CFTC and SEC Issue Joint Final Rules Providing Guidance on the Definition of the “Swap” and “Security-Based Swap” Triggering Compliance Obligations under other Dodd-Frank Rules

The Commodity Futures Trading Commission (the “CFTC”) and the Securities Exchange Commission (the “SEC” and together with the CFTC, the Commissions”), in consultation with the Board of Governors of the Federal Reserve System, have jointly adopted final rules and interpretations (the “Swap Rules”), pursuant to Section 721 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). Specifically, the Swap Rules:

1. further define the terms “swap,” “security-based swap,” (“SBS”) and “security-based swap agreement” (collectively, the “Title VII Instruments”);
2. further clarify and prescribe regulations regarding the term
   “mixed swap;” and
3. govern books and records with respect to “security-based swap agreements”.

The Swap Rules took effect on October 12, 2012 (the “Effective Date”) at which time, compliance obligations under many other rulemakings under the Dodd-Frank Act was triggered.

The Dodd-Frank Act provides a broad and extensive definition of the term “swap” that includes numerous agreements, contracts and transactions commonly referred to as swaps. Although the statutory definitions of the terms “swap” and “security-based swap” are comprehensive, the Commissions have adopted the Swap Rules to further clarify whether certain types of agreements, contracts and transactions may be deemed swaps, SBSs or mixed swaps that will be regulated by the CFTC and/or the SEC, as applicable. In doing such, the Commissions have also prescribed the process for making the determination as to whether such agreements, contracts and transactions will be deemed swaps, SBSs or mixed swaps. Please note that the definitions under the Swap Rules can be technical and may diverge from common usage of terms like “swap” and “derivative.”

The Swap Rules provide an extensive and complex framework for determining whether a product may be deemed a swap, SBS, security-based swap agreement or mixed swap and as such, this memorandum is not intended to provide an exhaustive analysis of the Swap Rules, but instead, provides a summary of some of key attributes of the Swap Rules and some of the potential implications for hedge funds.

Set forth below is a brief summary table that highlights some of the key Title VII Instruments and whether such instruments will generally be classified as “swaps” and/or security-based swaps,” or are specifically excluded from such definitions. Additional information on such classifications can be found following the summary.

“Swaps” (subject to CFTC regulation)

• Swaps on Broad-based Security Indices
• Total Return Swaps (“TRS”) on broad-based security indices or two or more loans
• Credit Default Swaps (“CDS”) on broad-based security indices
• Swaps on Interest Rates, Other Monetary Rates and Yields (except as described under
  Further Definition of “SBS” below)
• Non-Deliverable Forwards in
  Foreign Exchange (“FX”)
• Non-Deliverable Forwards in Foreign Exchange (“FX”)
• Foreign Currency Options (unless traded on a securities exchange)
• Forward Rate Agreements (unless otherwise excluded)
• Swaps on Futures (except security futures)
• Options, Contracts for Differences (“CFD”) and Guarantees on any of the aforementioned swaps
• Security-Based Swap Agreements

“Security-based Swaps”(subject to SEC regulation)

• Swaps on Single-names, Single Loans and Narrow-based Security Indices
• TRS on single currency, loan, or narrow-based security index
• CDS on narrow-based security indices
• Security Futures (unless otherwise exempted)
• Yields where yield is a proxy for the price or value of a debt security, loan or narrow-based security index (except in the case of certain exempted securities)
• Options and CFDs on any of the aforementioned swaps

“Mxed Swaps” (subject to certain regulation by the CFTC and the SEC)

• “Mixed swaps” are instruments that generally would be considered security-based swaps, but also include criteria that are applicable to swaps that are not security-based (e.g., a swap where the underlying reference includes both a narrow-based security index and commodities)

Specifically Excluded from the swaps definitions

• FX Forwards and Swaps
• Insurance Products
• Physically Settled Forward Contracts
• Forward Contracts Embedded with Commodity Options or Volumetric Optionality
• Security Forwards
• Consumer and Commercial Agreements, Contacts and Transactions
• Loan Participations
• Bona Fide FX Spot Transactions
• Foreign Currency Options (if traded on a securities exchange)

Further Definitions of “Swap”

Under the Swap Rules, the Commissions have clarified that the following agreements, contracts
and transactions will be considered swaps and therefore subject to regulation by the CFTC:

