Regulators Define Key Dodd-Frank Terms "Swap" and "Security-based Swap" Triggering Title VII Compliance | Practical Law

Regulators Define Key Dodd-Frank Terms "Swap" and "Security-based Swap" Triggering Title VII Compliance | Practical Law

The CFTC and the SEC adopted joint final rules defining certain key terms that determine which transactions are subject to swaps regulation under Title VII of the Dodd-Frank Act. The issuance of these final rules triggers compliance obligations under many other final Dodd-Frank swaps rules.

Regulators Define Key Dodd-Frank Terms "Swap" and "Security-based Swap" Triggering Title VII Compliance

by PLC Finance and PLC Corporate & Securities
Published on 12 Jul 2012 • USA (National/Federal)
The CFTC and the SEC adopted joint final rules defining certain key terms that determine which transactions are subject to swaps regulation under Title VII of the Dodd-Frank Act. The issuance of these final rules triggers compliance obligations under many other final Dodd-Frank swaps rules.
On July 10, 2012, the CFTC and the SEC (collectively, the Commissions) adopted joint final rules under Title VII of the Dodd-Frank Act defining the terms "swap" and "security-based swap," among other terms. These rules determine which transactions will be subject to heightened oversight under Dodd-Frank swaps rules. The rules provide clarification regarding whether a particular transaction or instrument is a non-security-based swap (swap) subject to CFTC regulation, a security-based swap (SBS) subject to SEC regulation or a mixed swap subject to regulation by both Commissions. The rules also specify which transactions are neither swaps nor SBS.
These rules define these terms for purposes of the Dodd-Frank Act, the Commodity Exchange Act (CEA) and the Exchange Act.
The publication of these final rules in the Federal Register triggers the compliance dates for many other final Dodd-Frank swaps rules previously issued by the CFTC. Certain of these rules become effective on October 12, 2012.

Transactions That Are Swaps or Security-based Swaps

Under the final rules, the following transactions fall within the definition of the terms "swap" or "security-based swap" and are therefore regulated under Title VII and the CEA or the Exchange Act, as applicable:
  • Foreign exchange (FX) forwards and FX swaps, unless the Secretary of the Treasury issues a written determination that either foreign exchange swaps, foreign exchange forwards or both:
    • should not be regulated as swaps; and
    • are not structured to evade the Dodd-Frank Act.
    Even if the Secretary of the Treasury makes this determination, certain provisions of the CEA added by the Dodd-Frank Act would continue to apply to these transactions.
  • Foreign currency options (other than foreign currency options traded on a national securities exchange).
  • Non-deliverable forward contracts involving FX, currency, and cross-currency swaps.
  • Forward rate agreements (FRAs).
  • Contracts for differences.
  • Certain combinations and permutations of (or options on) swaps and SBS.
The determination as to whether a particular agreement, contract or transaction is a swap, SBS or mixed swap is made at the inception of the Title VII instrument. This determination will remain in place for the life of the instrument, unless the instrument is substantially amended or modified.
For example, if a Title VII Instrument on a broad-based security index becomes narrow-based during the course of its life, the instrument will remain a "swap" subject to CFTC regulation, unless it is substantially amended or modified.

Transactions That Are Swaps but Not Security-Based Swaps

Under the final rules, the following products are considered swaps but not SBS and are therefore regulated under Title VII and the CEA:
  • Instruments based on interest rates and other monetary rates.
  • Instruments based on rates or yields of US treasuries and certain other exempted securities (other than municipal securities).
  • Futures (other than futures on foreign government debt securities).

Transactions That Are Security-Based Swaps but Not Swaps

Under the final rules, the following products are considered SBS but not swaps and are therefore regulated under Title VII and the Exchange Act:
  • Instruments based on yields, where "yield" is a proxy for the price or value of a debt security, loan or "narrow-based security index," except in the case of certain exempted securities.
  • Total return swaps (TRS) based on a single security, loan, or narrow-based security index. Where counterparties embed interest-rate optionality or a non-securities component into the TRS, it will categorized as a mixed swap (see Mixed Swaps).
  • Instruments based on securities futures.

