On July 18, 2012, the Commodity Futures Trading Commission (“CFTC”) and Securities and Exchange Commission (“SEC”) jointly released final derivatives product definition rules (the “Derivatives Rules”). Through the Derivatives Rules, the CFTC and SEC (together, the “Commissions”) sought to, among other things: (i) clarify the definitions of swap, security-based swap (an agreement, contract, or transaction that satisfies either definition is referred to as a “Title VII instrument”), security-based swap agreement, and mixed swap; and (ii) assist market participants in determining whether particular agreements, contracts, and transactions fall within or outside of these definitions. The Derivatives Rules implement provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), establishing a comprehensive framework for the regulation of over-the-counter derivatives. SEC Chairman Mary L. Shapiro stated, “Approving the product rules and interpretations is another foundational step in the establishment of a new regulatory regime for derivatives.” The Derivatives Rules will generally be effective 60 days after publication in the Federal Register. This client alert highlights the Derivatives Rules and some important exclusions from the definitions established by the Derivatives Rules.
Title VII of the Dodd-Frank Act (“Title VII”) requires that the SEC and CFTC, in consultation with the Board of Governors of the Federal Reserve System, shall jointly further define the terms “swap,” “security-based swap,” and “security-based swap agreement.” Title VII further provides that the SEC and CFTC shall jointly establish such regulations regarding “mixed swaps” as may be necessary to carry out the purposes of swap and security-based swap regulation under Title VII.
While the CFTC is charged with regulating swaps, the SEC has authority to regulate security-based swaps. In addition, the CFTC will regulate single-definition credit default swaps (“CDS”), whereas the SEC will regulate index CDS. Both agencies will have regulatory authority over mixed swaps.
The following chart illustrates the characterization of certain instruments pursuant to the Derivatives Rules and related interpretations:
Please click here to view the chart.
This chart provides a summary, for reference use only. It does not cover the entire list of instruments that have been characterized under the Derivatives Rules nor does it cover all exemptions from the general rule of characterization that may be applicable in certain cases. Readers should contact counsel when making determinations as to the characterization of certain instruments. The following client alert discusses the characterization of the instruments identified above and its implications in more detail.
Defining a Swap and a Security-Based Swap
The Derivatives Rules define the term “swap” by reference to the Commodity Exchange Act (“CEA”) Section 1a(47). According to the Derivatives Rules, a swap includes:
- a cross-currency swap;
- a currency option, foreign currency option, foreign exchange option, and foreign exchange rate option;
- a foreign exchange forward;
- a foreign exchange swap;
- a forward rate agreement; and
- a non-deliverable forward involving foreign exchange.
A security-based swap is defined as a swap based on a single security or loan or a narrow-based group or index of securities (including any interest therein or the value thereof), or events relating to a single issuer or issuers of securities in a narrow-based security index. Security-based swaps are included within the definition of “security” under the Securities Exchange Act of 1934 (the “Exchange Act”) and the Securities Act of 1933 (the “Securities Act”).
The CFTC has stated that a guarantee of a swap is an integral part of a swap and, therefore, the term swap includes a guarantee of such swap, to the extent that a counterparty to a swap position would have recourse to the guarantor in connection with the position. The SEC has taken the position that the guarantee of a security-based swap is itself a security. Each of the Commissions plans to address the reporting requirements relating to guarantees in a separate release.
Defining a Mixed Swap
Mixed swaps are instruments that are both swaps and security-based swaps. The Commissions have stated that the scope of the mixed swap definition is narrow. The Commissions have adopted two rules regarding the regulation of mixed swaps:
- The first rule provides compliance obligations for parties to bilateral uncleared mixed swaps in which at least one party is registered with both Commissions. Under the Derivatives Rules, in order to facilitate the trading of these instruments, certain key provisions of the CEA and related CFTC rules as well as the requirements of the federal securities laws will apply to such mixed swaps.
- For all other mixed swaps, the second rule establishes a process for persons to request that the Commissions issue a joint order permitting such persons (and any other person that subsequently lists, trades, or clears that class of mixed swap) to comply, as to parallel provisions only, with specified parallel provisions of either the CEA or the Exchange Act, and related rules and regulations, instead of being required to comply with parallel provisions of both the CEA and the Exchange Act.