• Non-Deliverable Forwards in Foreign Exchange (“FX”)
• Currency Swaps and Cross-Currency Swaps
• Foreign Currency Options (unless traded on a securities exchange)
• Forward Rate Agreements (unless otherwise excluded)
• Interest Rates, Other Monetary Rates and Yields: Title VII Instruments where payments are based solely on interest rates, other monetary rates (unless based on one or more securities) or yields (except as described under Further Definition of “SBS” below)
• Title VII Instruments based on Futures (except security futures), including certain debt securities of enumerated foreign governments
• Broad-based Security Indices Title VII Instruments on any “broad-based” security index (i.e., not a “narrow-based security index, as described under Further Definition of “SBS” below)
• Total Return Swaps (“TRS”): on broad-based security indices or two or more loans
• Credit Default Swaps (“CDS”): Where the underlying reference is not a narrow-based security index or the issuers of securities in a narrow-based security (as described under Further Defiition of “SBS” below)
• Options on any of the aforementioned swaps
• Contracts for Differences (“CFD”) on any of the aforementioned swaps Generally, a CFD will be considered a swap or security-based swap (unless otherwise excluded) based on the nature of the underlying product.
• Guarantees on any of the aforementioned swaps
• Security-Based Swap Agreements
• Security-based swap agreements (“SBSA“) are swaps which the CFTC has primary regulatory authority, but for which the SEC has antifruad, antimanipulation, and certain other authority. The Swap Rules clarify that suchs SBSAs will not require additional books and records requirements, beyond what is already required for swaps.

Further Definition of “Security-based Swap”

Under the swap Rules, the Commissions have clarified that the following agreements, contracts
and transactions will be deemed security-based swaps that are subject to regulation by the SEC:

• Single-names; Single Loans: Title VII Instruments based on a single security or a
  single loan
• Narrow-based Security Indices: Title VII Instruments based on “narrow-based” security indices

  Narrow-based Security Indices

  The Commissions have provided guidance that an index will be considered a “narrow-based” security index if, among other things, it meets any of the following four criteria:

  1. it has nine or fewer component securities;
  2. a component security comprises more than 30% of the index’s weighting;
  3. the five highest weighted component securities in the aggregate comprise more than 60 percent of the index’s weighting; or
  4. 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), except that if there are two or more securities with equal weighting that could be included in the calculation of the lowest weighted component securities comprising, in the aggregate, 25 percent of the index’s weighting, such securities shall be ranked from lowest to highest dollar value of average daily trading volume and shall be included in the calculation based on their ranking starting
     with the lowest ranked security.

  The Commissions use alternate tests for determine whether volatility indices and debt security indices are “narrow-based.”

  Volatility Indices

  A volatility index is a narrow-based security index unless it meets all of the following criteria (in which case, it is a “broad-based” volatility index):

  1. it measures the magnitude of changes (as calculated in accordance with the Commissions’ criteria) in the level of an underlying index that is not a narrow-based security index;
  2. it has more than nine component securities, all of which are options on the
     underlying broad-based index;
  3. it contains no one component security that comprises more than 30% of the index’s weighting;
  4. its five highest-weighted component securities do not comprise in the aggregate more than 60% of the index’s weighting;
  5. the lowest 25% of the index’s weighting has an average daily trading volume of more than $50,000,000 (or $30,000,000 in the case of indexes
     with more than 15 component securities), subject to certain conditions;
  6. options on the index are listed and traded on a national securities exchange under the Securities Exchange Act of 1934; and
  7. the aggregate average daily trading volume in options on the index is at least 10,000 contracts per day, calculated as of the previous six calendar months.

  Debt Indices

  A debt index is a narrow-based security index unless it meets all of the following criteria (in which case, it is a “broad-based” debt index):

  1. it comprises more than nine debt securities that are issued by more than nine non-affiliated issuers;
  2. the securities of no issuer included in the index comprise in the aggregate more than 30% of the index’s weighting;
  3. the securities of any five non-affiliated issuers in the index do not comprise in the aggregate more than 60% of the index’s weighting; and
  4. its debt securities or issuers thereof satisfy certain public information availability requirements.
• Security Futures (i.e., a futures contract on a single security or narrow-based security index (unless otherwise exempted))
• TRS on a single currency, loan, or narrow-based security index, unless interest rate payments act merely as financing component or the TRS is based on non-security-based components (in which case the TRS would be a mixed swap)
• CDS where the underlying reference is a narrow-based security index or the issuers of securities in a narrow-based security index

  With respect to CDS, the Commissions apply an alternate test to determine whether a reference underlying a particular CDS is based on a narrow-based security index or the issuers of a narrow-based security index (and therefore deemed a security-based swap). The CFTC will consider a CDS to be on a narrow-based security index if any one of the following criteria is met:

  1. there are nine or fewer component securities or non-affiliated issuers of securities that are reference entities included in the index;
  2. the effective notional amount allocated to any reference entity or the
     securities of an issuer included in the index comprises more than 30 percent of the index’s weighting;
  3. the effective notional amount allocated to any five non-affiliated reference entities or the securities of any five non-affiliated entities included in the index comprises more than 60 percent of the index’s weighting; or
  4. no more than 80 percent of the index’s weighting is comprised of reference
     entities or securities in the index that satisfy a public information availability test or a reference entity or security that does not satisfy such test comprises more than 5 percent of such index’s weighting.

