces its own jewelry from raw materials it purchases from another entity's gold mine, these contracts could qualify as commercial and, assuming they satisfy the other requirements of the Brent Interpretation, be forwards.
c) Physical Exchange Transactions
Exchange transactions in nonfinancial commodities that are intended for deferred delivery may fall within the forward exclusion. Thus, a commercial merchandising transaction whose primary purpose is to transfer ownership of a physical commodity between two parties who intend physical delivery is likely to be an excluded forward.
Example. A gas utility enters 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 a different delivery point for the primary purpose of transferring ownership of the physical commodity in order to rationalize the delivery of supplies to where they are needed at a price that generally reflects the differences in value at the different delivery points.
d) Forward Transactions with Monthly or Other Fees
Agreements that otherwise meet the requirements set forth in the Adopting Release would be forwards if there is no optionality (as to delivery or otherwise) other than what is permitted under the CFTC's interpretation. Monthly or other fees that do not have the characteristics of option premiums will not convert the transactions from forwards to options.
Example. A fuel delivery agreement under which a joint power agency provides a municipal utility with a long-term supply of natural gas from a natural gas project it develops with others may be an excluded forward under circumstances in which the utility would pay the power agency through direct capital contributions to the developers for the developing costs. It would also pay the power agency a monthly fee for the natural gas supplied from the project. The fee would be composed of an operating cost component, an interstate pipeline transportation cost component, and an operating reserve cost component. The utility's generation facility would be used to supply a portion of its expected retail electric load.
e) Cleared or Exchange-Traded Forwards
Because the issue is beyond the scope of the Product Definitions rulemaking, the CFTC declined to adopt a safe harbor for exchange-traded contracts with respect to which more than 50 percent of contracts go to delivery and 100 percent of counterparties are commercial counterparties. If the CFTC considers the issue, it will likely do so only after soliciting additional public comment.
3. Commodity Options and Commodity Options Embedded in Forward Contracts
Commodity options are swaps under the statutory definition. However, commodity options embedded in forward contracts could qualify for the forward exclusion. The CFTC intends to apply its 1985 Office of General Counsel Interpretation to the treatment of forward contracts in nonfinancial commodities that contain embedded options.15 Under a two-step facts-and circumstances analysis, the CFTC will consider whether the embedded option operates on the price or the delivery term of the forward contract and will also look to the secondary trading of the Instrument.16
Accordingly, a forward contract containing an embedded commodity option(s) will be considered an excluded nonfinancial commodity forward if the embedded option:
- May be used to adjust the forward contract price, but does not undermine the overall nature of the contract as a forward contract;
- Does not target the delivery term, so that the predominant feature of the contract is actual delivery;17 and
- Cannot be severed and marketed separately from the overall forward contract.
The CFTC has also provided an interpretation with respect to forwards with embedded volumetric optionality. These may satisfy the forward exclusion if:
- The embedded optionality does not undermine the overall nature of the Instrument;
- The predominant feature of the Instrument is actual delivery;
- The embedded optionality cannot be severed and marketed separately from the Instrument;
- The seller of a nonfinancial commodity underlying the Instrument intends at the time it enters into the Instrument to deliver the underlying nonfinancial commodity if the optionality is exercised;
- The buyer intends at the time the Instrument is entered into to take delivery of the underlying nonfinancial commodity if it exercises the optionality;
- Both parties are commercial parties; and
- The exercise or non-exercise of the embedded volumetric optionality is based primarily on physical factors or regulatory requirements that are influencing supply and demand and are outside of the parties' control.
