Final Product Definitions Under Title VII of Dodd-Frank

Transcription

1 Final Product Definitions Under Title VII of Dodd-Frank CFTC and SEC Adopt Rules and Guidance to Further Define Swap, Security-Based Swap, Mixed Swaps and Other Swap-Related Terms EXECUTIVE SUMMARY Pursuant to the regulatory framework established by Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act ( Dodd-Frank ), the Commodity Futures Trading Commission ( CFTC ) has regulatory authority over swaps under the Commodity Exchange Act ( CEA ), the Securities and Exchange Commission ( SEC, and with the CFTC, the Commissions ) has regulatory authority over security-based swaps under the Securities Exchange Act of 1934 (the Exchange Act ), and the Commissions share jurisdiction with respect to mixed swaps (generally, security-based swaps that are also based on specified elements indicative of swaps). Section 721 of Dodd-Frank sets forth definitions of the terms swap and mixed swap, and Section 761 of Dodd-Frank defines a security-based swap ; Section 712(d)(1) requires that the Commissions, in consultation with the Board of Governors of the Federal Reserve System (the Board ), further define certain terms used in Title VII of Dodd-Frank, including swap and security-based swap. The CFTC and SEC have issued a joint release (the Adopting Release ) 1 adopting final rules (the Final Rules ) and interpretive guidance to clarify the treatment of certain agreements, contracts and transactions under the defined terms. 2 The Adopting Release addresses, among other things: insurance products; forward contracts (including forward contracts with embedded optionality on certain terms); consumer and commercial contracts; loan participations; New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney

2 foreign-exchange related instruments; instruments based on interest rates (or other monetary rates) and yields; total return swaps ( TRS ); instruments based on futures contracts; the definition of a narrow-based security index in determining whether an instrument is a swap or security-based swap and the definition of an index in connection with an indexed credit-default swap ( index CDS ); procedures for requesting guidance from the Commissions on the characterization of an instrument; and mixed swaps and the mechanism for evaluating the applicability of certain regulatory requirements to mixed swaps. The Adopting Release also adopts rules addressing the CFTC s anti-evasion authority and provides guidance on how the CFTC will exercise that authority. The Adopting Release was published in the Federal Register on August 13, The Final Rules will be effective October 12, 2012, provided that the compliance date with respect to the definition of securitybased swap solely for purposes of the Exchange Act Exemptive Order 3 and the SB Swaps Interim Final Rules 4 will be December 11, 2012 and the compliance date for the interpretation regarding guarantees of swaps (discussed in Section I. B) will be the same as the effective date of the rules the CFTC will promulgate to define the obligations applicable to such guarantees. The swap, security-based swap and mixed swap definitions will determine when the regulatory responsibilities of many market participants, and compliance with many of the CFTC s requirements under Title VII will be required. Compliance with the SEC s requirements under Title VII will not be required earlier than 180 days after the effective date. 5-2-

3 Table of Contents I. PRODUCTS NOT DEFINED AS SWAPS OR SECURITY-BASED SWAPS... 5 A. INSURANCE PRODUCTS... 5 B. TREATMENT OF GUARANTEES OF SWAPS AND SECURITY-BASED SWAPS... 7 C. THE FORWARD CONTRACT EXCLUSION Forward Contracts in Nonfinancial Commodities... 8 a. Forward Exclusion from the Swap and Future Delivery Definitions... 8 i. Brent Interpretation... 9 ii. Withdrawal of the Energy Exemption iii. Nonfinancial Commodities b. Commodity Options and Commodity Options Embedded in Forward Contracts i. Volumetric Optionality ii. Certain Physical Commercial Agreements, Contracts or Transactions Fixed and Contingent Security Forwards D. CONSUMER AND COMMERCIAL AGREEMENTS E. LOAN PARTICIPATIONS F. TRANSACTIONS IN REGIONAL TRANSMISSION ORGANIZATIONS AND INDEPENDENT SYSTEM OPERATORS II. FOREIGN EXCHANGE AND OTHER FOREIGN CURRENCY TRANSACTIONS A. FOREIGN EXCHANGE PRODUCTS Interpretation Regarding Foreign Exchange Spot Transactions Retail Foreign Currency Options III. INTERPRETATION OF SWAP WITH RESPECT TO FORWARD RATE AGREEMENTS, CONTRACTS FOR DIFFERENCES, AND COMBINATIONS AND PERMUTATIONS OF, OR OPTIONS ON, SWAPS AND SECURITY-BASED SWAPS IV. RELATIONSHIP BETWEEN SWAPS AND SECURITY-BASED SWAPS A. TITLE VII INSTRUMENTS BASED ON INTEREST RATES, OTHER MONETARY RATES, AND YIELDS B. TOTAL RETURN SWAPS C. SECURITY-BASED SWAPS BASED ON A SINGLE SECURITY OR LOAN AND SINGLE-NAME CREDIT DEFAULT SWAPS D. TITLE VII INSTRUMENTS BASED ON FUTURES E. USE OF CERTAIN TERMS AND CONDITIONS IN TITLE VII INSTRUMENTS V. THE TERMS NARROW-BASED SECURITY INDEX AND ISSUERS OF SECURITIES IN NARROW-BASED SECURITY INDEX A. APPLICATION OF THE DEFINITION OF NARROW-BASED SECURITY INDEX Statutory Definition of Narrow-Based Security Index The 2004 Joint Order Criteria The 2006 Joint Rules The 2009 Joint Order B. INDEX CREDIT DEFAULT SWAPS The Number Component and Concentration Components Affiliation of Reference Entities and Issuers of Securities with Respect to Index CDS Public Information Availability Regarding Reference Entities and Securities C. SECURITY INDEXES AND PORTFOLIOS D. INDEXES THAT MIGRATE FROM BROAD TO NARROW OR VICE VERSA E. METHOD OF SETTLEMENT OF INDEX CDS VI. MIXED SWAPS

