On July 10, 2012, the Commodity Futures Trading Commission (“CFTC” or “Commission”) voted to approve a Final Rule further defining the statutory term “swap” under the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”).1 In addition to providing greater clarity regarding what contracts will be considered swaps and therefore may be subject to reporting, clearing, capital and margin requirements under the Dodd-Frank Act and CFTC rules, publication of the Final Rule in the Federal Register (which is expected by approximately mid-August 2012) will start the countdown toward the enforceability of several other regulations that were previously issued by the CFTC, such as registration requirements for swap dealers and major swap participants, mandatory reporting of swap information to a swap data repository, and spot month position limits on designated futures contracts and price-linked swaps. Issuance of the Final Rule is a critical milestone toward full implementation of the Dodd-Frank regulatory scheme.2
The Final Rule excludes from the definition of “swap” forward contracts of a non-financial commodity that are intended to be physically settled. The CFTC also reaffirmed that cash-settled commodity options are swaps, but that forward commodity contracts with embedded optionality - whether volumetric, term, or point of delivery - may be excluded from the definition of “swap” if certain conditions described more fully below are met. The Final Rule does not directly address the status of certain transactions regulated by the Federal Energy Regulatory Commission, including financial transmission rights or ancillary services, although these transactions are the subject of a petition for exemptive relief currently before the CFTC. Moreover, acknowledging that the regulations leave some ambiguity regarding whether certain contracts will be considered swaps, the CFTC has established a review process by which market participants may request the Commission to determine whether a particular instrument is or is not a swap.
The Final Rule will be effective 60 days after the date of publication in the Federal Register except with regard to swap guarantees, which will be the subject of a separate CFTC interpretive order.
Scope of Definition. The Final Rule incorporates the statutory definition of “swap” as provided in Section 1a(47) of the Commodity Exchange Act. The statutory definition broadly covers instruments used to transfer financial risk, including any agreement, contract, or transaction that:
- is a put, call, cap, floor, collar, or similar option for the purchase or sale – or based on the value – of interest rates, currencies, commodities, securities, instruments of indebtedness, indices, quantitative measures, or other financial or economic interest or property of any kind;
- provides for a purchase, sale, payment, or delivery that is dependent on some event, non-event, or contingency associated with a financial, commercial, or economic consequence;
- provides for the exchange of payment based on the value or level of interest rates, currencies, commodities, securities, instruments of indebtedness, indices, quantitative measures, or other financial or economic interest or property of any kind and that transfers financial risk associated with a future change in any such value or level without also conveying a current or direct ownership interest in an asset;
- is, or in the future becomes, commonly known to the trade as a swap; and
- is a combination or permutation of, or option on, any agreement, contract, or transaction described above.
As more fully described below, under authority granted the CFTC in Section 721(b) of the Dodd-Frank Act, the CFTC expressly included within the definition of “swap” certain types of currency and foreign exchange transactions, listed below, as well as transactions that are willfully structured to evade the requirements of the Dodd-Frank Act and/or CFTC rules.
Exclusions from Swap Definition. The Dodd-Frank Act expressly excludes from the “swap” definition futures contracts, options on futures contracts, and non-financial forward contracts that are intended to be physically settled.3 In the Final Rule, the CFTC expounds upon the statutory definition by expressly excluding certain categories of financial products and contracts that might otherwise be considered swaps. These include traditional insurance products, forward contracts that do not actually result in physical delivery, forward commodity contracts with embedded optionality, and certain foreign exchange or currency products.
Traditional Insurance. As provided in 17 C.F.R. § 1.3(xxx)(4), traditional insurance products subject to state or Federal insurance supervision are not considered swaps under the Final Rule. The Final Rule sets forth a non-exclusive safe harbor based upon product and provider tests intended to verify that the transaction in question qualifies as insurance. An instrument that fails to satisfy the safe harbor provisions is not necessarily a swap (or security-based swap), but its regulatory status will require additional analysis based on the facts and circumstances of the transaction.4
Forward Contracts. The statutory “swap” definition expressly excludes “any sale of a nonfinancial commodity or security for deferred shipment or delivery, so long as the transaction is intended to be physically settled.”5 In the Final Rule, the CFTC defines the contours of the exclusion for non-financial forward contracts, especially as applied to “book-out” transactions and physical exchange transactions.
