The Dawn of Dual Regulation for Private Funds and Advisors: SEC and CFTC Adopt Final Swap Product Definitions
Title VII of the Dodd-Frank Act (Title VII) established a comprehensive regulatory framework for the over-the-counter derivatives market. Recently, the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) jointly adopted final rules and interpretations that further define certain key terms under the Commodity Exchange Act (the CEA) and the Securities Exchange Act of 1934 (the ’34 Act), each as amended by Title VII. These definitions (the product definitions) effectively determine which derivatives transactions are subject to regulation by the SEC or the CFTC or, in some cases, both agencies.
For many private investment funds and advisors that utilize more than a de minimis amount of swaps and other commodity interests (as defined in the CEA) in their investment portfolios, these final rules will trigger an obligation to register with the CFTC as commodity pool operators (CPOs) and commodity trading advisors (CTAs) pursuant to previous CFTC rulemaking. For these purposes, the term “swaps” includes a wide range of instruments such as interest rate swaps, caps and collars, and currency and cross-currency swaps, as well as credit default swaps and total return swaps on broad-based security indexes (or multiple loans), among other types of transactions. It is expected that most funds and advisors will have until December 31, 2012 to register with the CFTC if they are not otherwise exempt.
General Framework for OTC Derivatives Regulation.
Under Title VII, the CFTC is given regulatory authority over “swaps” and the SEC is given regulatory authority over “security-based swaps.” Both agencies are given responsibility for prescribing regulations with respect to “mixed swaps.” Accordingly, the reforms of Title VII and all of the related derivatives rulemaking by the SEC and CFTC under the Dodd-Frank Act hinge on whether a particular transaction is a swap, a security-based swap or a mixed swap.
The statutory definition of “swap” is very broad. It includes any transaction having certain swap-like characteristics or which is otherwise commonly known as an interest rate swap; a rate floor cap or collar; a cross-currency rate swap; a basis swap; a currency swap; a foreign exchange swap; a total return swap; an equity index swap; an equity swap; a debt index swap; a debt swap; a credit spread; a credit default swap; a weather swap; an energy swap; a metal swap; an agricultural swap; an emissions swap or a commodity swap. The definition also includes any transaction that is, or in the future becomes, commonly known to the trade as a swap.
A number of transaction types are explicitly excluded from the term “swap” even if they otherwise fall within the definition of that term. Chief among those excluded items are “security-based swaps,” which are broadly defined as swaps based on a single security, a loan, a narrow-based group or index of securities or events relating to a single issuer or issuers of securities in a narrow-based security index. As mentioned above, security-based swaps fall within the SEC’s regulatory purview.
Interpretations of Statutory Definitions
In light of the broad wording of the statutory product definitions, and in response to comments received from a variety of financial market participants, the final rules release contains interpretations that explicitly exclude from the new product definitions certain transactions that have not previously been considered swaps or security-based swaps but might otherwise fall within such definitions. These interpretations provide, among other things, that:
- Various insurance products will not be treated as swaps or security-based swaps so long as the particular insurance product and/or its provider meets certain criteria.
- Certain consumer transactions entered into primarily for personal, family or household purposes, and certain customary commercial or business arrangements, such as interest rate caps or locks on mortgage loans, homeowners’ heating oil price caps or collars, fixed or variable interest rate mortgage loans, employment contracts, leases, service contracts and commercial agreements containing escalation clauses linked to an underlying commodity such as interest rates or a consumer price index, will not be treated as swaps or security-based swaps.
- Loan participations will generally not be treated as swaps or security-based swaps so long as they constitute a current or future direct or indirect ownership interest in the related loan or commitment, and meet certain other conditions set forth in the final rules.
- Security forwards such as sales of Fannie Mae, Freddie Mac and Ginnie Mae mortgage-backed securities in the “to-be-announced” market will not be treated as swaps or security-based swaps.
The release also contains interpretations to clarify that certain transactions explicitly fall within the scope of the new swap and/or security-based swap definitions. For example, swaps on interest rates or indexes, currency and cross-currency swaps, and swaps on futures will be treated as swaps, while swaps on securities futures will be treated as security-based swaps. Foreign exchange swaps and forwards will be treated as swaps, unless the U.S. Treasury issues a written determination that either or both should not be regulated as swaps. Swaps on rates or yields of U.S. Treasuries and other exempted securities (other than municipal securities) will be treated as swaps, but not security-based swaps. Swaps on prices or yields of foreign government securities will be treated as security-based swaps.
In connection with the final rules, the SEC and CFTC also issued an interpretation to clarify certain principles for determining whether particular types of transactions are swaps, security-based swaps or mixed swaps. As a general matter, the characterization of a particular type of transaction will be determined prior to execution but not later than when the parties offer to enter into the transaction, and that characterization will remain the same throughout the life of the transaction unless the transaction agreement is modified or amended in some material respect. In the case of a swap on a narrow-based security index, for example, that swap will remain a security-based swap for regulatory purposes regardless of whether the index migrates from a narrow-based index to a broad-based index during the life of the instrument.