4 A. SCOPE OF DEFINITION B. APPLICABLE REGULATION VII. SECURITY-BASED SWAP AGREEMENTS VIII. PROCESS FOR REQUESTING INTERPRETATIONS CONCERNING THE CHARACTERIZATION OF SWAPS, SECURITY-BASED SWAPS AND MIXED SWAPS IX. ANTI-EVASION A. TREATMENT OF SWAPS BY THE CFTC Business Purpose Fraud, Deceit, or Unlawful Activity B. TREATMENT OF SECURITY-BASED SWAPS BY THE SEC

5 I. PRODUCTS NOT DEFINED AS SWAPS OR SECURITY-BASED SWAPS A. INSURANCE PRODUCTS Consistent with the proposing release for the product definitions (the Proposing Release ), 6 the Adopting Release indicates that [t]he Commissions are aware of nothing in Title VII to suggest that Congress intended for traditional insurance products to be regulated as swaps or security-based swaps. Rather than extending the insurance exclusion to all products subject to the supervision of insurance regulatory authorities, which had been the approach suggested by a number of commenters, 7 the Commissions set forth specific criteria that will entitle an agreement to benefit from a non-exclusive Insurance Safe Harbor exclusion from the definitions of swap and security-based swap. These criteria relate to both the type of product and its provider. Agreements that fall outside of the Insurance Safe Harbor will not automatically be captured as swaps or security-based swaps; rather they will be subject to a facts and circumstances analysis to determine whether they are excluded insurance or covered swaps or security-based swaps. Parties to a transaction may also seek an interpretation from the Commissions as to whether the transaction is a swap or security-based swap (a process discussed in Section VIII below). Under the preemption provision in Section 722(b) of the Dodd-Frank Act, an agreement that is determined to be a swap will not be considered to be insurance and may not be regulated as an insurance contract under the law of any state. The Insurance Safe Harbor applies to any insurance agreement that: is in a product that either meets certain conditions (the Product Test ) or is one of a number of listed traditional insurance products ( Enumerated Products ); and meets certain conditions relating to the provider of the product (the Provider Test ). The Product Test, which is substantially the same as proposed in the Proposing Release, covers any agreement that, by its terms or by law, as a condition of performance: requires the beneficiary of the agreement to have an insurable interest therein and carry the risk of loss continuously throughout the duration of the agreement; 8 requires that a loss occur and be proved, and that any payment or indemnification be limited to the value of the insurable interest; is not traded, separately from the insured interest, on an organized market or over-thecounter; 9 and for financial guaranty insurance only, acceleration of the policy in the event of a payment default or insolvency of the obligor must be at the sole discretion of the insurer. -5-

6 Certain traditional insurance products that are specifically listed are excluded from the definition of swap and security-based swap, as long as they meet the Provider Test (discussed below), even if the Product Test is not met. These Enumerated Products consist of: surety bonds; fidelity bonds; life insurance; health insurance; long-term care insurance; title insurance; property and casualty insurance; annuities (regardless of tax treatment); disability insurance; insurance against default on individual residential mortgages (i.e., private mortgage insurance, as distinguished from financial guaranty of mortgage pools); and reinsurance or retrocession of any Enumerated Products (so long as such reinsurance or retrocession is not accomplished by entering into swaps or security-based swaps). 10 The Commissions, however, declined to cover as Enumerated Products certain other categories of contracts suggested by some commenters, such as guaranteed investment contracts ( GICs ), synthetic GICs, funding agreements, structured settlements, deposit administration contracts, immediate participation guaranty contracts, industry loss warrants, and catastrophe bonds. Such contracts will, therefore, only constitute insurance (rather than a swap or security-based swap) if they meet the Product Test and Provider Test, or otherwise qualify as insurance based on a facts and circumstances analysis. The Provider Test requires that an agreement that either meets the Product Test or is an Enumerated Product must also: be provided by a person (whether or not organized as an insurance company) 11 that is subject to supervision by the insurance commissioner (or similar official or agency) of any state or by the United States or an agency or instrumentality thereof, and be an agreement regulated as insurance under applicable state law or the laws of the United States; or be provided, directly or indirectly, by the United States, any State or any of their respective agencies or instrumentalities (including programs provided by such entities but administered by third parties), or pursuant to a statutorily authorized program of the United States, a State or agency or instrumentality; or in the case of reinsurance only, be provided by a person (wherever incorporated or organized) 12 to another person (i.e., the cedent) that otherwise satisfies the Provider Test, provided that: (i) the reinsurer is not prohibited by applicable state law or the laws of the United States from offering such agreement to the cedent that satisfies the Provider Test; (ii) the underlying agreement to be reinsured satisfies the Product Test or is one of the Enumerated Products; and (iii) except as otherwise permitted under applicable state law, 13-6-

