On May 23, the Commodity Futures Trading Commission (CFTC) and the SEC published final rules and interpretive guidance under the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) defining the terms “swap dealer,” “security-based swap dealer,” “major swap participant,” and “major security-based swap participant.” The Dodd-Frank Act divided the regulation of swaps between “swaps” overseen by the CFTC and “security-based swaps” overseen by the SEC. Unless exempt under the new rules, market participants covered by the definitions will be required to register as dealers or major participants and will be subject to requirements governing margin, minimum capital, and business conduct.

In some cases, the final rules modify the rules and guidance proposed by the two agencies in December 2010. As a result, the final rules will encompass a smaller number of market participants than would have been covered by the proposed rules. The CFTC estimates that approximately 125 market participants will be covered by the definitions of swap dealer and major swap participants, while the SEC estimates that 50 or fewer market participants will be classified as security-based swap dealers and that five (and possibly no) market participants will be classified as major security-based swap participants.

The final rules will become effective on July 23, 2012. Market participants will be required to register as dealers or major participants upon the effectiveness of additional CFTC and SEC joint final rules defining “swap” and “security-based swap” that were adopted by the SEC on July 9 and the CFTC on July 10.

The final rules adopted on May 23 can be viewed at http://cftc.gov/ucm/groups/public/@lrfederalregister/documents/file/2012-10562a.pdf. A more detailed discussion of the final rules prepared by Hogan Lovells can be found at http://www.hoganlovells.com/cftc-and-sec-adopt-joint-final-rule-defining-swap-dealer-security-based-swap-dealer-major-swap-participant-and-major-security-based-swap-participant-07-16-2012/.

Coverage of the new rules

Swap dealer and security-based swap dealer. Under the Dodd-Frank Act, as reflected in the new rules, a “swap dealer” is defined as a person who:

  • Holds itself out as a dealer in swaps;
  • Makes a market in swaps;
  • Regularly enters into swaps as an ordinary course of business for its own account; and
  • Engages in activity causing itself to be commonly known in the trade as a dealer or market maker in swaps.  

The statute defines “security-based swap dealer” in an identical manner, with such a dealer engaged in activity involving “security-based swaps” rather than “swaps.” Unless otherwise indicated in the following summary, references to a “swap dealer” also include a security-based swap dealer.

The final rules provide exemptions from the requirement to register as a swap dealer for a person that enters into swaps but does not do so as part of its “regular business” and whose swap dealing is below a de minimis threshold. The final rules also provide exemptions for swaps that, among other things, hedge physical positions, are in connection with a loan from an insured depository institution, or are entered into between affiliates.

The CFTC and the SEC intend that, in determining whether it is a swap dealer, a person should first apply the statutory definition of that term in light of the interpretive guidance provided in the adopting release relating to the types of activities indicative of dealer status, including “holding oneself out as a dealer,” “being commonly known as a dealer,” and “making a market in swaps.” The person should then exclude from the swap dealer determination any swaps that do not arise from swap dealing, such as swaps hedging physical positions. Finally, if the person determines that it is engaged in swap dealing, it should determine whether its swap dealing activity exceeds the applicable de minimis threshold. The person will be subject to regulation as a swap dealer only if its activities exceed that threshold.

The Dodd-Frank Act requires the CFTC and the SEC to exempt from designation as a swap dealer or security-based swap dealer any entity “that engages in a de minimis quantity” of dealing “in connection with transactions with or on behalf of customers.” Responding to comments that the proposed de minimis thresholds were too low, the agencies substantially increased the thresholds, except in connection with swaps entered into with “special entities,” and eliminated restrictions on the number of counterparties and swaps. (A “special entity” is a federal agency, state, state agency, city, county, municipality, other political subdivision of a state, employee benefit plan, government plan, or endowment.) Under the final rules, a person is exempt from the definition of swap dealer or security-based swap dealer if the aggregate effective notional amount of covered dealing activity over the preceding 12 months (subject to a phase-in) does not exceed:

  • With respect to swaps, $3 billion subject to a phase-in level of $8 billion;
  • With respect to security-based swaps that are credit default swaps, $3 billion subject to a phase-in level of $8 billion;
  • With respect to security-based swaps that are not credit default swaps, $150 million subject to a phase-in level of $400 million; and
  • With respect to swaps or security-based swaps entered into with special entities, $25 million.