The Adopting Release contains a number of specific examples from comment letters of contracts with and without embedded options that could, under their specific facts and circumstances, satisfy the forward exclusion, including capacity contracts, transmission or transportation service agreements, tolling agreements, and peaking supply contracts.
a) Physical Commercial Instruments
The CFTC will look at the specific facts and circumstances of physical commercial agreements (e.g., tolls on power plants, transportation agreements on natural gas pipelines, and natural gas storage agreements) and will consider them not to be options if three conditions are met:
- The subject of the Instrument is usage of a specified facility or part of a facility and not the purchase or sale of the commodity that will be processed, stored, created, or transported using the facility;
- The Instrument grants the buyer, through an unconditional obligation of the seller, the exclusive use of the facility or part of the facility for the specified term; and
- Payment is for the use of the facility rather than for the option to use it. Thus even though the buyer has optionality as to whether to use the facility, it has the legal right to do so.
Examples. Scheduling electricity transmission or gas transportation into storage will not be exercising an option if the three conditions are met. However, if the right to use the facility is only obtained through the payment of a demand or reservation fee and the actual use entails further payment of storage, rents, or other usage or service fees, the Instrument would be a commodity option (and thus a swap).18
b) Energy Management Agreements
Energy Management Agreements (EMAs), which are not defined in the Adopting Release, can cover a variety of services and transactions. Thus, the CFTC has declined to state categorically whether EMAs are swaps. However, in general, if the transaction underlying the EMA (e.g., the fuel acquisition or sale of excess energy generation) is not itself a swap, the EMA should not transform it into a swap. Conversely, if swaps were to be executed as a result of or pursuant to an EMA, the parties would need to consider the circumstances to determine whether the swaps regime is implicated.
c) Liquidated Damages Provisions
A contractual liquidated damages provision in an Instrument involving physical settlement of a nonfinancial commodity will not necessarily make the Instrument ineligible for the forward exclusion as long as the parties intend that it be physically settled.
C. Consumer and Commercial Instruments
Consumer Instruments entered into primarily for personal use and commercial Instruments that involve customary business arrangements are not swaps or security-based swaps even though the statute could be read to cover them. Key components in assessing whether an Instrument is not a Title VII Instrument are, first, that the payment terms are not severable, and second, that the Instrument is not traded and thus does not involve risk-shifting arrangements with financial entities. In general, an assignment of an obligation does not mean the obligation is "traded."
The definitions of swap and security-based swap do not include any "identified banking products." Thus, the CEA generally does not cover (and the CFTC has no jurisdiction over) any fixed or variable interest rate commercial loans or mortgages entered into by a bank that are identified banking products.19 If a lender is not a bank, however, the statutory definitions could be read to cover these Instruments.
The Commissions' interpretation clarifies that commercial Instruments, including fixed or variable interest rate commercial loans or mortgages (including those with embedded interest rate locks, caps, floors, or options), are excluded from the Product Definitions regardless of whether they are entered into by banks or nonbanks. To the extent that embedded elements provide exposure to new risks, however, the Instruments could be Title VII Instruments.
1. Loan Participations
Loan participations are also excluded from the swap and security-based swap definitions. Under a loan participation, a lender transfers a participation in the economic risks and benefits of all or a portion of a loan or commitment with a borrower to another party as an alternative or precursor to assigning the loan or commitment or interest therein. Two types of loan participations exist in the market today: an LSTA-style participation, which transfers a beneficial ownership interest in the underlying loan or commitment, and an LMA-style participation, which creates a debtor-creditor relationship between the grantor and the participant under which a future beneficial ownership interest is conveyed. The Adopting Release clarifies that a loan participation that represents a current or future direct or indirect ownership interest in the loan or commitment, based on the presence of a number of characteristics, is not a Title VII Instrument.
D. Regulatory Treatment of Foreign Exchange and Other Instruments
The name or label used by the parties to an Instrument is not determinative of whether the Instrument would fall within the Product Definitions. Rather, the key question is whether the Instrument's terms and characteristics satisfy the Product Definitions. Documentation, while relevant, would not be dispositive.