Book-outs. The Final Rule accepts that some transactions originally arranged as forward contracts may not conclude with physical delivery. A party’s delivery obligation may be extinguished by a book-out transaction. In order for the original contract to avoid being included in the “swap” definition, the book-out transaction must meet the CFTC’s “Brent Interpretation”6 requirements: namely, a subsequent, independently negotiated transaction between commercial market participants that extinguishes the binding physical delivery obligation required by an earlier agreement and is not provided for by the terms of the earlier agreement. The CFTC expanded the Brent Interpretation within the context of exclusion from the swap definition to include all nonfinancial commodities7 and noted that physical netting agreements would qualify as a book-out transaction, provided that the parties had intended when entering into the transactions to make or take delivery of the commodity covered by the transaction. Similarly, a liquidated damages provision would not necessarily turn an otherwise qualified forward physical contract into a swap, if the parties intended to make delivery of the commodity at the time the agreement was made.
Physical Exchange Transaction. The CFTC concluded that straightforward physical exchange transactions are forward contracts excluded from the definition of “swap.” Based on the facts of the example provided by a commenter – taking delivery of a commodity at point A in exchange for the same quantity of the same commodity to be delivered at point B, perhaps at a different price to reflect demand – the CFTC reasoned that the primary purpose of such a transaction is the transfer in ownership of nonfinancial commodities and that the parties intended to physically settle the transaction. The CFTC therefore concluded that such transactions are excluded from the definition of swap.
Commodity Options and Options Embedded in Forward Contracts. As noted above, the CFTC reaffirmed in the Final Rule that cash-settled commodity options are generally swaps. In previous rulemakings, the CFTC had both determined that commodity options are swaps and issued an interim final rule that incorporates a “trade option exemption” for commodity options if the parties to the option contract intend the option to be physically settled if and when it is exercised.8 The Final Rule addressing the “swap” definition reaffirms those previous rulemakings.
Where commodity options are embedded in physical forward contracts, the CFTC found similarities with the existing forward contract exclusion from the scope of futures contracts. It proposed to apply its interpretation – specifically as it concerns In re Wright9 – to forward contracts of nonfinancial commodities with embedded optionality. Under the CFTC’s reasoning in Wright, based upon the facts and circumstances of the transaction, such a contract is considered a nonfinancial commodity forward contract 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; and
- cannot be severed and marketed separately from the overall forward contract in which it is embedded.
The phrase “delivery term” refers not to the length of contract or an extension to the contract, but the delivery amount. The CFTC emphasized the need for the agency to be vigilant in ensuring that commodity options contracts that should be regulated as swaps not avoid regulation under the forward contract exclusion for nonfinancial commodities.
Volumetric optionality. Responding to a chorus of industry comments seeking to have contracts with volumetric optionality treated as physical forwards rather than swaps, the Final Rule states that an agreement (or contract or transaction) with embedded volumetric optionality may be excluded from the definition of “swap” if seven distinct factors are met. They are:
- the embedded optionality does not undermine the overall nature of the agreement as a forward contract;
- the predominant feature of the agreement is actual delivery;
- the embedded optionality cannot be marketed independently from the overall agreement;
- at the time the agreement is entered into, the seller of a nonfinancial commodity intends to deliver the commodity if the option is exercised;
- in contrast to a commodity option, at the time the agreement is entered into, the buyer of a nonfinancial commodity intends to take delivery of the underlying nonfinancial commodity if exercised;
- both parties are commercial parties engaged in the business of the underlying commodity; and
- the exercise or non-exercise of the option is based primarily on physical factors or regulatory requirements outside the control of the parties and those physical factors are influencing demand for, or supply of, the nonfinancial commodity.