7 the total amount reimbursable by all reinsurers for such agreement does not exceed the claims or losses paid by the cedent; or in the case of non-admitted insurance (which refers to insurance products on a non-admitted basis through surplus lines brokers), be provided by a person who (i) is located outside of the United States and listed on the Quarterly Listing of Alien Insurers as maintained by the International Insurers Department of the National Association of Insurance Commissioners or (ii) meets the eligibility criteria for non-admitted insurers under applicable State law. 14 The Adopting Release also includes a grandfather provision, excluding from the definitions of swap and security-based swap any agreement entered into on or before the effective date of the Final Rules that, at the time it was entered into, would have satisfied the Provider Test as of the time of the effectiveness of the Final Rules. B. TREATMENT OF GUARANTEES OF SWAPS AND SECURITY-BASED SWAPS The Adopting Release provides that guarantees of swaps and guarantees of security-based swaps will be treated differently. An interpretation by the CFTC provides that the term swap includes a guarantee of a swap, to the extent that a counterparty to the guaranteed swap would have recourse against the guarantor in connection with the position, because a guarantee of a swap is an integral part of the swap. The CFTC expects to address the practical implications of this interpretation in a separate rulemaking. In considering the effects this interpretation may have on guarantors, the Adopting Release notes that the CFTC may regulate as a swap dealer a parent or other guarantor who guarantees swap positions of persons who are not subject to capital regulation by the CFTC. 15 The Adopting Release also indicates that the CFTC anticipates the following future guidance: proposing real-time and regulatory reporting requirements with respect to guarantees of swaps; explaining the extent to which the duties and obligations of swap dealers and major swap participants pertaining to guarantees of swaps are already satisfied to the extent such obligations are satisfied with respect to the related guaranteed swaps; and addressing the effects, if any, of this interpretation on position limits and large trader reporting requirements. In contrast, consistent with the SEC s historical treatment of guarantees, the Adopting Release explains that a guarantee of an obligation under a security-based swap, including financial guaranty insurance of a security-based swap, will neither constitute a separate security-based swap nor be considered part of the guaranteed security-based swap. Rather, because guarantees of a security are treated as securities under the Securities Act of 1933 (the Securities Act ) and security-based swaps are included in the definition of security contained in the Securities Act and the Exchange Act, a guarantee of a securitybased swap will be a security subject to federal securities law regulation. The SEC plans to address the reporting of guarantees of security-based swaps in a separate rulemaking. -7-

8 C. THE FORWARD CONTRACT EXCLUSION The statutory definitions of the terms swap and security-based swap under Dodd-Frank exclude any sale of a nonfinancial commodity or security for deferred shipment or delivery, so long as the transaction is intended to be physically settled. The Adopting Release provides several interpretations as to the scope of this exclusion. 1. Forward Contracts in Nonfinancial Commodities Section 1a(47) of the CEA defines swap to exclude any sale of a nonfinancial commodity... for deferred shipment or delivery [where] the transaction is intended to be physically settled (the forward contract exclusion ). The Adopting Release explains that the scope of the forward contract exclusion will be interpreted in a manner consistent with the CFTC s historical interpretation of the forward contract exclusion from the prohibition on off-exchange futures under the CEA, as it existed prior to Dodd-Frank, including the entire body of precedent distinguishing forwards from futures. In general, whether a specific transaction meets the forward contract exclusion is to be assessed based on a facts and circumstances analysis. The interpretations in the Adopting Release provide guidance as to factors that may be considered for this purpose, as well as the applicability of the forward contract exclusion in particular contexts (such as where a transaction that provides for physical delivery is booked-out or otherwise settled without physical delivery) and to particular products (by defining the scope of nonfinancial commodities eligible for the forward contract exclusion). a. Forward Exclusion from the Swap and Future Delivery Definitions The CFTC notes in the Adopting Release that its historical interpretation has been that, in order to qualify as forward contracts under the statutory exclusion, transactions must be commercial merchandising transactions. 16 The Adopting Release quotes the so-called Brent Interpretation 17 as follows: [t]he underlying postulate of the [forward] exclusion is that the [CEA s] regulatory scheme for futures trading simply should not apply to private commercial merchandising transactions which create enforceable obligations to deliver but in which delivery is deferred for reasons of commercial convenience or necessity. 18 An important factor in assessing whether a transaction may qualify for the forward contract exclusion is whether the parties intend for the transaction to be physically settled. Consistent with the Proposing Release, the Adopting Release acknowledges that forward contracts that are not actually physically settled may nevertheless qualify for the exclusion, provided that the parties are commercial entities entering into the transaction for commercial purposes with the ability and intent to deliver and take delivery. In particular, the Adopting Release affirms that the Brent Interpretation will apply to the forward exclusion from the swap definition. The Brent Interpretation was issued in 1990 to address the practice of bookouts in connection with physical oil transactions and characterized such contracts as forwards eligible for -8-

