Title VII of the Dodd-Frank Act,1 titled the “Wall Street Transparency and Accountability Act of 2010” (the “Act”), was enacted on July 21, 2010. Under the Act, which is generally intended to bring the $600 trillion over-the-counter derivatives market under greater regulation, the Commodity Futures Trading Commission (“CFTC”) will have primary responsibility for the regulation of “swaps” and the Securities Exchange Commission (“SEC” and, together with the CFTC, the “Commissions”) will have primary responsibility for the regulation of “security-based swaps.” Since our last update, the Commissions have continued to propose rules and consider comments in connection with the implementation of the Act. A summary of certain noteworthy developments since our last update follows.2
CFTC Re-Opens Comment Periods for Numerous Proposed Rules
Amid an outpouring of concern expressed by market participants regarding the torrid pace of the promulgation of proposed regulations implementing the Act, the CFTC reopened (or extended) the comment period for 32 proposed rules it had issued.3 In reopening (or extending) these comment periods, the CFTC noted that it had consulted and coordinated with other regulators, held hundreds of meetings with market participants and other members of the public, and received thousands of comments on its proposed rules, which together enabled it to “present a complete mosaic of [its] proposed regulatory framework for swaps.”4 Nevertheless, the CFTC reopened (or extended) the comment periods until June 3, 2011 to allow the public an additional opportunity to comment on the new regulatory framework, including regarding the costs and benefits of the proposed rules. In its notice re-opening and extending the relevant comment periods, the CFTC also requested comments on the order in which it should issue final rulemakings in connection with the Act.
CFTC Inspector General Suggests More Robust Cost-Benefit Analyses
The Office of the Inspector General of the CFTC (“OIG”) issued a report (the “OIG Report”) on April 15th regarding the cost-benefit analyses formulated by the CFTC in connection with four rulemakings under the Act: (i) the definitions of key terms; (ii) confirmation, portfolio reconciliation and compression requirements for swap dealers (“SDs”) and major swap participants (“MSPs” and, together with SDs, “Regulated Entities”), (iii) core principles and other requirements for designated contract markets; and (iv) the duties of Regulated Entities.5 The OIG Report acknowledged that the CFTC was in the midst of a daunting task in implementing the Act within the contemplated timeframe, and that it had already published some 50 rulemakings in connection with the Act since its enactment. However, it found that the Office of General Counsel (“OGC”) appeared to take a more dominant role than the Office of the Chief Economist (“OCE”) in formulating the analyses at issue and noted that “similar economic analyses in the context of federal rulemaking have proved perilous for financial market regulators.”
The dominance of the OGC in the process struck the OIG as odd, especially since the CFTC was an agency that regularly engaged in economic analysis. Moreover, the cost-benefit analyses did not always appear to the OIG to acknowledge the cost issues addressed by the technical side of the rulemaking team. The OIG further noted that the cost-benefit analyses lacked any data whatsoever regarding the CFTC’s internal costs to implement the Act. The OIG Report concluded that a more robust process for formulating the cost-benefit analyses for these rulemakings was clearly permitted and desirable, and recommended that greater input from the OCE should be included in any revised methodology.
CFTC Proposes Margin Rules for Uncleared Swaps
On April 28th, the CFTC, after consulting with the SEC and “prudential regulators,” published proposed rules (the “Proposed Margin Rules”)6 regarding initial and variation margin for uncleared swaps entered into by Regulated Entities that are not subject to regulation by a prudential regulator.7 The proposed rules would not impose margin requirements on non-financial entities (commonly referred to as “commercial end-users”).8
Under the Proposed Margin Rules, Regulated Entities would be required to have two-way collateral arrangements, collecting both initial and variation margin from one another in connection with each swap, with no threshold of uncollateralized exposure (although a $100,000 “minimum transfer amount,” or nuisance amount, would apply to transfers). Also, Regulated Entities would be required to collect, but not deliver, initial and variation margin in connection with each swap with a financial entity, with a threshold of uncollateralized exposure, if any, linked to the risk level of the financial entity to the financial system.9 However, a Regulated Entity would not be required to collect initial or variation margin for a swap with a non-financial entity; rather, a Regulated Entity simply would be required to enter into a privately-negotiated credit support arrangement with such an entity.