Impact of Derivatives Rules on CPO and CTA Registration
Commodity Pool Operators (“CPOs”) and Commodity Trading Advisors (“CTAs”) have been watching the development of the Derivatives Rules closely. They have been particularly concerned about these definitions in light of the newly effective CPO and CTA registration requirements under CFTC Rule 4(a) and the inclusion of swaps in the definition of “commodity interest,” along with the exemption from registration as a CPO provided by CFTC Rule 4.13(a)(3) (i.e., the de minimis trading exemption). Since swap trading activity will count toward the de minimis trading limits imposed by the CFTC Rule 4.13(a)(3) exemption, managers must now be cognizant of the amount of such activity conducted by their managed pools in order to determine the availability of this exemption from registration. The Derivatives Rules should provide some further clarity to CPOs and CTAs as to what types of agreements, contracts, and transactions are excluded from the definition of swap for purposes of falling under the jurisdiction of the CFTC and satisfying the 4.13(a)(3) de minimis trading threshold. The Lowenstein Sandler PC Investment Management Group Client Alert addressing CPO and CTA registration requirements and available exemptions from registration is available here.
FX Contracts That Are Title VII Instruments
Though currently treated as swaps under the Derivatives Rules, foreign exchange swaps and foreign exchange forwards will not be considered swaps if the Secretary of the Treasury determines to exempt them, in which case certain requirements such as reporting and business conduct standards would continue to apply. The Derivatives Rules explicitly define the term “swap” to include the following products: foreign currency options, commodity options (other than foreign currency options executed or traded on a national securities exchange), non-deliverable forwards in foreign exchange, currency swap, currency option, cross-currency swaps, forward rate agreements, certain contracts for differences, options to enter into swaps, and forward swaps.
Insurance Products as Title VII Instruments
Under the Derivatives Rules, insurance products will not be considered swaps or security-based swaps if they meet any of the following three provisions and satisfy the “provider test” as defined below.
- Grandfather Provision: A product will not be considered a swap or security-based swap if it is an existing insurance agreement, contract, or transaction entered into before the effective date of the Derivatives Rules and the provider of the product satisfies the “provider test.”
- Product Safe Harbor: A product will not be considered a swap or security-based swap if the agreement, contract, or transaction is provided in accordance with the provider test and satisfies the following conditions:
- The beneficiary of the insurance product must have an insurable interest and thereby bear the risk of loss with respect to that interest continuously throughout the duration of the agreement, contract, or transaction.
- The loss must occur and be proved, and any payment or indemnification for loss must be limited to the value of the insurable interest.
- The agreement, contract, or transaction must not be traded separately from the insured interest, on an organized market or over the counter.
- With respect to financial guaranty insurance only, in the event of a payment default or insolvency of the obligor, any acceleration of payments under the policy must be at the sole discretion of the insurer.
- Enumerated Product Safe Harbor: A product will not be considered a swap or security-based swap if the product is provided in accordance with the provider test and falls within the following categories: surety bond; fidelity bond; life insurance; health insurance; long-term care insurance; title insurance; property and casualty insurance; annuities; disability insurance; private mortgage insurance; and reinsurance (including retrocession) of any of the foregoing.
The following persons or entities satisfy the “provider test”:
- A person subject to supervision by the insurance commissioner of any state or by the federal government and the agreement, contract, or transaction is regulated as insurance under applicable state or federal law
- The United States, any state, or any of their respective agencies or instrumentalities, as well as statutorily authorized programs of each
- In the case of reinsurance, a person providing the agreement, contract, or transaction to another person eligible under the “provider test,” provided that: (a) such person is not prohibited by applicable state or federal law from offering such agreement, contract, or transaction to such other person; (b) the agreement, contract, or transaction to be reinsured satisfies the product test safe harbor or is an enumerated product (as described above); and (c) the total amount reimbursable by all reinsurers under such agreement, contract, or transaction does not exceed the losses or claims paid by the person writing the risk being ceded or transferred to a re-insurer, unless otherwise permitted by applicable state law
- In the case of non-admitted insurance, a person that: (a) is located outside of the United States and listed on the National Association of Insurance Commissioners’ Quarterly Listing of Alien Insurers; or (b) meets the eligibility criteria for non-admitted insurers under applicable state law
In the Derivatives Rules the Commissions have clarified that the product safe harbor, the enumerated product safe harbor, and the provider test are non-exclusive safe harbors (the “Insurance Safe Harbors”), such that if a product fails to satisfy the Insurance Safe Harbors, that does not necessarily mean that the product is a swap or security-based swap. However, these products would be subject to a facts and circumstances analysis to make the determination of whether such product is a swap, a security-based swap, or insurance.