1. Foreign Exchange Instruments Subject to Treasury's Swap Determination
Under the DFA, foreign exchange forwards and foreign exchange swaps are swaps unless the Treasury Secretary determines in writing that either or both are not structured to evade the DFA and should not be regulated as swaps. Even if the Treasury Secretary issues this determination, however, certain CEA reporting and business conduct standards would continue to apply. While the Treasury Secretary has issued a proposed determination that would exempt both foreign exchange forwards and foreign exchange swaps from the swap definition, it has not yet issued a final determination.20 Accordingly, these Instruments and the applicable requirements are incorporated in the final rules.
2. Foreign Exchange Instruments Not Subject to Treasury's Swap Determination
The Treasury Secretary's determination will not affect other types of foreign exchangeInstruments, such as foreign currency options, currency swaps and cross-currency swaps, andnon-deliverable forward contracts involving foreign exchange, all of which are and will beregulated as swaps.21
3. Foreign Exchange Spot Transactions
The CFTC does not have jurisdiction under the CEA over spot transactions. Because foreign exchange spot transactions typically settle two business days after the trade date, they could be deemed to fall within the new CEA definition of "foreign exchange forward" under the DFA and be viewed as swaps. The CFTC has determined that, notwithstanding the delayed settlement, a bona fide foreign exchange spot transaction settled on a customary timeline is not a swap.
4. Retail Foreign Currency Options
The Adopting Release makes clear that retail foreign currency options are not swaps as long as they meet the description of such Instruments in Section 2(c)(2)(B) of the CEA, which permits off-exchange transactions in non-exchange-traded options on foreign currency with counterparties that are not eligible contract participants.
5. Forward Rate Agreements
Notwithstanding use of the term "forward" in their name, forward rate agreements—i.e., over-the-counter contracts for a single cash payment, due on settlement and based on a spot rate and apre-specified forward rate—are swaps because they provide for the future payment based on thetransfer of interest rate risks between the parties and not the transfer of an ownership interest inthe underlying asset or liability.
6. Combinations and Permutations of, or Options on, Swaps and Security-
The DFA defines a Title VII Instrument to include combinations and permutations of, or optionson, swaps and security-based swaps (whether or not such Instruments now exist). Thus, a"swaption" (an option on a swap) is a swap. Similarly, a "forward swap" is a swap.
7. Contracts for Differences
A contract for differences (CFD) is an agreement to exchange the difference in value of anunderlying asset between the time the CFD is established and the time it is terminated. CFDs canbe traded on a number of products, including Treasury instruments, foreign exchange rates,commodities, equities, and stock indexes. Unless otherwise excluded, CFDs are Title VIIInstruments. However, because they are highly variable and complex, each CFD will need to beanalyzed separately to determine whether it is a swap, a security-based swap, or excluded fromthe Product Definitions.
III. RELATIONSHIP BETWEEN SWAP AND SECURITY-BASED SWAP
Once a Title VII Instrument is characterized as either a swap or a security-based swap, that characterization will not change over the Title VII Instrument's life unless it is amended during its term. While the characterization of most Title VII Instruments should be relatively uncomplicated, in some instances the analysis may be quite complex. Thus, in addition to being able to rely on the interpretations contained in the Adopting Release, discussed below, market participants also may request a joint interpretation from the Commissions (to be issued within
120 days) on the characterization of specific Instruments, pursuant to a new rule modeled after the process established by Section 718 of the DFA for determining the status of "novel derivative products."
1. Title VII Instruments Involving Rates and Yields
Title VII Instruments based on interest or other monetary rates would generally be swaps while those based on the yield or value of a single security, loan, or narrow based security index would be security-based swaps. However, because market participants often use the terms "rate" and "yield" in different ways, the Commissions' interpretation clarifies that when payments exchanged under a Title VII Instrument are based solely on the levels of rates that are not themselves based on one or more securities, the Title VII Instrument would be a swap.
Interbank offered rates, e.g., LIBOR, money market rates, government target rates, general lending rates, rates derived from an index of any rates, certain secured lending rates under money market rates, and other monetary rates such as the Consumer Price Index all would be "rates." In addition, the volatility, variance, rate of change (or spread or correlation), or index based on any of these or on their averages also would be "rates."
