Background Entity Definitions Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) provides for comprehensive regulation of the over-the-counter (“OTC”) derivatives markets, including regulation of swap dealers, security-based swap dealers, major swap participants and major security-based swap participants. These dealers and participants will be required to register with either or both the U.S. Commodity Futures Trading Commission (the “CFTC”) and the U.S. Securities and Exchange Commission (the “SEC,” and, together with the CFTC, the “Commissions”), depending on the categories of OTC derivatives in which they transact, and comply with business conduct, margin, capital, recordkeeping and reporting rules. Certain of these rules have been finalized, but many remain in proposal form. Title VII generally takes a bifurcated approach to the regulation, giving the CFTC jurisdiction over “swaps” and the SEC jurisdiction over “security-based swaps” while giving both Commissions jurisdiction over “mixed” swaps. Notwithstanding Dodd-Frank’s bifurcated approach to the regulation of OTC derivatives, Sections 712(a)(1) and 712(b)(1) require the Commissions to consult and coordinate with each other and other prudential regulators prior to commencing any rulemaking with respect to the OTC derivatives markets in order to assure regulatory consistency and comparability between the applicable rules and regulations promulgated by the two Commissions and other regulators.
Section 712(d)(1) of Title VII of Dodd-Frank addresses the regulation of OTC derivatives by mandating the Commissions, in consultation with the Federal Reserve Board, jointly to define further the terms “swap dealer,” “security-based swap dealer,” “major swap participant,” “major security-based swap participant” and “eligible contract participant” (the “Entity Definitions”). On December 1, 2010 and December 3, 2010, the CFTC and the SEC, respectively, held open meetings approving the joint proposal of the Entity Definitions.1 On April 18, 2012, the Commissions held separate open meetings to vote on whether to approve final Entity Definitions. By a vote of 5-0 of the SEC Commissioners and 4-1 of the CFTC Commissioners (with Commissioner O’Malia voting in the negative), the Commissions approved the final Entity Definitions. The text of the final Entity Definitions was made available on the Commissions’ websites on April 27, 2012.2 The final Entity Definitions will generally be effective 60 days after publication in the Federal Register.3
Title VII of Dodd-Frank also mandates that the Commissions jointly define the terms “swap,” “security-based swap” and “security-based swap agreement.” The Commissions have not yet publicly indicated when they will finalize these “product definitions.” However, given that these “product definitions” are central to the full implementation of Dodd-Frank, the completion of those rules is a high priority for both Commissions.
Although this Sidley Update addresses the “swap dealer,” “security-based swap dealer,” “major swap participant,” and “major security-based swap participant” definitions, it does not address in detail the registration or regulatory regimes applicable to entities that meet any of these definitions. The primary requirements that will apply to such entities include registration with the relevant Commission, capital and margin rules, reporting and recordkeeping obligations and internal and external business conduct rules.
Commodity Options On April 18, 2012, the CFTC also approved new rules with respect to the regulation of commodity options (the “Commodity Option Rule”).4 Under the existing CFTC rules, OTC commodity options are permissible only if they are transacted in accordance with conditions for so-called “trade options” that exempt them from being required to be traded on CFTC-regulated designated contract markets. Such conditions include that: (a) the commodity options may only be offered to producers, processors, commercial users or merchants handling the commodity which is the subject of the commodity option (or the products or byproducts thereof) and (b) such producer, processor, commercial user or merchant is entering into the commodity option transaction solely for business purposes. The current “trade option” rule has been rescinded and replaced with a similar exemption, as discussed below.
Section 721 of Dodd-Frank, which added new section 1a(47) to the Commodity Exchange Act (“CEA”), defines “swap” to include not only “any agreement, contract, or transaction commonly known as,” among other things, “a commodity swap,” but also includes “[an] option of any kind that is for the purchase or sale, or based on the value, of 1 or more . . . commodities[.]” Therefore, the Commodity Option Rule rescinds the existing Part 32 rules and adds a new Part 32 to the CFTC’s rules to make commodity options subject to the same regulatory regime that Dodd-Frank mandates for other types of swaps, allowing any person to transact commodity options on or subject to the rules of a CFTC-regulated designated contract market.
The new Commodity Option Rule also includes an interim final rule that will exempt commodity options that are intended to be physically-settled and are purchased by commercial users of the commodities underlying the options from certain Dodd-Frank requirements, similar to the existing “trade option” rule discussed above. The new “trade option” exemption is applicable to “exempt” commodities such as metals and energy commodities, as well as agricultural commodities. If the “trade option” is exercised, it must result in the physical-delivery of the commodity, either immediately or for deferred delivery. Pursuant to the interim final rule, physically-settled commodity options will only be subject to recordkeeping and reporting obligations, large trade reporting, position limits, swap dealers and major swap participants requirements and antifraud and antimanipulation regulations.
For purposes of the new Commodity Option Rule, the CFTC used the term “commodity option” to apply solely to commodity options not excluded from the swap definition set forth in CEA Section 1a(47)(A). The CFTC and the SEC will be publishing a definitions rulemaking to further define, among other things, the term “swap,” which will also address the determination of whether a commodity option or a transaction with “optionality” is subject to the swap definition in the first instance. If a commodity option or a transaction with optionality is excluded from the scope of the final swap definition to be published by the Commissions, the final Commodity Option Rule and/or interim final rule would no longer be applicable to such option or transaction.
Each party to an exempt “trade option” must comply with the CFTC’s Part 45 recordkeeping requirements and at least one party with the CFTC’s Part 45 reporting requirements. If neither party has previously been required to comply with the Part 45 reporting obligations, each party will be required to submit an annual filing to the CFTC by March 1 following the end of the calendar year in which the trade option was transacted, on new Form TO, the “Annual Notice Filing for Counterparties to Unreported Trade Options,” setting forth details of the trade option.
Although the Commodity Option Rule and the interim final rule will become effective on June 26, 2012, the compliance date will be 60 days after the publication by the CFTC and SEC of the definition of a “swap” and, with respect to any other specific swap rule that applies to commodity options because they are swaps, the compliance date will be the same as the compliance date for the other specific swap rule.
Swap Dealer and Security-Based Swap Dealer The definitions of “swap dealer” and “security-based swap dealer” adhere closely to the four-prong Dodd-Frank statutory text and include a person who:
- holds itself out as a dealer in swaps (or security-based swaps),
- makes a market in swaps (or security-based swaps),
- regularly enters into swaps (or security-based swaps) with counterparties as an ordinary course of business for its own account or
- engages in activity causing it to be commonly known in the trade as a dealer or market maker in swaps (or security-based swaps).
The Commissions explicitly describe the prongs as “disjunctive,” meaning that “dealer” characterization can be determined from a person engaging in any enumerated activity even if it does not engage in any of the others. The “dealer” definitions as adopted do not, however, seek to include a person that enters into swaps or security-based swaps “for such person’s own account, either individually or in a fiduciary capacity, but not as part of a regular business.”5
In general, a person that engages in activities of the types described above is required to register as a “swap dealer” with the CFTC, or as a “security-based swap dealer” with the SEC, unless such activities are limited to excluded or disregarded activities or to levels of activity falling beneath an applicable de minimis threshold. In other words, the onus is on the putative registrant, not with the relevant Commission, to initiate registration – subject of course to the authority of the Commissions to take enforcement actions in response to a person’s failure to register – if such person falls within the applicable definitional criteria. As contemplated in the December 2010 proposal, the Adopting Release sets forth final rules allowing a registrant to limit its dealer designation to specified categories of swaps or security-based swaps, or to specific activities within such categories. Registration with the CFTC as a swap dealer brings with it the requirement to become a member of a national futures association and to comply with the requirements of association membership, as well as the CFTC’s requirements applicable to swap dealers pursuant to Dodd-Frank rulemaking. SEC registration as a security-based swap dealer imports a comparable requirement to belong to and comply with the rules of a self-regulatory organization, along with adhering to the full range of the SEC’s applicable Dodd-Frank rules. Currently, the National Futures Association and the Financial Institution Regulatory Authority (FINRA) are respectively the only such organizations in existence in this regard.
