Financial Services Alert - August 21, 2012

Goodwin Procter issued a Client Alert concerning the Iran Threat Reduction and Syria Human Rights Act of 2012 (the “Act”).  The Act broadens the scope of U.S. economic sanctions in ways that will impact many U.S. companies, including financial institutions, and their foreign affiliates.  The Act’s two most significant provisions relating to Iran (i) expand the reach of U.S. sanctions against Iran and its government to foreign entities owned or controlled by “U.S. persons,” and (ii) require domestic and foreign companies that issue securities traded on a U.S. exchange to disclose to the SEC certain sanctions-related business dealings of the issuer and its affiliates.

The Dodd-Frank Act provides a comprehensive framework for regulating over-the-counter (“OTC”) derivatives, including with respect to the regulation of key market participants, the introduction of clearing and execution requirements and the enhancement of the rulemaking and enforcement authorities of the Commodity Futures Trading Commission (the “CFTC”) and the Securities and Exchange Commission (the “SEC” and, collectively with the CFTC, the “Commissions”).  One of the key characteristics of the Dodd-Frank Act is the bifurcation of the regulation of derivatives between the Commissions.[1]  Specifically, the CFTC was given jurisdiction over swaps, the SEC was given jurisdiction over security-based swaps and the CFTC and SEC were given joint jurisdiction over mixed swaps.  Accordingly, identifying an instrument as a swap, security-based swap or mixed swap is critical to determining which Commission has jurisdiction over the instrument and, consequently, which rules and regulations will apply to the instrument. 

The Dodd-Frank Act, itself, includes definitions of the term “swap,” “security-based swap,” and “security-based swap agreement.”[2]  The Commissions recently published joint final rules (the “Product Definition Rules”), which expand on these statutory definitions and include regulations applicable to “mixed swaps,” and the adopting release for the Product Definition Rules provides extensive interpretational guidance for the application of these definitions.  The Product Definition Rules also include a process for requesting a joint interpretation from the Commissions regarding whether an instrument is a swap, a security-based swap, or a mixed swap. 

Notably, the publication of the Product Definition Rules is a significant step in the implementation of the Dodd-Frank Act regulatory regime for OTC derivatives because the effectiveness of the Product Definition Rules triggers compliance commencement dates for a number of other CFTC regulations  and informs compliance obligations.  The Product Definition Rules will be effective on October 12, 2012.

What is a “Swap”?

A swap is, generally speaking, any agreement, contract, or transaction—

1. that is a put, call, cap, floor, collar, or similar option of any kind that is for the purchase or sale, or based on the value, of 1 or more interest or other rates, currencies, commodities, securities, instruments of indebtedness, indices, quantitative measures, or other financial or economic interests or property of any kind;
2. that provides for any purchase, sale, payment, or delivery (other than a dividend on an equity security) that 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;
3. that provides on an executory basis for the exchange, on a fixed or contingent basis, of one or more payments based on the value or level of one or more interest or other rates, currencies, commodities, securities, instruments of indebtedness, indices, quantitative measures, or other financial or economic interests or property of any kind, or any interest therein or based on the value thereof, and that transfers, as between the parties to the transaction, in whole or in part, the financial risk associated with a future change in any such value or level without also conveying a current or future direct or indirect ownership interest in an asset (including any enterprise or investment pool) or liability that incorporates the financial risk so transferred;
4. that is an agreement, contract, or transaction that is, or in the future becomes, commonly known to the trade as a swap;
5. including any security-based swap agreement which meets the definition of “swap agreement” as defined in Section 206A of the Gramm-Leach-Bliley Act (15 U.S.C. 78c note) of which a material term is based on the price, yield, value, or volatility of any security or any group or index of securities, or any interest therein; or
6. that is any combination or permutation of, or option on, any agreement, contract, or transaction described in any of clauses (i) through (v). [3]

Swaps, for example, include instruments that are based solely on certain interest rates or other monetary rates that are not, in turn, based on securities.  The adopting release offers a non-exclusive list of relevant rates, including:  interbank offered rates such as LIBOR and Euribor; money market rates such as the Federal Funds Effective Rate; government target rates such as the Federal Reserve discount rate; general lending rates such as a prime rate or a rate in the commercial paper market; other monetary rates such as the Consumer Price Index or the rate of change in the money supply; and other rates such as the volatility, variance, rate of change of, or index based on any of the foregoing rates.

