The Commodity Futures Trading Commission (the “CFTC”) and the Securities and Exchange Commission (the “SEC”, and together with the CFTC, the “Commissions”) recently adopted final rules (the “Product Rules”)1 defining the terms “swap” and “security-based swap” and providing related interpretive guidance on a wide range of issues. Among other things, these rules will affect private fund managers as they evaluate whether they may claim an exemption from registration as a commodity pool operator (“CPO”) or a commodity trading advisor (“CTA”) under the Commodity Exchange Act (the “CEA”) or whether they may have to register.2 The Product Rules become effective sixty days after publication in the Federal Register, which is expected to occur shortly. This CFTC Update provides a high-level summary of some of the most significant aspects of a lengthy and extraordinarily complex document, and is not intended to be detailed or comprehensive.
The Product Rules are among the most important of the numerous CFTC and SEC rulemakings undertaken to implement the new regulatory framework for swaps and security-based swaps under Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). Pursuant to this framework, the CFTC has regulatory authority over swaps, the SEC has regulatory authority over security-based swaps, and the CFTC and SEC jointly regulate mixed swaps. In this regard, the CFTC and the SEC, in consultation with the Board of Governors of the Federal Reserve System, are authorized to define further the terms “swap” and “security-based swap.” The Product Rules implement that authority and also will affect the scope and/or timing of certain other Dodd-Frank Act rulemakings, including rules imposing clearing, trade execution, reporting and recordkeeping requirements, position limits, business conduct standards, rules requiring registration of swap dealers and major swap participants, as well as the applicability of the CPO and CTA registration and related requirements under the CEA and the CFTC’s regulations thereunder. As a result, the Product Rules have far-reaching implications for the transition to the new regulatory regime under the Dodd-Frank Act.
Swaps and Security-Based Swaps
The Product Rules set forth the parameters for determining whether a particular position, agreement, contract or transaction (each a “Title VII Instrument”) is a “swap” or “security-based swap,” and such determination is based upon the terms and conditions of the particular instrument and the nature of, among other things, “the prices, rates, securities, indexes, or commodities upon which such instrument is based”.3
In general, Title VII Instruments on interest rates and other monetary rates (including interbank offered rates, money market rates, government target rates, general lending rates, rates from indexes and other monetary rates) are swaps, while Title VII Instruments 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), except in the case of certain government debt obligations). It is worth noting that a Title VII Instrument based solely on the level of a constant maturity U.S. Treasury rate is a swap under the Product Rules because U.S. Treasuries are expressly carved out of the security-based swap definition. Thus, a Title VII Instrument based on the 10-year U.S. Treasury bond yield would be a swap, but a Title VII Instrument based on a 10-year corporate bond yield would be a security-based swap. Note that transactions in Title VII Instruments which are solely security-based swaps would not trigger registration requirements under the CEA and the CFTC’s regulations.
As noted above, a Title VII Instrument based on a narrow-based security index is generally considered a security-based swap. However, if a Title VII Instrument is based on an index that is not a narrow-based index (i.e., a “broad-based index”), then such Title VII instrument is a swap. As defined in the CEA and the Securities Exchange Act of 1934 (the “Exchange Act”), an equity index is a narrow-based security index if, among other things, it meets any of the following four criteria:
- It has nine or fewer component securities;
- a component security comprises more than 30% of the index’s weighting;
- the five highest weighted component securities in the aggregate comprise more than 60 percent of the index’s weighting; or
- the lowest weighted component securities comprising, in the aggregate, 25 percent of the index’s weighting have an aggregate dollar value of average daily trading volume of less than $50,000,000.
Credit Default Swaps
The SEC will regulate credit default swaps (“CDS”) on single names, loans and narrow-based security indexes, while the CFTC will regulate CDS on broad-based security indexes. The characterization of a particular CDS as a swap or a security-based swap turns primarily on whether the underlying for such CDS references a narrow-based or broad-based index. In this regard, the Product Rules set forth specific guidelines for determining whether, in the context of CDS, an index is narrow-based or broad-based. While analogous to the traditional narrow-based index definition discussed above, the CDS narrow-based index determination incorporates additional factors that reflect the differences between equity index and entity index underliers.