As noted below, in the Adopting Release, the Commissions responded to commenters not by altering the Dodd-Frank definitions’ text in the Entity Definitions themselves but rather (1) by conditionally excluding certain specified varieties of swap or security-based swap activity from consideration in determining whether a person is a swap dealer or security-based swap dealer, (2) by raising substantially certain of the originally proposed de minimis threshold amounts, both during a temporary phase-in period aimed at allowing for staff study and thereafter (in each case subject to specified conditions and to refinement pursuant to final Commission rulemaking), (3) by clarifying further how a person can limit the scope of its registration and (4) by providing guidance in the Adopting Release, considerably greater detail than previously on the interpretive questions of “holding out,” “commonly known,” “market making” and “not as part of a regular business” and on the distinction between “dealers” and “traders.”
Excluding Insured Depository Institutions from the “Swap Dealer” Definition for Swaps in Connection with Loan Origination Taking its cue from the Dodd-Frank statutory exclusion from the defined term “swap dealer” for an insured depository institution (“IDI”) “to the extent that it offers to enter into a swap with a customer in connection with originating a loan with that customer,” the Adopting Release provided clarification on the circumstances in which swaps entered into by an IDI with customers will not be considered in making a swap dealer determination. Swaps of IDIs that will not be taken into account in such a determination will be required to meet the following conditions:
- the IDI enters into the swap with the customer no earlier than 90 days before and no later than 180 days after the date of execution of the applicable loan agreement, or no earlier than 90 days before and no later than 180 days after any transfer of principal to the customer by the IDI pursuant to the loan;
- either the notional item underlying the swap is, or is directly related to, a financial term of such loan (including the loan’s duration, rate of interest, the currency or currencies in which it is made and its principal amount) or the swap is required, as a condition of the loan under the IDI’s loan underwriting criteria, to be in place in order to hedge price risks incidental to the borrower’s business and arising from potential changes in the price of a commodity (other than an excluded commodity);
- the duration of the swap does not extend beyond termination of the loan;
- the IDI is either (1) the sole source of funds to the customer under the loan; (2) committed under the loan agreement to be the source of at least 10 percent of the maximum principal amount under the loan or (3) committed under the loan agreement to be the source of a principal amount that is greater than or equal to the aggregate notional amount of all swaps entered into by the IDI with the customer in connection with the financial terms of the loan;
- the aggregate notional amount of all swaps entered into by the customer in connection with the financial terms of the loan is, at any time, not more than the aggregate principal amount outstanding under the loan at that time;
- if the swap is not accepted for clearing by a derivatives clearing organization, the IDI reports the swap as required (absent an exception from such reporting);
- “origination” of the relevant loan by the IDI is demonstrated through its direct transfer of the loan amount to the customer, its participation in a syndicate of lenders that is the source of the loan amount that is transferred to the customer, its purchase or receipt of a participation in the loan or its otherwise being the source of funds that are transferred to the customer pursuant to the loan or any refinancing of the loan and
- the loan is not a sham and is not a synthetic loan such as a loan credit default swap or loan total return swap.
As with the other transactional exclusions, the IDI loan-related swap exclusion is not a general exemption from registration applicable to IDIs: it merely removes from view all swaps of the IDI that fall within its conditions in determining whether the IDI is a swap dealer subject to the registration and other requirements of Dodd-Frank. Importantly, there is no analogous provision in the Adopting Release for security-based swaps offered by IDIs to customers in connection with lending activities to be disregarded in determination of whether the IDI is a security-based swap dealer.
Disregarding Swaps between Majority-Owned Affiliates and Certain Swaps between Cooperatives and Their Members The final “dealer” definitions set forth in the Adopting Release including a provision (also applicable to certain aspects of the major participant definitions as described below) under which a person’s swaps with majority-owned affiliates will not be considered in the dealer determination. In addition, the final definition of “swap dealer” (but notably not that of “security-based swap dealer,” and also in neither of the final major participant definitions) similarly provides that swaps between a cooperative and its members are not considered in the swap dealer determination, subject to reporting, monitoring and risk management requirements and limitation as to type (to swaps on commodities that are not “excluded commodities,” where the cooperative is an association of producers).
Disregarding Certain Swaps that Hedge Physical Positions The Adopting Release includes provisions in the “swap dealer” definition to the effect that swaps entered into for hedging physical positions (as defined) are excluded from the swap dealer determination. Note that there is no comparable exclusion for any security-based swaps that might be thought analogous to physical position hedging swaps from the security-based swap dealer determination. Note also that there is no Dodd-Frank statutory provision supporting a generalized carve-out from “dealer” treatment for activity constituting hedging or mitigating commercial risks and the December 2010 proposal contained no such provision. Pursuant to an interim final rule as set forth in the Adopting Release, and thus allowing for additional comment on the provision, the CFTC sought to exclude certain hedging swap activity – both in relation to the de minimis exception as described below and more generally in relation to the swap dealer determination. Under this CFTC rule, the swap dealer determination for any person will not take a swap into account if:
- the swap is for the purpose of offsetting or mitigating the person’s price risks that arise from the potential change in the value of one or several (a) assets that the person owns, produces, manufactures, processes or merchandises or anticipates owning, producing, manufacturing, processing or merchandising; (b) liabilities that the person owns or anticipates incurring or (c) services that the person provides, purchases or anticipates providing or purchasing;
- the swap represents a substitute for transactions made or to be made or positions taken or to be taken by the person at a later time in a physical marketing channel;
- the swap is economically appropriate to the reduction of the person’s risks in the conduct and management of a commercial enterprise;
- the swap is entered into in accordance with sound commercial practices and
- the person does not enter into the swap in connection with activity structured to evade designation as a swap dealer.
The CFTC’s interim final rule disregarding swaps to hedge physical positions notably does not incorporate the bona fide hedging provisions of its position limit rule.6 Nevertheless, it draws upon the language in the CFTC’s position limit rule concerning bona fide hedging. The interim final rule is also, by its terms, a safe harbor, but only insofar as all of its conditions are met: a broader (or more principles-based) exclusion would not serve the statutory purposes of the “swap dealer” definition. For this reason, the exclusion of all swaps that hedge or mitigate commercial risk for certain aspects of the major swap participant definition was determined by the CFTC not to be appropriate in the context of the swap dealer definition, with the result that the meanings and contours of the term “hedging” have proliferated under Dodd-Frank rulemaking.7 Consistent with the interim final rule, then, broad “hedging activity” not falling within the confines of physical position hedging remains relevant, among many other factors, in determining whether a party is a swap dealer. The CFTC chose to implement its physical position hedging swap exclusion, with language that focuses on the purpose or intent behind a swap, rather than its effect, on an interim basis in view of the wide range of comments regarding the implications of hedging for dealing activity that were received after the December 2010 proposal, and to allow for adjustments to either the rule or the CFTC’s related interpretive guidance to be made more easily in light of further comments and experience with the rule.