Where a "yield" is calculated based on the price or changes in price of a debt security, loan, or narrow-based security index, it is used as a proxy for the price or value of the underlying instrument. Thus, the Title VII Instrument based on a yield would be a security-based swap.
However, 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 a rate, then the Title VII Instrument would be a swap (or perhaps a mixed swap depending on other references in the Title VII Instrument).
c) Title VII Instruments Based on Government Debt Obligations
Title VII's definition of security-based swap expressly excludes Instruments that meet the definition only because they reference, are based on, or settle through the transfer, delivery, or receipt of an exempted security,22 other than a municipal security. Thus, where certain exempted securities, such as US Treasury securities, are the only underlying reference of a Title VII Instrument involving securities, the Title VII Instrument is a swap and not a security-based swap. Because foreign government securities are not exempted securities, however, if the underlying reference of a Title VII Instrument is the price, value, or yield derived from a foreign government security or index thereof, the Title VII Instrument is a security-based swap.
2. Total Return Swaps
A total return swap (TRS) is a Title VII Instrument under which the seller typically makes a payment based on the price appreciation and income from an underlying security, security index, or one or more loans. The buyer makes a financing payment often based on a variable interest rate 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 interest or income payments. Where a TRS is based on a single security or loan or a narrow-based security index, it is a security-based swap.
a) Loan TRS
Under Title VII, a security-based swap includes a swap that is based on a single security or loan. Because a loan is not a security, a narrow-based security index does not include loans. Title VII, therefore, does not address the definitional status of a swap on two or more loans. The Commissions have determined that the statute requires that a loan TRS (or other type of swap) on two or more loans must be treated differently from a TRS or other swap on two securities and is a swap and not a security-based swap.
3. Security-Based Swaps Based on a Single Issuer or Loan and Single-Name CDS
A single-name CDS based on a single reference obligation is a security-based swap. In addition,a Title VII Instrument based on the occurrence of an event that relates to a single issuer of asecurity in an index and that directly affects the financial condition, obligations, or statements ofthe issuer is a security-based swap.23 Examples of such events in the case of a CDS include thebankruptcy of an issuer or a default on one of the issuer's debt securities or loans. In the contextof CDS on asset-backed securities (ABS) or MBS, a triggering event could include a principalwrite-down or an interest shortfall.
4. Title VII Instruments Based on Futures Contracts
A Title VII Instrument based on a futures contract can be a swap, a security-based swap, or a mixed swap. Where the underlying reference is a security future, the Title VII Instrument will be a security-based swap. Conversely, where the Title VII Instrument is a futures contract that is not a security future, the Title VII Instrument will be a swap. A security future is a futures contract on a single security—other than an exempted security (except for a municipal security)—or a narrow-based security index, including any interest therein or based on the value thereof.
Where a futures contract is on the foreign government debt securities of 21 enumerated foreign governments24 and it satisfies certain conditions, the contract is not considered a security future, and a Title VII Instrument based on such a contract is a swap. The Commissions acknowledge that the new rules could result in a different characterization of a Title VII Instrument that is based directly on a foreign government debt security and one based on a qualifying futures contract on a debt security of one of the enumerated foreign governments.
5. Matching Fixed Terms in Title VII Instruments
Classification as a swap or security-based swap of a Title VII Instrument with a fixed term or condition that is informed by a security, rate, or other commodity will not be affected by the nature of what informed the fixed term or condition as long as the term or condition is set at the time of execution of the Instrument and remains unchanged over the life of the Instrument. A Title VII Instrument that allows for resets or changes in a rate that follows the yield of a security, however, is a security-based swap.
An interest rate swap in which floating payments based on LIBOR are exchanged for fixed rate payments of five percent (a rate that was quoted based on the yield of a security at the time of execution) is a swap and not a security-based swap as long as that rate does not vary over the life of the interest rate swap.
A borrower that issues a five-year amortizing $100 million debt security with a semi-annual coupon of LIBOR plus 250 basis points contemporaneously enters into a five-year interest rate swap on $100 million notional, the terms of which are informed by the debt security (i.e., it receives semi-annual payments of LIBOR plus 250 basis points in exchange for five percent fixed rate payments). The matching of related terms of a debt security, without more (e.g., contingencies on characteristics of the debt security that could change in the future), will not turn a swap into a security-based swap or a mixed swap.
6. Narrow-Based Security Index
As defined in the CEA and the Exchange Act,25 a security index generally is narrow-based if It meets any one of the following conditions:
- 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 million (or $30 million if an index has more than 15 component securities).
Because the statutory definition is largely geared towards equity indexes, however, the Commissions have over the years provided guidance on the application of the definition to futures contracts on volatility indexes and debt security indexes,26 which includes a public information availability requirement designed to substitute for the average daily trading volume test. Except with respect to index CDS, market participants may rely on the Commissions' past guidance in determining whether a security index is narrow-based.
7. CDS and Index CDS
While the underlying reference for most cleared CDS is a single entity or an index of entities rather than a single security or index of securities, the underlying reference could also be a single security or security index. Thus, a CDS is a security-based swap where the underlying reference is a single entity (i.e., a single-name CDS), a single obligation of a single entity (i.e., a CDS on a specific bond, loan, or ABS), or an index CDS where the underlying reference is a narrow security-based index.
Because the narrow-based security index statutory language and Commission guidance were designed respectively with equity and futures markets in mind, they are not necessarily appropriate in the context of index CDS. The Commissions have thus adopted rules with separate criteria for determining when an index underlying CDS is narrow-based, including criteria related to credit events and "reference entities." Some of these criteria, e.g., those that relate to number and concentration percentages, track the criteria applicable to non-CDS indexes, but others are applicable only to the analysis of index CDS.
The new rules further define "issuers of securities in a narrow based security index" in the context of an index CDS to make sure that the term includes a reference entity that is "an issuer of securities that is a borrower with respect to any loan identified in an index of borrowers or loans."27 If an index CDS is based on an index of loans, an event relating to a loan in the index, such as a default, is an event "relating to" the borrower.
The index CDS rule provisions are also intended to ensure that an index that is concentrated in a small number of reference entities or securities, or a few affiliated reference entities or a few securities issued by affiliated issuers, will fall within the narrow-based index definition. Affiliation, for purposes of the index CDS test only, is determined by a greater than 50 percent ownership or voting power control threshold. Affiliated reference entities or issuers included in an index will be counted together for the number and concentration criteria except with respect to issuing entities of ABS, which will not be aggregated.
The rules are also designed to ensure that no entity or security will be counted in the index unless a credit event with respect to that entity or security affects payout under a CDS on the index.28
In addition, exempted securities (other than municipal securities) will not be counted for purposes of determining whether a CDS index is narrow-based.
a) Public Information Availability
Because index CDS most commonly reference entities or securities that do not trade or are not listed, criteria relating to average daily trading volume are inappropriate. The Commissions therefore have adopted a public information availability test, similar to that for debt security indexes, designed to reduce the likelihood of manipulation. Under this test, even if an index is not narrow-based under the number or concentration criteria, it will be narrow based if any of its component reference entities or securities fails to meet at least one of seven criteria in the public information availability test. However, if all the other entities or securities in the index that satisfy the public information availability test make up at least 80 percent of the index's weighting and the failing reference entity or security comprises less than five percent of the index's weighting, the index will not be narrow-based. The Commissions' rationale is that information about a predominant percentage of the reference entities or securities in the index will be publicly available, making manipulation less likely.
Reference entities or issuers included in an index (except for issuers of ABS) may in some cases rely on an affiliated entity to satisfy some of the criteria for the public information availability test. Indexes compiled by third-party index providers are not excluded from the public information availability test.
b) Settlement of Index CDS
The way an index CDS settles following a credit event may or may not affect its characterization. For example, if a broad-based index CDS includes a mandatory physical settlement provision that requires physical delivery (i.e., purchase and sale)29 of a non exempted security or loan in the event of a credit event, the index CDS is a mixed swap. If a broad-based index CDS includes a mandatory cash settlement provision, it is a swap, even if the cash settlement is based on the value of a non-exempted security or a loan.
8. Portfolios of Securities
A security index is generally designed to reflect the performance of a market or sector by reference to representative securities or interests in securities. Instead of using established indexes, market participants sometimes enter into Title VII Instruments where the underlying reference is a portfolio of securities either selected by the parties or compiled by a third-party index provider at the request of the parties. Where one or both of the counterparties has discretionary authority to change the composition of the portfolio, whether directly or indirectly, and where changes are not made only according to fixed predetermined criteria, the portfolio will be treated as a narrow security-based index and thus the Title VII Instrument will be a security-based swap.
9. Title VII Instruments that Migrate Between Broad and Narrow-Based Indexes
As noted above, whether a Title VII Instrument is a swap, a security-based swap, or a mixed swap is determined before execution and no later than when the parties offer to enter into the Title VII Instrument. If the index underlying a Title VII Instrument migrates from being broad-based to narrow-based or vice versa during its life, its characterization will not change from the initial characterization regardless of whether it was entered into bilaterally or executed on or subject to the rules of a regulated trading platform.30
If a market participant wants to offset a swap or enter into a new swap on a DCM, SEF, or FBOT where the underlying broad-based index has migrated to a narrow-based index, the offset or new swap would, absent action by the Commissions, be prohibited from being traded on any of those trading platforms. The converse is also true with respect to security based swaps trading on SBSEFs or NSEs. To avoid potential disruption, the final rules will apply a "tolerance period" and a subsequent "grace period" to these Title VII Instruments if certain conditions are met. These provisions will allow Title VII Instruments that are based on an index that have migrated, and that were trading before the migration, to continue to trade during the permitted period on the original platform. These rules will not result in any recharacterization of any outstanding Title VII Instruments, however.
If material terms of a Title VII Instrument are amended during its life based on an exercise of discretion and not on predetermined criteria or a self-executing formula, the amended Title VII Instrument will be viewed as a new Title VII Instrument and reassessed accordingly.
If an index with predetermined criteria that would cause the nature of the index to change from broad to narrow-based or vice versa during the life of a Title VII Instrument based on the index, that Title VII Instrument will be viewed as a mixed swap throughout its life. In this context, however, if under the index's criteria the index may but will not necessarily migrate, the initial characterization (either swap or securities-based swap) will control throughout the life of the Title VII Instrument.
1 Joint Final Rule and Interpretations, Further Definition of "Swap," "Security-Based Swap," and "Security-Based Swap Agreement"; Mixed Swaps; Security-Based Swap Agreement Recordkeeping Adopting Release, 77 Fed. Reg. 48207 (Aug. 13, 2012).
2 Dodd-Frank Wall Street Reform and Consumer Protection Act (DFA), Pub. L. 111-203, 124 Stat. 1376 (2010), Sections 712 (a)(8) and (d)(1), 721(b) and (c), and 761(b). These provisions also require that, in adopting the joint rules, the Commissions consult with the Board of Governors for the Federal Reserve System.
3 The SEC has not yet finalized its security-based swap dealer/major security-based swap participant registration rules.
4 Under the DFA, security-based swaps are included in the definition of "security" and are subject to the Securities Exchange Act of 1934 (Exchange Act) and the Securities Act of 1933 (Securities Act), and the rules and regulations thereunder. The Adopting Release does not contain any interpretations on the applicability of provisions of the Exchange Act and the Securities Act to security-based swaps.
5 Commodity Exchange Act (CEA) Section 1a(47)(A).
6 Exchange Act Section 3(a)(68)(A).
7 Financial guaranty policies that meet the conditions set forth in the Adopting Release and that are issued by persons meeting the Provider Test would generally not be regulated as swaps or security-based swaps. However, as we discuss below, the CFTC takes the view that insurance of a swap is itself a swap and should be treated the same as all other guarantees of swaps.
