The final countdown: Dodd-Frank compliance to begin as SEC and CFTC issue key rules re swaps activities

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The Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission have approved joint final rules and interpretations (the Swap Definition Rule) that:

 

(i) further define the terms “swap,” “security-based swap,” and “security-based swap agreement”

(ii) explain how the SEC and CFTC will treat “mixed swaps”, which are transactions that are both swaps and security-based swaps and

(iii) set procedures governing books and records for “security-based swap agreements.” 

 

For entities that engage in swaps activities, the Swap Definition Rule is the most important rule that the CFTC has issued, because it begins the countdown for complying with an array of requirements under the Dodd-Frank Act.  The SEC approved the Swap Definition Rule unanimously, but Commissioner Chilton of the CFTC voted against the Swap Definition Rule.

 

The Swap Definition Rule generally adopts the statutory definition of the term “swap,” which provides that the term “swap” includes nearly all derivatives except exchange-traded futures. The Swap Definition Rule specifies that certain types of transactions are swaps, including foreign exchange swaps and forwards, foreign currency options, commodity options, non-deliverable forwards in foreign exchange, cross-currency swaps, forward rate agreements, contracts for differences, options to enter into swaps and forward swaps. The CFTC and SEC are issuing interpretations that will clarify that certain spot transactions in foreign exchange will not be considered swaps.  The Swap Definition Rule also specifies that certain other types of transactions are  not swaps, including insurance, certain consumer transactions (e.g., transactions to obtain a mortgage), certain commercial transactions that involve customary business arrangements (e.g., fixed or variable interest rate commercial loans or mortgages) and loan participations.

 

The CFTC and SEC are issuing final rules and interpretations that are intended to clarify which products will constitute insurance, consumer transactions and commercial transactions, and therefore not swaps or security-based swaps.  The CFTC clarifies that guarantees of swaps are themselves swaps, and the SEC clarifies that guarantees of security-based swaps are themselves securities (each agency will release additional guidance to address reporting requirements for such guarantees). 

 

Additionally, the Swap Definition Rule clarifies that the forward contract exclusion from the definition of “swap” should be interpreted consistently with the CFTC’s existing forward exclusion with respect to futures contracts.   The Swap Definition Rule also provides that “book-out” transactions will be treated as forward contracts rather than swaps.  For energy companies, the Swap Definition Rule contains two key provisions related to the forward exclusion.  First, the Swap Definition Rule provides that environmental commodities such as offsets, allowances and RECs, are nonfinancial commodities that qualify for the forward exclusion.  Second, the Swap Definition Rule provides guidance regarding forward contracts with embedded volumetric optionality, treating such contracts as forwards when the volumetric optionality is due to physical factors or regulatory requirements beyond the control of the parties.  In order to qualify as a forward contract, contracts with embedded volumetric optionality must meet a seven-factor test.  The CFTC will seek additional comment on this seven-factor test.

 

The Swap Definition Rule clarifies:

 

(1) which instruments are “swaps” subject to CFTC jurisdiction

(2) which instruments are “security-based swaps” subject to SEC jurisdiction and

(3) which instruments are “mixed swaps” subject to combined CFTC and SEC jurisdiction (the CFTC and SEC both agree that the “mixed swap” category will be narrow). 

 

The Swap Definition Rule also provides guidance regarding “security-based swap agreements,” which are subject to CFTC regulatory authority but over which the SEC has antifraud and certain other authority.  Finally, the Swap Definition Rule adopts anti-evasion rules, which will define as a swap those transactions that have been willfully structured to evade regulation under the Commodity Exchange Act.

 

The Swap Definition Rule will become effective 60 days after it is published in the Federal Register.  It is the most important rule the CFTC has adopted under the Dodd-Frank Act because it begins the countdown for compliance with an array of other important rules.  These include:

  • Swap dealer (SD) and major swap participant (MSP) registration – the compliance date for these rules (i.e., the date by which SDs and MSPs must register with the CFTC) is the effective date of the Swap Definition Rule.
  • External business conduct standards for SDs and MSPs – the compliance date for these rules is the later of October 15, 2012 or the date by which SDs and MSPs must apply for registration, which is the same as the effective date of the Swap Definition Rule.  If the Swap Definition Rule is published in the Federal Register in July, then the effective date of the Swap Definition Rule will be in September.  Therefore, the compliance date for the external business conduct standards will likely be on October 15, 2012.
  • Reporting, recordkeeping and daily trading obligations for SDs and MSPs – for SDs and MSPs that are currently registered with the SEC or regulated by a prudential regulator, the compliance date for these rules will be the date by which SDs and MSPs must apply for registration, which is the same as the effective date of the Swap Definition Rule.  For SDs and MSPs that are not registered with the SEC or regulated by a prudential regulator, the compliance date is the later of September 30, 2012 or the date by which SDs and MSPs must apply for registration, so the compliance date will likely be September 30, 2012.  Pursuant to the Proposed Exemptive Order that the CFTC issued on June 29, 2012, the compliance date for other “internal business conduct standards” for US SDs and MSPs has been delayed to January 1, 2013.
  • Position limits – the compliance date for the first phase of CFTC-set position limits, which will include spot-month limits for 28 commodities and non-spot month limits for nine of those commodities, will be the effective date of the Swap Definition Rule.
  • Real-time reporting – the real-time reporting rules adopt a three-phased compliance approach.  In the first phase, which will begin on the effective date of the Swap Definition Rule, all SDs, MSPs, Swap Execution Facilities (SEFs) and Designated Contract Markets (DCMs) will be required to comply with real-time reporting requirements for publicly reportable swap transactions in the interest rate and credit asset classes.  In the second phase, which will begin 90 days after the effective date of the Swap Definition Rule, all SDs, MSPs, SEFs and DCMs will be required to comply with real-time reporting requirements for publicly reportable swap transactions in the foreign exchange, equity, and ‘‘other commodity’’ asset classes.  Finally, in the third phase, which will begin 180 days after the effective date of the Swap Definition Rule, real-time reporting obligations will apply to all publicly reportable swap transactions in all asset classes, including swap transactions that involve only non-SDs/MSPs.
  • Swap data reporting and recordkeeping – the reporting and recordkeeping rules adopt a three-phased compliance approach.  In the first phase, which will begin on the effective date of the Swap Definition Rule, SDs and MSPs must comply with reporting and recordkeeping requirements for credit swaps and interest rate swaps.  In the second phase, which will begin 90 days after the effective date of the Swap Definition Rule, SDs and MSPs must comply with reporting and recordkeeping requirements for equity swaps, foreign exchange swaps, and “other commodity” swaps.  In the third phase, which will begin 180 days after the effective date of the Swap Definition Rule, all non-SD/MSP counterparties must comply with the reporting and recordkeeping rules.
  • Agricultural swaps – the compliance date for this rule is the effective date of the Swap Definition Rule.
  • Commodity options and the interim final rule adopting a new trade option exemption – the compliance date for these rules is the effective date of the Swap Definition Rule.  However, for purposes of complying with CFTC rules 32.2(a) (permitting commodity options subject to the CEA and CFTC rules, including the swaps rules) and 32.3 (permitting trade options), the compliance date shall be the compliance date for the Swap Definition Rule.  The compliance date for the Swap Definition Rule is unclear because the CFTC and SEC have not yet posted the Swap Definition Rule.
  • Registration of swap data repositories (SDRs) – SDRs must register with the CFTC by the effective date of the Swap Definition Rule.
  • Inclusion of swaps in the Rule 4.13(a)(3) de minimis trading thresholds – In addition to the Swap Definition Rule, the CFTC has proposed to amend the definition of "commodity interest" in CFTC Rule 1.3 to include swaps. If this definition is amended, now that the Swap Definitional Rule has been adopted, commodity pool operators of funds that engage in swaps would need to count swaps towards the de minimis trading limits imposed by the Rule 4.13(a)(3) exemption.

 

End-user clearing exception final rule

 

The CFTC also issued a final rule that implements Section 2(h)(7) of the Commodity Exchange Act by exempting end users from the clearing requirement that would otherwise apply under Section 2(h)(1) of the CEA.  In accordance with Section 2(h)(1), the end-user exception will be available only to non-financial entities that are using the swap for “hedging or mitigating commercial risk.”  If any entity elects to use the end-user exception when it enters into a swap, the reporting party must report the swap to an SDR (or to the CFTC if no SDR is available) and provide notice of the election and the identity of the electing counterparty.

 

Additionally, the following information must be provided by either (1) the electing party in an annual filing, or (2) the reporting party on a swap-by-swap basis:

  • whether the electing counterparty is a financial entity electing the end-user exception on behalf of an affiliate
  • whether the underlying swap hedges or mitigates commercial risk
  • how the electing counterparty generally meets its obligations regarding non-cleared swaps; and, if the electing counterparty is an “SEC Filer,” whether its board of directors has approved the decision to enter into swaps exempt from clearing and trading requirements

 

Finally, the final rule allows “small financial institutions” to elect the end-user exception.  Under the final rule, “small financial institutions” include banks, savings associations, farm credit system institutions, and credit institutions with total assets of US$10 billion or less.

 

Proposed rule to exempt certain swaps executed by cooperatives from the Swap Clearing Requirement

 

The proposed rule would extend the end-user exception by providing that cooperatives that act in financial markets on behalf of end-users can elect the end-user exception, even though the cooperative itself may have assets in excess of US$10 billion.  The proposed rule would only permit a cooperative to elect this exemption if all of a cooperative’s members are (1) non-financial entities, (2) small financial institutions that can elect the end-user exception or (3)  other cooperatives whose members fall into the first two categories.  The exemption would only be permitted for swaps related to member activities, including swaps entered into with cooperative members in connection with originating loans and swaps entered into by cooperatives that hedge or mitigate risks associated with member loans or loan-related swaps.

 

The reporting requirements under the proposed rule are similar to those under the end-user exception final rule.

 

For more information about these timelines, please contact:

 

Marc Horwitz

 

Edward Johnsen 

 

Mary Anne Mason

 

Wesley Nissen 

 

Bradley Phipps 

 

Christopher Steelman 

 

 

As events develop, DLA Piper is monitoring the regulators' actions. To learn more about this landscape, visit our library of Dodd-Frank Act updates.