9 the forward contract exclusion from the off-exchange futures prohibition. The Adopting Release expands the Brent Interpretation to apply to all nonfinancial commodities, a term explained below, rather than just oil, as had been the case under the Brent Interpretation. The Adopting Release also expands the Brent Interpretation with respect to the types of transactions covered, incorporating the relief provided under the so called Energy Exemption, which was issued in 1993 and permits a wider variety of forms of settlement of forwards without physical delivery. 19 As discussed below, the Energy Exemption is withdrawn in light of this incorporation. The Adopting Release identifies the following additional factors that may be used when assessing whether a transaction is eligible for the forward contract exclusion: contract size; demonstrable commercial need for the product; the underlying purpose of the contract (e.g., whether the purpose of the claimed forward is to sell physical commodities, hedge risk or speculate); the regular practices of the commercial entity with respect to its general commercial business and its forward and swap transactions more specifically; and whether the absence of physical settlement is based on a change in commercial circumstances. i. Brent Interpretation Book-out transactions meeting the requirements specified in the Brent Interpretation that are effectuated through a subsequent, separately negotiated agreement between the commercial parties to the original transaction qualify for a safe harbor under the forward contract exclusion. The requirements that must be met include that: The agreement provides a binding obligation to make or take delivery without providing any right to offset, cancel, or settle on a payment-of-differences basis; The book-out is effected through a separate, individually negotiated new agreement; There is no obligation or arrangement to enter into such book-out and the book-out is not provided for by the terms of the agreement as initially entered into; and Either party to the initial agreement is entitled to require the other party to make or accept physical delivery, as applicable, in order to meet such other party s obligations under the initial agreement. Book-outs may be effected by oral agreement; however, such agreement must be followed in a commercially reasonable timeframe by a confirmation in some type of written or electronic form. The Brent Interpretation safe harbor is available only to commercial market participants that regularly make or take delivery of the referenced commodity in the ordinary course of their business. 20 Adopting Release interprets commercial in the context of the Brent Interpretation as: related to the business of a producer, processor, fabricator, refiner or merchandiser, 21 clarifying that [w]hile a market participant need not be solely engaged in commercial activity to be a commercial market participant within the meaning of the Brent Interpretation... the business activity in which it makes or takes delivery -9- The

10 must be commercial activity for it to be a commercial market participant As an example of activity that would not qualify as commercial, the Adopting Release points to a hedge fund s investment activity in derivatives on physical commodities. Investment activity, at least without some connection to a physical commodity business, would not qualify as commercial and therefore would be inadequate to qualify the hedge fund as a commercial market participant with respect to the relevant commodity; as a result, the hedge fund would not be able to rely on the Adopting Release interpretations permitting book-outs and other settlements without delivery with respect to contracts referencing such commodity. ii. Withdrawal of the Energy Exemption Because the Brent Interpretation is expanded to cover all nonfinancial commodities, the Adopting Release withdraws the Energy Exemption. The Adopting Release preserves the ability of parties to forward contracts to utilize a variety of settlement mechanisms (e.g., the seller s passage of title and the buyer s payment and acceptance of the underlying commodity; taking delivery of the commodity in some instances and in others instead passing title to another intermediate purchaser in a chain; physically exchanging one quality, grade or type of physical commodity for another quality, grade or type of physical commodity; and physical netting agreements) and bona fide termination rights (including force majeure provisions and upon counterparty insolvency, default or other inability to perform) that have been permitted under the Energy Exemption. iii. Nonfinancial Commodities The forward contract exclusion is limited to nonfinancial commodities. The Adopting Release interprets nonfinancial commodity to include a commodity that can be physically delivered and is an exempt commodity 23 or an agricultural commodity. 24 A nonfinancial commodity may also include an intangible commodity, other than an excluded commodity, 25 which meets certain conditions. These conditions are that ownership of the commodity can be conveyed in some manner and the commodity can be consumed. As examples of intangible commodities that may meet these conditions, the Adopting Release discusses certain environmental commodities including emission allowances, carbon offsets and credits, and renewable energy credits. b. Commodity Options and Commodity Options Embedded in Forward Contracts The Adopting Release reaffirms that commodity options are swaps under the statutory swap definition, and does not provide additional interpretation regarding commodity options. The CFTC has previously adopted rules governing commodity options and, on an interim final basis, providing a trade option exemption. 26 The Adopting Release provides interpretations that would permit certain types of forward contracts to qualify for the forward contract exemption notwithstanding the fact that they contain embedded optionality. Specifically, the release provides additional interpretations regarding forwards with embedded

11 volumetric optionality, optionality in the form of evergreen and renewal provisions, and optionality with respect to delivery points and delivery dates. The Adopting Release includes an interpretation that a forward contract that contains one or more embedded commodity options will be considered an excluded nonfinancial commodity forward contract (and not a swap) if the embedded options: may be used to adjust the forward contract price, but do not undermine the overall nature of the contract as a forward contract; do not target the delivery term, so that the predominant feature of the contract is actual delivery; and cannot be severed and marketed separately from the overall forward contract in which they are embedded. In evaluating whether an agreement containing an option qualifies for the forward contract exclusion, the CFTC will look to the specific facts and circumstances of the transaction as a whole to evaluate whether the optionality operates on the price or delivery term of the contract, and whether an embedded commodity option is marketed or traded separately from the underlying contract. Citing a pre-dodd-frank interpretation, 27 the Adopting Release notes that an option cannot be a forward under CFTC precedent, because under the terms of the contract the optionee has the right, but not the obligation, to make or take delivery, while under a forward contract, both parties must have binding delivery obligations: one to make delivery and the other to take delivery. i. Volumetric Optionality While the Adopting Release confirms that commodity options are generally treated as swaps, the Adopting Release does provide that embedded optionality with respect to delivery, so called volumetric optionality, would not disqualify the transaction from being eligible for the forward contract exclusion if: the embedded optionality does not undermine the overall nature of the transaction as a forward contract; the predominant feature of the transaction is actual delivery; the embedded optionality cannot be severed and marketed separately from the overall transaction in which it is embedded; the seller of a nonfinancial commodity underlying the transaction with embedded volumetric optionality intends, at the time it enters into the transaction, to deliver the underlying nonfinancial commodity if the optionality is exercised; the buyer of a nonfinancial commodity underlying the transaction with embedded volumetric optionality intends, at the time it enters into the transaction, to take delivery of the underlying nonfinancial commodity if it exercises the embedded volumetric optionality; both parties are commercial parties; and -11-

