The broad definition of a “swap” in the Dodd-Frank Act, read literally, would encompass many transactions that Congress never intended to cover, so the SEC and the CFTC have jointly promulgated regulations that provide that many of those transactions are not treated as swaps. However, a recent SEC Investor Alert, stating that fantasy stock trading games may be considered swaps if they award prizes, suggests a more expansive reading of the definition by the regulators.
The term “swap” is defined to include any transaction in which a payment “is dependent on the occurrence, nonoccurrence, or the extent of the occurrence of an event or contingency associated with a potential financial, economic, or commercial consequence,” subject to certain exceptions. 7 U.S.C. § 1a(47). Since this definition could include almost any type of transaction, Dodd-Frank provided the SEC and CFTC with broad power to further define the terms. As explained in their 500+ page Release, the commissions adopted rules and interpretations excluding from the definition of “swap” certain types of insurance products, guarantees, consumer and commercial agreements, contracts and transactions, and a host of other transactions that are not commonly understood to be swaps.
According to the SEC’s Investor Alert (and related tweets!), fantasy stock trading games, where players manage an imaginary portfolio of stocks, may be considered swaps and run afoul of the laws governing the sale of swaps if players are charged entry fees and prizes are awarded based on performance of the imaginary portfolio, no matter how small the entry fees and prizes may be.
The SEC indicates that, under the literal statutory definition, it would likely consider the fantasy game to be a “swap” and, more particularly, a “securities-based swap” (defined, in part, as a swap whose value is based upon a narrow-based index of securities or a single security) falling within the SEC’s jurisdiction. The SEC also would likely consider the fantasy game to violate the provisions of Dodd-Frank prohibiting the sale of security-based swaps to persons who are not “eligible contract participants” – which, for an individual, requires at least $5 million, and in some cases $10 million, invested on a discretionary basis – unless the transaction is effected on a national securities exchange. See 15 U.S.C. § 78(f)(1); 7 U.S.C. § 1a(18).
The SEC recently settled an enforcement proceeding against a website operator, Sand Hill Exchange, that bought and sold “contracts” with website users under which the users could receive payments based on the future performance of privately-held companies that subsequently went public. Claiming that these transactions were securities-based swaps sold in violation of Dodd-Frank, the SEC obtained a cease and desist order prohibiting the company from continuing its business. The SEC cites Sand Hill Exchange in its Investor Alert, although the contracts bought and sold in Sand Hill appear materially different, and closer to transactions commonly understood as swaps, than the fantasy stock trading games described in the alert.
There may or may not be good reason to ban pay-to-play stock fantasy games. However, regulating these activities as “securities-based swaps,” limited to “eligible contract participants” unless traded on a national securities exchange, seems to force the conduct into a Procrustean bed that just doesn’t fit.
More importantly, the SEC’s position demonstrates the regulator’s willingness to apply a broad definition of “swap.” This may have ramifications for many other types of transactions that may come within the literal definition and are not specifically excluded by the current rules and interpretations.