Swaps also include instruments based solely on currencies, commodities, and certain other variables.  Instruments for which the underlying reference is a futures contracts other than a security future will generally be considered a swap.  A total return swap (“TRS”) is a swap if its underlying reference is a broad-based security index, two or more loans that are not securities, or certain United States debt securities.  Similarly, a credit default swap (“CDS”) is a swap if its underlying reference is a broad-based security index.

Foreign Exchange Forwards and Foreign Exchange Swaps

Foreign exchange forwards and foreign exchange swaps are swaps for purposes of the Product Definition Rules; however, the Secretary of the Treasury does have the authority to exclude these types of transactions from the definition of swap.  The Department of the Treasury issued a proposed determination that would exempt foreign exchange swaps and foreign exchange forwards from the definition of “swap” for most purposes in April 2011 but that proposal has not yet been finalized or adopted. 

Even if excluded from the definition of “swap” by the Secretary of the Treasury, such transactions would, however, continue to be subject to certain provisions of the Commodity Exchange Act, including record keeping and reporting requirements.  Furthermore, swap dealers and major swap participants engaging in such transactions would still be subject to certain business conduct standards in relation to such transactions.

The CFTC clarified in the Product Definition Rules that foreign currency options, non-deliverable forward contracts involving foreign exchange, and currency swaps and cross-currency swaps cannot be excluded from the definition of swap by the Secretary of the Treasury.

Security-based swaps and a number of other instruments are excluded from the definition of “swap,” as discussed below.

What is a “Security-Based Swap”?

In general, a “security-based swap” is any agreement, contract, or transaction that is a swap that is based on (i) a narrow-based security index, including any interest therein or on the value thereof; (ii) a single security or loan, including any interest therein or on the value thereof; or (iii) the occurrence, nonoccurrence, or extent of the occurrence of an event relating to a single issuer of a security or the issuers of securities in a narrow-based security index, provided that such event directly affects the financial statements, financial condition, or financial obligations of the issuer. [4]

For example, a TRS is a security-based swap if its underlying reference is a single security, a single loan, or a narrow-based security index.  Similarly, a CDS is a security-based swap if its underlying reference is a single security or loan, or any interest therein or on the value thereof.  CDS that are triggered based on certain events of a single issuer of a security, such as bankruptcy or certain default events, are also security-based swaps, as are index CDS in which the underlying reference is a narrow-based security index.  An option to enter into a CDS that is a security-based swap is itself a security-based swap.

Other examples also underscore that determinations of whether an instrument is a security-based swap or a swap (or mixed swap) are product specific, and not categorical.  For example,  contracts for differences may either be swaps or security-based swaps, depending upon the underlying product.  An instrument which references a security future (a futures contract on a single security or narrow-based security index), generally, will be a security-based swap. However, if the underlying reference is a futures contract that is based on the debt securities of one or more of a set of countries specified by the SEC, it will generally be a swap, not a security-based swap. 

What is a “Mixed Swap”?

A “mixed swap” is a security-based swap that is also based on the value of one or more interest or other rates, currencies, commodities, instruments of indebtedness, indexes, quantitative measures, other financial or economic interest or property of any kind (other than a single security or a narrow-based security index), or the occurrence, non-occurrence, or the extent of the occurrence of an event or contingency associated with a potential financial, economic, or commercial consequence other than those relating to a single issuer of a security or the issuers of securities in a narrow-based security index. [5]

Examples of mixed swaps noted in the adopting release include instruments for which the underlying reference is a portfolio of securities (other than broad-based security indexes) and commodities, and “best of” or “out performance” swaps, the payment of which are determined based upon the higher of the performance of a security and a commodity (e.g., an instrument which references the price of oil and the value of an oil corporation stock).  According to the guidance in the adopting release, an interest rate swap the terms of which may change based upon variable characteristics of a debt security, such as an interest rate that may adjust based on the future price of a debt security, would also be a mixed swap.  Other examples include certain total return and credit default swaps.

Essentially, then, a mixed swap derives its value from an underlying security, loan, narrow-based security index, or similar reference, as well as from an underlying reference that would normally characterize a swap, and is therefore both a “swap” and a “security-based swap.”  In their guidance, the Commissions indicate that this category is intended to be narrow, existing primarily to prevent a regulatory gap between swaps and security-based swaps. 

What is a “Security-Based Swap Agreement”?

