Last month, the U.S. Commodity Futures Trading Commission (CFTC) and the U.S. Securities and Exchange Commission (SEC) adopted highly anticipated final rules to, among other things, further define the terms “swap dealer” and “major swap participant” (Final Entity Rules).1 The Final Entity Rules are significant because persons2 that meet the swap dealer or major swap participant definitions will be required to register with the CFTC and comply with a myriad of substantive regulatory requirements including, among others, internal and external business conduct standards and capital, margin, recordkeeping and reporting requirements. The Final Entity Rules are considered a key component of the new regulatory regime that the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) imposes on over-the-counter derivatives.
Although it is unlikely that most hedge funds and other private funds that use swaps will fall within the swap dealer and major swap participant categories, advisers to such funds should nonetheless carefully review those funds’ exposure to swaps in light of the Final Entity Rules. In addition, even if a hedge fund or other private fund does not meet the swap dealer or major swap participant criteria, the use of swaps (or other commodity interests)3 by such funds may cause them to fall within the statutory “commodity pool” definition,4 thereby causing their advisers to fall within the “commodity pool operator” (CPO) or “commodity trading advisor” (CTA) definitions.5 Generally, CPOs and CTAs must register with the CFTC and comply with a number of CFTC regulations.
The Final Entity Rules have yet to be published in the Federal Register. The following discussion is based on statements made by CFTC Commissioners and staff at an April 18, 2012, open meeting, at which the Final Entity Rules were approved, and on a pre-publication draft of the Final Entity Rules that is available on the CFTC’s website. Although the Final Entity Rules will become effective 60 days after they are published in the Federal Register, swap dealers and major swap participants will not be required to register with the CFTC until 60 days after the effective date of a final CFTC/SEC rule that further defines the term “swap.”6
The “Swap Dealer” and “Major Swap Participant” Definitions
- Swap Dealers
The Final Entity Rules closely follow the statutory language of the Dodd-Frank Act in defining the term “swap dealer” as any person that: (a) holds itself out as a dealer in swaps; (b) makes a market in swaps; (c) regularly enters into swaps with counterparties as an ordinary course of business for its own account; or (d) engages in activity causing itself to be commonly known in the trade as a dealer or market maker in swaps.
According to CFTC staff, a person, in determining whether it could be designated as a swap dealer, should begin by looking to the statutory and regulatory definitions of the term, bearing in mind that a person that enters into swaps solely for its own account (either in an individual or fiduciary capacity), but not as a part of its regular business, is automatically excluded from the definition. Next, a person should look to interpretive guidance contained in the Final Entity Rules adopting release. This guidance addresses the concepts included in the swap dealer definition and provides for consideration of all of the relevant facts and circumstances concerning a person’s swap activity. Also, in general, the SEC’s dealer-trader distinction, which forms a basis for identifying which persons fall within the long-standing definition of dealer under the Securities Exchange Act of 1934, may be applied to interpret the statutory definition of the term “swap dealer.”
Pursuant to the Final Entity Rules, certain swaps are excluded from the swap dealer determination altogether, including: (a) swaps entered into by an insured depository and a customer in connection with originating a loan; (b) swaps between majority-owned affiliates; and (c) swaps between an agricultural or financial cooperative and its members. In addition, the CFTC has adopted an interim final rule as part of the Final Entity Rules that: (a) stipulates that swaps entered into for hedging physical positions are also excluded from the swap dealer determination; and (b) defines “hedging” in a manner akin to the CFTC’s long-standing interpretation of bona fide hedging. This definition of hedging is significantly more narrow than the “hedging or mitigating commercial risk” standard used in the major swap participant definition (discussed below). Several CFTC Commissioners expressly invited market participants to comment on the interim final rule.
Persons whose activities could cause them to fall within the swap dealer definition may nonetheless be exempt from regulation by the CFTC if the person’s swap positions fall below a de minimis threshold, which the Final Entity Rules set at an aggregate gross notional amount (i.e., the value of a person’s swaps) of no more than $3 billion over the preceding 12 months.7
The de minimis threshold will be phased-in over a three-year period. During the phase-in period the de minimis threshold will effectively be $8 billion. As a result of the de minimis threshold, the CFTC expects that approximately 125 persons will be deemed to be swap dealers. Moreover, a person that is covered by the swap dealer definition and is required to register as such may apply to the CFTC to limit its designation as a swap dealer to specified categories of swaps or specified activities. In an attempt to regulate persons engaged in significant trading activity that falls short of requiring registration as a swap dealer, the Final Entity Rules also provide new requirements for “floor traders.” According to CFTC staff, such persons could include high-frequency traders.
- Major Swap Participants
The Final Entity Rules define a “major swap participant” as:
- A person that maintains a “substantial position” in any of the major swap categories (rate swaps, credit swaps, equity swaps and any other commodity swaps), excluding positions held for hedging or mitigating commercial risk and positions maintained by certain employee benefit plans for hedging or mitigating risks in the operation of the plan;
- A person whose outstanding swaps create “substantial counterparty exposure” that could have serious adverse effects on the financial stability of the United States banking system or financial markets; or
- Any financial entity8 that: (i) maintains a “substantial position” in any of the major swap categories; (ii) is highly leveraged to the amount of capital it holds; and (iii) is not subject to capital requirements established by a federal banking regulator. For an entity to be deemed “highly leveraged,” the Final Entity Rules adopt a ratio of total liabilities to equity of 12 to 1, as determined in accordance with U. S. Generally Accepted Accounting Principles.