Disregarding Swaps Entered into by Floor Traders, as Floor Traders One major area of comment upon the Commissions’ December 2010 proposal was the apparent requirement for certain commodity trading businesses (including the trading operations of international major energy companies, food companies, chemical companies and power producers, as well as independent commodity trading firms) to register as swap dealers. From the outset, however, both Commissions were eager to distinguish “dealing” activity in the derivatives markets from “trading,” as the SEC has historically done in relation to activity in the securities markets.
One specific outgrowth of both the CFTC’s expressed policy intentions in this regard and the many comments submitted by potentially affected firms was the addition, in relation to the swap dealer definition but not in relation to the security-based swap dealer definition, of terms under which certain swaps of “floor traders” are not considered in the swap dealer determination. Swaps a person enters into “in its capacity as a floor trader” are not considered in such determination if the person:
- is registered with the CFTC as a floor trader pursuant to its applicable rule;
- enters into swaps with proprietary funds for that trader’s own account solely on or subject to the rules of a designated contract market or swap execution facility and submits each such swap for clearing to a derivatives clearing organization;
- is not an affiliated person of a registered swap dealer;
- does not directly, or through an affiliated person, negotiate the terms of swap agreements, other than price and quantity or to participate in a request for quote process subject to the rules of a designated contract market or a swap execution facility; 8
- does not directly or through an affiliated person offer or provide swap clearing services to third parties;
- does not directly or through an affiliated person enter into swaps that would qualify as hedging physical positions under the safe harbor summarized above or hedging or mitigating commercial risk pursuant to the “hedging” definitional rule associated with the major swap participant definition (except for any such swap executed opposite a counterparty for which the transaction would qualify as a bona fide hedging transaction);
- does not participate in any market making program offered by a designated contract market or swap execution facility and
- notwithstanding the fact such person is not registered as a swap dealer, such person complies with the recordkeeping and risk management requirements of CFTC Rules §§ 23.201, 23.202, 23.203 and 23.600 with respect to each such swap “as if it were a swap dealer.”9
De Minimis Exception to “Swap Dealer” and “Security-Based Swap Dealer” Designation The Dodd-Frank definitions of “swap dealer” and “security-based swap dealer” mandate that the Commissions establish exceptions from designation as a “swap dealer” or “security-based swap dealer” for any entity that engages in a de minimis quantity of dealing in connection with transactions with or on behalf of customers. In the December 2010 proposal, the Commissions concluded that the de minimis exceptions should address dealing activity sufficiently small that the dealer regulations attendant to registration are not warranted. In the Adopting Release, the Commissions noted that the de minimis exceptions also further interests of regulatory efficiency and that notions of cost-benefit analysis support the de minimis exceptions.
The de minimis exceptions in the December 2010 proposal included three necessary factors to qualify for such exceptions: (i) the aggregate effective amount, measured on a gross basis, of swaps or security-based swaps entered into by a party could not exceed $100 million, or $25 million with regard to “special entities” (federal agencies, states, state agencies, ERISA and governmental plans); (ii) a party could engage in dealing activity with no more than 15 counterparties and (iii) the party’s dealing activity would be limited to no more than 20 swaps or security-based swaps.
While the exceptions in the final rules set forth in the Adopting Release follow the proposed exceptions by including a cap on the aggregate gross notional amount of swaps or security-based swaps using, in general, 12-month look-back period, the threshold amounts in the final rules were increased to $3 billion for swaps, $3 billion for credit default swaps that constitute security-based swaps (generally speaking, single-name credit default swaps) and $150 million for all other security-based swaps. The Commissions opted not to raise the $25 million threshold amount with regard to “special entities.” The Commissions further opted to retain proposed text that clarifies that, if the stated notional amount of a swap or security-based swap is leveraged or enhanced by its structure, the calculation with respect to the party is to be based upon the transaction’s “effective notional amount” rather than its stated notional amount.10 However, the Commissions transitionally provided for a look-back period of the lesser of 12 months and the period of time following effectiveness of the rules, rather than over the prior 12 months under the December 2010 proposal. The final rules clarify that a party must include swaps and security-based swaps entered into by affiliates for purposes of calculating the gross notional amounts – a clarification intended to prevent evasion of registration through the establishment of affiliates and division of business among them. The Adopting Release also clarifies that the de minimis exceptions generally apply to “dealing activities,” rather than all transactions (particularly including hedging and proprietary trading). However, the Commissions’ approaches to the inclusion of swaps or security-based swaps executed as hedges or proprietary trades in connection with dealing activity differ: for the security-based swap exception, the hedge or proprietary trading position would count toward the threshold, while for the swap exception, the hedge or proprietary trading position would not count toward the threshold.11
The Commissions also included phase-in periods during which the thresholds for gross notional amounts, other than the $25 million threshold with regard to “special entities” necessary to qualify for the de minimis exceptions will be higher, so as to promote an orderly transition for the market.12 During the phase-in period, the thresholds are $8 billion with respect to swaps, $8 billion with respect to credit default swaps that constitute security-based swaps and $400 million with respect to all other security-based swaps. Both Commissions’ phase-in periods commence on the effective date of the final rules. In the case of the CFTC, a 30-month period is provided for staff data study and reporting on “swap dealer” definitional topics and the de minimis threshold, including in principle the level of the notional amount threshold, the factors for identifying swap dealing activity (including the dealer-trader distinction), the potential use of objective tests or safe harbors, the exclusion of certain types of swaps from “dealer” analysis, potential alternative approaches to the de minimis exception and other topics deemed relevant by the CFTC staff. In the case of the SEC, the period allowed for data study and reporting by the staff is extended to three full years, but the reportable topics are more wide-ranging, and include issues relevant to “major security-based swap participant” determination, not just “dealer” analysis. Nine months after the publication of the reports by the respective Commission staff as required by the final rules, such Commission must either terminate the phase-in period or determine that it is necessary or appropriate to propose alternative thresholds (in which case the phase-in period will terminate). If a phase-in period is not terminated by the relevant Commission, the phase-in period will automatically terminate either (x) as to swap dealer determination, five years after the date that a swap repository first receives swap data in accordance with the CFTC’s final rule or (y) as to security-based swap dealer determination, five years after the “data collection initiation date” (i.e., the last compliance date for registration as a security-based swap dealer or major security-based swap participant, or the first date on which compliance with trade-by-trade reporting for credit-related and equity-related security-based swaps to a registered security-based swap data repository is required).
The Commissions opted not to retain the proposed cap on number of counterparties or the proposed cap on the number of swaps or security-based swaps which a party may execute under the de minimis exceptions.
The Adopting Release also includes some additional transitional clarifications in this regard. First, a party registered as a dealer may apply to withdraw its registration with the relevant Commission while continuing to engage in dealing activity in reliance on a de minimis exception, as long as the party has been registered as a dealer for at least 12 months and satisfies the conditions of the applicable de minimis exception. Second, a party that has not registered as a dealer by virtue of the applicable de minimis exception but that no longer can take advantage of such exception, must register with the relevant Commission within two months of the first month-end after no longer being able to rely on the applicable exception. Lastly, the final rules clarify that a party which meets the criteria of either de minimis exception may choose to voluntarily register as a swap dealer or security-based swap dealer nonetheless.
