Regulatory Fundamentals – Swaps, Security-based Swaps and the Coming into Effect of the SEC’s Security-based Swap Dealer Regulatory RegimeRegulatory Fundamentals – Swaps, Security-based Swaps and the
Coming into Effect of the SEC’s Security-based Swap Dealer Regulatory
Regime
• Product definitions: “swaps”, “security-based swaps” and “mixed swaps”; some statutory exclusions
• Examples to illustrate exclusions and CFTC/SEC jurisdictional boundaries
• Other line-drawing examples: forwards, options, commercial agreements
• Significance of “eligible contract participant” status
2
Title VII SBS Timeline
Source: SEC Division of Trading and Markets, FAQs on Key Dates for Registration
3
transactions between a non-US
person and a foreign branch of a US person. 17 C.F.R. § 240.3a71-
3(b)(1)(iii)(A)(2).
Source: 84 FR 68550, 68607 4
What is a Swap?
• a broad class of underliers and events:
– 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 (“swap underlier”), CEA § 1a(47)(A)(i), (iii);
– the occurrence, or non-occurrence, or extent of occurrence, of an event or contingency associated with a potential financial, economic, or commercial consequence (“contingency realization”), CEA § 1a(47)(A)(ii);
• and virtually any economic dependency on the underlier or event, including
– options to purchase or sell, or based on the value of, a swap underlier,
– payments or deliveries dependent on a contingency realization, and
– an executory exchange, on a fixed or contingent basis, of one or more payments based on the value or level of a swap underlier, and that transfer all or part of the financial risk associated with a future change in such value or level without also conveying a current or future direct or indirect ownership interest in the asset or liability that incorporates the financial risk
5
• Also included within the “swap” definition are:
– any agreement that is, or in the future becomes, commonly known to the trade as a swap
– any combination or permutation of, or option on, the transactions defined as swaps
• But the breadth of the definition is tempered by:
– statutory exclusions, CEA § 1a(47)(B) and (E);
– regulatory safe harbors for insurance;
– interpretive guidance in the adopting release for the Product Definitions, 77 Fed. Reg. 48208 (Aug. 13, 2012) and elsewhere; and
– in some cases, availability of a “trade option” exemption, CFTC Regs. Part 32.
6
Security-Based Swaps
• A security-based swap is an instrument that (but for the exclusion in CEA §1a(47)(B)(x)) would be a swap and that is based on –
– a ‘narrow-based’ securities index;
– a single security or loan; or
– an event relating to a single issuer of a security or the issuers of a narrow-based securities index, provided that the event directly affects the financial statements, financial condition or financial obligations of the issuer
• Certain exempted securities: However, the term “security-based swap” does not include any agreement, contract, or transaction that meets the definition of a security-based swap only because such agreement, contract, or transaction references, is based upon, or settles through the transfer, delivery, or receipt of an exempted security under paragraph (12), as in effect on January 11, 1983 (other than any municipal security as defined in paragraph (29) as in effect on January 11, 1983), unless such agreement, contract, or transaction is of the character of, or is commonly known in the trade as, a put, call, or other option. SEA §3(a)(68)(C)
7
Security-Based Swaps (cont’d)
• As defined in the CEA and SEA, a narrow-based securities index is an index that has 9 or fewer component securities, or in which a component security comprises more than 30 percent of the index's weighting, or that does not meet certain other criteria related to diversification, liquidity or the availability of public information about issuers. CEA §1a(35); SEA §3(a)(55).
• This statutory definition is modified in guidance and regulations to tailor it to index credit defaults swaps, indexes of debt securities and equity volatility indexes. The resulting amalgam of rules is extremely complex.
• The Dodd-Frank Act amended the definitions of “security” under the ’33 Act (SA) and ’34 Act (SEA) to include a “security-based swap”
• SA § 2(a)(18) and SEA §§ 3(a)(13) and (14) provide that the terms “purchase” and “sale” of a security-based swap shall mean the “the execution, termination (prior to its scheduled maturity date), assignment, exchange, or similar transfer or conveyance of, or extinguishing of rights or obligations under, a security-based swap, as the context may require.”