The method of settlement also impacts whether a CDS is a swap or a security-based swap. If an index CDS is based on a broad-based security index and includes mandatory physical settlement, such an index CDS is a mixed swap. Conversely, if an index CDS is based on a broad-based index and requires cash settlement, such index CDS is a swap and not a security-based swap, even if cash settlement is based on the value of a non-exempted security or a loan.
The Commissions recognize that the underlying for many CDS is a single entity or an index of entities as opposed to a single security or index of securities as is the case for equity swaps. Thus, the Commissions take this distinction into account by stating that a particular CDS is a security-based swap if the underlying is (i) a narrow-based security index or (ii) the issuers of a narrow-based security index. Otherwise, the CDS is broad-based and therefore a swap. This look-through approach is designed to harmonize the treatment of CDS with other Title VII Instruments under the Product Rules.
The Commissions provide guidance that the determination of whether a Title VII Instrument is a swap, a security-based swap, or a mixed swap is made prior to execution. If the security index underlying a Title VII Instrument migrates from broad-based to narrow-based, or vice versa, the characterization of that Title VII Instrument generally will not change. However, if the terms of a Title VII Instrument are amended during its life based on the parties’ discretion, and not through a pre-determined formula or criteria, such modified Title VII Instrument will be treated as a new Title VII Instrument, and its characteristics must be reassessed to determine what type of Title VII Instrument it is at that time. Additionally, if a Title VII Instrument includes criteria or a formula intentionally designed to cause the underlying broad-based index to become or assume the characteristics of a narrow-based index, or vice versa, then such Title VII Instrument is a mixed swap during its entire life.
Total Return Swaps
A total return swap (“TRS”) on a single currency, loan, or narrow-based security index (as described above) generally is a security-based swap. However, if a TRS includes embedded interest rate optionality or a non-securities component, such as the price of oil or a currency hedge, it is a mixed swap. Additionally, TRS on a broad-based index or on two or more loans (which one would expect to be considered “narrow-based”) is a swap rather than a security-based swap.
Foreign Exchange Transactions
The Product Rules provide that Foreign Exchange (“FX”) swaps and FX forwards are swaps, subject to a determination by the Secretary of the Treasury to exempt them from regulation as such. It is noteworthy that on April 29, 2011, the Department of the Treasury issued a notice of proposed determination exempting FX swaps and FX forwards from the swap definition; however, a final determination has not yet been made.4 That being said, even if the Secretary of the Treasury issues a final determination that FX swaps and FX forwards are exempt from regulation as swaps, such products will still be subject to swap reporting requirements and, if engaged in by swap dealers or major swap participants, the business conduct standards. Additionally, certain Title VII Instruments are outside the scope of products that the Secretary of the Treasury is authorized to exempt, including foreign currency options, FX non-deliverable forwards, currency swaps and cross-currency swaps. Thus, these FX derivatives are generally swaps, as described below.5
Foreign Currency Options
Foreign currency options, including options on FX swaps or on FX forwards, are swaps. However, foreign currency options that are traded on a national securities exchange are securities and not swaps or security-based swaps.
Non-Deliverable Forward Contracts Involving Foreign Exchange
Non-deliverable forwards (“NDFs”), which are similar to FX forwards except that they are typically settled at maturity in U.S. dollars and do not require physical delivery of currencies, are “swaps” under clause (A)(iii) of the swap definition.6 The CFTC clarifies that, despite their “forward” label, NDFs are not covered by the forward contract exclusion because “currency is outside the scope of the forward contract exclusion for nonfinancial commodities”.7
Currency Swaps and Cross-Currency Swaps
Swaps in which the fixed legs or floating legs based on various interest rates are exchanged in different currencies are termed “currency” or “cross-currency” swaps. The CFTC clarifies that both currency swaps and cross-currency swaps are swaps under the Product Rules (and are neither FX swaps nor FX forwards).
Contracts for Differences
A contract for differences (“CFD”) generally is an agreement to exchange the difference in value of an underlying asset between the time at which a CFD position is established and the time at which it is terminated. If the value increases, the seller pays the buyer the difference, and if the value decreases, the buyer pays the seller the difference. CFDs are based on a number of products, including U.S. Treasuries, FX rates, commodities, equities, and stock indexes, and are generally traded outside of the United States. The Product Rules specify that CFDs, unless otherwise excluded, fall within the scope of the swap or security-based swap definition, as applicable, based upon the nature of the underlying asset. Thus, market participants will need to review the features of the underlying asset of a CFD to determine whether it is a swap or a security-based swap.