  Additionally, if a broad-based index CDS includes mandatory physical settlement it will
  be considered a mixed swap.

  Consequently, a CDS that does not meet such criteria would be considered a broad-based
  security index CDS that is a swap.

  • Yields: Title VII Instruments on “yields,” where yield is a proxy for the price or value of a debt security, loan or narrow-based security index (except in the case of certain exempted securities)
  • Options on any of the aforementioned swaps
  • CFDs on any of the aforementioned swaps

  Guidance on “Mixed Swaps”

  A “mixed swap” is a Title VII Instrument that would otherwise be deemed a security-based swap, but it is also “based on the value of 1 or more interest or other rates, currencies, commodities, instruments of indebtedness, indices, 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…” For example, a Title VII Instrument where the underlying reference includes a narrow-based security index would typically be considered a security-based swap, however, if the instrument also included underlying references to commodities it would have characteristics of both a swap and a securities-based swap and therefore be considered a mixed swap, subject to regulation by both the CFTC and the SEC.

  Bilateral uncleared mixed swaps (generally, mixed swaps that are not cleared or subject to the rules of an exchange) will be subject to securities law regulation and they will also be subject to certain CFTC regulation, including the anti-fraud, anti-manipulation and other provisions of the business conduct standards in CEA and the rules promulgated thereunder for mixed swaps. All other mixed swaps (i.e., not bilateral uncleared mixed swaps) will be subject to a process that requires the Commissions (upon request) to issue a joint order regarding the regulation of such mixed swap, with respect to the parallel regulatory provisions that would apply to such mixed swaps.

  Neither Swaps nor Security-Based Swaps

  Under the Swap Rules, the Commissions have determined that certain agreements, contracts and
  transactions will not be considered Title VII Instruments regulated by the Commissions,
  including certain 1) FX Forwards and FX Swaps, 2) Insurance Products, 3) Physically Settled Forward Contracts, 4) Forward Contracts Embedded with Commodity Options or Volumetric Optionality, 5) Security Forwards, 6) Consumer and Commercial Agreements, Contracts and Transactions, 7) Loan Participations, 8) Bona Fide FX Spot Transactions, and 9) Foreign Currency Options (if traded on a securities exchange).

Following is a summary of some of the guidance that the Commissions have provided for determining whether a product fits into one of the categories that are excluded from being a Title VII Instrument.

FX Forwards and FX Swaps

Although FX Forwards and FX Swaps fit within the definition of a swap, on November 16, 2012, the Treasury Department issued an exemption for these products from the definition. We will be distributing a Legal Update on the Treasury’s determination in the coming days.

Insurance Products

To avoid miscategorizing certain products that historically were treated as insurance products as swaps, the Commissions have adopted a non-exclusive “Insurance Safe Harbor” that provides that certain agreements, contracts and transactions will not be considered to be Title VII Instruments. It is important to note that a product that does not fit into the Insurance Safe Harbor will not necessarily be considered a Title VII instrument; such product will require further analysis of the applicable facts and
circumstances. The “Insurance Safe Harbor” provides an exclusion from regulation as a Title VII Instrument if a product (i) is one of the Enumerated Products (as defined below) or meets the commissions’ “Product Test,” which sets forth certain criteria, that if met would indicate such product is an insurance product, and (ii) meets the Commissions “Provider Test,” which sets forth certain criteria regarding the type of provider that must offer the product in order for it to be included in the Insurance Safe Harbor. The “Enumerated Products” include surety bonds, fidelity bonds, life insurance, health
insurance, long-term care insurance, title insurance, property and casualty insurance, annuities, disability insurance, insurance against default on individual residential mortgages (commonly known as private mortgage insurance, as distinguished from financial guaranty of mortgage pools) and reinsurance (including retrocession) of any of the foregoing.

The Swap Rules also include a “grandfather” provision that provides an exclusion from regulation as a Title VII Instrument for a product that is entered into on or before the effective date of the Swap Rules and at such time that it was entered into, the transaction met the Provider Test.

It is important to note, that the CFTC considers a guarantee of a swap, to the extent that the counterparty to the position would have recourse to the guarantor in connection with such position, to be a swap. The CFTC intends to issue additional guidance regarding the implications of guarantees on the interpretation of the term “swap.” The SEC, however, will not consider a guarantee of a security-based swap to be a separate security-based swap, although such guarantee is a security under the Securities Act of 1933.

Physically Settled Forward Contracts: The “Forward Contract Exclusion”

The statutory definition of “swap” provides an exclusion for forward contracts for non-financial commodities, provided that such contracts are intended to be physically settled. The CFTC has provided guidance that it will interpret this exclusion consistently with prior CFTC positions excluding certain forwards from CFTC oversight and will use a “facts and circumstances” approach to determine, among other things, the parties’ intent to deliver such commodity.