The CFTC stated that each of the seven factors must be satisfied in order for a contract with embedded volumetric optionality to fall within the physical forward exclusion from the swap definition. Further, a determination of whether an agreement with embedded optionality meets the forward contract exclusion is dependent on the relevant facts and circumstances surrounding the agreement. In response to comments about energy agreements, the CFTC noted that agreements for capacity, transmission (or transportation), tolling, and peaking supply may satisfy the elements of a forward with embedded volumetric optionality, depending on the applicable facts.
The CFTC has requested comments on its classification of contracts with embedded volumetric optionality. Specifically, it requests comments on the appropriateness of the factors and whether they serve the intended goal of distinguishing between forwards with volumetric optionality on the one hand, and commodity options on the other. The deadline for comments is 60 days from publication of the Final Rule in the Federal Register.
Other variable term agreements not swaps. A provision extending the term of a commercial contract, whether through election of a party or through evergreening, is not considered embedded optionality. In response to comments, the CFTC reasoned that an extension term – such as a renewal term in a five-year power purchase agreement – is not an option on the delivery term in that the extension will require additional deliveries but will not alter the volume required in a given period. Further, embedded optionality as to delivery points and delivery dates, while variable, will not cause a transaction that otherwise qualifies as a forward contract to be considered a swap.
Also, the CFTC reasoned that certain physical commercial agreements, such as tolling agreements, natural gas transportation agreements, and natural gas storage agreements may have option-like features but would not be considered an option if:
- the subject of the agreement is the usage of a specific facility (or part thereof) rather than the purchase or sale of a related commodity such as natural gas or electricity;
- the agreement grants the buyer the exclusive use of the facility (or part thereof) during the term of the agreement and the seller is obliged to grant the buyer exclusive use; and
- the payment for the use of the facility (or part thereof) is a payment of the use of the facility rather than the option to use it.
The option in these agreements, the CFTC reasoned, is the option to use the facility and represents merely the decision of the party to use what has already been paid for. In contrast, if the right to use the specified facility is obtained only by payment of a demand charge or reservation fee and the exercise of that right requires further usage or storage fees, such an agreement is a commodity option subject to the swap definition. Clients may wish to obtain clarification from the CFTC on this interpretation as many energy transactions are structured in this manner.
Foreign Exchange and Currency Products. The Final Rule explicitly defines the term “swap” to include certain currency and foreign exchange products.10 Those products are:
- cross-currency swaps;
- currency options, foreign currency options, foreign exchange options, and foreign exchange rate options;
- foreign exchange forwards;
- foreign exchange swaps;
- forward rate agreements; and
- non-deliverable forwards involving foreign exchange.11
Exceptions. There are exceptions to the general rule, however. Foreign exchange forwards and foreign exchange swaps will be considered to be swaps unless the Secretary of Treasury finds that either or both products (a) should not be regulated as swaps and (b) are not structured to evade the regulations promulgated by the CFTC.12 Even if the Secretary of the Treasury excepts FX swaps and forwards from the bulk of Dodd-Frank regulation, certain reporting requirements and business conduct standards will still apply.
Foreign exchange options traded on a national securities exchange are not swaps under federal securities laws. Further, the CFTC excluded from the definition of “swap” foreign exchange spot transactions, which must settle by actual delivery of the relevant currency within two business days or longer if such longer delivery period is customary for the relevant market.
Anti-Evasion Rules. The CFTC interprets the Dodd-Frank Act to provide the Commission broad powers to prevent evasion of the requirements of that Act. The anti-evasion rules apply to:
- swaps that are willfully structured to evade the provisions of Title VII in the Dodd-Frank Act;
- currency and interest rate swaps that are willfully structured as foreign exchange forwards or foreign exchange swaps to evade the new regulations; and
- transactions willfully structured as a banking product to evade the new regulations where the bank is not subject to regulatory jurisdiction of an appropriate Federal banking agency.