Swaps and SBS on Security Indexes

The final rules will define "narrow-based security index" and "issuers of securities in a narrow-based security index" for purposes of determining whether an index-based CDS is a swap, an SBS or a mixed swap. The CFTC has traditionally defined a narrow-based security index as an index with nine or fewer components.
The final rules also provide for mechanisms for addressing the treatment of indexes that fluctuate between being narrow-based and broad-based.

Mixed Swaps

Mixed swaps are both swaps and SBS. The Commissions have narrowly defined the category of mixed swaps. The Commissions have jointly adopted the following final rules on mixed swaps:
  • Mixed swaps remain subject to both SEC and CFTC regulatory requirements.
  • The parties to mixed swaps may request modified regulatory treatment by joint order of the Commissions.

Transactions that are Not Swaps or Security-Based Swaps

The final rules outline a number of products that are not considered swaps or SBS and are therefore not subject to regulation under Title VII of the Dodd-Frank Act, the CEA or the Exchange Act.

Deliverable Forward Contracts

Most physically settled non-financial forward contracts are excluded from the "swap" and "security-based swap" definitions (see "The Forward Contract Exclusion," p. 73 of final rules). These definitions exclude “any sale of a non-financial commodity or security for deferred shipment or delivery, so long as the transaction is intended to be physically settled.”

Insurance

Under the final rules, an insurance product is not considered a swap or SBS if it falls under any of the following three exemptions:
  • Grandfather for Existing Transactions. The product is an existing insurance agreement, contract or transaction entered into before the effective date of these final rules and was provided by a person or entity that satisfied the "provider test" (see Insurance Provider Test).
  • Product Safe Harbor. The agreement, contract or transaction is provided in accordance with the "provider test" (see Insurance Provider Test) and satisfies all of the following conditions:
    • the beneficiary of the insurance product has an insurable interest and bears the risk of loss on that interest continuously through the duration of the agreement, contract or transaction;
    • the loss occurred and is proven;
    • all payment on or indemnification of the loss is limited to the value of the insurable interest;
    • the agreement, contract or transaction is not traded, separately from the insured interest, on an organized market or over-the-counter; and
    • for financial guaranty insurance, only if, after a payment default under the insured obligation or insolvency of the obligor, any acceleration of payments under the policy is at the sole discretion of the insurer.
  • Enumerated Product Safe Harbor. The product is provided in accordance with the "provider test" (see Insurance Provider Test) and is any of the following:
    • a surety bond;
    • a fidelity bond;
    • life insurance;
    • health insurance;
    • long-term care insurance;
    • title insurance;
    • property and casualty insurance;
    • an annuity;
    • disability insurance;
    • insurance against default on individual residential mortgages; or
    • reinsurance (including retrocession) of any of these products.

Insurance Provider Test

Under the final rules, a person or entity satisfies the "provider test" if any of the following apply:
  • It is the US government, any state government or any US or state agency or instrumentality, or a statutorily authorized program of any of these.
  • It is subject to supervision by the insurance commissioner of any state or by the federal government, and the applicable agreement, contract or transaction is regulated as insurance under applicable state or federal law.
  • In the case of reinsurance, the person is providing the agreement, contract or transaction to another person that is eligible under the provider test, provided that:
    • the offering entity is not prohibited by applicable state or federal law from offering such agreement, contract or transaction to the offeree;
    • the agreement, contract or transaction to be reinsured falls under the product safe harbor or the enumerated product safe harbor; and
    • the total reimbursable amount by all reinsurers under such agreement, contract or transaction does not exceed the losses or claims paid by the cedant, unless otherwise permitted by applicable state law.
  • In the case of non-admitted insurance, the offering entity is:
    • located outside of the US and listed on the National Association of Insurance Commissioners' Quarterly Listing of Alien Insurers; or
    • meets the eligibility criteria for non-admitted insurers under applicable state law.