12 the exercise or non-exercise of the embedded volumetric optionality is based primarily on physical factors, or regulatory requirements, that are outside the control of the parties and are influencing demand for, or supply of, the nonfinancial commodity. The Adopting Release indicates that, where a transaction requires delivery of a non-nominal volume of a nonfinancial commodity, even if an embedded volumetric option is exercised, the predominant feature of the contract will be viewed as actual delivery. 28 As an example, the Adopting Release describes a forward contract that calls for the delivery of 10,000 bushels of wheat and includes an option for an additional 5,000 bushels of wheat. With respect to the fourth and fifth elements, the Adopting Release explains that they are designed to ensure that both parties intend to make or take delivery, subject to the relevant physical factors or regulatory requirements, which may lead the parties to deliver more or less than originally intended. The seventh element is designed to ensure that the volumetric optionality is primarily driven by physical factors or regulatory requirements that influence supply and demand and are outside of the parties control, and that the optionality is a commercially reasonable way to address uncertainty associated with those factors. The Adopting Release also addresses several specific contracts and contractual provisions, indicating that: Certain full requirements contracts and output contracts will not be viewed as containing embedded volumetric optionality, and would be subject to the same facts and circumstances analysis applicable to other transactions that might be within the forward contract exclusion. Capacity contracts, transmission (or transportation) services agreements, 29 tolling agreements, 30 and peaking supply contracts all must be individually analyzed to determine whether they satisfy the elements of the forwards with embedded volumetric options interpretation set forth above, or may satisfy other portions of the forward contract exclusion interpretation. Provisions extending the term of the contract (such as evergreen provisions) will not be viewed as providing an option as to delivery. Provisions permitting alternative delivery points and delivery dates will not cause a transaction that otherwise qualifies as a forward contract to be considered a swap. A liquidated damages provision will not exclude a contract from qualifying for the forward contract exclusion and the CFTC will utilize a facts and circumstances approach in determining whether the parties to a particular agreement with a liquidated damage provision have the requisite intent to deliver. Generally, when evaluating whether an agreement with embedded volumetric optionality qualifies for the forward contract exclusion, the CFTC will look to the relevant facts and circumstances of the transaction as a whole. This interpretation by the CFTC turns on criteria that market participants may find difficult to evaluate, including what factors will affect the volume to be delivered. To the extent that the CFTC s standard for permitted optionality is not met, the contract may qualify as a trade option under the regulations previously promulgated by the CFTC

13 The Adopting Release solicits comments relating to the circumstances in which contracts with embedded volumetric optionality should qualify for the forward contract exclusion. Among other things, comments are requested on: whether the elements, and in particular the seventh element, set forth in the interpretation to distinguish forwards with embedded volumetric optionality from commodity options are appropriate and sufficient; and whether the interpretation is sufficiently clear with respect to capacity contracts, transmission (or transportation) services agreements, peaking supply contracts, and tolling agreements. ii. Certain Physical Commercial Agreements, Contracts or Transactions The Adopting Release includes an interpretation that confirms certain commodity-related facility lease-like transactions will not constitute options, if each transaction satisfies the following three conditions: the subject of the transaction is usage of a specified facility or part thereof rather than the purchase or sale of the commodity that is to be created, transported, processed or stored using the specified facility; the transaction grants the buyer the exclusive use of the specified facility or part thereof during its term, and provides for an unconditional obligation on the part of the seller to grant the buyer the exclusive use of the specified facility or part thereof; and the payment for the use of the specified facility or part thereof represents a payment for its use rather than the option to use it. In this context, the CFTC would not consider actions such as scheduling electricity transmission, gas transportation or injection of gas into storage to be exercising an option if all three elements described above are satisfied. In contrast, if the right to use the specified facility is only obtained via the payment of a demand charge or reservation fee, and the exercise of the right (or use of the specified facility or part thereof) entails the further payment of actual storage fees, usage fees, rents, or other analogous service charges not included in the demand charge or reservation fee, such transaction will be viewed as a commodity option subject to the swap definition. The Adopting Release notes that in evaluating whether flexible physical commercial agreements that meet the three-part test qualify for the forward contract exclusion, the CFTC will look to the specific facts and circumstances of the transaction as a whole. Here the CFTC has established a standard that is novel and outside the expectations of many market participants. interpretation. Many contracts involving storage or pipeline deliveries could be captured by this new 2. Fixed and Contingent Security Forwards The definitions of swap and security-based swap exclude any sale of a... security for deferred shipment or delivery, so long as the transaction is intended to be physically settled (the security forward exclusion ). The Adopting Release adopts the interpretation of the security forward exclusion provided in the Proposing Release, which restates the statutory exclusion, without modification. Specifically, the -13-