17 C.F.R. § 1.3(xxx)(6). See also 17 C.F.R. §1.6.13
In determining whether a transaction has been willfully structured to evade regulation, the CFTC intends to evaluate the substance of the transaction rather than its form to discourage evasion through “clever draftsmanship.”14 Generally, the CFTC asserts that it will evaluate each transaction on a case-by-case basis.
Factors. The CFTC reviewed anti-evasion rules promulgated by other federal regulators and determined that certain factors are relevant to a case-by-case determination. These factors include:
Business Purpose Test. The CFTC will consider the legitimate business purpose of structuring a transaction, entity, or instrument. While a structure solely motivated by a legitimate business purpose will be excluded from the anti-evasion regulations, the CFTC may find willful evasion if evasion of the swap regulations is a purpose – and not necessarily the principal purpose – for structure.
Fraud, Deceit, or Unlawful Activity. Similar to IRS tax evasion rules, the CFTC will consider the extent to which a particular activity involves deception or other illegitimate activity in determining whether it is intended to evade regulation under Dodd-Frank. While deception is a factor to be considered, the CFTC does not require proof of deception as a prerequisite to a finding of evasion.
An instrument that is willfully structured to evade the regulation of swaps will be deemed a swap for purposes of the CFTC’s regulations and shall be considered in determining whether a person that so acted is a swap dealer or a major swap participant. Further, anti-evasion activities conducted outside the United State may be subject to enforcement by the CFTC.
Difference between Swaps and Security-Based Swaps. The CFTC and the Securities and Exchange Commission (“SEC”) sought to clarify the differences between “swaps” and “security-based swaps” in the Final Rule. While reiterating that the status of a particular instrument should be based on the attendant facts and circumstances, the Commission and SEC provided some bright lines to distinguish between the two types of instruments.
Rates. Broadly speaking, instruments based on interest or other monetary rates are swaps while instruments based on yield or value of a single security, loan, or narrow-based security index (see below) are security-based swaps. For convenience, the Commission provided a list of rates which would support the determination that an instrument based solely on those rates is a swap.
Narrow-based Security Index. An instrument which references a “narrow-based security index” is a security-based swap while an instrument that references a broad-based security index is a swap. The regulations incorporate the statutory definition, which state that an index is a narrow-based security index if:
- it has 9 or fewer component securities;
- any component security comprises greater than 30% of the index’s weighting;
- the 5 highest weighted component securities account for more than 60% of the index’s weighting; or
- the lowest weighted component securities comprising, together, 25% of the index’s weighting have, generally, an aggregate dollar value of average daily trading volume of less than $50 million.
Government Debt. Similarly, if the underlying reference instrument is government debt, such as the price of a U.S. Treasury security, then the instrument is considered a swap. A harder case is presented if the instrument is based on a futures contract on government debt. The SEC has exempted from the Exchange Act futures trading on the debt securities of 21 countries.15 As such, a futures contract on the debt securities of those 21 countries may be considered a swap under the criteria set forth in 17 C.F.R. § 1.3(bbbb).
Mixed Swaps. A mixed swap is both a security-based swap and a swap. For example, an instrument in which the underlying references are the value of an oil corporation stock and the price of oil is a mixed swap. Also, so-called “best of” swaps that require payment based on the higher of the performance of a security and a commodity are mixed swaps. In regulating mixed swaps under 17 C.F.R. § 1.9, the Commission and the SEC agreed that where at least one party is dually registered as a swap dealer or major swap participant with the CFTC and similarly with the SEC, a bilateral uncleared mixed swap will be subject to all of the rules of the SEC and limited rules of the CFTC. Any person intended to list, trade, or clear other mixed swaps may request a joint order from the Commission and the SEC permitting the person to comply with the specified parallel provisions of either of those commissions.
Click here to link to the Final Rule.