The foregoing highlights only portions of the interpretive guidance provided in the final release with respect to various financial instruments, agreements and transactions. Because derivatives transactions are often highly engineered and may contain a number of different elements which themselves may constitute swaps or security-based swaps, close analysis will undoubtedly be required to determine the proper characterization of these transactions under the products definitions. In order to assist market participants in this analysis, the final rules also establish a process for parties to request a joint interpretation from the CFTC and SEC as to the proper characterization of a particular instrument (or class thereof) as a swap, security-based swap or mixed swap, although neither agency is under any obligation to do so.
Impact of Final Product Definitions on Private Funds
Following the date of publication of these final product definition rules in the Federal Register (the Publication Date), a number of other SEC and CFTC rules will take effect with respect to the OTC derivatives market on a phased-in basis, including mandatory registration of swap dealers and major swap participants, business conduct requirements, position limits and various recordkeeping and reporting requirements, among other things.
As mentioned above, one of the most significant consequences of these final product definitions rules for private investment funds and advisors is that any fund that engages in more than a de minimis amount of trading in swaps (and other commodity interests) will be required to register as a CPO with, and be subject to regulation by, the CFTC even if such fund does not otherwise trade a significant amount of other commodity interests. The advisor to any such fund may also have to register with the CFTC as a CTA unless (i) it does not generally hold itself out to the public as a commodity trading advisor, and it has provided commodity trading advice to no more than 15 persons in the preceding 12 months, or (ii) it is an SEC registered investment adviser whose business does not primarily consist of providing commodity trading advice and who does not act as advisor to any pool engaged primarily in the trading of commodity interests, or meets another applicable exemption.
Private investment funds should keep in mind that swaps are defined very broadly, as described above, and swaps utilized for hedging purposes are counted the same as speculative swaps for purposes of the de minimis exemption from CFTC registration. For example, in the case of credit default swaps on security indexes, which may frequently be used for hedging purposes, unless the swap is based on a narrow-based index of securities (or events relating to issuers of securities in a narrow-based security index), the swap will be subject to CFTC regulation and be treated as a swap that counts against the threshold for the de minimis exemption.
For more information regarding this alert, please contact Neil Casey (212.631.4414; firstname.lastname@example.org) in our New York office or Merritt Cole (215.864.7018; email@example.com) in our Philadelphia office.
 Title VII is otherwise known as the “Wall Street Transparency and Accountability Act of 2010.”
 If a fund (and advisor) that is relying on the de minimis exemption from CPO registration set forth in CFTC Rule 4.13(a)(3) is no longer entitled to rely on that exemption following the effective date of the final product definition rules (i.e. because swaps will be counted against the de minimis threshold), it will be required to make a notice filing with the CFTC and meet certain other requirements for no-action relief in order to be entitled to the December 31, 2012 deadline. Otherwise, its deadline for registration will be 60 days following such effective date. See CFTC Press Release PR6302-12 “CFTC’s Division of Swap Dealer and Intermediary Oversight Issues Time-Limited No-Action Relief to Certain CPOs and CTAs to Meet Registration and Compliance Obligations” dated July 13, 2012.
 Additionally, Title VII gives the SEC antifraud authority over and access to certain market information concerning “security-based swap agreements,” which are otherwise subject to CFTC regulation. Security-based swap agreements include swaps on broad-based security indexes and swaps on U.S. Treasury bonds and other exempted securities (other than municipal securities).
 Section 1(a)(47) of the CEA, which is cross-referenced in Section 3(a)(69) of the ’34 Act.
 Section 3(a)(68) of the ’34 Act, which is cross-referenced in Section 1a(42) of the CEA.
 In order to qualify for the de minimis trading exemption from registration (CFTC Rule 4.13(a)(3)), the fund must not be marketed as a “vehicle for trading in the commodity futures or commodity options market” and must meet one of the following two tests at all times: (i) the aggregate initial margin and premiums required to establish all “commodity interest” positions (including swaps and security futures products) determined at the time the most recent position was established do not exceed 5% of the liquidation value of the fund’s portfolio or (ii) the aggregate net notional amount of such positions, determined at the time the most recent position was established, does not exceed 100% of the liquidation value of the fund’s portfolio. For this purpose, liquidation value of a fund’s portfolio is calculated taking into account unrealized profits and losses (excluding the “in-the-money” amount of any option that is in-the-money at the time of purchase). In addition, fund investors must be “accredited investors” under Regulation D of the Securities Act of 1933 or meet certain other sophistication requirements.
 For this purpose, a corporation, partnership, limited liability company, trust or other legal organization that receives commodity interest trading advice based on its investment objectives rather than the individual investment objectives of its shareholders, partners, members or beneficiaries may be treated as a single person.
 In order to qualify as a narrow-based securities index, one of the following four criteria must be met: (i) the index has nine or fewer component securities; (ii) a component security compromises more than 30% of the index's weighting; (iii) the five highest weighted component securities in the aggregate comprise more than 60% of the index's weighting; or (iv) the lowest weighted component securities comprising, in aggregate, 25% of the index's weighting have an aggregate dollar value of average daily trading volume of less than $50 million (or in the case of an index with more than 15 component securities, $30 million).