Security Forwards

Under the final rules, security forwards, including mortgage-backed securities (MBS) that are eligible to be sold in the "to be announced" market, are not considered swaps or SBS.

Consumer and Commercial Transactions

Consumer transactions that are not considered swaps or SBS include (but are not necessarily limited to):
  • Agreements, contracts or transactions to acquire or lease real or personal property, to obtain a mortgage, to provide personal services, or to sell or assign rights owned by a consumer (such as intellectual property rights).
  • Agreements, contracts or transactions that provide for an interest rate cap or lock on a consumer loan or mortgage, where the benefit of the rate cap or lock is realized by the borrower only if the loan or mortgage is made to that borrower.
  • Consumer loans or mortgages with variable rates of interest, including such loans with provisions for the rates to change on certain events related to the borrower, such as a higher rate of interest following a borrower default.
Commercial transactions not considered swaps or SBS include (but are not necessarily limited to):
  • Employment contracts and retirement benefit arrangements.
  • Sales, servicing and distribution arrangements.
  • Agreements, contracts or transactions for the purpose of effecting a business combination transaction.
  • Agreements for the purchase, sale, lease or transfer of real property, intellectual property, equipment or inventory.
  • Warehouse lending arrangements in connection with building an inventory of assets in anticipation of a securitization of such assets (such as in a securitization of mortgages, student loans, or receivables).
  • Mortgage or mortgage purchase commitments, or sales of installment loan agreements, contracts or receivables.
  • Fixed or variable interest rate commercial loans entered into by banks and nonbanks.
  • Commercial agreements, contracts, and transactions (including, but not limited to, leases, service contracts and employment agreements) containing escalation clauses linked to an underlying commodity such as an interest rate or consumer price index.

Loan Participations

After some uncertainty during the rulemaking process, the final rules clarify that loan participations, including so-called "LMA-style" and "LSTA-style" loan participations, are not considered swaps or SBS. Loan participations are therefore not subject to Title VII regulations.

Other Aspects of the Final Rules

Product Characterization. The rules establish a process that allows market participants regulated by either agency to request a determination from both agencies as to whether a product is a swap, an SBS or a mixed swap when it is unclear what category the product falls under.
Anti-evasion. The rules expand the definition of the term "swap" (but not the term "security-based swap") to include transactions that are willfully structured to evade the provisions of Title VII that cover swaps. Specific provisions apply to:
Guarantees. The SEC (but not the CFTC) stated its belief that a guarantee of an obligation under an SBS is neither a separate SBS nor part of the original SBS. However, the SEC will consider, in further rulemaking, requiring the reporting of information about any guarantees and the guarantors of obligations under SBS in connection with the reporting of the SBS transaction itself.

Effective Date and More Information

The final rules become effective on October 12, 20112 (60 days after publication in the Federal Register). For purposes of the application of the US securities laws to security-based swaps (see Application of Securities Laws to Security-based Swaps), the effective date will be February 11, 2013 (180 days after publication in the Federal Register.
For more information on these rules, see the CFTC's Q&A and Fact Sheet and the SEC's Fact Sheet.
For more information on other final Title VII definitional swaps rules, see Practice Note, Is Your Client a Swap Dealer or Major Swap Participant? Breakdown of Final Dodd-Frank Definitional Rulemaking.
For more information about the regulation of swaps and derivatives under the Dodd-Frank Act, see Practice Note, Summary of the Dodd-Frank Act: Swaps and Derivatives.

Other Title VII Rules Triggered

The publication in the Federal Register of the final rules defining the terms "swap" and "security-based swap" (final definitional rules) triggers the implementation dates of a host of final Title VII rules that have already been adopted. The following rules have been triggered: