The SEC and CFTC Voted to Further Define “Swap”, “Security-Based Swap”, and “Security-Based Swap Agreement” and Finalize Related Requirements; CFTC Finalizes End-User Exception
The Securities Exchange Commission (“SEC”) and the Commodity Futures Trading Commission (“CFTC”, jointly with the SEC, the “Commissions”) have approved joint final rules and interpretations that, among other things, further define “swap” and “security-based swap” and govern “mixed swaps”. The definitions of “swap,” “security-based swap” and “mixed swaps” will determine the applicability of many of the regulatory requirements imposed under the Dodd-Frank Wall Street Reform and Consumer Protection Act. Although the release adopting the final rules (the “Product Final Release”) is not yet available, the SEC and CFTC have each released a fact sheet and the CFTC has released a Q&A, which discuss the Product Final Release selectively and at a high level (collectively, the “Product Fact Sheet”). Separately, the CFTC published a fact sheet and Q&A that discuss, again selectively and at a high level, the end-user exception to the clearing and platform execution requirements that will be applicable to certain swaps (collectively, the “End-User Fact Sheet”). Our memorandum reflects (and is limited to) the information made available in the Product Fact Sheet and the End-User Fact Sheet, with a focus on how the two relevant rulemakings appear to have evolved since being proposed.1 We will supplement this memorandum with a more comprehensive memorandum after the Product Final Release is made available.
Consistent with the proposing release for the product definitions (the “Proposing Release”), the Product Fact Sheet indicates that insurance transactions will be excluded from the definition of “swap” and “security-based swap” provided such transactions:
- are in a product that either meets certain conditions (“Product Conditions”) or is one of a number of listed “traditional” insurance products (“Enumerated Products”), and
- meet certain conditions relating to the provider of the product (“Provider Conditions”).
With two exceptions, there is no indication of substantial changes to the Provider Conditions within the Product Fact Sheet. The two changes expand the Provider Conditions to cover non-admitted insurers (i.e., providers of excess/surplus lines insurance) that are located outside the United States and listed on the Quarterly Listing of Alien Insurers (as maintained by the National Association of Insurance Commissioners) or that meet the eligibility criteria for non-admitted insurers under applicable state law and to eliminate the proposed requirement that the insurance provider be an insurance company whose primary and predominant activity is the writing of insurance or reinsurance.
The Product Conditions will remain substantially the same as those proposed in the Proposing Release. With respect to the Enumerated Products, which are certain traditional insurance products excluded from the definition of "swap" and "security-based swap" (provided that the Provider Conditions are met), the Product Fact Sheet indicates that these will be identified in the final rules (as opposed to in the interpretive guidance as was the case in the Proposing Release). The Enumerated Products identified by the Product Fact Sheet are surety bonds; fidelity bonds; life insurance; health insurance; long-term care insurance; title insurance; property and casualty insurance; annuities (irrespective of their tax treatment); disability insurance; insurance against default on individual residential mortgages (i.e. private mortgage insurance); and reinsurance or retrocession of any of the listed Enumerated Products so long as it is not accomplished by entering into swaps or security-based swaps.
Based on the Product Fact Sheet, the Product Final Release will confirm that the safe-harbor for insurance products is non-exclusive, meaning that transactions that do not meet the Product Conditions, are not in an Enumerated Product, or do not meet the Provider Conditions may nevertheless be excluded from the definitions of “swap” and “security-based swap” under a facts and circumstances analysis. The Product Fact Sheet also indicates that the Commissions are including a grandfather provision in the final rules, which provides that a transaction entered into on or before the effective date of the product definitions will not fall within the definition of “swap” or “security-based swap” provided that, at the time it was entered into, the transaction met the Provider Conditions.
The Product Final Release will include an interpretation by the CFTC that the term “swap” includes a guarantee of a swap, to the extent that a counterparty to the guaranteed swap would have recourse against the guarantor. The CFTC expects to address the practical implications of this interpretation, including applicable reporting requirements, in a separate rulemaking.
In contrast, the Product Fact Sheet indicates that the SEC will treat guarantees of security-based swaps as separate securities. This is consistent with the SEC‟s historical approach to the treatment of guarantees of securities. The SEC plans to address the reporting of guarantees of security-based swaps in a separate rulemaking.
The Product Final Release will provide that loan participations are not swaps or security-based swaps if the participation purchaser is acquiring a current or future direct or indirect ownership interest in the related loan or commitment subject to satisfaction of certain conditions to be specified in the Product Final Release. The Product Fact Sheet also indicates that the requirement in the Proposing Release that a loan participation be a “true participation” is not carried forward.
Forward Exclusion from the Swap Definition for Nonfinancial Commodities
The definition of “swap” added by the CEA excludes “any sale of a nonfinancial commodity . . . for deferred shipment or delivery, so long as the transaction is intended to be physically settled” (the “forward contract exclusion”). The Product Final Release will include a CFTC interpretation clarifying the scope of the forward contract exclusion. In particular, the forward contract exclusion will be interpreted in a manner consistent with the CFTC‟s historical exclusion of forwards from the prohibition of off-exchange futures contracts. This historical exclusion viewed transactions by commercial market participants that regularly make or take delivery of the referenced commodity in the ordinary course of their business as forward contracts, notwithstanding that the relevant transaction might later be settled by “book out” or another means not involving physical settlement provided that the book out or other form of settlement is effectuated through a subsequent, separately negotiated agreement. The Product Final Release will provide that oral book outs are permissible if they are followed in a commercially reasonable timeframe by a written or an electronic confirmation. The Product Fact Sheet suggests that exempt and agricultural commodities that may be physically delivered as well as certain environmental commodities will be treated as “nonfinancial commodities” and, therefore, will be eligible for the forward contract exclusion.
The Product Fact Sheet indicates that certain contract provisions (such as liquidated damage provisions and renewal/evergreen provisions) will not disqualify a transaction from the forward contract exclusion. The Product Fact Sheet also indicates that, in certain limited circumstances, forwards with embedded volumetric optionality will be within the forward contract exclusion. This contrasts with the Proposing Release, which covered price optionality only. We expect that, where the volumetric optionality is based on physical factors or regulatory requirements beyond the control of the parties, a transaction containing such optionality would be able to qualify for the forward contract exclusion provided that the conditions to the exclusion were otherwise satisfied.
In the Proposing Release, the CFTC stated that it would retain the 1990 Brent interpretation with respect to certain energy transactions, but would rescind the 1993 Energy Exemption. Comments received by the CFTC urged retention of the Energy Exemption. Although the Product Final Release will rescind the Energy Exemption, the Product Final Release will recognize the types of settlement that may be utilized in connection with forward contracts to include netting of quantities and other approaches that reduce or obviate delivery obligations, as provided in the 1993 Energy Exemption.
Transactions that are Swaps or Security-Based Swaps
As expected, the Product Final Rules will confirm that foreign exchange forwards and foreign exchange swaps (“FX Products”) will be swaps, absent a determination by the Secretary of the Treasury to exempt them. If exempted, FX Products would remain subject to certain requirements under the CEA, including certain reporting requirements and business conduct standards.
The Commissions are issuing an interpretation providing that certain foreign exchange spot transactions will not be treated as foreign exchange forwards under the CEA. The transactions include certain foreign currency trades made in connection with a foreign securities transaction that is settled within the settlement cycle for the associated securities transaction. In addition, the Final Product Release will contain an interpretation that retail foreign currency options described in Section 2(c)(2)(B) of the CEA are not “swaps”.
The Commissions also are issuing an interpretation that options on swaps or security-based swaps will be swaps or security-based swaps. Moreover, the Final Product Release will clarify that forward rate agreements, notwithstanding their “forward” label, are swaps (unless otherwise excluded by statute).
Relationship Between Swaps and Security-Based Swaps
The Commissions appear largely to have adopted the rules relating to the definition of security-based swaps and the relationship between security-based swaps and swaps as proposed.
Similar to the proposed rules, the determination as to whether a transaction is a swap or a security-based swap will be made, at the latest, at the time when the offer to enter into the transaction is made. The transaction will remain a swap or security-based swap throughout its life (subject to regulation by the relevant regulator). For example, if a narrow-based security index becomes a broad-based security index after the determination is made, that instrument will remain under the jurisdiction of the SEC as a security-based swap. The opposite is true for broad-based security indexes.
The Product Final Release will provide guidance regarding the terms “narrow-based security index” and “issuers of narrow-based security index”, as well as guidance with respect to the meaning of “index”. The Product Fact Sheet indicates that a credit default swap on a broad-based index will be treated as:
- a mixed swap if it provides for mandatory physical settlement; or
- a swap if it provides for cash or auction settlement.
The Product Final Release will establish a procedure whereby the parties to an instrument may request a joint interpretation by the Commissions regarding whether the relevant instrument is a swap or a security-based swap.
Treatment of Instruments Based on Rates or Yield
The Products Final Release will provide that instruments based on interest rates and other monetary rates are swaps. Instruments based on “yields” (where yield is a proxy for the price or value of a debt security, loan or narrow-based security index) are security-based swaps; provided that an instrument on a yield of US Treasuries or other exempted securities (other than municipal securities) would be a swap rather than a security-based swap. According to the Product Fact Sheet, a total rate of return swap based on two or more loans will be a swap subject to CFTC regulation.
As was the case under the Proposed Rules, the category of mixed swaps will be very narrow and intended to ensure that there are no gaps in the regulation of swaps and security-based swaps. A bilateral, uncleared mixed swap will be a transaction that is both a swap and a security-based swap. Mixed swaps with dealers and major participants registered with both the CFTC and SEC as a counterparty will be subject to key provisions of the CFTC rules and requirements of the federal securities laws. All other mixed swaps will be regulated either:
- pursuant to a joint order from the Commissions determining whether the mixed swap will be governed by the CEA and/or the Exchange Act; or
- by the parallel requirements of both the CEA and the Exchange Act.
The Product Fact Sheet indicates that the product definitions will become effective 60 days after publication in the Federal Register except that certain interim relief provided by the SEC under the Exchange Act, the Trust Indenture Act of 1939 and the Securities Act of 1933 will remain in effect for 180 days after such publication. Effectiveness of the product definitions will begin the countdown to effectiveness of other regulations that were tied to the product definitions.
Under Title VII, mandatory clearing and platform execution obligations will be imposed with respect to certain swaps, subject to an elective exception generally available where a non-financial end-user is entering into a swap to hedge or mitigate commercial risk and meets certain procedural requirements (the “end-user exception”). If an end-user seeking to rely on this exception is an SEC filer, it must, in addition to meeting the other conditions to qualifying for the exception, obtain board-level approval to enter into uncleared swaps. Language in the End-User Fact Sheet suggests that this approval may be provided generally rather than on a transaction-by-transaction basis.
The End-User Fact Sheet also indicates that the CFTC adopted an exemption from the definition of “financial entity” applicable to banks, savings associations, farm credit system institutions, and credit unions with total assets of $10 billion or less. As a result, such institutions will be eligible for the end-user exception; provided that its other conditions are met.