8
• Bilateral uncleared, off-facility mixed swaps entered into by dually-registered dealers:
– Subject to Federal securities laws and regulations (including SEC SBS regulation) and only specified provisions of the Commodity Exchange Act and regulations (See Rule 3a68-4(b))
• Other mixed swaps:
– Process for requesting a joint SEC-CFTC order that permits compliance, as to parallel provisions only, with specified parallel provisions of either the Securities Exchange Act (and regulations) or Commodity Exchange Act (and regulations) (See Rule 3a68-4(c))
• Process for requesting a joint SEC-CFTC interpretation as to whether a particular agreement is a swap, SBS or mixed swap. (See Rule 3a68-2)
9
Selected Statutory Exclusions
• any sale of a nonfinancial commodity or security for deferred shipment or delivery, so long as the transaction is intended to be physically settled (“excluded forward”)
• “foreign exchange forwards” and “foreign exchange swaps,” as defined in CEA § 1a(24) and (25), pursuant to a determination by the Secretary of the Treasury that the instruments “should not be regulated as swaps”, but certain provisions of the CEA and related regulations remain applicable
• any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities, including any interest therein or based on the value thereof, that is subject to— (I) the Securities Act of 1933; and (II) the Securities Exchange Act of 1934
• any agreement, contract, or transaction providing for the purchase or sale of 1 or more securities on a fixed basis that is subject to— (I) the Securities Act of 1933; and (II) the Securities Exchange Act of 1934
• any agreement, contract, or transaction providing for the purchase or sale of 1 or more securities on a contingent basis that is subject to the Securities Act of 1933 and the Securities Exchange Act of 1934, unless predicated on the occurrence of a bona fide contingency that might reasonably be expected to affect or be affected by the creditworthiness of a non-party
• any note, bond, or evidence of indebtedness that is a security, as defined in section 2(a)(1) of the Securities Act of 1933
• certain capital-raising transactions by an issuer entered into directly or through an underwriter (as defined in section 2(a)(11) of the Securities Act of 1933)
10
Selected Statutory Exclusions (cont’d)
• any agreement, contract, or transaction a counterparty of which is a Federal Reserve bank, the Federal Government, or a Federal agency that is expressly backed by the full faith and credit of the United States
• any “security-based swap” other than a “mixed swap”
11
• Swap – SOFR Compounded vs. Fixed IRS
• Security-based swap – single-name CDS or narrow-based index CDS
• Security but not SBS – certain forwards and options on securities
• Mixed swap – single-stock total return swap with embedded non- securities component (other than interest rate under a financing leg)
• Some non-intuitive cases —
– Exempted securities (e.g., US Treasuries)
– Yield as a proxy for the price of a debt security
– “Quanto” or ”compo” FX dependence (See 77 F.R. at 48265. Compare fn. 650 to the description of a “compo” equity swap)
– Aggregations of single-name transactions vs. a transaction on a broad- based index
12
At the Boundaries of the Swap Definition
• “forlorn ultimate border of reality beyond which a cloud of legend, rumour and surmise began” – Patrick Leigh Fermor
• “the middle ground between light and shadow, between science and superstition” – Twilight Zone (TV series, 1959-1964)
• “as the interpretation is not intended to be a bright-line test …, if the particular arrangement does not meet all of the identified characteristics and factors, the arrangement will be evaluated based on its particular facts and circumstances” – 77 Fed. Reg. 48248 (discussing “commercial agreements” interpretation)
13
Interest rates vs. yield as a proxy for price of a security; U.S. Treasuries as exempt securities
• An executory exchange of payments based solely on an interest rate (e.g., fixed-for-floating swap based on LIBOR, or SOFR compounded in arrears) is a swap
• Consider a derivative based on the yield of a debt security, loan or narrow-based security index where yield is a proxy for the price of the security or loan
– Example: On a future date X, Party A will pay a fixed rate and Party B will pay the yield-to-maturity on date X of a specified debt security. (The instrument has no other underlying reference.)
– YTM = discount rate at which the sum of discounted scheduled cash flows is equal to the current price.
• The instrument is a security-based swap unless based on an exempted, non-muni security (as of the date of enactment of the Futures Trading Act of 1982)
• U.S. Treasury securities belong to this class of exempted securities; the forward YTM agreement described in the example above, if based on a U.S. Treasury security, is a swap (by construction, the agreement has no other underlying reference that is a non-exempted security)
• The agreement (with a U.S. Treasury underlier) is also a “security-based swap agreement” because “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” and it is not a security-based swap. See 77 F.R. 48293-9
14
Total Return Swaps on Loans (LTRS)
• A group or index of loans that are not securities (typical case) could not be a narrow-based securities index. 77 F.R. 48266
• The CFTC and SEC interpretation appears to assume LTRS terms such that the event- driven prong of the SBS definition is not relevant. In this case, a LTRS “based on” two or more non-securities loans is a swap and not a SBS. But see …
• Interpretation on aggregations of instruments executed at the same time but separately confirmed: each instrument must be analyzed separately. 77 F.R. 48267
– Master confirmations are cited as having the “same general structure” as such aggregations. Id. at n. 692, n. 886.
• Variable interest rate-based payments that “act merely as a financing component” would not cause a TRS that is a SBS to be characterized as a mixed swap.