Regulated Entities and financial entities would be generally permitted to deliver the following forms of collateral to satisfy initial margin requirements: (i) cash; (ii) obligations of (or guaranteed by) the United States or any agency thereof; (iii) senior debt obligations of the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation, a Federal Home Loan Bank, or the Federal Agricultural Mortgage Corporation; and (iv) insured obligations of Farm Credit Services banks. However, only cash and U.S. Treasury securities would be permitted to satisfy variation margin requirements. Unlike other counterparties, non-financial entities would be permitted to deliver non-traditional forms of collateral, as specified in their credit support arrangements with Regulated Entities, as long as the value of such collateral is “reasonably ascertainable” on a periodic basis. Specified haircuts would apply to all non-cash collateral.
Initial margin, generally, would be calculated using a qualifying model approved by the CFTC and would have to cover 99% of price changes, by product and by portfolio, over at least a 10-day liquidation horizon. Variation margin would be calculated, among other things, pursuant to a method agreed by the parties in their credit support arrangement, consistent with certain requirements specified in the Proposed Margin Rules and set forth with sufficient specificity to allow the counterparty, the CFTC and any applicable prudential regulator to calculate margin requirements independently.
Under the Proposed Margin Rules, initial margin for swaps between Regulated Entities could not be held directly but, rather, would have to be held at a third-party custodian and not be rehypothecated. Regulated Entities must offer non-Regulated Entities the opportunity to have initial (but not variation) margin segregated. Significantly, the Proposed Margin Rules would not apply retroactively to swaps entered into before the effectiveness of the related final rules. On May 12th, the CFTC extended the comment deadline for the Proposed Margin Rules until July 11th, so that it would coincide with the deadline for its proposed rules on capital requirements (discussed below).
On May 17th, New York federal legislators, led by Senators Charles Schumer and Kirsten Gillibrand, sent a letter to the heads of the Federal Reserve Board, the CFTC, the FDIC and the OCC warning that margin rules proposed by various regulators would inevitably result in a competitive disadvantage for U.S. firms operating globally. In particular, the legislators expressed concern about the extraterritorial application of these margin rules, which would require non-U.S. subsidiaries and affiliates of U.S. banks to demand collateral in connection with derivatives transactions from non-U.S. customers. Absent a harmonization of rules with non-U.S. regulators, the relevant margin requirements would result in regulatory arbitrage, as they would incentivize non- U.S. customers to move business to European (or other) counterparts which did not have similar requirements. The legislators asked the regulators to reconsider the extraterritorial application of the regulators’ proposed margin rules and urged them to work closely with international regulators to ensure that they adopted as rigorous a regulatory regime for over-the-counter (“OTC”) derivatives as the U.S. was adopting.
CFTC Proposes Capital Rules for Swaps
Section 731 of the Act required the CFTC to adopt capital requirements for Regulated Entities that are not subject to regulation by prudential regulators. In preparing the capital requirements it proposed on May 12th (the “Proposed Capital Rules”),10 the CFTC consulted with the SEC and the prudential regulators. The Proposed Capital Rules essentially provide rules for Regulated Entity qualifying capital, as well as minimum levels of such qualified capital that must be maintained. The Proposed Capital Rules encompass both amendments to existing CFTC rules for futures commision merchants (“FCMs”), as well as new rules applicable to Regulated Entities that are not FCMs.
Regulated Entities that are also FCMs would be required to meet existing requirements for FCMs to hold minimum levels of adjusted net capital, and would also be required to calculate the required minimum level as the greatest of: (i) a fixed dollar amount (currently $20,000,000); (ii) the amount required for FCMs also acting as retail foreign exchange dealers; (iii) 8% of the risk margin required for customer and non-customer exchangetraded futures positions and OTC swap positions cleared by a derivatives clearing organization (“DCO”); (iv) the amount of adjusted net capital required by a registered futures association of which such FCM is a member; and (v) if the FCM is also registered as a securities broker or dealer, the amount of net capital required by SEC rules.
Regulated Entities that are not also FCMs but that are non-bank subsidiaries of U.S. bank holding companies would be required to meet the same capital requirements applicable to bank holding companies, which generally means a minimum ratio of qualifying total capital to risk-weighted assets of 8%, half of which (and at least $20,000,000) would be required to be in the form of Tier 1 capital.