14 Adopting Release restates that this exclusion involves an agreement to purchase one or more securities, or groups or indexes of securities, at a future date at a certain price. The Adopting Release points to security forwards for an example of instruments potentially covered by this exemption, explaining that a security forward transaction provides for the sale of a security at the time the forward contract is entered into with the performance of the contract deferred or delayed, 32 and that, if such transaction is intended to be physically settled, the Commissions believe it would be within the security forward exclusion and therefore outside the swap and security-based swap definitions. The Adopting Release emphasizes that additional exclusions may apply to transactions in securities. In particular, the Adopting Release notes that the purchase or sale of one or more securities on a contingent basis that is subject to the Securities Act and the Exchange Act would be excluded, unless the agreement predicates the purchase or sale on the occurrence of a bona fide contingency that might reasonably be expected to affect or be affected by the creditworthiness of a party other than a party to the agreement. The Adopting Release also confirms that forward sales of mortgage backed securities in the To-Be- Announced market would fall within the exclusion for sales of securities on a deferred settlement or delivery basis (as well as the separate exclusion from the definition of swap for the purchase or sale of one or more securities on a fixed basis or, depending on its terms, a contingent basis) even though an actual mortgage backed security is not in existence at the time the forward sale is entered into. D. CONSUMER AND COMMERCIAL AGREEMENTS The Adopting Release provides interpretive guidance that excludes certain consumer and commercial agreements from the definitions of swap and security-based swap. The interpretive guidance includes lists of consumer and commercial agreements that are excluded from those definitions, which lists are the same as in the Proposing Release except that additional examples are provided, and the interpretive guidance sets forth standards that can be used to evaluate whether non-enumerated agreements may be excluded as consumer or commercial agreements. Consumer agreements that will not be considered swaps or security-based swaps when entered into by consumers (natural persons) as principals (or by their agents) primarily for personal, family, or household purposes include: agreements to acquire or lease real or personal property, to obtain a mortgage, to provide personal services, or to sell or assign rights owned by such consumer (such as intellectual property rights); agreements to purchase products or services at a fixed price or a capped or collared price, at a future date or over a certain time period (such as agreements to purchase for personal use or consumption nonfinancial energy commodities, including agreements to purchase home heating fuel or agreements involving residential fuel storage, in either case, where the consumer takes delivery of and uses the fuel, and the counterparty is a merchant that delivers in the service area where the consumer resides); -14-

15 agreements that provide for an interest rate cap or lock on a consumer loan or mortgage, where the benefit of the rate cap or lock is realized only if the loan or mortgage is made to the consumer; consumer loans or mortgages with variable rates of interest or embedded interest rate options, including such loans with provisions for the rates to change upon certain events related to the consumer, such as a higher rate of interest following a default; service agreements that are consumer product warranties, extended service plans, or buyer protection plans, such as those purchased with major appliances and electronics; consumer options to acquire, lease, or sell real or personal property, such as options to lease apartments or purchase rugs and paintings, and purchases made through consumer layaway plans; consumer transactions where, by law or regulation, the consumer may cancel the transaction without legal cause; and consumer guarantees of credit card debt, automobile loans, and mortgages of a friend or relative. Commercial agreements involving customary 33 business arrangements (whether or not involving a forprofit entity) that will not be considered swaps or security-based swaps include: employment contracts and retirement benefit arrangements; sales, servicing, or distribution arrangements; agreements for the purpose of effecting a business combination transaction; the purchase, sale, lease, or transfer of real property, intellectual property, equipment, or inventory; warehouse lending arrangements in connection with building an inventory of assets in anticipation of a securitization of such assets (such as in a securitization of mortgages, student loans, or receivables); mortgage or mortgage purchase commitments, or sales of installment loan agreements or contracts or receivables; fixed or variable interest rate commercial loans or mortgages entered into by banks and nonbanks, including the following: fixed or variable interest rate commercial loans or mortgages entered into by the Farm Credit System institutions and Federal Home Loan Banks; 34 fixed or variable interest rate commercial loans or mortgages with embedded interest rate locks, caps, or floors, provided that such embedded interest rate locks, caps, or floors are included for the sole purpose of providing a lock, cap, or floor on the interest rate on such loan or mortgage and do not include additional provisions that would provide exposure to enhanced or inverse performance, or other risks unrelated to the interest rate risk being addressed; fixed or variable interest rate commercial loans or mortgages with embedded interest rate options, including such loans or mortgages that contain provisions causing the interest rate to change upon certain events related to the borrower, such as a higher rate of interest following a default, provided that such embedded interest rate options do not include additional provisions that would provide exposure to enhanced or inverse performance, or other risks unrelated to the primary reason the embedded interest rate option is included; and -15-