Major swap participant and major security-based swap participant. Entities that are not required to register as swap dealers or security-based swap dealers still may be required to register as major swap participants or major security-based swap participants.

Under the Dodd-Frank Act, as reflected in the new rules, a “major swap participant” is defined as any of the following persons:

  1. A person that maintains a “substantial position” in swaps or security-based swaps for any of the major swap or security-based swap categories described below, excluding (1) positions for “hedging or mitigating commercial risk” and (2) positions maintained by certain ERISA employee benefit plans for the primary purpose of hedging or mitigating any risk directly associated with the ERISA plan’s operations;
  2. A person whose outstanding swaps or security-based swaps create “substantial counterparty exposure” that could have serious adverse effects on the financial stability of the U.S. banking system or financial markets; or
  3. A “financial entity” that (1) is “highly leveraged” relative to the amount of capital such entity holds and that is not subject to capital requirements established by an appropriate federal banking agency and (2) maintains a substantial position in outstanding swaps or security-based swaps in any major swap or security-based swap category. The rules contain an identical definition of a “major security-based swap participant” for a person engaged in activity involving security-based swaps. Unless otherwise indicated in the following summary, references to a “major participant” include both a major swap participant and a major security-based swap participant.

The determination of major participant status under the three tests above will turn primarily on the application of the definitions of “substantial position,” “hedging or mitigating commercial risk,” “substantial counterparty exposure,” “financial entity,” and “highly leveraged” contained in the new rules. 

Major swap and security-based swap categories. The first and third tests above used in determining whether a person is a major participant require the person first to assign all of its swaps or security-based swaps to the appropriate major categories of swaps and security-based swaps. 

The CFTC adopted rules creating the following four major categories of swaps for use in the definition of “major swap participant”:

  1. Rate swaps (any swap primarily based on one or more reference rates, such as interest rates, currency exchange rates, and inflation rates or other monetary rates);
  2. Credit swaps (any swap primarily based on default, bankruptcy, and other credit-related risks related to, or the total return on, loans or other instruments of indebtedness or related indices);
  3. Equity swaps (any swap primarily based on equity securities or related indices); and
  4. Other commodity swaps (any swap not included in the first three categories, including any swap based on physical commodities).

The SEC’s rules create the following two categories of security-based swaps for use in the definition of “major security-based swap participant”:

  1. Debt security-based swaps (any security-based swap based, in whole or in part, on loans or other instruments of indebtedness or on credit events relating to one or more issuers or securities); and
  2. Other security-based swaps.

Substantial position . Under the first test for major participant status, a person will qualify as a major swap participant or a major security-based swap participant if it maintains a “substantial position” (subject to certain exclusions) in any of the major swap or security-based swap categories identified above. A person will have a substantial position if the amount of its swaps or security-based swaps exceeds certain specified thresholds in either part of a two-part test. The first part of the test examines whether the person’s “aggregate uncollateralized outward exposure” (its uncollateralized, out-of-the-money positions) exceeds the following thresholds:

  • For rate swaps, $3 billion or more in daily average aggregate uncollateralized outward exposure.
  • For credit swaps, equity swaps, other commodity swaps, and security-based swaps, $1 billion or more in daily average aggregate uncollateralized outward exposure.

The second part of the test examines whether the sum of the person’s (1) aggregate uncollateralized outward exposure and (2) “aggregate potential outward exposure” (the potential exposure of the person’s swap and security-based swap positions) exceeds the following thresholds:

  • For rate swaps, $6 billion or more of the sum of the daily average aggregate uncollateralized outward exposure and the daily average aggregate potential outward exposure.
  • For credit swaps, equity swaps, other commodity swaps, and security-based swaps, $2 billion or more of the sum of the daily average aggregate uncollateralized outward exposure and the daily average aggregate potential outward exposure.