Limited Purpose Designation as a Dealer As a general rule, a person who is a swap dealer or security-based swap dealer is deemed to be such a dealer with respect to each swap or security-based swap it enters into, regardless of the category of the swap or security-based swap or the person’s activities in connection therewith. However, under the final rules, the relevant Commission may limit the registrant’s designation as such a dealer to specified transaction types or activities. The CFTC’s final rule elaborates further, providing for making (limitative) application to the CFTC, for CFTC determination and for effectiveness of CFTC designation of relevant limitations in this regard, and allowing for limitative applications to be made at the same time as or after an original registration as a swap dealer. The CFTC’s final rule, while providing additional detail as described above, is to substantially the same effect as the December 2010 proposal in this connection, as is the SEC’s analogous final rule.
General Interpretive Guidance The Commissions had listed several distinguishing characteristics of swap dealers and security-based swap dealers in the December 2010 proposal, including that:
- dealers tend to accommodate demand for swaps and security-based swaps from other parties;
- dealers are generally available to enter into swaps or security-based swaps to facilitate other parties’ interest in entering into those instruments;
- dealers tend not to request that other parties propose the terms of swaps or security-based swaps; rather, dealers tend to enter into those instruments on their own standard terms or on terms they arrange in response to other parties’ interest and
- dealers tend to be able to arrange customized terms for swaps or security-based swaps upon request, or to create new types of swaps or security-based swaps at the dealer’s own initiative.
Dealer – Trader Distinction In the Adopting Release, the Commissions drew substantially upon the SEC’s “dealer – trader distinction” in describing dealer attributes. For purposes of the Securities Exchange Act of 1934, as amended (“Exchange Act”), in relation to securities market regulation, the SEC has long sought to identify the type of market participant that is a “dealer,” as opposed to a trader that buys and sells securities for its own account “with some frequency.”13 That (securities) dealers are required by the Exchange Act to register as such with and be regulated by the SEC, while traders are not, makes the dealer – trader distinction appealing from the perspective of the Commissions as they seek to delineate their regulatory reach. Nevertheless, the Commissions acknowledged in the Adopting Release that the analogy from cash securities markets to derivative markets is imperfect: the latter are marked by less activity than markets involving certain types of securities. In derivative transactions, there is no separate “issuer” whose obligations or ownership interest is exchanged – each party is in essence an “issuer.” In derivative markets, electronic trading systems (other than certain futures and options exchanges) have yet to take hold, in contrast to some cash securities markets. Crucially, in most (uncleared) over-the-counter derivatives, the parties remain obligated to exchange cash flows with each other long after the transaction is executed, while in cash markets mutual obligations terminate upon settlement. However, in advancing the dealer – trader distinction for both swaps and security-based swaps, the Commissions sought to apply the Dodd-Frank statutory provisions in an effective and logical way. In the Adopting Release the Commissions cite the following Dodd-Frank policy aims:
- advancing financial responsibility (e.g., the ability to satisfy obligations, and the maintenance of counterparties’ funds and assets) associated with dealing activities;
- protecting counterparties and
- promoting market efficiency and transparency.
The Dodd-Frank statutory framework has led the Commissions to seek to apply a dealer – trader distinction in order to identify the persons that should be regulated either due to the nature of their interactions with counterparties or to promote market stability and transparency in light of such persons’ market roles.
The Commissions put forward several closely comparable factors that serve to identify persons as swap dealers or security-based swap dealers:
Swap Dealer FactorsSecurity-Based Swap Dealer FactorsProviding liquidity by accommodating demand for or facilitating
interest in swaps, holding oneself out as willing to enter into
swaps (independent of whether another party has already
expressed interest), or being known in the industry as being
available to accommodate demand for swaps Advising a counterparty as to how to use swaps to meet the
counterparty’s hedging goals, or structuring swaps on behalf
of a counterparty Having a regular clientele and actively advertising or soliciting
clients in connection with swaps Acting in a market maker capacity on an organized exchange
or trading system for swaps Helping to set the prices offered in the swap market (such as
by acting as a market maker) rather than taking those prices
(although the fact that a person regularly takes the market price
for its swaps does not foreclose the possibility that the person may be a swap dealer) Providing liquidity to market professionals or other persons in connection with security-based swaps Seeking to profit by providing liquidity in connection with security-based swaps Providing advice in connection with security-based swaps or structuring security-based swaps Presence of regular clientele and actively soliciting clients Use of inter-dealer brokers Acting as a market maker on an organized security-based swap exchange or trading system
As well, the Adopting Release advanced the Commissions’ positions that (i) a willingness to enter into swaps (or security-based swaps) on either side of the market is not a prerequisite to dealer status; (ii) the dealer analysis does not turn on whether a person’s dealing activity constitutes that person’s sole or predominant business; (iii) a customer relationship is not a prerequisite to dealer status; and (iv) in general, transacting in the market for the purpose of hedging, absent other activity, is unlikely to be indicative of dealing.
Naturally, whether a person is acting as a dealer will turn upon all of the relevant facts and circumstances, as informed by the interpretive guidance set forth in the Adopting Release.
Other “Dealing” Criteria The Commissions specifically sought to provide additional guidance on the interpretive questions of “holding out,” “commonly known,” “market making” and “not as part of a regular business:”
- “Holding out” and “commonly known:” As was apparent in the December 2010 proposal, self-identification as a dealer (including ISDA membership in the category of “Primary Members”) is one key hallmark of dealing activity, as is identifiability as a dealer by other market participants, and the identifying traits that a person employs or that market participants associate with a person “should not be considered in a vacuum, but should instead be considered in the context of all [its] activities.”
- “Market making:” Although commenters had sought to categorize various business patterns as either indicative of or inconsistent with market making, the Commissions broadly clarified that market making means “routinely” (but not necessarily continuously) “standing ready to enter into swaps at the request or demand of a counterparty.” The Commissions proceeded to specify inclusively that routinely:
quoting bid or offer prices, rates or other financial terms for swaps on an exchange; responding to requests made directly, or indirectly through an interdealer broker, by potential counterparties for bid or offer prices, rates or other similar terms for bilaterally negotiated swaps; placing limit orders for swaps or receiving compensation for acting in a market maker capacity on an organized exchange or trading system for swaps is activity indicative of market making. The Commissions went on to mention that the framework for distinguishing dealers from traders (discussed more fully below) may be usefully applied in interpreting activities of these four types, further asserting that market making need not be two-way in order to signify dealing activity, and that to disregard on-exchange trading of swaps both would be inconsistent with Dodd-Frank and would not address the important consideration of readiness to enter swaps (versus being aware of prospective counterparties’ identities).
- Not part of “a regular business:” The Commissions stated that the terms “ordinary course of business” and “a regular business” are “essentially synonymous” for the purpose of the “swap dealer” definition. The Commissions posited that whether a dedicated subsidiary, division, department or trading desk is maintained, or whether swap dealing business is a person’s “primary” or merely an “ancillary” business, is not necessarily important to determining a person to be a dealer – “so long as the person’s swap dealing business is identifiable.” Entering into swaps to meet the business or risk management needs of a counterparty, maintaining a separate profit and loss statement for swap activity, or treating swap activity as a profit center, or allocating staff and resources to “dealer-type activities with counterparties” (such as credit analysis, customer onboarding, document negotiation, confirmation generation, requesting novations and amendments, monitoring exposure and collateral, monitoring covenant compliance and reconciliation of trade discrepancies) would indicate a regular dealing business. These counterparty- or customer-oriented elements were explicitly incorporated in the Commissions’ interpretation of the definitional rule. The Commissions declined to adopt a per-se exclusion, for persons in a physical commodity business, of swaps entered into in connection with that business, while expressing the belief that in most cases such swap activity is not dealing activity. Because the Commissions see the use of swaps to be evolving, particularly looking forward to the period after initial Dodd-Frank implementation has run its course, they concluded that adopting per-se exclusions would be inappropriate.