– Financing terms may also involve adding/subtracting a spread, or calculating the financing rate in a currency other than that of the reference asset
– However, additional interest rate or currency exposures that are unrelated to the financing of the TRS, or that otherwise shift or limit risks related to the financing (e.g., rate cap), may cause the TRS to be a mixed swap. 77 F.R. 48264 – 65
15
Exclusion of Forwards on Nonfinancial Commodities
• The term “swap” does not include “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 CFTC interprets “nonfinancial commodity” to mean an “agricultural commodity” or “exempt commodity” that, in either case, can be physically delivered. 77 F.R. 48232
– An exempt commodity is a commodity that is not an agricultural commodity or an “excluded commodity.” CEA 1a(20). In general terms, an excluded commodity is a rate, currency, financial instrument, index, measure of economic or commercial risk, or contingency that, in any such case, meets criteria set out in CEA 1a(19).
• What about intangible commodities, such as renewable energy credits (RECs), emission allowances, etc.?
– Per CFTC interpretation, an intangible commodity is eligible for the forward exclusion if ownership can be conveyed in some manner and the commodity can be consumed
– Environmental commodities are consumed (e.g., by emitting pollutant, or retiring) “in order to comply with the terms of a mandatory or voluntary environmental program.” They “can be delivered through electronic settlement or contractual attestation.” 77 F.R. 48233-35
16
Swap vs. Forward: Optionality that Adjusts Price
• Per CFTC interpretation, an embedded option on the nonfinancial commodity will not cause an otherwise excluded forward contract to be considered a swap if the embedded option(s):
– are used to adjust the forward contract price, but do not undermine the overall nature of the contract as a forward;
– do not “target the delivery term,” so that actual delivery remains the predominant feature of the contract; and
– cannot be severed from and marketed separately from the overall forward contract. 77 F.R. 48237
• Examples
– Contract to buy regularly scheduled amounts at a floating price, subject to a cap or collar (delivery term unaffected)
– Contract under which the obligation to buy is contingent on the price of a different commodity reaching a specified level (not a price adjustment)
17
• Embedded volumetric optionality
– 7 factor test; problems determining intent; 2015 revision to clarify the 7th element:
– “The embedded volumetric optionality is primarily intended, at the time that the parties enter into the agreement, contract, or transaction, to address physical factors or regulatory requirements that reasonably influence demand for, or supply of, the nonfinancial commodity.” See 80 F.R. 28239 (May 18, 2015)
• Requirements contracts; renewal/evergreen provisions; optionality as to delivery points and dates. See 77 F.R. 48239 – 40.
• Lease-like transactions: rights to use transmission, transportation, or storage facilities
– Per CFTC interpretation, not an option if (1) the contract is for the usage of a specified facility rather than the purchase and sale of the commodity to be stored, (2) the contract grants the buyer the exclusive use of the facility (or a part of the facility) for its term and binds the seller to allow such use, and (3) the payment is for the actual use of the facility and not for an option to use the facility. See 77 F.R. 48242. “However, …”
– Issues with two-part fee structures: distinguishing a reservation fee from an option premium
– CFTC Office of General Counsel Response to FAQs (Nov. 14, 2012)
18
What is a commodity?
• CEA § 1a(9) defines “commodity” as “[an enumerated list of agricultural commodities], and all other goods and articles, … and all services, rights, and interests . . . in which contracts for future delivery are presently or in the future dealt in” [omitted text sets out an exception for onions and motion picture box office receipts or any index, measure, value, or data related to such receipts]
– The CFTC treats virtual currency as a commodity, not as foreign currency, and recent federal district court decisions have agreed (see McDonnell and My Big Coin Pay)
– 2 US futures exchanges self-certified bitcoin futures contracts in December 2017
– One of the issues considered in My Big Coin Pay was whether a virtual currency other than bitcoin satisfied the italicized language above. (The court rejected the CFTC’s argument that the relative clause modified only the last antecedent.)
19
Trade Options
• CFTC Regulations Part 32 exempt commodity option transactions from most swaps regulation, provided that:
– offeror is an ECP, or a commercial participant (a producer, processor, commercial user of, or merchant handling, the underlying commodity or byproducts) that is offering or entering into the commodity option solely for purposes of its business a such;
– offeror has a reasonable basis to believe the offeree meets the requirements of the exemption;
– offeree is a commercial participant, and such offeree is offered or entering into the commodity option solely for purposes of its business a such; and
– the commodity option is intended to be physically settled so that, if exercised, the option would result in the sale of an exempt or agricultural commodity for immediate or deferred shipment or delivery
• The obligations of non-dealers under Part 32 were simplified by amendments in March 2016, 81 F.R. 14966
• Trade options remain subject to Part 20 (large trader reporting), anti-fraud and anti-manipulation provisions, and if a swap dealer (SD) is a party Part 45 reporting by the SD (the non-SD is required to obtain an LEI and provide it to the SD), SD margin and capital, and certain other SD duties.