Loan Participations Generally Are Not Title VII Instruments
The Derivatives Rules make it clear that loan participations in which the purchaser is acquiring a current or future direct or indirect ownership interest in the related loan or commitment that is the subject of the loan participation (and certain other conditions are satisfied) are not swaps or security-based swaps and therefore are not subject to the Derivatives Rules. The characteristics identified by the Commissions are intended to distinguish loan participations from swaps or security-based swaps based on loans. The Commissions agreed with commentators that a loan participation does not have to be a “true participation” (i.e., whether the underlying assets have been legally isolated from the transferor’s creditors for U.S. bankruptcy law purposes) in order to fall outside the classification as a swap or security-based swap. The Commissions provided that this analysis is unrelated to whether a loan participation is a swap or security-based swap.
Exclusions from the Derivatives Rules for Forward Contracts in Nonfinancial Commodities, Security Forwards, Consumer Transactions, and Commercial Transactions
The Dodd-Frank Act excluded forward contracts in nonfinancial commodities from the definition of swap. The CFTC has issued an interpretation clarifying the scope of the forward contract exclusion for nonfinancial commodities from the swap definition and has stated that this forward exclusion will be interpreted in a manner that is consistent with the CFTC’s historical interpretation of the existing forward contract exclusion with respect to futures contracts.
The Commissions have adopted interpretations in conjunction with the Derivatives Rules, which clarify the following:
- Security forwards, including mortgage-backed securities that are eligible to be sold in the “to-be-announced” market, fall outside the definitions of swap and security-based swap.
- Consumer transactions (i.e., those entered into by consumers primarily for personal, family, or household purposes) are not considered swaps or security-based swaps (e.g., acquiring a lease or mortgage, consumer loans with fixed or variable interest rates).
- Commercial transactions, such as employment contracts, sales or servicing contracts, installment loan agreements, warehouse lending arrangements, and transactions involving real or personal property, among others, are not considered swaps or security-based swaps.
While these interpretations list certain consumer and commercial transactions that should not be considered swaps or security-based swaps, this list is not meant to be exhaustive. These interpretations provide for certain characteristics and factors that the Commissions will consider in determining whether consumer and commercial transactions that are not listed are swaps or security-based swaps.
Contracts as “Swaps,” “Security-Based Swaps,” or “Mixed Swaps”
Recognizing that it is not always simple to categorize a contract as a swap, a security-based swap, or a mixed swap, the Commissions included in the Derivatives Rules procedures to assist market participants in making this determination with respect to a particular Title VII instrument. The Derivatives Rules provide that any person may submit a request to the Commissions to provide a joint interpretation of how a particular agreement, contract, or transaction should be classified (i.e., swap, security-based swap, or mixed swap) and includes a deadline for the Commissions to respond to a request for joint interpretation. A person requesting such interpretation as to the characterization of a Title VII instrument must provide the Commissions with the person’s determination of the characterization of the instrument as well as supporting analysis and certain documentation. The Derivatives Rules also provide that if either Commission receives a proposal to list, trade, or clear an agreement, contract, or transaction (or class thereof) that raises questions as to the appropriate characterization of such agreement, contract, or transaction, the receiving Commission shall notify the other, and that either Commission, or their chairmen jointly, may submit a request for a joint interpretation as to the characterization of the Title VII instrument where no external request has been otherwise received.
The determination is to be made at the inception of the Title VII instrument (prior to execution, but no later than when an offer is made to enter into a Title VII instrument), and such characterization will remain throughout the life of the instrument unless the instrument is materially amended or modified. An interpretation issued in connection with the Derivatives Rules clarifies the classification of swaps, to be regulated by the CFTC, and security-based swaps, to be regulated by the SEC, in certain areas, including the following:
- Title VII instruments based on interest or other monetary rates will be considered swaps. Title VII instruments based on yields (where yield is a proxy for the price or value of a debt security, loan, or narrow-based security index) will be considered security-based swaps, except in the case of certain exempted securities.
- Title VII instruments based on rates or yields of U.S. Treasuries and certain other exempted securities (other than municipal securities) will be considered swaps and not security-based swaps.
- A total-return swap (“TRS”) based on a single security or loan or on a narrow-based security index generally will be considered a security-based swap.