A security-based swap agreement is a swap agreement of which “a material term is based on the price, yield, value, or volatility of any security or any group or index of securities, including any interest therein,” excluding security-based swaps.  Under the Product Definition Rules, security-based swap agreements are a type of swap, not a type of security-based swap, and therefore fall under the CFTC’s jurisdiction; however, the SEC’s anti-fraud and anti-manipulation rules also apply to security-based swap agreements. 

Broad-Based vs. Narrow-Based Security Indexes

As a general rule, an instrument the underlying reference of which is a broad-based security index is a swap and an instrument the underlying reference of which is a narrow-based security index is a security-based swap.  A “narrow-based security index” is an index that meets any one of the following criteria, as described in the Product Definition Rules: 

• it has nine or fewer components;
• it includes at least one component that comprises more than 30% of the index’s weighting;
• the five highest weighted components comprise, in the aggregate, more than 60% of the index’s weighting; or
• the lowest weighted component securities comprising, in the aggregate, 25 percent of the index’s weighting have an aggregate dollar value of average daily trading volume of less than $50,000,000 (or in the case of an index with more than 15 component securities, $30,000,000), subject to certain exceptions.[6]

Although the above definition of narrow-based security index is designed to apply to indexes composed of equity securities, according to interpretive guidance, the Commissions have previously extended and modified the definition to apply to futures contracts on volatility indexes and debt security indexes, and previous guidance regarding these types of indexes may generally be used in determining if the index is a narrow-based index or broad-based index.  The Product Definition Rules also include criteria for determining whether an index CDS is based on a narrow-based security index or a broad-based security index.

The term “broad-based security index” is not independently defined, but rather refers to security indexes that are not narrow-based.

CDS and TRS:  Swap, security-based swap or mixed swap?

What is Excluded from the Definition of “Swap” and “Security-Based Swap”?

A number of instruments and transactions that might otherwise fit the definition of “swap” or “security-based swap” are specifically excluded from the definitions.  Various types of consumer transactions entered into as part of a person’s household and personal life are not swaps or security-based swaps.  Consumer contracts include contracts to buy or lease real or personal property or to obtain a mortgage, contracts to purchase products or services for personal, family, or household purposes, consumer product warranties or extended service plans, and consumer guarantees of credit card debt or automobile loans of friends or relatives.

Similarly, common commercial transactions are also excluded from the definition of swap and security-based swap.  Guidance in the adopting release for the Product Definition Rules provides a lengthy list of commercial contracts which are neither swaps nor security-based swaps, including employment contracts, sales and servicing arrangements, merger agreements, agreements for the purchase or sale of real property or intellectual property, warehouse lending arrangements, mortgages, and fixed or variable interest commercial loans.  The guidance, however, also makes clear that the particular characteristics of a contract will be determinative of its status. 

For example, generally, loan participations are neither swaps nor security-based swaps.  The Commissions identify as a key characteristic of loan participations that a lender “transfers or offers a participation in the economic risks and benefits of all or a portion of a loan or commitment it has entered into with a borrower to another party as an alternative or precursor to assigning to such person the loan or a commitment or an interest in the loan or commitment.”[7] The adopting release lists several criteria that “should be present” in a loan participation for it to be excluded from the definitions of swap and security-based swap.

• The grantor of the loan participation is a lender under (or participant or sub-participant in) the loan.
• The aggregate participation in the loan does not exceed the principal amount of the loan;  the loan participation does not grant, in the aggregate, a greater interest to the participant than the grantor holds.
• The entire purchase price for the loan participation is paid in full when acquired and not financed.
• The loan participation provides the participant all of the economic benefit and risk of the whole loan or the part of the loan subject to the loan participation.

Forward contract exclusion for nonfinancial commodities

Forward contracts are excluded from the terms “swap” and “security-based swap.”  As referenced in the Commodity Exchange Act, a forward contract is “any sale of a nonfinancial commodity or security for deferred shipment or delivery, so long as the transaction is intended to be physically settled.”[8]  In the adopting release, the CFTC confirmed that this exclusion should be interpreted in a manner consistent with the existing forward exclusion with respect to futures contracts.

According to the guidance, a key element of a forward contract is that the primary purpose of the contract is to transfer ownership of the commodity and not just its price risk.  As a result, intent to deliver will be an element in determining whether a contract is a forward contract, according to interpretive guidance.  That being said, the CFTC confirmed that its prior interpretations with regard to “book-outs,” where cash is often used to settle physical delivery obligations, will continue to apply and the fact that cash is used to settle a contract instead of physical delivery will not automatically preclude the contract from being considered a forward.