8 After considering comments objecting to a reference to Generally Accepted Accounting Principles in the Product Test, the Commissions decided not to include such a reference. They also decided not to include a requirement that payment could not be based on the price, rate, or level of a financial instrument, asset, or interest, or any commodity
9 CEA Sections 1a(47)(B)(ii).
10 Joint Proposed Rule, Further Definition of "Swap," "Security-Based Swap," and "Security-Based Swap Agreement"; Mixed Swaps; Security-Based Swap Agreement Recordkeeping Proposed Rule, 76 Fed. Reg. 29818 (May 23, 2011).
11 Respectively, the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation, and the Government National Mortgage Association.
12 CEA Sections 1a(19) and (20).
13 CFTC, Statutory Interpretation Concerning Forward Transactions, 55 Fed. Reg. 39188 (Sep. 25, 1990).
14 Adopting Release at 81.
15 Characteristics Distinguishing Cash and Forward Contracts and "Trade" Options, 50 Fed. Reg. 39656 (Sep. 30, 1985).
16 Although the CFTC's interpretation on embedded options will be effective on the effective date of the Product Definitions, it has solicited additional comments.
17 Embedded optionality as to delivery points and delivery dates will not cause a transaction that otherwise qualifies as an excluded forward to be considered a swap.
18 In general, the CFTC has declined in the Adopting Release to address the status of transactions in Regional Transmission Organizations or Independent System Operators, including financial transmission rights and ancillary services. Some types of ancillary services that occur in RTOs or ISOs that are entered into between certain governmental entities, however, could be addressed by the CFTC through the public interest waiver process in Section 4(c)(6) of the CEA.
19 Legal Certainty for Bank Products Act of 2000 Section 403(a) (as amended by Section 725(g)(2) of the DFA).
20 Determination of Foreign Exchange Swaps and Foreign Exchange Forwards Under the Commodity Exchange Act, Notice of Proposed Determination, 76 Fed. Reg. 25774 (May 5, 2011).
21 Foreign exchange options traded on a national securities exchange are securities and are not swaps or security-based swaps.
22 As defined in Section 3(a)(12) of the Exchange Act.
23 Each transaction under an ISDA Master Agreement must be separately analyzed to determine whether it is a swap or security-based swap. The Master Agreement itself does not constitute a Title VII instrument based on an index or group of securities.
24 SEC Exchange Act Rule 3a12-8 (identifying the debt securities of 21 foreign governments that could qualify for different futures trading treatment).
25 Exchange Act Sections 3(a)(55)(B) and (C); CEA Sections 1a(35)(A) and (B).
26 Joint Final Rules: Application of the Definition of Narrow-Based Security Index to Debt Securities Indexes and Security Futures on Debt Securities, 71 Fed. Reg. 39434 (Jul. 13, 2006) Joint Order Excluding Indexes Comprised of Certain Index Options From the Definition of Narrow-Based Security Index, 69 Fed. Reg. 16900 (Mar. 31, 2004).
27 New Exchange Act Rule 3a68-1a and CEA Rule 1.3(zzz)(c)(3).
28 The Commissions expect that even though the wording of the definition of narrow-based security index is slightly different in the index CDS context, its application should yield results that are substantially the same as in the non-CDS context, i.e., if the "reference entities" in one index are the same as the "issuers" in another index, both should either be narrow-based or broad-based. However, because the affiliation definition in the CDS context uses a 50 percent threshold as opposed to a 20 percent threshold, the analysis might in fact lead to different results.
29 The federal securities laws will apply to the purchase and sale of the security.
30 Such trading platforms include designated contract markets, swap execution facilities, and foreign boards of trade FBOTs on the swaps side, and security-based swap execution facilities SBSEF and national securities exchanges NSE on the security-based swaps side.
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