In this connection, the CFTC has clarified that the statutory interpretation concerning forward transactions referred to as the “Brent Interpretation,” which excludes certain “book-outs” of non-financial commodities from the definition of “futures delivery,” will similarly be applied to “swap” delivery. Book-out transactions, meeting the criteria set forth in the Brent Interpretation — which generally requires a commercial market participant to regularly make or take delivery of the relevant commodity in the ordinary course of its business — should qualify for the forward contract exclusion if the book-out
is subsequently effectuated through a separately negotiated agreement.

Forward Contracts Embedded with Commodity Options or Volumetric Optionality

Options that are embedded in forward contracts will be considered an excluded nonfinancial commodity forward contract if, depending on the facts and circumstances, “the embedded option(s): (1) may be used to adjust the forward contract price, but do not undermine the overall nature of the contract as a forward contract; (2) do not target the delivery term (meaning that it does not affect the delivery amount), so that the predominant feature of the contract is actual delivery; and (3) cannot be severed and marketed separately from the overall forward contract in which they are embedded.”

Similarly, agreements, contracts and transactions containing “volumetric optionality” will qualify for the forward exclusion and not be deemed a swap if, depending on the facts and circumstances: “(i) the embedded optionality does not undermine the overall nature of the agreement as a forward contract; (ii) the predominant feature of the agreement is actual delivery; (iii) the embedded optionality cannot be severed and marketed separately from the overall agreement in which it is embedded; (iv) the seller of the nonfinancial commodity underlying the agreement intends, at the time it enters into the agreement, to deliver the underlying nonfinancial commodity if the optionality is exercised; (v) the buyer intends, at the time it enters into the agreement, to take delivery if it exercises the optionality; (vi) both parties are commercial parties; and (vii) the exercise or non-exercise of the 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.”

Loan Participations

A loan participation that is (i) a security under the federal securities laws, (ii) an identified banking product, or (iii) represents a future direct or indirect ownership interest in the loan that is subject to the loan participation, will be excluded from regulation as a Title VII Instrument, depending on the facts and circumstances.

Designation as a Swap, SBS or Mixed Swap by the Commissions

The determination of an instrument’s status as a swap, security-based swap or mixed swap should
be made prior to execution of such instrument and no later than when the parties offer to enter into the instrument. Upon characterization of an instrument as a swap or security-based swap such characterization will remain the same throughout the life of the instrument, unless the terms are materially modified. For example, if an instrument is based on a narrow-based securities index (therefore, a security-based swap) at the time the parties entered into it, the instrument will not be re-characterized as a swap if the index later becomes a broad-based security index and vice versa.

Certain Considerations for Hedge Funds

In addition to defining which products will be deemed Title VII Instruments that are subject to regulation by the CFTC and/or the SEC, the adoption of the Swap Rules is significant because the effective dates of many other rules and regulations promulgated under the Dodd-Frank Act are triggered by the completion of the Swap Rules.

Among other things, the promulgation of the Swap Rules has a profound effect on whether an operator of a private fund must register with the CFTC as a commodity pool operator (“CPO”). On February 24, 2012, the CFTC published a final rule in the Federal Register that rescinded Regulation 4.13(a)(4) (as of December 31, 2012), which provided an exemption from registration as a CPO. As such, operators of private funds that trade commodities must register as a CPO unless they can claim the limited trading exemption under Regulation 4.13(a)(3). As of January 1, 2013, “swaps,” as defined under the Swap Rules, will be considered “commodity positions” and therefore operators of private funds must include them in their calculation of the limited trading exemption. Similarly, operators of private funds that previously did not trade commodities would now have to register or claim an exemption if such private funds trade swaps.

Additionally, although many of the rules and regulations promulgated under the Dodd-Frank Act may not directly affect hedge funds (i.e., many rules place requirements on swap dealers and major swap participants), hedge fund managers should consider how they may be indirectly affected. For example, as swap dealers are preparing to comply with clearing requirements for swaps, which will be phased in over the coming months, such clearing requirements will require hedge fund managers to modify and/or enter into certain agreements that will govern the trading of cleared swaps. Similarly, on August 13, 2012 the International Swaps and Derivatives Association, Inc. (“ISDA”) issued the “DF Protocol” which will be used by swap dealers and market participants to amend existing trading documentation to ensure that swap dealers are in compliance with certain obligations under the Dodd-Frank Act.

Hedge funds managers should ensure that they have adequate time to comply with various rules
and regulations stemming from the Title VII Instruments. Furthermore, they will need time to properly negotiate and enter into relevant trading documentation to ensure that swaps and/or commodities trading is not disrupted or executed on less than favorable terms.