Vol. 77 Monday, No. 156 August 13, 2012

Part II

Commodity Futures Trading Commission 17 CFR Part 1

Securities and Exchange Commission

17 CFR Parts 230, 240 and 241 Further Definition of ‘‘Swap,’’ ‘‘Security-Based Swap,’’ and ‘‘Security-Based Swap Agreement’’; Mixed Swaps; Security-Based Swap Agreement Recordkeeping; Final Rule

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COMMODITY FUTURES TRADING • CFTC Web Site: via its Comments 5870, Office of Compliance, Inspections COMMISSION Online process: http:// and Examinations, Securities and comments.cftc.gov. Follow the Exchange Commission, 100 F Street NE., 17 CFR Part 1 instructions for submitting comments Washington, DC 20549. RIN 3038–AD46 through the Web site. SUPPLEMENTARY INFORMATION: • Mail: Address to David A. Stawick, Table of Contents SECURITIES AND EXCHANGE Secretary of the Commission, COMMISSION Commodity Futures Trading I. Background Commission, Three Lafayette Centre, II. Scope of Definitions of Swap and Security- 17 CFR Parts 230, 240 and 241 1155 21st Street NW., Washington, DC Based Swap 20581. A. Introduction [Release No. 33–9338; 34–67453; File No. • Hand Delivery/Courier: Same as B. Rules and Interpretations Regarding S7–16–11] mail above. Certain Transactions outside the Scope • Federal eRulemaking Portal: http:// of the Definitions of the Terms ‘‘Swap’’ RIN 3235–AK65 and ‘‘Security-Based Swap’’ www.regulations.gov. Follow the 1. Insurance Products Further Definition of ‘‘Swap,’’ instructions for submitting comments. (a) Types of Insurance Products ‘‘Security-Based Swap,’’ and All comments must be submitted in (b) Providers of Insurance Products ‘‘Security-Based Swap Agreement’’; English or, if not, accompanied by an (c) Grandfather Provision for Existing Mixed Swaps; Security-Based Swap English translation. Comments will be Insurance Transactions Agreement Recordkeeping posted as received to http:// (d) Alternative Tests www.cftc.gov. You should submit only (e) ‘‘Safe Harbor’’ AGENCY: Commodity Futures Trading information that you wish to make (f) Applicability of Insurance Exclusion to Commission; Securities and Exchange available publicly. If you wish the CFTC Security-Based Swaps Commission. (g) Guarantees to consider information that is exempt 2. The Forward Contract Exclusion ACTION: Joint final rule; interpretations; from disclosure under the Freedom of (a) Forward Contracts in Nonfinancial request for comment on an Information Act, a petition for Commodities interpretation. confidential treatment of the exempt (i) Forward Exclusion From the Swap and information may be submitted according Future Delivery Definitions SUMMARY: In accordance with section to the procedures established in § 145.9 (ii) Nonfinancial Commodities 712(a)(8), section 712(d)(1), sections of the CFTC’s Regulations.1 (iii) Environmental Commodities 712(d)(2)(B) and (C), sections 721(b) and The CFTC reserves the right, but shall (iv) Physical Exchange Transactions (v) Fuel Delivery Agreements (c), and section 761(b) of the Dodd- have no obligation, to review, pre- Frank Wall Street Reform and Consumer (vi) Cleared/Exchange-Traded Forwards screen, filter, redact, refuse or remove (b) Commodity Options and Commodity Protection Act (‘‘Dodd-Frank Act’’), the any or all of your submission from Commodity Futures Trading Options Embedded in Forward Contracts http://www.cftc.gov that it may deem to (i) Commodity Options Commission (‘‘CFTC’’) and the be inappropriate for publication, such as (ii) Commodity Options Embedded in Securities and Exchange Commission obscene language. All submissions that Forward Contracts (‘‘SEC’’) (collectively, ‘‘Commissions’’), have been redacted or removed that (iii) Certain Physical Commercial in consultation with the Board of contain comments on the merits of the Agreements, Contracts or Transactions Governors of the Federal Reserve interpretation will be retained in the (iv) Effect of Interpretation on Certain System (‘‘Board’’), are jointly adopting Agreements, Contracts and Transactions public comment file and will be (v) Liquidated Damages Provisions new rules and interpretations under the considered as required under the Commodity Exchange Act (‘‘CEA’’) and (c) Security Forwards Administrative Procedure Act and other 3. Consumer and Commercial Agreements, the Securities Exchange Act of 1934 applicable laws, and may be accessible Contracts, and Transactions (‘‘Exchange Act’’) to further define the under the Freedom of Information Act. C. Final Rules and Interpretations terms ‘‘swap,’’ ‘‘security-based swap,’’ FOR FURTHER INFORMATION CONTACT: Regarding Certain Transactions Within and ‘‘security-based swap agreement’’ CFTC: Julian E. Hammar, Assistant the Scope of the Definitions of the Terms ‘‘Swap’’ and ‘‘Security-Based Swap’’ (collectively, ‘‘Product Definitions’’); General Counsel, at 202–418–5118, regarding ‘‘mixed swaps;’’ and 1. In General [email protected], Lee Ann Duffy, 2. Foreign Exchange Products governing books and records with Assistant General Counsel, at 202–418– respect to ‘‘security-based swap (a) Foreign Exchange Products Subject to 6763, [email protected]; Mark Fajfar, the Secretary’s Swap Determination: agreements.’’ The CFTC requests Assistant General Counsel, at 202–418– Foreign Exchange Forwards and Foreign comment on its interpretation 6636, [email protected], or David E. Exchange Swaps concerning forwards with embedded Aron, Counsel, at 202–418–6621, (b) Foreign Exchange Products Not Subject volumetric optionality, contained in [email protected], Office of General to the Secretary’s Swap Determination Section II.B.2.(b)(ii) of this release. Counsel, Commodity Futures Trading (i) Foreign Currency Options DATES: Effective date: October 12, 2012. (ii) Non-Deliverable Forward Contracts Commission, Three Lafayette Centre, Involving Foreign Exchange Compliance date: The applicable 1155 21st Street NW., Washington, DC compliance dates are discussed in the (iii) Currency Swaps and Cross-Currency 20581; SEC: Donna M. Chambers, Swaps section of the release titled ‘‘IX. Special Counsel, at 202–551–5870, or (c) Interpretation Regarding Foreign Effective Date and Implementation’’. John Guidroz, Attorney-Adviser, at 202– Exchange Spot Transactions Comment date: Comments on the 551–5870, Division of Trading and (d) Retail Foreign Currency Options interpretation regarding forwards with Markets, or Andrew Schoeffler, Special 3. Forward Rate Agreements embedded volumetric optionality must Counsel, at 202–551–3860, Office of 4. Combinations and Permutations of, or Options on, Swaps and Security-Based be received on or before October 12, Capital Markets Trends, Division of 2012. Swaps Corporation Finance, or Wenchi Hu, 5. Contracts for Differences ADDRESSES: You may submit comments, Senior Special Counsel, at 202–551– D. Certain Interpretive Issues identified by RIN number 3038–AD46, 1. Agreements, Contracts, or Transactions by any of the following methods: 1 17 CFR 145.9. That May Be Called, or Documented

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Using Form Contracts Typically Used IV. Mixed Swaps Providing for the registration and for, Swaps or Security-Based Swaps A. Scope of the Category of Mixed Swap comprehensive regulation of swap 2. Transactions in Regional Transmission B. Regulation of Mixed Swaps dealers, security-based swap dealers, Organizations and Independent System 1. Introduction Operators 2. Bilateral Uncleared Mixed Swaps major swap participants, and major III. The Relationship Between the Swap Entered Into by Dually-Registered security-based swap participants; (ii) Definition and the Security-Based Swap Dealers or Major Participants imposing clearing and trade execution Definition 3. Regulatory Treatment for Other Mixed requirements on swaps and security- A. Introduction Swaps based swaps, subject to certain B. Title VII Instruments Based on Interest V. Security-Based Swap Agreements Rates, Other Monetary Rates, and Yields A. Introduction exceptions; (iii) creating rigorous 1. Title VII Instruments Based on Interest B. Swaps That Are Security-Based Swap recordkeeping and real-time reporting Rates or Other Monetary Rates That Are Agreements regimes; and (iv) enhancing the Swaps C. Books and Records Requirements for rulemaking and enforcement authorities 2. Title VII Instruments Based on Yields Security-Based Swap Agreements of the Commissions with respect to, 3. Title VII Instruments Based on VI. Process for Requesting Interpretations of among others, all registered entities and Government Debt Obligations the Characterization of a Title VII C. Total Return Swaps Instrument intermediaries subject to the D. Security-Based Swaps Based on a Single VII. Anti-Evasion Commissions’ oversight. Security or Loan and Single-Name Credit A. CFTC Anti-Evasion Rules Section 712(d)(1) of the Dodd-Frank Default Swaps 1. CFTC’s Anti-Evasion Authority E. Title VII Instruments Based on Futures (a) Statutory Basis for the Anti-Evasion Act provides that the Commissions, in Contracts Rules consultation with the Board, shall F. Use of Certain Terms and Conditions in 2. Final Rules jointly further define the terms ‘‘swap,’’ Title VII Instruments (a) Rule 1.3(xxx)(6) ‘‘security-based swap,’’ and ‘‘security- G. The Term ‘‘Narrow-Based Security (b) Rule 1.6 based swap agreement’’ (‘‘SBSA’’).4 Index’’ in the Security-Based Swap (c) Interpretation on the Final Rules Section 712(a)(8) of the Dodd-Frank Act Definition 3. Interpretation Contained in the 1. Introduction Proposing Release provides further that the Commissions 2. Applicability of the Statutory Narrow- (a) Business Purpose Test shall jointly prescribe such regulations Based Security Index Definition and Past (b) Fraud, Deceit or Unlawful Activity regarding ‘‘mixed swaps’’ as may be Guidance of the Commissions to Title VII B. SEC Position Regarding Anti-Evasion necessary to carry out the purposes of Instruments Rules Title VII. In addition, sections 721(b) 3. Narrow-Based Security Index Criteria for VIII. Miscellaneous Issues and 761(b) of the Dodd-Frank Act Index Credit Default Swaps A. Distinguishing Futures and Options provide that the Commissions may (a) In General From Swaps (b) Rules Regarding the Definitions of B. Transactions Entered Into by Foreign adopt rules to further define terms ‘‘Issuers of Securities in a Narrow-Based Central Banks, Foreign Sovereigns, included in subtitles A and B, Security Index’’ and ‘‘Narrow-Based International Financial Institutions, and respectively, of Title VII, and sections Security Index’’ for Index Credit Default Similar Entities 721(c) and 761(b) of the Dodd-Frank Act Swaps C. Definition of the Terms ‘‘Swap’’ and provide the Commissions with authority (i) Number and Concentration Percentages ‘‘Security-Based Swap’’ as Used in the to define the terms ‘‘swap’’ and of Reference Entities or Securities Securities Act (ii) Affiliation of Reference Entities and IX. Effective Date and Implementation ‘‘security-based swap,’’ as well as the Issuers of Securities With Respect to X. Administrative Law Matters—CEA terms ‘‘swap dealer,’’ ‘‘major swap Number and Concentration Criteria Revisions participant,’’ ‘‘security-based swap (iii) Public Information Availability A. Paperwork Reduction Act dealer,’’ and ‘‘major security-based swap Regarding Reference Entities and B. Regulatory Flexibility Act participant,’’ to include transactions and Securities C. Costs and Benefits Considerations entities that have been structured to (iv) Affiliation of Reference Entities and XI. Administrative Law Matters—Exchange Issuers of Securities With Respect to Act Revisions Certain Criteria of the Public Information A. Economic Analysis 4 In addition, section 719(d)(1)(A) of the Dodd- Availability Test B. Paperwork Reduction Act Frank Act requires the Commissions to conduct a joint study, within 15 months of enactment, to (v) Application of the Public Information C. Regulatory Flexibility Act Certification Availability Requirements to Indexes determine whether stable value contracts, as XII. Statutory Basis and Rule Text defined in section 719(d)(2) of the Dodd-Frank Act, Compiled by a Third-Party Index are encompassed by the swap definition. If the Provider I. Backbround Commissions determine that stable value contracts (vi) Treatment of Indexes Including On July 21, 2010, President Obama are encompassed by the swap definition, section Reference Entities That Are Issuers of signed the Dodd-Frank Act into law.2 719(d)(1)(B) of the Dodd-Frank Act requires the Commissions jointly to determine whether an Exempted Securities or Including 3 Exempted Securities Title VII of the Dodd-Frank Act (‘‘Title exemption for those contracts from the swap 4. Security Indexes VII’’) established a comprehensive new definition is appropriate and in the public interest. 