16 commercial agreements (including, but not limited to, leases, service contracts, and employment agreements) containing escalation clauses linked to an underlying commodity such as an interest rate or consumer price index. The Adopting Release makes clear that the lists of excluded consumer and commercial agreements are not intended to be exhaustive. To determine whether similar types of transactions entered into by consumers or commercial entities are swaps or security-based swaps, the Commissions will consider the following characteristics and factors: whether the agreement contains severable payment obligations, whether or not contingent; whether the agreement is traded on an organized market or over-the-counter; and in the case of a consumer arrangement, whether the arrangement involves an asset of which the consumer is the owner or beneficiary, or that the consumer is purchasing, or involves a service provided, or to be provided, by or to the consumer, or in the case of a commercial arrangement, whether the arrangement is entered into by commercial or non-profit entities as principals (or by their agents) to serve an independent commercial, business, or non-profit purpose, and not for speculative, hedging, or investment purposes. The Commissions note that the two key components that distinguish consumer and commercial agreements from swaps and security-based swaps are: (i) the payment provisions of the agreement are not severable; and (ii) the agreement is not traded on 35 an organized market or over-the-counter, and therefore does not involve risk-shifting arrangements with financial entities The characteristics and factors described in the guidance are not intended to be the exclusive means to determine whether a consumer or commercial arrangement constitutes a swap or security-based swap. If there is a type of transaction that is not enumerated above, or does not have all the characteristics listed above (including new types of transactions that may be developed in the future), the Adopting Release explains that such transaction will be evaluated based on its particular facts and circumstances. Parties to such transactions may also seek an interpretation from the Commissions as to whether the transactions is a swap or security-based swap. E. LOAN PARTICIPATIONS The Adopting Release notes that, depending on the facts and circumstances, a loan participation may be excluded from the definition of swap on account of (a) constituting a security under the federal securities laws (and thus falling under the exclusion of purchases and sales of a security on a fixed or contingent basis from the definition of swap), or (b) being an identified banking product (and thus excluded from CFTC jurisdiction and from the security-based swap and security-based swap agreement definitions). For loan participations not excluded as securities or identified banking products, the Adopting Release provides guidance as to circumstances in which those loan participations would fall outside of the swap and security-based swap definitions. Specifically, for a loan participation to not be considered a swap or security-based swap, the loan participation must represent a current or future direct or indirect ownership

17 interest in the loan or commitment that is the subject of the loan participation. In evaluating whether the loan participation represents such an ownership interest, the following characteristics should be present: The grantor of the loan participation is a lender under, or a participant or sub-participant in, the loan or commitment that is the subject of the loan participation; The aggregate participation in the loan or commitment that is the subject of the loan participation does not exceed the principal amount of such loan or commitment. Further, the loan participation does not grant, in the aggregate, to the participant in such loan participation a greater interest than the grantor holds in the loan or commitment that is the subject of the loan participation; The entire purchase price for the loan participation is paid in full when acquired and not financed. The Commissions believe a purchase price would not be paid in full if the grantor of the loan participation extends financing to the participant or if such participant leverages its purchase, including by posting collateral to secure a future payment obligation; and The loan participation provides the participant all of the economic benefit and risk of the whole or part of the loan or commitment that is the subject of the loan participation. The Adopting Release confirms that a loan participation does not have to be a true participation in order for the loan participation to fall outside the swap and security-based swap definitions. 36 The Adopting Release also clarifies that the interpretation applies to loan participations that are entered into both with respect to outstanding loans and with respect to a lender s commitments to lend and fund letters of credit (e.g., under a revolving credit facility). F. TRANSACTIONS IN REGIONAL TRANSMISSION ORGANIZATIONS AND INDEPENDENT SYSTEM OPERATORS The Adopting Release notes that, to the extent that transactions occur through Regional Transmission Organizations or Independent System Operators, or are entered into between entities described in Section 201(f) of the Federal Power Act, they may be subsequently addressed through the public interest waiver process in CEA section 4(c)(6). The Adopting Release does not take up commenters requests that the Commissions exclude such transactions by rule from the definition of swap. II. FOREIGN EXCHANGE AND OTHER FOREIGN CURRENCY TRANSACTIONS A. FOREIGN EXCHANGE PRODUCTS The Adopting Release includes interpretive clarifications of the status of products related to foreign currencies (including foreign exchange rates). With respect to these products, the Adopting Release follows the Proposing Release except in providing additional interpretations regarding foreign exchange spot transactions and retail foreign currency options. As adopted, the Final Rules explicitly define the term swap to include cross-currency swaps, currency options, foreign currency options, foreign exchange options, foreign exchange rate options, foreign -17-

18 exchange forwards, foreign exchange swaps and non-deliverable forwards involving foreign exchange. The Adopting Release cautions that this list is non-exclusive. With respect to foreign exchange forwards and foreign exchange swaps ( FX Products ), the Adopting Release confirms that these products will be considered swaps unless the United States Secretary of the Treasury ( Secretary ) issues a written determination that either or both should be exempted from the definition. Notwithstanding such determination, FX Product transactions will still be subject to certain requirements, including regulatory and historic reporting requirements under Section 4r of the CEA and, when entered into by a swap dealer or major swap participant, the business conduct standards under Section 4s(h) of the CEA. The Final Rules clarify that the following products will not qualify as FX Products: currency swaps, cross-currency swaps, currency options, foreign currency options, foreign exchange options, foreign exchange rate options and non-deliverable forwards involving foreign exchange. 1. Interpretation Regarding Foreign Exchange Spot Transactions Comments on the Proposing Release identified concerns that certain spot market currency transactions, including those involved in effecting purchases of foreign securities, may be captured within the definition of swap and thus subject to regulation. In response to these concerns, the Adopting Release includes an interpretation that a bona fide foreign exchange spot transaction, which is defined as a foreign exchange transaction that is settled on the customary timeline of the relevant spot market, is not within the definition of the term swap. 37 The interpretation explains that, generally, a foreign exchange transaction will be considered a bona fide foreign exchange spot transaction if it settles via an actual delivery of the relevant currencies within two business days. However, a foreign exchange transaction with a longer settlement period concluding with the actual delivery of the relevant currencies may be considered a bona fide spot transaction depending on the customary timeline of the relevant market. To assess whether a transaction qualifies as a bona fide foreign exchange spot transaction, the Commissions will look at the relevant facts and circumstances. The Adopting Release notes that an unintentional settlement failure or delay for operational reasons or due to a market disruption is not expected to undermine the character of a bona fide spot foreign exchange transaction as such. The Adopting Release provides interpretive relief to certain foreign currency transactions that are entered into in connection with foreign security transactions. Under the interpretation, a purchase or sale of an amount of foreign currency solely to effect the purchase or sale of a foreign security, where the amount of the foreign currency is equal to the amount needed to purchase, or to be received upon the sale of, such foreign security will be a bona fide spot foreign exchange transaction (and therefore exempted from the definition of a swap ) if: the security and related foreign currency transactions are executed contemporaneously in order to effect delivery by the relevant securities settlement date, and -18-