Noting that the statutory definition is functional and encompasses how a person holds itself out in the market, in the December 2010 proposal the Commissions had stressed that their interpretive approach should not be constrained or overly technical. This emphasis on “activities,” rather than “entity classification,” was carried through to the final “dealer” definitions set forth in the Adopting Release – an aspect that was of considerable importance to CFTC Commissioner O’Malia, whose dissenting Statement for the Federal Register provided a counterpoint in this respect to the Statement of CFTC Chairman Gensler. The interpretive guidance provided by the CFTC and the SEC in the Adopting Release is understandably similar and codependent in some respects, but the Adopting Release makes clear that the interpretation of each Commission may differ from that of the other as regards the persons subject to its respective jurisdiction14 and indeed is not binding upon the other and, in the case of the SEC, is entirely distinct from the interpretation of the term “dealer” under the Exchange Act.
Major Swap Participant and Major Security-Based Swap Participant The final definitions of “major swap participant” and “major security-based swap participant” (together “Major Participants”) focus on the market impacts and risks associated with a person’s swap and security-based swap positions, in contrast to the swap dealer and security-based swap dealer definitions, which focus on a person’s activities and account for the amount or significance of those activities only in the context of the de minimis exception. Nevertheless, persons that qualify as major swap participants or major security-based swap participants will be subject to a regulatory regime that is substantially similar to the regulatory regime applicable to swap dealers and security-based swap dealers.
The final Major Participant definitions will capture any entity that is not a swap dealer or security-based swap dealer, and that meets one of the following tests:
- the entity maintains a “substantial position” in any “major category” of swaps or security-based swaps, excluding positions held for hedging or mitigating commercial risk and positions maintained by certain employee benefit plans for hedging for mitigating risks in the operation of the plan;
- the entity has outstanding swaps or security-based swaps that create “substantial counterparty exposure” that could have serious adverse effects on the financial stability of the United States banking system or financial markets and
- any “financial entity” that is “highly leveraged” relative to the amount of capital such entity holds and that is not subject to capital requirements established by an appropriate Federal banking agency and that maintains a “substantial position” in any of the major swap or security-based swap categories.
Although the three-prong test above is derived from the statutory definitions of “major swap participant” and “major security-based swap participant” under Dodd-Frank, the final Entity Definitions refine and elaborate on the statutory definitions in a number of important ways. In the Adopting Release, the Commissions addressed the following: (1) the “major categories” of swaps and security-based swaps, (2) the meaning of “substantial position,” (3) the meaning of “hedging or mitigating commercial risk,” (4) the meaning of “substantial counterparty exposure,” and (5) the meanings of “financial entity” and “highly leveraged.” In most respects, the final Major Participant definitions are highly similar to the versions that were initially proposed by the Commissions.
Major Categories The final Entity Definitions include four major categories of swaps and two major categories of security-based swaps. Major swap participants and major security-based swap participants are permitted to apply to the Commissions to be designated as such with respect to only specific major categories. If such limited designation is approved, the limited designation major swap participant or major security-based swap participant will be deemed to be a major participant with respect to each swap or security-based swap category or categories for which it is so designated, regardless of the market participant’s activities in connection with such category or categories of swaps.
Major swap categories:
- Rate swaps – any swap which is primarily based on one or more reference rates, including any swap of payments determined by fixed and floating interest rates, currency exchange rates, inflation rates or other monetary rates, any foreign exchange swap and any foreign exchange option other than an option to deliver currency.
- Credit swaps – any swap that is primarily based on instruments of indebtedness, including any swap primarily based on one or more broad-based indices related to debt instruments or loans, and any swap that is an index credit default swap or total return swap on one or more indices of debt instruments.
- Equity swaps – any swap that is primarily based on equity securities, including any swap based on one or more broad-based indices of equity securities and any total return swap on one or more equity indices.
- Other commodity swaps – any swap that is not included in the rate swap, credit swap or equity swap categories.
Major security-based swap categories:
- Debt security-based swaps – any security-based swap that is based on one or more instruments of indebtedness (including loans), or on a credit event relating to one or more issuers or securities, including any security-based swap that is a credit default swap, total return swap on one or more debt instruments, debt swap, debt index swap or credit spread.
- Other security-based swaps – any security-based swap that is not in the debt security-based swap category.
Substantial Positions The Commissions have set the thresholds at which a market participant’s position in any major category of swap or security-based swap will be considered a “substantial position.” As required by Dodd-Frank, these thresholds were set at the levels that the Commissions deemed “prudent for the effective monitoring, management, and oversight of entities that are systematically important or can significantly impact the financial system of the United States.” Under the final Entity Definitions, a person will be considered to have a “substantial position” in a major swap or security-based swap category if the person meets either of the following tests:
- daily average aggregate uncollateralized outward exposure (i.e., “current exposure”) of $1 billion in any major category ($3 billion for rate swaps) or
- current exposure plus daily average aggregate potential outward exposure (i.e., “potential exposure”) of $2 billion in any major category ($6 billion for rate swaps).
The thresholds adopted by the Commissions are unchanged from the proposed Entity Definitions and the Commissions have indicated that they believe they are sufficiently high that only a small number of non-dealer entities are likely to be deemed to be major swap or security-based swap participants. The thresholds are to be calculated as arithmetic daily means, using each business day within the calendar quarter as data points.
Current Exposure The Commissions’ tests for current exposure require a person to aggregate its current exposure, obtained by marking-to-market using industry standard practices, of each swap and security-based swap position with negative value in a major category, and to deduct the value of the collateral the person has posted in connection with those positions. In calculating current exposure, a person is required to, with respect to each of its swap and security-based swap counterparties in a given major category, determine the dollar value of the aggregate current exposure arising from each of its swap positions with negative value (subject to netting, as described below) in that major category by marking-to-market using industry standard practices, and to deduct from that dollar amount the aggregate value of the collateral the person has posted with respect to the positions. The aggregate uncollateralized outward exposure is the sum of those uncollateralized amounts across all of the person’s counterparties in the applicable major category.
Netting of current exposures is permitted in calculating current exposure if the person has one or more master netting agreements in place with a particular counterparty. Calculation of net exposure may take into account offsetting positions entered into with that particular counterparty involving swaps or security-based swaps (in any major category) as well as securities financing transactions (consisting of securities lending and borrowing, securities margin lending and repurchase and reverse repurchase agreements) and other financial instruments that are subject to netting offsets for purposes of applicable bankruptcy law, if and to the extent these are consistent with the offsets permitted by the relevant master netting agreement(s). If current exposure is calculated on a net basis with a particular counterparty, the final rules provide a formula for allocation of the resulting net exposure to each of the major categories for purposes of analyzing whether the person has a substantial position. The addition of this formula represents a change from the proposed Entity Definitions.
Potential Exposure The Commissions’ tests for determining potential exposure require a person to calculate outward exposure in each major category as the aggregate of two amounts. First, the potential exposure for each of the person’s swap or security-based swap positions in a major category that are not subject to daily mark-to-market margining and are not cleared by a registered or exempt clearinghouse. For such positions, potential exposure equals the notional principal amount, multiplied by specified conversion factors on a position-by-position basis, reflecting the type of swap or security-based swap and the remaining maturity of the position. Certain pre-paid or fully-satisfied obligations and obligations that are supported by dedicated cash collateral may be excluded from these calculations. The rules also cap the potential exposure associated with positions by which a person buys credit protection under a CDS and purchases of options with remaining payment obligations at the net present value of unpaid premiums under such agreements. Further adjustments based on bank capital rules are to be made with respect to positions with counterparties where there are master netting agreements in place, with the result of multiplying the exposure of such positions by between 0 and 0.60, depending on the effect of the netting agreement.
Second, the potential exposure for each of the person’s swap and security-based swap positions in such major category that are either subject to daily mark-to-market margining or are cleared by a registered or exempt clearing agency or derivatives clearing organization. The amount of potential exposure with respect to such positions is the number that would be calculated under the immediately preceding bullet point, adjusted by a multiplier of 0.1 with respect to cleared positions and 0.2 for positions that are subject to daily mark-to-market margining, but not clearing.
Note that, unlike with respect to current exposure, the calculation of potential exposure is not reduced to reflect positions that are fully collateralized. However, due to the significant reduction in potential exposure for positions subject to mark-to-market margin, the inclusion of fully collateralized positions is nevertheless unlikely to trip the applicable thresholds for the majority of market participants.
Hedging or Mitigating Commercial Risk The first prong of the Major Participant tests excludes from the current exposure and potential exposure tests those positions that are “held for hedging or mitigating commercial risk.” Whether or not a position qualifies as a hedge under this standard is not relevant for the second or third prongs of the definitions. The determination of whether a swap or security-based swap is entered into to “hedge or mitigate commercial risk” is a facts and circumstances determination that takes a market participant’s overall hedging and risk mitigation strategies into account and is made at the time a position is entered into.
Substantial Counterparty Exposure The final definition of “substantial counterparty exposure” uses the same calculation methodology as the definition of “significant position,” except that the “substantial counterparty exposure” test must be calculated with respect to all swaps positions in the aggregate and all security-based swap positions in the aggregate. Furthermore, the calculation must include all positions, including those held for the purpose of hedging or mitigating commercial risk. Under the final rules, a person will be deemed to have substantial counterparty exposure if that person has $5 billion in current exposure to swaps, $8 billion in current plus potential exposure in swaps, $2 billion in current exposure to security-based swaps or $4 billion in current exposure plus potential exposure to security-based swaps.
Highly Leveraged Financial Entities A financial entity that is “highly leveraged,” not subject to prudential capital requirements, and maintains a “substantial position” in any of the major swap or security-based swap categories is required to register as a major swap or security-based swap participant. Under the final rules, to be deemed to be “highly leveraged,” the entity must meet a ratio of total liabilities to equity of 12 to 1, to be determined in accordance with U.S. Generally Accepted Accounting Principles. Among those entities considered “financial entities” are commodity pools, hedge funds, certain employee benefit plans and entities predominantly engaged in activities that are in the business of banking of financial in nature. Employee benefits plans are allowed to exclude obligations to pay benefits to plan participants from their calculation of liabilities and substitute instead the total value of plan assets for equity.
Application to Inter-Affiliate Swaps and Security-Based Swaps Under the final definitions of major swap participant and major security-based swap participant, the Commissions determined to exclude from consideration a person’s swaps and security-based swaps for which the counterparty is a majority-owned affiliate. Market participants may enter into such transactions for a variety of reasons, including allocation of risk within a corporate group, and such transactions do not pose the same likelihood of risk to the broader markets as transactions with third parties. Under the proposed rules, the Commissions had proposed to exclude only those swaps or security-based swaps between wholly-owned affiliates, but they expanded the exclusion for affiliate transaction to include transactions with majority-owned affiliates in response to comments on the proposal.
Timing Requirements A person that is not currently registered as a major swap participant or major security-based swap participant, but that meets the criteria described above as a result of its swap or security-based swap activities in a fiscal quarter, will not be deemed to be a major swap or security-based swap participant until the earlier of the date on which it submits a complete application for registration, or two months after the end of that quarter. Furthermore, if a person that is not currently registered as a major swap or security-based swap participant meets the criteria described above to be considered a major swap or security-based swap participant in a given fiscal quarter, but does not exceed any applicable threshold by more than 20% in that quarter, that person will be allowed a grace period of one fiscal quarter. If that person exceeds any applicable threshold for the next fiscal quarter, the person will be deemed to be a major swap or security-based swap participant, as applicable.
Calculation Safe Harbors and Liability for Failing to Register While it is generally expected that a small number of market participants will maintain sufficiently large swap or security-based swap portfolios to be deemed major swap or security-based swap participants, many market participants have expressed concern that they will nevertheless be required to perform complex daily calculations to ensure that they remain below the applicable thresholds. In order to address this concern, the Commissions adopted three “calculation safe harbors” designed to provide for less-frequent and less-complex testing to determine major participant status.
A person will not be deemed to be a major participant if (i) the express terms of the person’s arrangements relating to swaps and security-based swaps with its counterparties at no time would permit the person to maintain a total uncollateralized exposure of more than $100 million to its counterparties, including any exposure that may result from the application of thresholds or minimum transfer amounts established by credit support annexes or similar arrangements, and (ii) the person does not maintain notional swap or security-based swap positions of more than $2 billion in any major category of swaps or security-based swaps, or more than $4 billion in aggregate.
A person will not be deemed to be a major participant if (i) the express terms of the person’s arrangements relating to swaps and security-based swaps with its counterparties at no time would permit the person to maintain a total uncollateralized exposure of more than $200 million to its counterparties, including any exposure that may result from thresholds or minimum transfer amounts, and (ii) the person performs the major participant calculations as of the end of every month, and the results of each of those monthly calculations indicate that the person’s swap or security-based swap positions lead to no more than one-half of the level of current exposure plus potential future exposure that would cause the person to be a major participant.
A person will not be deemed to be a major participant if the person’s current uncollateralized exposure in connection with a major category of swaps or security-based swaps is less than $500 million (or less than $1.5 billion with regard to the rate swap category) and the person performs certain modified major participant calculations as of the end of every month, and the results of each of those monthly calculations indicate that the person’s swap or security-based swap positions in each major category of swaps or security-based swaps are less than one-half of the substantial position threshold.
The foregoing safe harbors are not intended to imply that failure to meet any of the three tests will lead to a presumption that the entity in question is a major swap or security-based swap participant. The Commissions have expressed no view on when a particular market participant must perform either the abbreviated calculations provided in the safe harbors or the more extensive calculations required by the major participant definitions themselves. Frequency of calculation must be determined on an individual basis based on a market participant’s market activity and business model. Nevertheless, market participants “will face liability if they knowingly or unknowingly meet one of the major participant definitions without registering as a major participant.”