Exclusion for Insurance Products

The Commissions made it clear that it is not intended that traditional insurance products that are already subject to regulation by a state or a federal regulator be captured by the definition of swap or security-based swap.  To that end, the Product Definition Rules provide a non-exclusive safe harbor:  an insurance product will not be a swap or security-based swap if it meets the criteria of the “Provider Test” and also either (i) meets the criteria of  the “Product Test” or (ii) is included on the enumerated products list (included in the release’s interpretive guidance and at Rule 1.3(xxx)(4)(i)(C)).  The Product Test establishes requirements for the product, such as requiring that the beneficiary has an insurable interest and carries the risk of loss, that the loss must occur as a condition of performance, and that the contract must not be traded separately from the insured interest.  The “Provider Test” requires the provider fall into a list of categories, including a person subject to supervision by a state or federal insurance commissioner. Additionally, the Product Definition Rules include a “grandfather exclusion” from the definition of swap and security-based swap for insurance product transactions entered into prior to the effective date of the Product Definition Rules provided that at the time of entering into such a transaction, it met the criteria of the Provider Test.

Anti-Evasion Rules

As part of the Product Definition Rules, the CFTC adopted anti-evasion rules and related interpretations that apply to any transactions that are willfully structured to evade the regulations governing swaps.  In determining if a transaction was intentionally structured to evade the rules, the CFTC will not consider the form, label, or written documentation relating to the transaction as dispositive; rather, it will consider all of the facts and circumstances.  In particular, the CFTC will consider if the structure of the transaction has a relevant business purpose.

In contrast, the SEC decided not to adopt anti-evasion rules at this time with respect to security-based swaps.  The SEC took the view that new rules are not needed because security-based swaps, as securities, are subject to existing securities regulations including anti-fraud and anti-manipulation regulations.

Key Dates:  Product Definition Rules Trigger Compliance Obligations Under Certain CFTC Rules[9]  

The publication of the Product Definition Rules in the Federal Register on August 13, 2012 triggered the countdown to the commencement of compliance obligations for a number of other CFTC regulations affecting swaps and the parties to swap transactions.

Key Dates for Certain CFTC Regulations Affected by the Joint CFTC-SEC Product Definition Rules

October 12, 2012

“Position Limits for Futures and Swaps,” 76 FR 71626, became effective on January 17, 2012.  These rules establish position limits for certain physical commodity futures and options contracts as well as physical commodity swaps that are economically equivalent to such contracts.  The compliance date for most provisions of these rules is October 12, 2012 (60 days after the Product Definition Rules are published in the Federal Register).  For more information on this rule see “CFTC Adopts Final Rules on Position Limits Which ISDA and SIFMA Challenge in Federal District Court.”

“Commodity Options,” 77 FR 25320, became effective on June 26, 2012.  These rules repeal and replace the CFTC’s existing regulations regarding commodity options.  The compliance date for these rules is October 12, 2012 (60 days after the Product Definition Rules are published in the Federal Register).

“Swap Data Repositories:  Registration Standards, Duties and Core Principles,” 76 FR 54538, establishes registration requirements, statutory duties, core principles, and certain compliance obligations for registered swap data repositories.  These rules became effective on October 31, 2011, and permit prospective swap data repositories to apply for registration as such starting on that date.  However, the compliance date for provisions involving mandatory registration and compliance with these registration rules is October 12, 2012, the effective date of the Product Definition Rules.

The rules entitled “Registration of Swap Dealers and Major Swap Participants,” 77 FR 2613, went effective on March 19, 2012.  These rules govern the registration of swap dealers and major swap participants and require swap dealers and major swap participants, and those who intend to engage in business as such, to apply for registration by no later than the latest effective date of the entity definition rules and the Product Definition Rules.  In practice, this means an application deadline of October 12, 2012 (60 days after the Product Definition Rules are published in the Federal Register).

“Business Conduct Standards for Swap Dealers and Major Swap Participants with Counterparties,” 77 FR 9734, became effective on April 17, 2012.  The rules require swap dealers and major swap participants to meet a number of external business conduct standards.  The compliance commencement date is October 12, 2012 (by its terms, the rule’s compliance commencement date is the later of (i) 180 days after its effective date, which is October 14, 2012, and (ii) the date on which swap dealers or major swap participants are required to apply for registration, which is October 12, 2012.  Therefore, the compliance commencement date is October 14, 2012.  However, this is a Sunday; the preceding business day is October 12, 2012). 