5. Evaluation of Title VII Instruments on regulatory framework for swaps and Section 719(d)(1)(B) also requires the Commissions security-based swaps. The legislation to issue regulations implementing the Security Indexes That Move From Broad- determinations made under the required study. Based to Narrow-Based or Narrow-Based was enacted, among other reasons, to Until the effective date of such regulations, the to Broad-Based reduce risk, increase transparency, and requirements under Title VII do not apply to stable (a) In General promote market integrity within the value contracts, and stable value contracts in effect (b) Title VII Instruments on Security financial system, including by: (i) prior to the effective date of such regulations are not Indexes Traded on Designated Contract considered swaps. See section 719(d) of the Dodd- Markets, Swap Execution Facilities, Frank Act. The Commissions currently are 2 Foreign Boards of Trade, Security-Based See Dodd-Frank Wall Street Reform and conducting the required joint study and will Consumer Protection Act, Public Law 111–203, 124 Swap Execution Facilities, and National consider whether to propose any implementing Stat. 1376 (2010). The text of the Dodd-Frank Act regulations (including, if appropriate, regulations Securities Exchanges is available at http://www.cftc.gov/LawRegulation/ determining that stable value contracts: (i) Are not H. Method of Settlement of Index CDS OTCDERIVATIVES/index.htm. encompassed within the swap definition; or (ii) are I. Security-Based Swaps as Securities 3 Pursuant to section 701 of the Dodd-Frank Act, encompassed within the definition but are exempt Under the Exchange Act and Securities Title VII may be cited as the ‘‘Wall Street from the swap definition) at the conclusion of that Act Transparency and Accountability Act of 2010.’’ study.

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evade the requirements of subtitles A carry out the purposes of Title VII.10 In for the ANPR closed on September 20, and B, respectively, of Title VII. addition, the SEC is given antifraud 2010.13 The Commissions received Section 712(d)(2)(B) of the Dodd- authority over, and access to comments addressing the Product Frank Act requires the Commissions, in information from, certain CFTC- Definitions and/or mixed swaps in consultation with the Board, to jointly regulated entities regarding SBSAs, response to the ANPR, as well as adopt rules governing books and records which are a type of swap related to comments in response to the 14 requirements for SBSAs by persons securities over which the CFTC is given Commissions’ informal solicitations, 11 registered as swap data repositories regulatory authority. from a wide range of commenters. (‘‘SDRs’’) under the CEA,5 including To assist the Commissions in further Taking into account comments received uniform rules that specify the data defining the Product Definitions (as well on the ANPR, the Commissions elements that shall be collected and as certain other definitions) and in published a notice of proposed maintained by each SDR.6 Similarly, prescribing regulations regarding mixed rulemaking in the Federal Register on 15 section 712(d)(2)(C) of the Dodd-Frank swaps as may be necessary to carry out May 23, 2011. The comment period Act requires the Commissions, in the purposes of Title VII, the for the Proposing Release closed on July Commissions published an advance 16 consultation with the Board, to jointly 22, 2011. Together, the