Eligible Contract Participant The definition of “eligible contract participant” was added to the CEA by the Commodity Futures Modernization Act of 2000 (“CFMA”). Status as an ECP was designed, among other things, to demarcate those persons considered “retail” and therefore afforded additional protections under the futures and securities laws from those considered “non-retail.” Parties that were not ECPs could not rely on any of the exemptions and exclusions under the futures or securities laws created by the CFMA. Although Dodd-Frank eliminated the exemptions and exclusions added by the CFMA, it similarly adopts the ECP definition as the dividing line between retail and non-retail parties and as an indicator that a party requires additional protections under the futures and securities laws. Specifically, Dodd-Frank makes it unlawful for any person, other than an ECP, to enter into a swap or security-based swap other than on or through a designated contract market or national securities exchange, respectively. ECPs, on the other hand, may enter into swaps and security-based swaps through swap execution facilities and security-based swap execution facilities or on a bi-lateral basis (to the extent that the contract is not subject to an exchange-trading requirement under Dodd-Frank). The definition of ECP also ties into the definition of “dealer” under the Exchange Act and is relevant to determining whether state gaming and bucket shop laws are preempted under the Exchange Act with respect to security-based swaps. 15 In addition, offers and sales of security-based swaps to non-ECPs will be unlawful unless a valid registration statement meeting the requirements of the Securities Act of 1933, as amended, is in effect with respect to such contract. Under the CEA, parties must qualify as ECPs to avoid application of new retail commodity rules and retail forex rules.
Dodd-Frank amended the ECP definition in several ways: (1) it required that commodity pools seeking to enter into certain OTC foreign exchange transactions, in addition to meeting the pre-existing requirements, must not have any participants that are not themselves ECPs (this is known as the “ECP forex look-through”); (2) it raised the “discretionary investments” threshold for government entities and their instrumentalities, agencies or departments from $25 million to $50 million and (3) it changed the test for individuals to qualify as ECPs such that instead of requiring them to have “total assets” exceeding $10 million ($5 million, if hedging), individuals will instead need to have $10 million ($5 million, if hedging) in “amounts invested on a discretionary basis.” The final Entity Definitions did not make any further refinements to the second or third changes to the ECP definition. However, the final Entity Definitions do make substantial changes from the treatment of commodity pools under the statutory ECP definition. The final Entity Definitions also make certain changes and refinements unrelated to commodity pools.
The Final Entity Definitions The final Entity Definitions elaborate on the statutory change to definition of ECP in several key ways. First, persons otherwise subject to registration and regulation under Dodd-Frank with respect to their swap and security-based swap activities will be deemed to be ECPs. Second, the ECP forex look-through was substantially altered such that the disruption and increased compliance and trading costs that would have resulted from the proposed ECP forex look-through will largely be avoided.16 Third, non-U.S. commodity pools operated by non-U.S. CPOs will be considered ECPs solely for purposes of entering into OTC forex transactions. Fourth, with respect to entities entering into swaps to hedge or mitigate commercial risk that seek to rely on the “entity prong” of the ECP definition, such entities will be allowed to count the net worth of certain of their owners in calculating their own net worth.
Expansion to Include Otherwise Regulated Entities The final Entity Definitions expand the statutory definition of ECP to include major swap participants, major security-based swap participants, swap dealers and security-based swap dealers. These entities were added on the basis that they are likely to be the most active and largest users of swaps and security-based swaps and that they will otherwise be subject to extensive regulation by the Commissions under Dodd-Frank.
Substantial Changes to the ECP Forex Look-Through A commodity pool may enter into over-the-counter transactions in foreign currency for a variety of purposes, including hedging the exchange rate risk inherent in investments made by the pool that are denominated in a currency other than the pool’s functional currency, hedging the exchange rate risk inherent in accepting investments from pool participants in currencies other than the pool’s functional currency, making directional investments in particular currencies or taking relative investment positions in currency pairs or groups. Commodity pools may engage in a variety of different types of OTC transactions to achieve these purposes, including off-exchange foreign currency futures, off-exchange options on foreign currency futures, off-exchange options on foreign currency, leveraged or margined foreign currency transactions or foreign currency transactions that are financed by the offeror, the counterparty or a person acting in concert with the offeror or counterparty (collectively, “OTC forex transactions”). Commodity pools that qualify as ECPs are largely exempt from the CEA and regulations of the CFTC with respect to such transactions. Commodity pools that do not qualify as ECPs are subject to the CFTC’s retail forex regulatory regime, which imposes certain requirements and restrictions on counterparties to the pool and on the operator of the pool.
The proposed Entity Definitions would have made it substantially more difficult and expensive for many commodity pools to engage in OTC forex transactions by forcing most commodity pools to engage in OTC forex transactions on a retail basis and only with certain enumerated types of counterparties. The Commissions made substantial changes to the ECP forex look-through in the final entity definitions in response to comment letters submitted by Sidley Austin LLP, as well as other law firms and industry groups.17 In summary, the final definition of ECP will apply the ECP forex look-through in limited instances in which commodity pools have been structured in a manner designed to allow non-ECPs to gain exposure to OTC forex transactions through a pooled vehicle in a manner designed to evade the requirements of Dodd-Frank, the CEA and CFTC regulations and/or for small commodity pools. Most commodity pools will be able to continue to engage in OTC forex transactions on a non-retail basis.
The proposed look-through rule under the final Entity Definitions was materially amended, via new CFTC Rule 1.3(m)(5) such that a commodity pool directly engaged in OTC forex transactions (referred to in the final Entity Definitions as a “transaction-level commodity pool”) will not be considered an ECP, solely with respect to OTC forex transactions, if it has one or more direct participants that are not themselves ECPs. The indirect participants in the pool (e.g., investors in a feeder fund that invests in the transaction-level commodity pool) will be disregarded unless the transaction-level commodity pool, a commodity pool holding a direct or indirect interest (through one or more intermediate tiers of pools) in the transaction-level commodity pool or any pool in which the transaction-level commodity pool holds a direct or indirect interest has been structured to evade the provisions of Title VII of Dodd-Frank relating to swaps. Whether a given commodity pool has been structured in an evasive manner will be a factual determination that must be made on a case-by-case basis.18 The Commissions indicated that the use of OTC forex transactions as an asset class itself (rather than as a hedge) is a material fact in determining that a commodity pool is not an ECP under this rule. With respect to a single-level commodity pools engaged in OTC forex transactions, the Commissions have also indicated that they will interpret such a pool as being an ECP if it otherwise meets the requirements of the commodity pool prong, even if the pool has one or more non-ECP participants, so long as the pool is engaged in OTC forex transactions solely for bona fide hedging purposes.19 This rule requires commodity pools to obtain representations from direct investors that they are ECPs, to monitor transferees and to redeem investors who are no longer ECPs.
The Commissions have also added another subsection under the final Entity Definition rules available commodity pools to qualify as ECPs. Almost all hedge funds and commodity pools are likely to rely on this new CFTC Rule 1.3(m)(8) as it provides a more straightforward way to be treated as an ECP for purposes of engaging in OTC forex transactions. The new prong provides that a commodity pool will be an ECP for purposes of OTC forex transactions if (1) it is not formed for the purpose of evading the retail forex provisions of the CEA and related CFTC rules, (2) it has total assets exceeding $10 million and (3) it is formed and operated by a CPO that is either registered or exempt from registration under CFTC Rule 4.13(a)(3).20
In effect, the Commissions’ changes to the ECP forex look-through convert the proposed “indefinite look-though” rule for commodity pools into the final “evasion-based look-through” rule. The refinements in CFTC Rules 1.3(m)(5) and (8) represent a substantial alteration of the proposed approach to the ECP forex look-through.