“Swap Dealer and Major Swap Participant Recordkeeping, Reporting, and Duties Rules; Futures Commission Merchant and Introducing Broker Conflicts of Interest Rules; and Chief Compliance Officer Rules for Swap Dealers, Major Swap Participants, and Futures Commission Merchants,” 77 FR 20128 (the “Duties, Conflicts, and CCO Rules”), are complex rules consisting of a number of largely independent provisions.  While compliance with certain provisions of these rules is already required, compliance commencement dates for other provisions depend upon factors, including the dates on which swap dealers and major swap participants are required to register with the CFTC (October 12, 2012).  For example, October 12, 2012 will be the compliance date for provisions of the Duties, Conflicts, and CCO Rules on:

• the monitoring of position limits, diligent supervision, conflicts of interest, general information, and antitrust provisions applicable to all swap dealers and major swap participants
• clearing activities provisions applicable to futures commissions merchants
• recordkeeping, reporting limits, and risk management provisions applicable to those swap dealers and major swap participants that are currently regulated by a U.S. prudential regulator or are SEC registrants
• the business continuity, disaster recovery, and Chief Compliance Officer provisions for those swap dealers and major swap participants that are currently regulated by a U.S. prudential regulator or are SEC registrants
• the recordkeeping, reporting limits, and risk management provisions for those swap dealers and major swap participants that are not currently regulated by a U.S. prudential regulator and are not SEC registrants

December 28, 2012

The compliance date for additional provisions of the Duties, Conflicts, and CCO Rules is the date that is the later of 270 days after the publication of the Duties, Conflicts, and Chief Compliance Officer Rules in the Federal Register and the date on which swap dealers and major swap participants are required to apply for registration (October 12, 2012).  As noted above, the Duties, Conflicts, and CCO Rules were published on April 3, 2012, so the date that is 270 days later is December 29, 2012,[10] which is the later date and, therefore, the date on which the compliance period begins with respect to the applicable provisions of the Duties, Conflicts, and CCO Rules.  Provisions for which the compliance requirements commence on this date include the business continuity and disaster recovery provisions applicable to those swap dealers and major swap participants that are not regulated by a U.S. prudential regulator and are not registered with the SEC. 

March 29, 2013

Additional provisions of the Duties, Conflicts, and CCO Rules have an even later compliance start date:  specifically, the later of (1) 360 days after the publication of the Duties, Conflicts, and CCO Rules in the Federal Register and (2) the date on which swap dealers and major swap participants are required to apply for registration.  The compliance date for these provisions therefore is March 29, 2013.  Such provisions include the Chief Compliance Officer provisions with respect to swap dealers and major swap participants that are not currently regulated by a U.S. prudential regulator and are not SEC registrants, as well as futures commission merchants that were registered with the CFTC on the effective date of the Duties, Conflicts, and CCO Rules (which was June 4, 2012) and are not currently regulated by a U.S. prudential regulator and are not SEC registrants.

Three transaction reporting rules phase in compliance, keying off of the publication of the Product Definition Rules in the Federal Register.  “Real-Time Public Reporting of Swap Transaction Data,” 77 FR 1182 (“Real Time Reporting Rules”), went effective on March 9, 2012.  Those rules govern the public reporting of certain swap transaction data.  The rules entitled “Swap Data Recordkeeping and Reporting Requirements,” 77 FR 2136 (“Swap Data Recordkeeping Rules”), went effective on March 13, 2012 and require parties to adhere to certain requirements regarding recordkeeping and reporting of swap data.  “Swap Data Recordkeeping and Reporting Requirements:  Pre-Enactment and Transition Swaps,” 77 FR 35200 (“Swap Data Recordkeeping (Transition) Rules”), became effective on August 13, 2012 and requires parties to adhere to certain requirements regarding the recordkeeping and reporting of data pertaining to swaps that precede, but remain effective after, the date on which the Dodd-Frank Act was enacted, as well as swaps executed on or after that date but before the compliance date of the rule.  Each of these three transaction reporting rules has three compliance start dates, which are summarized in the chart below. 

Transaction Reporting Rules Phase-in

Product Definitions Inform Compliance Obligations

A number of CFTC rules are affected by the final product definition of the term “swap.”  One example is “Commodity Pool Operators and Commodity Trading Advisors:  Compliance Obligations,” 77 FR 11252, which became effective on April 24, 2012.  These new CFTC rules amend a number of regulations relevant to commodity pool operators (“CPOs”) and commodity trading advisors (“CTAs”), and the definition of swap is relevant to determining certain exemptions from the registration requirements.  The inclusion of swaps under the CFTC’s jurisdiction will also impact the registration (and thus reporting) obligations of CPOs and CTAs.