Regulated Entities that are neither FCMs nor bank holding company subsidiaries would be required to maintain a minimum tangible net equity (generally, based on net equity, as determined under U.S. generally accepted accounting principles, minus intangibles such as goodwill) equal to $20,000,000, plus additional amounts for market risk and OTC derivatives credit risk.
Under the Proposed Capital Rules, a Regulated Entity may apply for CFTC approval to use internal models to determine its capital requirements. The Proposed Capital Rules also include certain financial condition reporting and recordkeeping requirements for Regulated Entities, similar to those currently applicable to FCMs.
CFTC Proposes Recordkeeping and Reporting Rules for Legacy Swaps
On April 25th (the “Proposed Reporting Rule Date”), the CFTC issued proposed rules (the “Proposed Reporting Rules”)11 establishing recordkeeping and reporting requirements for pre-enactment swaps (i.e., swaps entered into before the July 21, 2010 enactment of the Act that remain outstanding) and transition swaps (i.e., swaps entered into on or after the enactment date of the Act, but prior to the compliance date specified in the CFTC’s final swap data reporting rules) that are not accepted for clearing by a DCO, which constitute “uncleared swaps.” Under Section 729 of the Act, at least one party to an uncleared swap must be responsible for reporting data concerning that swap to a swap data repository (“SDR”). The reporting party is generally the party in the best position to perform the reporting obligation. Specifically, if only one party to a swap is an SD, then the SD is responsible for reporting; if one party is an MSP and the other party is neither an SD nor an MSP, then the MSP is responsible for reporting; where parties have the same status, then the parties are to decide between them which party is responsible for reporting. Section 729 also provides for reporting directly to the CFTC of uncleared swaps that are not accepted by an SDR and, in connection therewith, requires that books and records be kept in a manner and for the time required by the CFTC to facilitate such reporting.
Following enactment of the Act, the CFTC issued certain interim final rules regarding pre-enactment and transition swaps. As contemplated in those interim final rules, the Proposed Reporting Rules were issued to address the following matters: (i) records, information and data that must be retained for historical swaps; (ii) the timeframe for reporting data to an SDR or the CFTC; and (iii) the specific data required to be reported. Among other things, the Proposed Reporting Rules would require that parties retain records of an asset class-specific set of minimum, primary economic terms for swaps in existence on or after the Proposed Reporting Rule Date (for swaps that expired or terminated before such date, less rigorous requirements would apply). The Proposed Reporting Rules include a detailed appendix in which the minimum primary economic terms data for historical swaps are specified by asset class.
SEC Proposes Beneficial Ownership Rule for Security-Based Swaps
The Act amended the Securities Exchange Act of 1934, as amended (the “Exchange Act”), in several important respects in connection with “security-based swaps,”12 including amending the definition of “security” in Section 3(a)(10) of the Exchange Act to include security-based swaps. The Act also amended Sections 13(d) and 13(g) of the Exchange Act (regarding beneficial ownership reporting requirements) to include any person who “becomes or is deemed to become a beneficial owner of any [listed security] upon the purchase or sale of a security-based swap that the [SEC] may define by rule.” Finally, the Act added Section 13(o) to the Exchange Act, which provides that a person is deemed to acquire beneficial ownership of an equity security in connection with the purchase or sale of a security-based swap only to the extent that the SEC determines (after consultation with the prudential regulators and the Secretary of the Treasury), that the purchase or sale provides incidents of ownership comparable to direct ownership of the equity security.
