CFTC and SEC Publish Final Definitions of “Swap” and “Security-Based Swap”

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.