20
Commercial Agreements Interpretation
• Intended to “allow commercial and non-profit entities to continue to operate their businesses and operations without significant disruption”
• Non-exhaustive list of commercial agreements that will not be considered swaps (e.g., earn-outs or contingent value rights in M&A transactions, contingent obligations in securitizations based on failure of reps and warranties about the securitized assets, service contracts with escalation clauses)
• Common characteristics of the listed transactions:
– do not contain payment obligations, whether or not contingent, that are severable from the agreement, contract, or transaction;
– not traded on an organized market or over-the- counter; and
– 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
• other than for speculative, hedging, or investment purposes.
• If the particular arrangement does not meet all of the identified characteristics, it will be evaluated based on its particular facts and circumstances. 77 F.R. 48247-50
21
Form/label not controlling
• Documenting a transaction using an industry standard form agreement that is typically used for swaps and security-based swaps is not dispositive as to the status of the agreement as a swap or security-based swap, but it may be a relevant factor. 77 F.R. 48260
• Conversely, if the transaction satisfies the swap or security-based swap definitions, the fact that the parties refer to it by another name would not take it outside the Dodd-Frank Act regulatory regime
• This principle is consistent with CFTC and court decisions on futures contracts and securities, which have looked to the economic substance of an instrument. See 77 F.R. 48260 n.604
• The principle also appears in the CFTC’s anti-evasion rule, CFTC Regs. 1.3, paragraph (6) of the definition of “swap”:
– An agreement, contract, or transaction that is willfully structured to evade any provision of Subtitle A of the Wall Street Transparency and Accountability Act of 2010, including any amendments made to the Commodity Exchange Act thereby (Subtitle A), shall be deemed a swap for purposes of Subtitle A and the rules, regulations, and orders of the Commission promulgated thereunder
– The form, label, and written documentation of an agreement, contract, or transaction shall not be dispositive in determining whether the agreement, contract, or transaction has been willfully structured to evade as provided above
– However, no agreement, contract, or transaction structured as a security (including a security- based swap) shall be deemed a swap pursuant to the anti-evasion rule
22
(v) a corporation, partnership, proprietorship, organization, trust, or other entity—
(I) that has total assets exceeding $10,000,000;
(II) the obligations of which under an agreement, contract, or transaction are guaranteed or otherwise supported by a letter of credit or keepwell, support, or other agreement by an entity described in subclause (I), in clause (i), (ii), (iii), (iv), or (vii), or in subparagraph (C); or
(III) that—
(aa) has a net worth exceeding $1,000,000; and
(bb) enters into an agreement, contract, or transaction in connection with the conduct of the entity’s business or to manage the risk associated with an asset or liability owned or incurred or reasonably likely to be owned or incurred by the entity in the conduct of the entity’s business; …
But see the “further definition” in CFTC Regs. § 1.3 re: commodity pools, retail forex look-through, etc.
23
• Limitation on participation in off-exchange derivatives:
– “unlawful for any person, other than an eligible contract participant, to enter into a swap unless the swap is entered into on, or subject to the rules of, a board of trade designated as a contract market”, CEA § 2(e)
– corresponding prohibition for security-based swaps that are not effected on a registered national securities exchange, SEA § 6(l)
– prohibition on offers and sales of security-based swaps to persons who are not ECPs unless a registration statement is in effect as to the security-based swaps, Securities Act § 5(e). Securities Act Rule 135d (publication and distribution of quotations and research reports not deemed to constitute an offer if conditions of the rule are satisfied)
• CFTC Letter No. 12-17:
– swap guarantors, and jointly and severally liable counterparties, generally must be ECPs. (Market response: savings clauses and keepwells in credit agreements and ISDAs)
– No-action position for certain “anticipatory ECPs”
• ECP status used to define the scope of the retail foreign currency and retail commodity transaction regimes under CEA § 2(c)(2)(B) – (E).
24
Mayer Brown is a global services provider comprising associated legal practices that are separate entities, including Mayer Brown LLP (Illinois, USA), Mayer Brown International LLP (England), Mayer Brown (a Hong Kong
partnership) and Tauil & Chequer Advogados (a Brazilian law partnership) (collectively the “Mayer Brown Practices”) and non-legal service providers, which provide consultancy services (the “Mayer Brown Consultancies”).
The Mayer Brown Practices and Mayer Brown Consultancies are established in various jurisdictions and may be a legal person or a partnership. Details of the individual Mayer Brown Practices and Mayer Brown
Consultancies can be found in the Legal Notices section of our website. “Mayer Brown” and the Mayer Brown logo are the trademarks of Mayer Brown. © Mayer Brown. All rights reserved.
mayerbrown.comAmericas | Asia | Europe | Middle East