Security-Based Swap Agreements
Security-based swap agreements (“SBSAs”) are swaps involving securities over which the CFTC has primary regulatory and enforcement jurisdiction, but for which the SEC also has, among other things, anti-fraud jurisdiction. The term “security-based swap agreement” is defined as a “swap agreement” (as defined in section 206(A) of the Gramm-Leach-Bliley Act8) of which “a material term is based on the price, yield, value or volatility of any security or any group or index of securities, including any interest therein,” but does not include a security-based swap. The Commissions acknowledge that it is not always easy to define an SBSA. However, swaps on broad-based indexes, such as the S&P 500 Index and swaps on exempted securities (other than municipal securities), such as U.S. Treasury bonds, would constitute SBSAs. The Commissions also clarify that there are no additional books and records requirements for SBSAs other than those required for swaps.
Under the Dodd-Frank Act, a “mixed swap” is both a “swap” and a “security-based swap.” For example, mixed swaps would include a Title VII Instrument in which the underlying references are the price of oil and the value of an oil corporation stock or a narrow-based index of oil corporation stocks, or certain “best of” or “out performance” swaps that require a payment based on the higher of the performance of a security and a commodity (that is a non-security).
Under this approach, a mixed swap generally would be subject to dual regulation under parallel provisions of the CEA and the federal securities laws. However, the Product Rules provide for special treatment of a mixed swap in certain circumstances. For example, a bilateral, uncleared mixed swap in which one of the counterparties is dually registered as a dealer or major participant with both the CFTC and the SEC will be subject to the securities law regulatory framework, but only to certain key provisions of the CEA and CFTC rules, which do not appear to include CPO and CTA registration and related requirements. In addition, for all other mixed swaps, the Product Rules provide for a process whereby a person who wishes or intends to list, trade or clear such a mixed swap (or class thereof) may request the agencies to issue a joint order providing for regulation of the mixed swap, as to parallel provisions only, pursuant to specified parallel provisions of either the CEA and/or the Exchange Act and related rules and regulations, instead of parallel provisions of both the CEA and the Exchange Act. For this purpose, “parallel provisions” refer to comparable provisions of the CEA and the Exchange Act that were added by the Dodd-Frank Act with regard to swaps and security-based swaps, and the rules and regulations thereunder.
Transactions That are Not Swaps or Security-Based Swaps
The Commissions note that nothing in the Dodd-Frank Act suggests that Congress intended for traditional insurance products to be regulated as swaps or security-based swaps. Thus, the Commissions make clear that certain contracts provided by certain entities, each meeting specific requirements, would be considered an insurance product and not a swap or security-based swap pursuant to a non-exclusive safe harbor. The safe harbor requires that the product and the provider of the product meet certain requirements, including, but not limited to, the beneficiary having an insurable interest that is the subject of the contract, and the provider being supervised by the insurance regulator of a state or the United States or an agency or instrumentality thereof. In this regard, the Product Rules enumerate certain traditional insurance products, such as life insurance, private mortgage insurance, health insurance and property and casualty insurance, that will not be considered a swap or security-based swap, provided that they are offered by a provider that meets certain requirements. The Product Rules also include a grandfather provision for existing transactions that provides that a transaction entered into prior to the effective date of the Product Rules will be considered insurance and not a swap or a security-based swap, provided that such transaction was offered by a provider that meets certain requirements.