These amendments created uncertainty regarding the treatment of security-based swaps under the existing beneficial ownership reporting rules of the Exchange Act. In order to address this concern, the SEC issued a proposed rule13 (the “Proposed Beneficial Owner Rule”). The Proposed Beneficial Owner Rule would clarify that the existing rules concerning beneficial ownership will continue to apply to security-based swaps after the provisions of the Act become effective. The SEC is effectively proposing to “readopt without change” the relevant beneficial ownership rules and clarify that, even after the effectiveness of Section 13(o), persons who purchase or sell security-based swaps will remain within the scope of the existing Exchange Act rules to the same extent as they are now. The SEC highlights that the proposed readoption of the relevant portions of the beneficial ownership rules “is neither intended nor expected to change any existing administrative or judicial application or interpretation of the rules.”14
Although the Proposed Beneficial Owner Rule is intended to preserve the status quo, the SEC made several statements in the release that may be important for market participants. First, the SEC noted that it is engaged in a separate effort to modernize reporting under Sections 13(d) and 13(g) of the Exchange Act. Further, the SEC cautioned that a person who does not hold voting or investment power over securities that are subject to a security-based swap may still be deemed to have beneficial ownership of those securities if the security-based swap is part of a plan or scheme to evade the relevant reporting requirements.15 Finally, the SEC pointed out that if a person enters into a security-based swap for the purpose or effect of changing or influencing the control of the issuer of the securities subject to the security-based-swap, that person will be deemed to be a beneficial owner under Rule 13d-3(d)(1).16
Commissions Issue Joint Proposed Definitions
On April 27th, the Commissions issued joint proposed rules and interpretive guidance (the “Joint Rules and Guidance”) addressing the scope of the terms “swap” and “security-based swap” under the Act, the two critical definitions in determining whether a financial instrument comes under regulation.17 The Commissions also issued proposed rules and interpretive guidance on the relationship between the definitions of swap and securitybased swap and clarified which instruments would be subject to regulation by the CFTC, SEC, or both, in the case of “mixed swaps” (discussed below). In issuing these rules and guidance, the Commissions highlighted that the name or label parties use to identify a product is not dispositive in determining that instrument’s status under the Act; rather, a product’s terms and characteristics will be evaluated in making such a determination.
The Act itself included comprehensive lists of financial instruments that would qualify as “swaps” and “securitybased swaps.” The Joint Rules and Guidance provide additional guidance as to whether certain transaction types should be included in those definitions. Generally, the Commissions determined that foreign currency options, non-deliverable (foreign exchange) forwards, currency swaps, cross-currency swaps and forward rate agreements18 will constitute swaps. The Commissions also determined that insurance products, forward contracts, consumer and commercial agreements, contracts, and transactions, and loan participations will fall outside the scope of the Act.
With respect to insurance products, the Joint Rules and Guidance would generally exclude State- or federallyregulated insurance products that are provided by State- or federally-regulated insurance companies. Specifically, an instrument would be excluded from the relevant definitions if it has the following characteristics: (i) the instrument beneficiary has an insurable interest and thereby carries the risk of loss with respect to that interest continuously throughout the duration of the instrument; (ii) the loss must occur and be proved, with indemnification or payment therefor limited to the value of the insurable interest; (iii) the instrument is not traded on an organized market or OTC; and (iv) with respect to financial guaranty insurance only, acceleration of payments under the policy is at the sole discretion of the insurer. It is not clear whether the fourth characteristic of this test would be satisfied by a termination payment on a credit default swap (“CDS”) under which a monoline insurance company provides financial guaranty insurance. This ambiguity was compounded by a potential discrepancy in the relevant commentary provided by each of the Commissions with respect to “wraps” of swaps (with the CFTC apparently believing more strongly than the SEC that such wraps themselves should also constitute swaps). The Joint Rules and Guidance request comments as to whether a wrap is sufficiently different from the underlying swap being insured to justify excluding it from the relevant definitions. The Commission also provided guidance specifically excluding from the relevant definitions products such as surety bonds, life insurance, health insurance, property and casualty insurance and certain annuity products, so long as such products were offered by an appropriate company and were regulated as insurance under the laws of any State or by the United States.
With respect to forward contracts, the Commissions noted that such contracts on nonfinancial commodities and security forwards (so long as they are “intended to be physically settled,” as required by the Act) would not be considered swaps or security-based swaps, although a forward contract with an embedded commodity option would be subject to a three-part analysis in establishing its regulatory status under the Act.19
Moreover, the Joint Rules and Guidance indicated that the Commissions do not believe that Congress intended to regulate customary consumer and commercial transactions under the Act. For example, transactions to acquire or lease real or personal property, mortgage rate locks and variable interest rate loans would not constitute swaps or security-based swaps. The Commissions further noted that two characteristics generally distinguish consumer and commercial agreements, contracts, and transactions from swaps or security-based swaps. Specifically, unlike swaps and security-based swaps: (i) the payment obligations under the arrangements are not severable; and (ii) the agreement, contract, or transaction is not traded on an organized market or OTC and does not involve risk-shifting arrangements with a financial entity.