These rules, among other things, (i) repealed the Rule 4.13(a)(4) CPO exemption, commonly referred to as the “sophisticated investor exemption,” and (ii) amended the 4.14(a)(8)(i)(D) CTA exemption which was previously available to advisers to 4.13(a)(4) pools to remove the reference to 4.13(a)(4), both of which have been heavily relied on by operators and advisers to private funds.  Pursuant to the new rules, a CPO or CTA that claimed one of these exemptions prior to April 25, 2012 may continue to rely on the exemption until December 31, 2012.  Additionally, the CFTC staff issued a no-action letter on July 10, 2012 which effectively extended the availability of these exemptions until December 31, 2012 for new pools launched after July 10, 2012 provided the new pools meet the requirements set forth in the no-action letter (as discussed in the July 17, 2012 Financial Services Alert.)

These rules require that registered CPOs with at least $5 billion in assets under management attributable to commodity pools as of June 30, 2012 must submit reports to the CFTC on Form CPO-PQR by November 29, 2012.  All other registered CPOs must submit reports to the CFTC on Form CPO-PQR by March 29, 2013.  The rules require that all registered CTAs submit reports to the CFTC on Form CTA-PR by February 14, 2013.  Compliance is required for all remaining provisions of the rule by December 31, 2012.  Entities that had been exempt from registering as CPOs and CTAs pursuant to Section 4.13(a)(4) and 4.14(a)(8), respectively, that will be required to register with the CFTC by December 31, 2012 as a result of the rules will not be required to comply with these reporting rules until they are registered as CPOs or CTAs.

On May 21, 2012, the Office of Foreign Assets Control (“OFAC”) of the U.S. Department of Treasury announced that Genesis Asset Managers, LLP, a U.S. investment manager (“GAM US”), agreed to remit $112,500 to settle potential civil liability for an apparent violation of the Iranian Transactions Regulations (“ITR”), 31 C.F.R. part 560, that occurred on or about August 1, 2007. 

GAM US, the investment manager of a UK Fund (“UK Fund”), had contracted with its UK subsidiary, Genesis Investment Management LLP (“GIM UK”) through an Investment Advisory Agreement, pursuant to which GIM UK provided investment advice and recommendations and carried out transactions as an agent of GAM US in accordance with the investment policies and strategies adopted from time to time by UK Fund.  In 2007, pursuant to this delegated authority, GIM UK purchased approximately $3 million of shares for UK Fund in a Cayman Islands company that invests exclusively in Iranian securities.

Aggravating Factors

OFAC noted several aggravating factors: GAM US allegedly failed to exercise a minimal degree of caution or care in the conduct that led to the apparent violation of the ITR; officers of GAM US were allegedly aware of the conduct giving rise to the apparent violation; substantial economic benefit was allegedly conferred to Iran, thereby undermining the objectives of the ITR; and GAM US allegedly did not have an OFAC compliance program in place at the time of the apparent violation.

Mitigating Factors

However, OFAC did not consider the violation egregious because GAM US has not received a penalty notice or Finding of Violation from OFAC for substantially similar violations; GAM US substantially cooperated with OFAC’s investigation by responding promptly and completely to OFAC’s requests for information, by voluntarily self-disclosing the apparent violation in question, and by agreeing to settle the matter without the issuance of a Prepenalty Notice; GAM US took appropriate remedial action; and GAM US may not have fully understood its OFAC obligations under U.S. law.

The CFTC’s Division of Swap Dealer and Intermediary Oversight issued additional guidance, in the form of frequently asked questions, regarding issues surrounding the registration of CPOs and CTAs, a topic covered in the July 17, 2012 Financial Services Alert.  The guidance covers topics such as determining which entity should register as a CPO, the treatment of wholly-owned subsidiaries, Forms CPO-PQR and CTA-PR, the De Minimis Exemption, the revocation of the QEP Exemption, transitioning between exemptions, and compliance dates.

Among the more noteworthy items discussed in the guidance are the following:

• Timing of Early Swaps. A newly-established fund whose general partner or manager intends to claim the De Minimis Exemption may put swaps in place before putting on its first deal.  Such an action would not prevent the general partner or manager from availing itself of the De Minimis Exemption even though its purchase of a commodity interest as its initial investment would likely cause it to violate the thresholds included in the De Minimis Exemption.  The guidance states that such funds should have a “reasonable time” to comply with the trading thresholds, but expressly declines to identify what a “reasonable time” is because that may vary based on the nature of the CPO and the pool.