- Where counterparties embed interest-rate optionality or a non-securities component into the TRS (such as the price of oil or a currency), such instrument will be considered a mixed swap.
- TRS based on broad-based security indexes or on two or more loans will be considered swaps.
- Generally, Title VII instruments on futures (other than futures on foreign government debt securities) will be considered swaps.
- Title VII instruments on security futures will be considered security-based swaps.
- Title VII instruments on futures on foreign government debt securities that are exempted by the SEC for purposes of futures trading under Rule 3a12-8 will be considered swaps, if certain other conditions are satisfied.
Classification of a Security Index as a Narrow-Based Security Index
The Derivatives Rules and related interpretations define the terms “narrow-based security index” and “issuers of securities in narrow-based security index,” including, for purposes of determining the status of index credit default swaps (“index CDS”) as either swaps or security-based swaps. These rules are similar to rules that the Commissions previously issued regarding debt security indexes but have been tailored to index CDS. The Derivatives Rules also address circumstances under which indexes migrate from broad-based to narrow-based (and vice versa). The general rule that the characterization of a Title VII instrument as a swap or security-based swap is made prior to execution, and that such characterization does not change throughout its life, applies equally to migrating indexes.
The Derivatives Rules and related interpretations with respect to the term “narrow-based security index” address:
- the existing criteria for determining whether a security index is a narrow-based security index and the applicability of past guidance of the SEC and CFTC regarding those criteria to Title VII instruments;
- new criteria for determining whether an index CDS for which the underlying reference is a group or index of entities or obligations of entities is based on an index that is a narrow-based security index;
- the meaning of the term “index”;
- a rule governing the tolerance period for Title VII instruments on security indexes traded on designated contract markets (“DCMs”), swap execution facilities (“SEFs”), foreign boards of trade (“FBOTs”), security-based SEFs, or national securities exchanges (“NSEs”), for which the security index temporarily moves from broad-based to narrow-based (or vice versa); and
- a rule governing the grace period for Title VII instruments on security indexes traded on DCMs, SEFs, FBOTs, security-based SEFs, or NSEs, for which the security index temporarily moves from broad-based to narrow-based (or vice versa) and the move is not temporary.
With respect to migrating Title VII instruments that are based on indexes listed on trading platforms, the Derivatives Rules and related interpretations provide:
- a market participant who enters into a Title VII instrument on a trading platform on a broad-based or narrow-based security index that migrates from broad-based to narrow-based (or vice versa) may hold that position until the expiration of the instrument without any change in regulatory obligations; and
- when market participants seek to offset or enter into new swaps (or security-based swaps) and the underlying index has migrated from broad to narrow (or vice versa), the tolerance period and grace period rules applicable to futures trading will apply.
Effective Date and Compliance Date
The effective date and compliance date for the Derivatives Rules will be 60 days after publication in the Federal Register, with the following exceptions:
- the compliance date for the interpretation regarding guarantees of swaps will be the effective date of the rules proposed in the separate CFTC release, when such rules are adopted by the CFTC; and
- solely for the purposes of the order granting temporary exemptions under the Exchange Act in connection with the pending revision of the definition of “security” to encompass security-based swaps, 76 FR 39927 (July 7, 2011) (granting temporary relief and providing interpretive guidance to make it clear that a substantial number of the requirements of the Exchange Act do not apply to security-based swaps as a result of the revised definition of “security” going into effect on July 16, 2011) and the exemptions for security-based swaps, 76 FR 40605 (July 11, 2011) (providing exemptions under the Securities Act, the Exchange Act, and the Trust Indenture Act of 1939 for those security-based swaps that prior to July 16, 2011, were security-based swap agreements and are defined as “securities” under the Securities Act and the Exchange Act as of July 16, 2011, due solely to the provisions of the Dodd-Frank Act), the compliance date for the final rules further defining the term security-based swap will be 180 days after publication in the Federal Register.
The compliance date for certain other rules promulgated by the Commissions pursuant to the Dodd-Frank Act will be the effective date of the Derivatives Rules, including:
- the date that swap dealers and major swap participants must register with the CFTC;
- the compliance date for reporting, recordkeeping, and daily trading obligations for swap dealers and major swap participants that are currently registered with the SEC or regulated by a prudent regulator;
- the date that swap data repositories must register with the CFTC; and
- the compliance date for the first phase of CFTC-imposed position limits.