Commissions notice of proposed rulemaking adopt rules governing books and records received approximately 86 written (‘‘ANPR’’) in the Federal Register on for SBSAs, including daily trading comment letters in response to the August 20, 2010.12 The comment period records, for swap dealers, major swap Proposing Release. The Commissions have reviewed and participants, security-based swap 10 Section 721(a) of the Dodd-Frank Act describes considered the comments received, and dealers, and security-based swap the category of ‘‘mixed swap’’ by adding new the staffs of the Commissions have met participants.7 section 1a(47)(D) to the CEA, 7 U.S.C. 1a(47)(D). Section 761(a) of the Dodd-Frank Act also includes with many market participants and Under the comprehensive framework the category of ‘‘mixed swap’’ by adding new other interested parties to discuss the for regulating swaps and security-based section 3(a)(68)(D) to the Exchange Act, 15 U.S.C. definitions.17 Moreover, the swaps established in Title VII, the CFTC 78c(68)(D). A mixed swap is defined as a subset of Commissions’ staffs have consulted is given regulatory authority over security-based swaps that also are based on the extensively with each other as required 8 value of 1 or more interest or other rates, currencies, swaps, the SEC is given regulatory commodities, instruments of indebtedness, indices, by sections 712(a)(1) and (2) of the authority over security-based swaps,9 quantitative measures, other financial or economic Dodd-Frank Act and have consulted and the Commissions shall jointly interest or property of any kind (other than a single with staff of the Board as required by prescribe such regulations regarding security or a narrow-based security index), or the occurrence, non-occurrence, or the extent of the section 712(d) of the Dodd-Frank Act. mixed swaps as may be necessary to occurrence of an event or contingency associated Based on this review and with a potential financial, economic, or commercial consultation, the Commissions are 5 7 U.S.C. 1 et seq. consequence (other than the occurrence, non- adopting rules and interpretations occurrence, or extent of the occurrence of an event 6 The CFTC has issued final rules regarding SDRs relating to a single issuer of a security or the issuers regarding, among other things: (i) The and, separately, swap data recordkeeping and of securities in a narrow-based security index, regulatory treatment of insurance reporting. See Swap Data Repositories: Registration provided that such event directly affects the Standards, Duties and Core Principles, 76 FR 54538 products; (ii) the exclusion of forward financial statements, financial condition, or (Sep. 1, 2011); Swap Data Recordkeeping and contracts from the swap and security- financial obligations of the issuer). Reporting Requirements, 77 FR 2136 (Jan. 13, 2012). 11 The SEC has also issued proposed rules regarding Section 761(a) of the Dodd-Frank Act defines the term ‘‘security-based swap agreement’’ by meetings with interested parties. See Public security-based swap data repositories (‘‘SBSDRs’’), Comments on SEC Regulatory Initiatives Under the including rules specifying data collection and adding new section 3(a)(78) to the Exchange Act, 15 U.S.C. 78c(a)(78). The CEA includes the definition Dodd-Frank Act/Meetings with SEC Officials, maintenance standards for SBSDRs, as well as rules of ‘‘security-based swap agreement’’ in located at http://www.sec.gov/spotlight/ regarding security-based swap data recordkeeping subparagraph (A)(v) of the swap definition in CEA regreformcomments.shtml; Public Submissions, and reporting. See Security-Based Swap Data section 1a(47), 7 U.S.C. 1a(47). The only difference located at http://comments.cftc.gov/Public Repository Registration, Duties, and Core between these definitions is that the definition of Comments/ReleasesWithComments.aspx; External Principles, 75 FR 77306 (Dec. 10, 2010); Regulation SBSA in the Exchange Act specifically excludes Meetings, located at http://www.cftc.gov/Law SBSR—Reporting and Dissemination of Security- security-based swaps (see section 3(a)(78)(B) of the Regulation/DoddFrankAct/ExternalMeetings/ Based Swap Information, 75 FR 75208 (Dec. 2, Exchange Act, 15 U.S.C. 78c(a)(78)(B)), whereas the index.htm. 2010). 