• Timing of De Minimis Calculation. The guidance clarifies that, notwithstanding language in the CFTC regulations pertaining to the De Minimis Exemption that require the thresholds to be complied with “at all times,” compliance with the trading limits is determined “at the time the most recent position was established.” As a result, if a CPO is able to avail itself of the De Minimis Exemption when it puts its positions in place, subsequent market movements, without more, will not prevent the CPO from continuing to use the exemption.


• Procedure for Moving from the QEP Exemption to the De Minimis Exemption.  The guidance specifies the procedure for CPOs that are currently availing themselves of the QEP Exemption (which has been withdrawn, although affected CPOs may continue to use the QEP Exemption until December 31, 2012) to transition to the De Minimis Exemption.  First, the CPO must withdraw its exemption under the QEP Exemption via written request to the NFA.  Once the NFA has confirmed that the withdrawal has been completed, the CPO may then electronically file with the NFA for the De Minimis Exemption.  The release also reminds readers that the CPO must notify its investors of the change.
• Interim Guidance to Funds-of-Funds on the De Minimis Exemption.  The release states that, although the CFTC is preparing new guidance to replace Appendix A to Part 4 of the CFTC regulations, CPOs of funds-of-funds may continue to rely on Appendix A until such new guidance is adopted.  Appendix A provides guidance to funds-of-funds regarding how to comply with the De Minimis Exemption, which is complex given the look-through to the holdings of a fund-of-funds in underlying funds.

The CFTC proposed a rule to exempt swaps between certain affiliates from the clearing requirement.  The proposal follows the Dodd-Frank Act and its related regulations, which collectively mandate the clearing of certain swaps.  The CFTC has previously issued a final rule (discussed in the July 17, 2012 Financial Services Alert) that provides an exception to clearing for end-users.

The proposal, which is based on the premise that affiliated counterparties internalize each other’s counterparty risk and have a greater incentive to perform than they would if their counterparties were unrelated, applies the exemption only to swaps between majority-owned affiliates whose financial statements are reported on a consolidated basis. The exemption would only be available to swaps between U.S. affiliates and swaps between a U.S. affiliate and a non-U.S. affiliate that (1) is located in a jurisdiction with a “comparable and comprehensive clearing regime,” (2) is otherwise required to clear the swaps it enters into with non-affiliated parties under United States law, or (3) does not enter into swaps with non-affiliated parties.  A corporate family relying on the exemption would also be required to subject inter-affiliate swaps to centralized risk management, to meet certain documentation and reporting rules, and, in the case of swaps between two financial entities, to post variation margin (unless both affiliates are 100% commonly-owned and commonly-guaranteed).

As noted in the release, the proposal is likely to benefit corporate entities in which the parent or a centralized “treasury” or similar subsidiary faces counterparties outside the corporate family, while engaging in inter-affiliate swaps to fund or otherwise facilitate the activities of its affiliates. 

The CFTC release proposing the rule notes that counterparties may, in certain circumstances, be eligible to invoke both the end-user exception and the inter-affiliate exemption and may choose to use either.  Because the end-user exception requires the electing counterparty to not be a “financial entity” (where certain “small financial institutions” are not considered “financial entities”), and because the end-user exception requires that the swap not being cleared be used to hedge or mitigate commercial risk, the CFTC suggests that the proposed inter-affiliate exemption will generally be used for swaps between affiliated financial entities or for swaps that do not hedge or mitigate commercial risk.

Comments on the proposal are due by September 30, 2012.

The CFTC issued a no-action letter granting temporary relief to persons eligible for the “trade option exemption” from certain CFTC regulations. The relief relates to final regulations on commodity options issued by the CFTC in April 2012. Because commodity options were governed by a regime that predated the Dodd-Frank Act, the final regulations included a final rule that generally subjects commodity options to the Dodd-Frank regime by permitting market participants to trade commodity options subject to the same rules applicable to other types of swaps. However, the final regulations also included an interim final rule that provides for a trade option exemption from several of the general swaps rules for certain physical delivery commodity options, subject to certain conditions.