19 actual delivery of the foreign security and foreign currency occurs by such deadline (such transaction, a Securities Conversion Transaction ). The Adopting Release views the customary timeline of foreign security transactions as the settlement date for the relevant securities, so that the exemption for foreign securities is consistent with the above general exemption for spot currency markets that take longer than two days to settle. The interpretation also provides that a Securities Conversion Transaction will not be considered leveraged, margined or financed within the meaning of section 2(c)(2)(C) of the CEA, which imposes restrictions on leveraged, margined and financed transactions in foreign currency with persons who are not eligible contract participants ( ECPs ) Retail Foreign Currency Options The Adopting Release provides that foreign currency options described in Section 2(c)(2)(B) of the CEA will not constitute swaps. Section 2(c)(2)(B) of the CEA would permit certain off-exchange foreign currency options to be entered into between non-ecps and enumerated regulated entities. The CFTC stated that this interpretation was intended to cure a scrivener s error in Dodd-Frank, which otherwise would have created a conflict between Section 2(c)(2)(B) of the CEA (which permits certain off-exchange foreign currency options entered into by non-ecps under specified conditions) and Section 2(e) of the CEA (which otherwise would have prohibited such retail off-exchange foreign currency options with non- ECPs). 39 III. INTERPRETATION OF SWAP WITH RESPECT TO FORWARD RATE AGREEMENTS, CONTRACTS FOR DIFFERENCES, AND COMBINATIONS AND PERMUTATIONS OF, OR OPTIONS ON, SWAPS AND SECURITY-BASED SWAPS Consistent with the Proposing Release, the Adopting Release clarifies the status of forward rate agreements and provides interpretations regarding: (i) combinations and permutations of, or options on, swaps or security-based swaps; and (ii) contracts for differences ( Cedes ) as follows: The term swap is explicitly defined to include forward rate agreements ( FRAs ). As with the foreign exchange-related products discussed above, the Final Rules provide that FRAs are not swaps if they fall within one of the specific exclusions set forth in the swap definition. An interpretation in the Adopting Release clarifies that an option or forward on a swap or security-based swap would, respectively, constitute a swap or security-based swap. The Adopting Release also clarifies that CFDs, unless otherwise excluded, will fall within the scope of either the swap or security-based swap definition. Whether a CFD is a swap or security-based swap will depend on the underlying product of that particular CFD transaction. The Adopting Release explains that because CFDs are highly variable and a CFD can contain a variety of elements that would affect its characterization, market participants should analyze the features of the underlying product of any particular CFD in order to determine whether the CFD is a swap or a security-based swap. -19-

20 IV. RELATIONSHIP BETWEEN SWAPS AND SECURITY-BASED SWAPS Title VII of Dodd-Frank provides the CFTC with jurisdiction over swaps and the SEC with jurisdiction over security-based swaps (swaps and security-based swaps are referred to herein as Title VII Instruments ). 40 The Commissions indicate that the determination of whether a Title VII Instrument is a swap or security-based swap should be made prior to execution, but no later than the date that the parties offer to enter into the instrument. As a general rule, the Commissions have determined that so long as the instrument s terms are not amended, modified or otherwise adjusted during the tenor of the instrument, such instrument will remain a swap or security-based swap, as applicable initially, throughout its lifetime. The Exchange Act defines a security-based swap as any swap that is based on: an index that is a narrow-based security index (the first prong ); a single security or loan (the second prong ); or 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 (the third prong ). Any security-based swap that also has components of a typical swap under the jurisdiction of the CFTC is a mixed swap. The regulation of such mixed swaps will be discussed under section VI. below. In the Adopting Release, the Commissions explain that each individual transaction executed under the same ISDA Master Agreement or Master Confirmation, even if entered into concurrently, should be analyzed separately as to whether it is a swap or a security-based swap, so long as a separate confirmation is sent for each such transaction. Accordingly, separately confirmed credit default swaps ( CDSs ), TRSs or other instruments would not be aggregated into a single instrument that is based on one index or group of securities (and the group or index that would have resulted from such an aggregation would not need to be tested under the narrow-based index definition). The Commissions have adopted this interpretation as a bright-line rule in order to reduce costs associated with determining whether an instrument is a swap or security-based swap. A. TITLE VII INSTRUMENTS BASED ON INTEREST RATES, OTHER MONETARY RATES, AND YIELDS In the Adopting Release, the Commissions provide guidance for determining whether an instrument on an interest rate, a monetary rate or a yield will be a swap or a security-based swap. If an instrument is based on the level of a specific interest rate or other monetary rate that is not itself based on one or more securities, the instrument would be a swap and not a security-based swap. The Adopting Release indicates that a rate swap may require payment based on differences between two floating rates, or require payment to be made based on the occurrence of an agreed upon event with respect to an interest -20-