13 definition of SBSA in the CEA does not contain a Copies of all comments received by the SEC on 7 The CFTC has issued final rules regarding similar exclusion. Instead, under the CEA, the the ANPR are available on the SEC’s Internet Web recordkeeping requirements for swap dealers and exclusion for security-based swaps is placed in the site, located at http://www.sec.gov/comments/s7-16- major swap participants. See Swap Dealer and general exclusions from the swap definition (see 10/s71610.shtml. Comments are also available for Major Swap Participant Recordkeeping, Reporting, CEA section 1a(47)(B)(x), 7 U.S.C. 1a(47)(B)(x)). Web site viewing and printing in the SEC’s Public and Duties Rules; Futures Commission Merchant Although the statutes are slightly different Reference Room, 100 F Street NE., Washington, DC and Introducing Broker Conflicts of Interest Rules; structurally, the Commissions interpret them to 20549, on official business days between the hours and Chief Compliance Officer Rules for Swap have consistent meaning that the category of of 10 a.m. and 3 p.m. Copies of all comments Dealers, Major Swap Participants, and Futures security-based swap agreements excludes security- received by the CFTC on the ANPR are available on Commission Merchants, 77 FR 20128 (Apr. 3, 2012). based swaps. the CFTC’s Internet Web site, located at http://www. _ _ 8 Section 721(a) of the Dodd-Frank Act defines 12 See Definitions Contained in Title VII of Dodd- cftc.gov/LawRegulation/DoddFrankAct/OTC 2 the term ‘‘swap’’ by adding section 1a(47) to the Frank Wall Street Reform and Consumer Protection Definitions.html. CEA, 7 U.S.C. 1a(47). This new swap definition also Act, 75 FR 51429 (Aug. 20, 2010). The ANPR also 14 See supra note 12. is cross-referenced in new section 3(a)(69) of the solicited comment regarding the definitions of the 15 See Further Definition of ‘‘Swap,’’ ‘‘Security- Exchange Act, 15 U.S.C. 78c(a)(69). Citations to terms ‘‘swap dealer,’’ ‘‘security-based swap dealer,’’ Based Swap,’’ and ‘‘Security-Based Swap provisions of the CEA and the Exchange Act, 15 ‘‘major swap participant,’’ ‘‘major security-based Agreement’’; Mixed Swaps; Security-Based Swap U.S.C. 78a et seq., in this release refer to the swap participant,’’ and ‘‘eligible contract Agreement Recordkeeping, 76 FR 29818 (May 23, numbering of those provisions after the effective participant.’’ These definitions are the subject of a 2011) (‘‘Proposing Release’’). date of Title VII, except as indicated. separate joint rulemaking by the Commissions. See 16 Id. 9 Section 761(a) of the Dodd-Frank Act defines Further Definition of ‘‘Swap Dealer,’’ ‘‘Security- 17 Information about meetings that CFTC staff the term ‘‘security-based swap’’ by adding new Based Swap Dealer,’’ ‘‘Major Swap Participant,’’ have had with outside organizations regarding the section 3(a)(68) to the Exchange Act, 15 U.S.C. ‘‘Major Security-Based Swap Participant’’ and implementation of the Dodd-Frank Act is available 78c(a)(68). This new security-based swap definition ‘‘Eligible Contract Participant,’’ 77 FR 30596 (May at http://www.cftc.gov/LawRegulation/DoddFrank also is cross-referenced in new CEA section 1a(42), 23, 2012) (‘‘Entity Definitions Release’’). The Act/ExternalMeetings/index.htm. Information about 7 U.S.C. 1a(42). The Dodd-Frank Act also explicitly Commissions also provided the public with the meetings that SEC staff have had with outside includes security-based swaps in the definition of ability to present their views more generally on organizations regarding the product definitions is security under the Exchange Act and the Securities implementation of the Dodd-Frank Act through available at http://www.sec.gov/comments/s7-16- Act of 1933 (‘‘Securities Act’’), 15 U.S.C. 77a et seq. their Web sites, dedicated electronic mailboxes, and 10/s71610.shtml#meetings.