Hedging or mitigating commercial risk. The first major participant test excludes positions held for “hedging or mitigating commercial risk” from the substantial position analysis. The exclusion is available to both non-financial and financial entities. With respect to swaps, these positions include swap positions that qualify as bona fide hedging under the Commodity Exchange Act (CEA) or for hedging treatment under certain accounting standards. Swap and security-based swap positions will qualify where they are economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise. The exclusion for hedging or mitigating of commercial risk extends to the hedging of risks of a person’s majority-owned affiliates.

Substantial counterparty exposure. Under the second major participant test, a person will qualify as a major participant if its outstanding swap or security-based swap positions are deemed to create “substantial counterparty exposure that could have serious adverse effects on the financial stability of the United States banking system or financial markets.” The calculations for this test will be performed in a manner identical to those for the “substantial position” test, except that this test looks to a person’s positions across all of the major categories of swaps and security-based swaps and provides no exclusions for positions that hedge or mitigate commercial risk or that hedge or mitigate risks directly associated with the operation of ERISA plans. 

Under the CFTC’s rules, a person will qualify as a major swap participant if (1) its daily average aggregate uncollateralized outward exposure across all major swap categories exceeds $5 billion or (2) the sum of its daily average aggregate uncollateralized outward exposure and daily average uncollateralized potential outward exposure across all major swap categories exceeds $8 billion. Under the SEC’s rules, a person will qualify as a major security-based swap participant if (1) its daily average aggregate uncollateralized outward exposure across all major security-based swap categories exceeds $2 billion or (2) the sum of its daily average aggregate uncollateralized outward exposure and daily average uncollateralized potential outward exposure across all major security-based swap categories exceeds $4 billion. 

Highly leveraged financial entity. Under the third major participant test, a person will qualify as a major participant if it is a “highly leveraged” “financial entity” that is not subject to the capital requirements of a federal banking agency and holds and maintains substantial positions in swaps or security-based swaps. As with the second major participant test, the third test does not provide exclusions for positions that hedge or mitigate commercial risk or that hedge or mitigate risks directly associated with the operation of ERISA plans.

A person will be considered to be “highly leveraged” if the ratio of its liabilities to equity exceeds 12 to 1, as determined in accordance with U.S. generally accepted accounting principles as of the last business day of a fiscal quarter. This standard differs from the proposed ratios of 8 to 1 and 15 to 1. The agencies noted in the adopting release that they adopted the ratio of 12 to 1 in consideration of the broker-dealer capital regulations that apply special provisions when a broker-dealer’s leverage exceeds 12 to 1.

Under the new rules, a “financial entity” is any of the following: 

  • A swap dealer or security-based swap dealer; 
  • A major swap participant or major security-based swap participant; 
  • A commodity pool as defined in section 1a(10) of the CEA; 
  • A private fund as defined in section 202(a) of the Investment Advisers Act of 1940; 
  • An employee benefit plan as defined in paragraphs (3) and (32) of section 3 of ERISA; or
  • A person predominantly engaged in activities that are in the business of banking or that are “financial in nature,” as defined in section 4(k) of the Bank Holding Company Act of 1956.

Major participant safe harbors. The new rules include three safe harbors for persons whose swap or security-based swap positions are so substantially below the major participant thresholds that they will not be required to conduct the various daily and quarterly determinations necessary for the major participant tests. Any person that satisfies one of the safe harbors will not be deemed to be a major participant.

The first safe harbor requires compliance with caps on uncollateralized exposure and notional positions. Under this safe harbor, a person will not be a major swap participant or major security-based swap participant if (1) the terms of the person’s swap or security-based swap contracts with its counterparties at no time would permit the person to maintain a total uncollateralized exposure of more than $100 million to all such counterparties and (2) the person does not maintain notional amounts of more than $2 billion in any major category of swaps or security-based swaps, or more than $4 billion in the aggregate.

The second safe harbor is available to a person that meets conditions for caps on uncollateralized exposure and results of monthly substantial position and substantial counterparty calculations. This safe harbor will be available to a person if (1) the terms of the person’s swap or security-based swap contracts with its counterparties at no time would permit the person to maintain a total uncollateralized exposure of more than $200 million to all such counterparties and (2) the person performs the substantial position and substantial counterparty calculations of the major participant test as of the end of every month, and the results of those monthly calculations indicate that the person’s swap or security-based swap positions are no more than (a) $1 billion in aggregate uncollateralized exposure plus aggregate potential outward exposure in any major category of swaps (excluding positions held for hedging or mitigating commercial risk) or (b) $2 billion in aggregate uncollateralized outward exposure plus aggregate potential outward exposure (without any exclusions).