The Commissions further clarified in the Joint Rules and Guidance that they would not interpret the definitions of swap and security-based swap to include loan participations in which the purchaser acquires: (i) a current or future direct or indirect ownership interest in the underlying loan; or (ii) a beneficial ownership interest in the economics of the underlying loan.
The Joint Rules and Guidance also address the relationship between swaps and security-based swaps, reasoning that the facts and circumstances (i.e., the specific terms and conditions of the instrument and the nature of the underliers on which it is based) existing at its time of the instrument’s execution should determine its status. If the instrument is based on interest or monetary rates (e.g., interbank offered rates, money market rates, government target rates, general lending rates, certain indexes), then that suggests it will constitute a “swap” and be subject to regulation by the CFTC under the CEA, but if it is based on the yield (i.e., price or value) of a single security, single loan, or narrow-based security index, then that suggests it will constitute a “security-based swap” and be subject to regulation by the SEC under the Exchange Act.
In addition, the Joint Rules and Guidance addressed the narrow category of instruments known as “mixed swaps,” which are generally defined under the Act as security-based swaps that are also based on one or more interest or other rates, currencies, commodities, etc. An example of a mixed swap is an instrument under which the underlying references are the value of an oil corporation stock and the price of oil. In order to avoid dual registration, persons intending to list, trade or clear mixed swaps may request that the Commissions issue a joint order permitting compliance with specified parallel provisions of the CEA and Exchange Act. In making such a request, a party would be required to provide the Commissions with all material information regarding the terms of the mixed swap, including its economic characteristics and purpose. Within 120 days of receipt of a complete request, the Commissions would be required to either issue a joint order or publicly detail the reasons for failing to do so.
One area of continuing focus relating to the scope of the definition of “swap” is the treatment of foreign exchange swaps and forwards (“FX Trades”). FX Trades represent about 5% of the OTC derivatives market. As we have addressed in previous editions of this publication, certain legislative proposals considered prior to passage of the Act suggested that FX Trades would not be regulated, as they are typically entered into by endusers for hedging purposes, they are typically short-dated and, unlike CDS, they were not at the root cause of any market turmoil. However, under the Act, such transactions were not given a full exemption but, rather, discretion was granted to the Secretary of the Treasury (the “Treasury”) to determine whether they should be exempt from regulation, after considering several factors.20 These factors include whether the required trading and clearing of FX Trades would create systemic risk, lower transparency, or threaten the financial stability of the United States. Any such determination made by the Treasury was required to be submitted to the appropriate committees of Congress and was to explain the “qualitative difference” between FX Trades and other classes of swaps that would make them “ill-suited” for regulation as swaps and identify “objective differences” between FX Trades, on the one hand, and other swaps, on the other hand, that warrant an exempted status.
In the absence of any Treasury determination, the Joint Rules and Guidance treated FX Trades as swaps. However, on April 29th, two days following the publication of the Joint Rules and Guidance, the Treasury issued its decision proposing that FX Trades be excluded from the definition of “swap” under the CEA. In making its determination, the Treasury noted that forcing FX Trades onto exchanges and requiring that they be centrally cleared was not necessary because existing procedures already mitigate the risk posed by such trades and ensure stability.21 In particular, the Treasury pointed out that these trades already have high levels of price transparency, effective risk management and electronic trading. Another significant consideration may have been the possibility that, as highlighted by the comments of certain market participants, the margin requirements that would be imposed on customers for cleared trades could push FX Trades offshore. It has been reported that U.S. commercial banks recorded $9.1 billion in revenue from foreign exchange derivatives trades in 2010, the largest source of revenue for bank derivatives and cash positions that year, according to the OCC.
Significantly, the Treasury proposal does not exempt FX Trades from the reporting requirements and business conduct standards of the Act. Moreover, if trades are structured as FX Trades to benefit from the Treasury exemption, anti-evasion rules under the Act would give regulators authority to regulate such trades as swaps.22