The Situation: The civil action of the Commodity Futures Trading Commission ("CFTC") against Archegos Capital Management LP and its CFO is but one of many civil and criminal matters arising out of Archegos's catastrophic failure in early 2021.
The Result: The U.S. District Court for the Southern District of New York recently dismissed this action with prejudice on the basis that the CFTC does not have jurisdiction over total return swaps ("TRS") on exchange-traded funds ("ETFs") and certain "custom baskets," which the court determined to be security-based swaps under the exclusive jurisdiction of the Securities and Exchange Commission ("SEC").
Looking Ahead: Although not necessarily surprising, the decision is one of first impression and provides important guidance to market participants seeking certainty of jurisdiction and rule-set compliance requirements. The decision also shines a light on the somewhat jagged border-line between "swaps" and "security-based swaps" and the historic competition between the CFTC and the SEC for jurisdiction over various products.
The CFTC commenced a civil action for fraud in April 2022 against Archegos Capital Management LP ("Archegos") and its CFO about a year after Archegos's highly leveraged positions exploded spectacularly and caused, according to the CFTC, in excess of $10 billion in losses for its counterparties. The complaint focused on two components of Archegos's synthetic portfolio: TRS on ETFs that tracked broad-based security indexes ("BBSIs"), such as the S&P 500, and on BBSI-based "custom baskets" that were negotiated between Archegos and its counterparties.
The defendants filed motions to dismiss on the basis that the CFTC lacks jurisdiction over the TRSs at issue. The court granted those motions with prejudice on September 19, 2023. CFTC v. Archegos Capital Mgmt LP, Case No. 22-CV-3401 (JPO), 2023 WL 6123102 (S.D.N.Y. Sept. 19, 2023).
The SEC, which is pursuing a parallel civil enforcement action in the same court, responded to the motions to dismiss with an amicus brief claiming exclusive jurisdiction over the Archegos TRSs, to which the CFTC replied asserting its own exclusive jurisdiction or, in the alternative, shared jurisdiction on the basis that the TRSs were "mixed swaps." This debate re-kindled jurisdictional battles dating back to the CFTC's creation in 1974. The most recent line was drawn by the Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. 111-203, 124 Stat. 1376 (2010), which gave the CFTC exclusive jurisdiction over "swaps," the SEC exclusive jurisdiction over "security-based swaps" ("SBSs") and the two agencies joint jurisdiction over "mixed swaps."
The key distinction between TRSs that are "swaps" and those that are SBSs is that an SBS is a swap in respect of a single security or a "narrow-based security index" ("NBSI") (roughly nine or fewer securities), whereas a "swap" relates to a BBSI. The clash between the SEC and the CFTC was over whether: (i) the ETF swaps were "based on" a BBSI (given that the ETFs reflected interests in a broad-based pool of securities): and (ii) the "custom basket" swaps lost their character as BBSI swaps by virtue of the ability of Archegos to remove individual names from the basket from time to time, subject to the counterparty's consent.
In our previous Commentary, we noted the difficulties with the CFTC's claim of jurisdiction over ETF swaps shortly after the CFTC complaint was filed. The court adopted the SEC's straightforward characterization of the matter: "[a]n ETF share represents an interest in the ETF, not an interest in the securities or the index of securities that the ETF is intended to track." The ETF TRSs were not "mixed swaps" either, in that they solely referenced the ETF shares (which are unquestionably SEC-jurisdictional). Curiously, the court did not squarely address the circumstances, if any, under which it is appropriate to "look through" an ETF or other security representing an interest in a collective investment pool to determine the nature of a TRS on the security, although a "no look-through" rule is perhaps implicit in the foregoing holdings.
On custom baskets, the CFTC and the SEC appeared to be in agreement in their 2012 joint "further definition" of swaps and SBSs that the "discretionary authority" on the part of "one or both parties" to add or subtract positions "on an 'at will' basis" from what would otherwise be a BBSI would cause that index to be treated as an NBSI.
The CFTC argued in its response brief that the counterparty "consent" requirement was contrary to the "at will" feature referenced in the "further definition" release but, as noted by the court, "the CFTC conflates discretionary authority and unilateral authority." The court further explained how the Commissions did not establish a "spectrum" of discretionary authority with the clear case of unfettered discretion by one party at one end and everything else "up for grabs."
Rather, the Commissions jointly established a fundamental dichotomy between situations in which "one or both" parties could alter the index in a "discretionary" manner (including through proposal and consent) and situations where an index is altered by a third-party provider (such as what occurs regularly with indices such as the S&P 500) or otherwise in accordance with a "pre-determined self-executing formula."
While the jurisdictional issue in this matter has been determined by the court, market participants should anticipate further disputes in other matters that implicate the question of which regulator has jurisdiction over derivative products. The SEC and CFTC have frequently clashed with each other over categories including security future products, mixed swaps, and cryptocurrencies.
Two Key Takeaways
- The Archegos decision, of course, represents "merely" the opinion of one district court, but it confirms industry practice and expectations regarding ETF TRSs and highlights the significance of discretionary versus non-discretionary adjustments to an index or portfolio.
- The historical turf wars between the CFTC and SEC for jurisdiction over swaps on securities indices and other products are likely to continue. The agencies themselves have little incentive not to seek expansion of their respective remits. Whether this decision will quell future disagreements is yet to be seen.