Guidance on Non-U.S. Pools Operated by Non-U.S. CPOs In the Adopting Release, the Commissions provided interpretive guidance that commodity pools limited solely to non-U.S. persons where the CPO is located outside of the United States, will be ECPs for purposes of entering into OTC forex transactions. No such relief was provided, however, that would make such commodity pools ECPs for other purposes under the futures and securities laws. Non-U.S. commodity pools will continue to be required to be ECPs in order to enter into OTC transactions in commodities other than foreign currency.
Net Worth of Owners of Entities Engaged in Hedging or Mitigating Commercial Risk The final Entity Definitions will permit a person that is not otherwise an ECP to qualify as an ECP, with respect to certain swaps, based on the collective net worth of its owners, subject to certain conditions, including that the owners are themselves ECPs. This represents a substantial divergence from the statutory definition of ECP, which solely allows a person to qualify as an ECP based on that person’s own financial resources. This has historically had the result of limiting structuring options, as an entity that is wholly owned by ECPs was not a per se ECP.
Other Issues In the Adopting Release, the Commissions also noted that commenters raised a number of additional interpretive and other issues that the Commissions may consider in a future interpretive or rulemaking release. Among the issues that may be addressed are the ECP status of jointly and severally liable borrowers and counterparties, non-ECPs guaranteed by ECPs, and non-ECP swap collateral providers; whether bond proceeds count toward the “owns and invests on a discretionary basis $50,000,000 or more in investments” element of the governmental ECP prong; the scope of the “proprietorship” element of the entity prong of the ECP definition; the meaning of the new “amounts invested on a discretionary basis” element of the individual prong of the ECP definition; whether persons can be ECPs in anticipation of receiving, but before they have received, the necessary assets and whether registered swap dealers will be permitted to act as counterparties to OTC retail forex transactions, notwithstanding that such entities (unless they are separately registered in a different capacity) are not listed in the CEA as permitted counterparties for such transactions.
In the Adopting Release, the CFTC also indicated that it is currently considering a draft petition for relief for certain entities described in Section 201(f) of the Federal Power Act.
Compliance Deadlines Compliance with CFTC Rule 1.3(m)(8)(iii), which requires that a commodity pool be formed by a registered CPO, will be required only with respect to commodity pools formed on or after December 31, 2012. Otherwise, the final Entity Definitions will go into effect 60 days after they are published in the Federal Register.
1 The text of the proposed Entity Definitions is available at http://www.gpo.gov/fdsys/pkg/FR-2010-12-21/pdf/2010-31130.pdf. The original comment period ended February 22, 2011. The comment period was subsequently extended to June 3, 2011. The Commissions received over 500 comment letters from interested parties. The text of the comment letter submitted by Sidley Austin LLP on February 22, 2011 is available at http://comments.cftc.gov/PublicComments/CommentList.aspx?id=933. The Sidley Austin LLP comment letter primarily addresses various issues for industry participants with respect to the application of proposed amendments to the definition of “eligible contract participant” (“ECP”). The Commissions made substantial changes in their proposed amendments to the ECP definition, as discussed below. These changes were highly beneficial to many groups of market participants. The Sidley Update on the proposed Entity Definitions is available at http://www.sidley.com/sidleyupdates/Detail.aspx?news=4638.
2Seehttp://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/federalregister041812b.pdf and http://www.sec.gov/rules/final/2012/34-66868.pdf (the “Adopting Release”).
3 As of the date of this Sidley Update, the Adopting Release had not yet been published in the Federal Register.
4 77 FR 25320 (April 27, 2012).
5See CEA section 1a(49)(C) and 17 C.F.R. § 1.3(ggg)(2); Exchange Act section 3(a)(71)(D) and 17 CFR § 240.3a71-1(b).
6See CFTC Regulation § 151.5(a)(1).
7See CFTC Regulation § 1.3(kkk).
8See CFTC Regulation § 1.3(kkk).
9 For commercial enterprises or trading firms that had been concerned over the substantial regulatory burden and cost of registration, membership in and compliance with the rules of a national futures association and compliance with the CFTC’s business conduct requirements, as well as the cost of adhering to the CFTC’s capital and counterparty margin requirements, if business activity can be confined to the parameters described above, the final “swap dealer” definition represents a significant improvement in the final rules over the December 2010 proposal. However, for the largest and most active of such firms, the prospect (once registering as a floor trader and conforming business activity to the above parameters) of having to register as a major swap participant may also have to be considered. Additionally, as is apparent from the parameters that relate to “affiliated persons”, the floor trader swap exclusion was not intended to allow firms with active swap trading businesses to avoid swap dealer registration altogether while continuing the full range of trading activities by, for example, ring-fencing certain parts of the business in a less-regulated offshore affiliate.
10 The Commissions elaborate to some degree upon the meaning and determination of “effective notional amount” in the Adopting Release, in the text accompanying footnotes 902 – 904, to assist in interpretation. Note that the term is also used in conjunction with the “major participant” definitions as summarized below. However, the commenters upon this construct (who had contended that it introduced ambiguity and uncertainty) and market participants that will have to apply it in order to fall within a de minimis exception may wish to seek further guidance.
11See Adopting Release at footnote 433.
12 In the final “security-based swap dealer” definition, the phase-in period is stated not to be available to the extent that a person engages in security-based swaps with natural persons other than those who qualify as eligible contract participants by virtue of having at least $5 million invested on a discretionary basis and entering into security-based swaps to manage asset or liability risk.
13 In the Adopting Release, at footnote 250, a citation to the first, 1951 edition of the seminal Securities Regulation treatise by Professor Loss includes the quoted words and is suggestive of the long history of this SEC doctrine.
14See Adopting Release at text accompanying footnote 158 (“[T]he interpretations regarding the application of the definitions differ in certain respects given the differences in the uses of and markets for swaps and security-based swaps.”).
15 Engaging in the business of buying and selling security based swaps with or for non-ECPs will be considered a dealing activity pursuant to Section 3a(5)(A) of the Securities Exchange Act once the Dodd-Frank amendments are fully implemented. State gaming and bucket shop laws will be preempted by Section 28(a)(3) of the Securities Exchange Act with respect to security-based swaps between ECPs. Note, however, that there is no similar preemption with respect to swaps under the CEA.
16 As proposed, the ECP forex look-through would have prevented any commodity pool from being an ECP with respect to OTC forex transactions if there was any non-ECP at any level of the pool structure.
17 The Commissions’ discussion of the Sidley Austin LLP comment letter begins at footnote 618 of the Adopting Release.
18 The use of one or more feeder funds for the purpose of tax efficiency, to obtain the trading efficiencies gained by the use of a single trading entity, to avoid the need to split and allocate trades, to avoid the need for duplicative trading arrangements and associated documentation, and to gain economies of scale in the administration of the commodity pool should, in most cases, be sufficient to avoid a finding of evasive structuring. Similarly, commodity pools using OTC forex transactions solely for bona fide hedging purposes should not generally be seen as structured to evade the ECP forex look-through.
19See footnote 652 of the Adopting Release.
20 The requirement that a commodity pool be “formed” by a registered or exempt CPO raises an interpretive question about whether the operator of a commodity pool must ensure that it is registered or exempt from registration at the time it causes the commodity pool in question to be formed. Note that, effective April 24, 2012, CFTC Rule 4.13(a)(4) is no longer available. See Sidley Update, CFTC Adopts Final Rules Amending CPO/CTA Registration and Compliance Obligations Investment Funds, February 14, 2012, available at http://www.sidley.com/sidleyupdates/Detail.aspx?news=5097.
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