A “trade option” is a commodity option transaction used by a commercial entity solely for purposes relating to its business involving the commodity. For example, a producer of a particular commodity might enter into a trade option to hedge against a decline in the price of that commodity. Trade options were largely unregulated prior to Dodd-Frank, but were included in Dodd-Frank’s definition of “swap” and therefore are subject to applicable CFTC regulations.  The interim final rule, however, would shield trade options from many of those regulations.  As stated in the release for the final regulations, “Trade options would not contribute to, or be a factor in, the determination of whether a market participant is [a swap dealer or major swap participant]; trade options would be exempt from the rules on mandatory clearing; and trade options would be exempt from the rules related to real-time reporting of swap transactions. However, trade options would still be considered for large trader reporting and position limits regulations, and swap dealers and major swap participants would need to count trade options for purposes of their capital and margin requirements. Finally, trade options would still be subject to antifraud and anti-manipulation rules.

Under the interim final rule, the relief discussed above would be granted if the “offeror,” or the seller of the commodity option, is either an eligible contract participant or a producer, processor, or commercial user of, or a merchant handling, the commodity which is the subject of the commodity option transaction, and is entering into the transaction solely for purposes related to its business as such. Furthermore, the offeror must have a reasonable basis for believing that the “offeree,” or the buyer of the commodity option, is a producer, processor, or commercial user of, or a merchant handling, the commodity which is the subject of the commodity option transaction, and entering into the transaction solely for purposes related to its business as such. Finally, both parties must intend that the commodity option be physically settled. Persons seeking to avail themselves of this relief must meet certain recordkeeping and reporting requirements.

Because the trade option exemption was crafted largely in response to comments on the proposed commodity option rule, the CFTC classified it as an “interim final rule,” rather than a final rule, and solicited public comment. It asked a number of questions in the rule release, requesting feedback on such matters as whether the interim final rule provides “an appropriate regulatory framework for trade options,” inquiring as to the trade option exemption’s likely market impact, asking whether the specific requirements of the exemption were appropriate, and so on.

A footnote in the rule release noted that the product definition rules, which had not yet been released, “will address the determination of whether a commodity option or a transaction with optionality is subject to the swap definition in the first instance. If a commodity option or a transaction with optionality is excluded from the scope of the swap definition…the final rule and/or interim final rule adopted herein are not applicable.”  However, when the product definition rules were ultimately published, they did not definitively settle the matter. Rather, although the product definition rules stated that certain “forwards with embedded volumetric optionality” (that is, forwards that are settled by physical delivery and in which customer demand for the underlying commodity may be variable) would be excluded from the swap definition, it also requested public comment about its interpretation, indicating the potential for further rulemaking or interpretive guidance on the subject.

In light of this uncertainty, the CFTC decided to issue no-action relief regarding the conditions of the trade option exemption to reduce the compliance burden on those intending to avail themselves of the trade option exemption while the CFTC reviews, together, comments on both the trade option exemption and on forwards with embedded volumetric optionality.

Although the no-action relief requires those utilizing the trade option exemption to comply with the position limits rules and antifraud and anti-manipulation rules as specified in the interim final rule, it does not require them to comply with the interim final rule’s various recordkeeping and reporting requirements, nor does it require swap dealers and major swap participants utilizing the exemption to comply with capital and margin requirements pertaining to swaps subject to the exemption. Only those parties eligible to use the trade option exemption may benefit from the relief.

The no-action relief expires on the earlier of (1) December 31, 2012 or (2) the effective date of any final rule, interpretation, or order taken by the CFTC regarding the trade option exemption interim final rule.

The Financial Crimes Enforcement Network (“FinCEN”) issued a ruling (the “Ruling”) to clarify that a loan or finance company subsidiary (an “LorF Subsidiary”) of a federally-regulated bank or other “financial institution” (as defined by the Bank Secrecy Act, or “BSA”) will be regarded by FinCEN as having complied with its compliance obligations under the BSA if the LorF Subsidiary: (i) is a subsidiary of a parent financial institution that is subject to at least anti-money laundering (“AML”) program and suspicious activity (“SAR”) reporting requirements; (ii) is required to comply with the AML and SAR regulations applicable to its parent financial institution; and (iii) is subject to examination by the Federal functional regulator of its parent financial institution.

The purpose of the Ruling, said FinCEN, is to avoid subjecting an LorF Subsidiary to redundant, overlapping regulations and examinations. For example, if an LorF Subsidiary of a national bank is subject to the OCC’s AML regulations for loan and finance company operating subsidiaries, the LorF Subsidiary will not be required to comply with FinCEN’s parallel regulations.