Forward Contract Exclusion from the Swap Definition for Nonfinancial Commodities
Pursuant to Section 1a(47)(B)(ii) of the CEA, the term “swap” does 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 scope of this exclusion determines whether a transaction is considered an excluded forward contract or a swap subject to regulation. For this purpose, the CFTC is providing guidance that this exclusion from the swap definition will be interpreted consistently with the CFTC’s traditional interpretation of the forward contract exclusion with respect to futures contracts.10
In addition, the CFTC is addressing a number of issues concerning the applicability of the forward contract exclusion. For example, the CFTC states that “booked-out” transactions in nonfinancial commodities (including, but not limited to, oil) which are entered into by commercial participants in connection with their business, that meet the requirements specified in the CFTC’s Brent Interpretation regarding forward contracts, and that are effected through a subsequent, separately negotiated agreement, qualify for the forward contract exclusion from the swap definition, despite the lack of settlement by physical delivery. However, in response to a comment, the CFTC explains that, for this purpose, a hedge fund’s investment activity in and of itself is not considered commercial activity within the scope of the CFTC’s Brent Interpretation. According to the CFTC, such activity could qualify as “commercial” activity and such contracts could qualify as forward contracts only if the hedge fund engages in some other type of business activity, such as owning a gold mine and selling the output of the gold mine for forward delivery.
The CFTC is also providing guidance regarding whether forward contracts with embedded optionality are considered forward contracts or swaps. In this regard, if a transaction is a commodity option rather than a forward contract, it is likely to be considered a swap because commodity options are generally included in the swap definition.11 The CFTC states that “a forward contract that contains an embedded commodity option or options will be considered an excluded nonfinancial commodity forward contract (and not a swap) if the embedded option(s): (1) may be used to adjust the forward contract price, but do not undermine the overall nature of the contract as a forward contract; (2) do not target the delivery term (meaning that it does not affect the delivery amount)12, so that the predominant feature of the contract is actual delivery; and (3) cannot be severed and marketed separately from the overall forward contract in which they are embedded.”13 Conversely, where the embedded commodity option(s) render delivery optional, the predominant feature of the contract cannot be actual delivery and, therefore, the embedded option(s) to not deliver prevents the contract from being regarded as a forward contract for a nonfinancial commodity.
In analyzing such transactions, the CFTC will look at the facts and circumstances to evaluate whether any embedded optionality operates on the price or delivery term of the contract and whether an embedded commodity option is marketed or traded separately from the underlying contract. The CFTC further clarifies that embedded optionality as to delivery points and delivery dates will not cause a transaction that otherwise qualifies as a forward contract to be considered a swap.14
The CFTC is also providing an interpretation regarding contracts with embedded volumetric optionality (the option to vary the delivery amount). Generally, volumetric optionality is permissible in excluded forward contracts so long as (i) the embedded optionality does not undermine the overall nature of the agreement as a forward contract; (ii) the predominant feature of the agreement is actual delivery; (iii) the embedded optionality cannot be severed and marketed separately from the overall agreement in which it is embedded; (iv) the seller of the nonfinancial commodity underlying the agreement intends, at the time it enters into the agreement, to deliver the underlying nonfinancial commodity if the optionality is exercised; (v) the buyer intends, at the time it enters into the agreement, to take delivery if it exercises the optionality; (vi) both parties are commercial parties; and (vii) the exercise or non-exercise of the optionality is based primarily on physical factors, or regulatory requirements, that are outside the control of the parties and are influencing demand for, or supply of, the nonfinancial commodity.15 Note that point (vii) does not mean that all factors involved in the decision to exercise an option must be beyond the parties’ control, but rather that the decision must be predominantly driven by factors affecting supply and demand that are beyond a party’s control.
Consumer and Commercial Agreements, Contracts and Transactions
The Commissions also are providing guidance that the following types of transactions do not constitute a swap or a security-based swap: consumer and commercial agreements entered into as part of operations relating to, among other things, acquisitions or sales of property, provisions of services, and employment of individuals, provided they are “customary business arrangements” such as sales, servicing and distribution agreements; the purchase, sale, lease or transfer of real property, intellectual property, equipment or inventory; fixed or variable interest rate commercial loans; and commercial agreements, contracts and transactions containing escalation clauses linked to an underlying commodity such as an interest rate or a consumer price index.16
The Commissions identify three considerations that will be important in utilizing this safe harbor. Specifically, such agreements (i) should not contain payment obligations, whether or not contingent, that are severable from the agreement; (ii) should not be traded on an organized market or over-the-counter; and (iii) in the case of commercial arrangements, should be entered into by such commercial entities to serve an independent commercial, business or non-profit purpose and other than for speculative, hedging or investment purposes.