The third safe harbor is available to a person with low uncollateralized outward exposure. Under this safe harbor, a person will not be deemed to be a major participant if, at the end of each month, (1) the person’s aggregate uncollateralized outward exposure with respect to its swap or security-swap positions in each major category of swaps or security-based swaps is less than $500 million (or less than $1.5 billion with respect to the rate swap category) and (2) for each major category of swaps or security-based swaps, the sum of (a) the person’s aggregate uncollateralized outward exposure with respect to its swap or security-based swap positions in the applicable major category and (b) the total notional principal amount of the person’s swap or security-based swap positions in the category (adjusted on a position-by-position basis by the CFTC’s or SEC’s multipliers) is less than $1 billion (or less than $3 billion with respect to the rate swap category). The final rules include an alternative simplified version of the third safe harbor test. 

Eligible contract participant. The Dodd-Frank Act added a subsection to the CEA stating that a person who is not an “eligible contract participant” may enter into swaps only on, or subject to the rules of, a designated contract market. The statute provides that an eligible contract participant includes swap dealers, security-based swap dealers, major swap participants, and major security-based swap participants. The final rules provide for additional tests under which an entity that is not itself an eligible contract participant may qualify as an eligible contract participant, such where the entity enters into a swap to hedge or mitigate its commercial risk and all of its owners are eligible contract participants and any of such owners has a net worth exceeding $1 million.

Effect of the new rules on energy companies and non-financial entities

As noted, the CFTC and the SEC expect that a relatively small number of companies will be required to register as dealers or major participants. Although each company will need to assess its status in light of its specific circumstances, companies can take steps to ensure that they do not fall within the ambit of the new rules.

Energy companies. Whether energy companies are swap dealers is likely to hinge on a particular energy company’s ability to use one of the exemptions to the definition. Because end-users in the energy markets often enter into swaps directly with each other, energy market participants often engage in the types of activities that are indicative of swap dealer status. The CFTC and the SEC recognized the situation of these companies, but elected not to exempt persons from the swap dealer definition based on the general nature of their business.

For energy companies that engage in conduct satisfying the swap dealer definition, the likeliest exemption will be the de minimis exemption. As discussed above, a person that qualifies as a swap dealer nevertheless will not be required to register as such if the aggregate effective notional amount of its swaps is $8 billion or less, which will fall to $3 billion or less following the phase-in period. However, government-owned public utilities, which are classified as “special entities” under the new rules, are limited to a de minimis exemption of only $25 million, which will severely limit swaps with such entities.

Non-financial manufacturing entities. The swap dealer definition is unlikely to capture non-financial entities engaged in manufacturing, but such entities could become subject to regulation as a major participant. “Non-financial entities” are entities other than (1) swap dealers or security-based swap dealers, (2) major participants, (3) commodity pools, (4) private funds, (5) employee benefit plans, and (6) persons predominantly engaged in activities that are in the business of banking or that are “financial in nature” (as defined in section 4(k) of the Bank Holding Company Act of 1956). 

Although the “substantial position” test incorporates relatively sizeable thresholds ranging from $1 billion to $6 billion depending on the major participant category and the part of the test being calculated, many non-financial manufacturing entities should be able to exclude much of their swap activity under the hedging or mitigating commercial risk exemption. The exemption is available to a person under both major participant categories for hedges designed to reduce the risks in the value of assets which the person owns, or anticipates owning, producing, manufacturing, processing, or merchandising in the ordinary course of its business, as well as the value of services which the person provides or purchases, or anticipates providing or purchasing. The CFTC provides a few additional qualifying exemptions for swaps that qualify as bona fide hedging under the CEA or under certain accounting standards. 

Manufacturers, however, should take care not to be over-hedged, enter into swaps that are not “economically appropriate,” or enter into swaps that introduce other types of risk to a degree that is greater than necessary to manage the risk. Any of these activities would place the exemption for that swap at risk and could require it to be included in the substantial position test.