Under the Final Entity Rules, a person maintains a “substantial position” in any of the major swap categories if it holds: (a) daily average uncollateralized outward exposure of $1 billion in the major swap category ($3 billion if the swaps are rate swaps); or (b) daily average uncollateralized outward exposure plus potential future exposure of $2 billion in the major swap category ($6 billion if the swaps are rate swaps). It should be noted that the process for calculating potential future exposure has been refined from the original proposal.
“Substantial counterparty exposure” is defined as holding $5 billion in daily average uncollateralized outward exposure or $8 billion in daily average uncollateralized outward exposure plus potential future exposure.
Finally, the Final Entity Rules clarify that whether swaps are entered into to “hedge or mitigate commercial risk” is a facts and circumstances determination that takes a person’s overall hedging and risk mitigation strategies into account and is made at the time that a swap is entered into by such person. The Final Entity Rules adopting release lists swap positions that would qualify as “hedging or mitigating commercial risk,” which include, among others, those positions that qualify as bona fide hedges. The CFTC expects that approximately 6 persons will be deemed major swap participants.
Implications of the Final Entity Rules for Hedge Funds and Other Private Funds
- Hedge Funds and Other Private Funds as Swap Dealers
It seems unlikely that hedge funds and other private funds will fall within the swap dealer category, particularly because the final definition of the term: (a) focuses on dealer activity and expressly refers market participants to the SEC’s dealer-trader distinction;9 (b) contains a high de minimis threshold; and (c) excludes swaps used for hedging purposes.10 Nonetheless, a careful review of the swap dealer definition is merited. Advisers to hedge funds and other private funds may wish to follow the CFTC staff’s roadmap, discussed above, to determine whether a fund could be deemed a swap dealer focusing on, among other things: (a) the purpose for which such funds use swaps; and (b) the manner in which funds are marketed to investors.
- Hedge Funds and Other Private Funds as Major Swap Participants
As to the major swap participant definition, advisers to hedge funds and other private funds that are concerned about whether they may be major swap participants should carefully review such funds’ current exposure to swaps and perform the requisite calculations for each prong of the major swap participant definition. According to the adopting release for the Final Entity Rules, the major swap participant definition is intended to capture those entities that pose a high degree of risk to the U.S. financial system generally—the CFTC has estimated that there will be a total of 6 entities classified as major swap participants. Thus, it seems unlikely that most hedge funds and other private funds would fall within the major swap participant definition, a view that is supported by: (a) the high thresholds contained in each of the major swap participant definition’s prongs; and (b) the exclusion for swaps that hedge or mitigate commercial risk (which is broader than the exclusion from swap dealer determinations for swaps that are hedges). Nonetheless, advisers to hedge funds and other private funds may wish to confirm that the funds they operate do not fall within the major swap participant definition.
Hedge Funds and Other Private Funds as Commodity Pools—Litigation Follows Adoption of Final CFTC Rules
Even if hedge funds or other private funds do not fall within the swap dealer or major swap participant categories, such funds’ use of swaps could have other implications. Namely, the use of swaps could cause hedge funds or other private funds to fall within the statutory “commodity pool” definition and, as a result, cause their advisers to fall within the statutory CPO or CTA definitions.
As discussed in a prior Legal Alert,11 the CFTC recently adopted final rules that amend the existing regulatory regime for CPOs and CTAs. Of particular importance to hedge funds and other private funds are the CFTC’s changes to an exclusion from the CPO registration requirement for advisers to investment companies. Previously, CFTC Rule 4.5 excluded from the CPO definition, without limitation, advisers to investment companies that are registered as such under the Investment Company Act of 1940. On February 9, the CFTC adopted amendments to CFTC Rule 4.5 that significantly narrowed its scope by making eligibility for the exclusion contingent on: (a) compliance with thresholds for the amount of nonhedge commodity interest positions that a registered investment company may have; and (b) the registered investment company not being marketed as a vehicle for investing in commodity interests. The CFTC’s amendments to CFTC Rule 4.5 became effective last month, although funds relying on the exclusion prior to its effective date may continue to rely on the exclusion, even if they do not meet the amended qualifications, until December 31, 2012.
The Investment Company Institute (ICI) and the U.S. Chamber of Commerce filed a complaint in the U.S. District Court for the District of Columbia against the CFTC last month alleging that the Commission violated the Administrative Procedure Act (APA) in adopting the amendments to CFTC Rule 4.5. According to the complaint, the CFTC failed to perform an appropriate cost-benefit analysis, as required by the APA, in adopting the amendments to Rule 4.5.
The ICI and Chamber of Commerce seek: (a) to enjoin the CFTC from enforcing the amendments to CFTC Rule 4.5; and (b) a declaration from the District Court that the amendments to Rule 4.5 (1) were promulgated without statutory authority, (2) were not promulgated with procedures required by law, and (3) are arbitrary and capricious. The ICI and Chamber of Commerce complaint is the second challenge by market participants of a CFTC final rule that was adopted in connection with the Dodd-Frank Act. The International Swaps and Derivatives Association, Inc., and the Securities Industry Financial Markets Association filed a joint legal challenge to the CFTC’s final position limits rules last December that also alleges that the CFTC failed to perform the requisite cost-benefit analysis.