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based swap definitions; (iii) the CFTC or the SEC may be impacted by term ‘‘swap.’’ 22 The statutory definition regulatory treatment of certain similarities and differences in the of the term ‘‘swap’’ also has various consumer and commercial contracts; Commissions’ regulatory programs for exclusions,23 rules of construction, and (iv) the regulatory treatment of certain swaps and security-based swaps. Title other provisions for the interpretation of foreign-exchange related and other VII calls on the SEC and the CFTC to the definition.24 One of the exclusions instruments; (v) swaps and security- consult and coordinate for the purposes to the definition of the term ‘‘swap’’ is based swaps involving interest rates (or of assuring regulatory consistency and for security-based swaps.25 The term other monetary rates) and yields; (vi) comparability to the extent possible.20 ‘‘security-based swap,’’ in turn, is total return swaps (‘‘TRS’’); (vii) Title Title VII also calls on the agencies to defined as an agreement, contract, or VII instruments based on futures treat functionally or economically transaction that is a ‘‘swap’’ (without contracts; (viii) the application of the similar products or entities in a similar regard to the exclusion from that definition of ‘‘narrow-based security manner, but does not require identical definition for security-based swaps) and index’’ in distinguishing between 21 rules. Although the Commissions may that also has certain characteristics certain swaps and security-based swaps, differ on certain rulemakings, as the specified in the statute.26 Thus, the including credit default swaps (‘‘CDS’’) relevant products, entities and markets statutory definition of the term ‘‘swap’’ and index CDS; and (ix) the are different, the Commissions believe also determines the scope of specification of certain swaps and that, as the CFTC and SEC regulatory agreements, contracts, and transactions security-based swaps that are, and are regimes share a statutory basis in Title that could be security-based swaps. not, mixed swaps. In addition, the VII, the costs and benefits of their Commissions are adopting rules: (i) To respective regimes should be broadly The statutory definitions of the terms clarify that there will not be additional similar and complementary. ‘‘swap’’ and ‘‘security-based swap’’ are books and records requirements In acknowledging the economic detailed and comprehensive, and the applicable to SBSAs other than those consequences of the final rules, the Commissions believe that extensive required for swaps; (ii) providing a Commissions recognize that the Product ‘‘further definition’’ of the terms by rule mechanism for requesting the is not necessary. Nevertheless, the Commissions to interpret whether a Definitions do not themselves establish the scope or nature of those substantive definitions could be read to include particular type of agreement, contract, certain types of agreements, contracts, or transaction (or class of agreements, requirements or their related costs and benefits. In determining the appropriate and transactions that previously have contracts, or transactions) is a swap, not been considered swaps or security- security-based swap, or both (i.e., a scope of these rules, the Commissions consider the types of agreement, based swaps, and nothing in the mixed swap); and (iii) providing a legislative history of the Dodd-Frank mechanism for evaluating the contract, or transaction that should be Act appears to suggest that Congress applicability of certain regulatory regulated as a swap, security-based intended such agreements, contracts, or requirements to particular mixed swaps. swap, or mixed swap under Title VII in Finally, the CFTC is adopting rules to light of the purposes of the Dodd-Frank transactions to be regulated as swaps or implement the anti-evasion authority Act. The Commissions have sought to security-based swaps under Title VII. provided in the Dodd-Frank Act. further define the terms ‘‘swap,’’ The Commissions thus believe that it is ‘‘security-based swap,’’ and ‘‘mixed important to further clarify the Overall Economic Considerations swap’’ to include agreements, contracts, treatment under the definitions of The Commissions are sensitive to the and transactions only to the extent that certain types of agreements, contracts, costs and benefits of their rules. In capturing these agreements, contracts, and transactions, such as insurance considering the adoption of the Product and transactions is necessary and products and certain consumer and Definitions, the Commissions have been appropriate given the purposes of Title commercial contracts. VII, and to exclude agreements, mindful of the costs and benefits In addition, commenters also raised contracts, and transactions to the extent associated with these rules, which questions regarding, and the provide fundamental building blocks for that the regulation of such agreements, Commissions believe that it is important the Title VII regulatory regime. There contracts, and transactions does not to clarify: (i) The exclusion for forward are costs, as well as benefits, arising serve the statutory purposes of Title VII, from subjecting certain agreements, so as not to impose unnecessary contracts from the definitions of the contracts, or transactions to the burdens for agreements, contracts, and terms ‘‘swap’’ and ‘‘security-based regulatory regime of Title VII.18 transactions whose regulation may not swap;’’ and (ii) the status of certain Additionally, there are costs that parties be necessary or appropriate to further commodity-related products (including will incur to assess whether certain the purposes of Title VII. various foreign exchange products and agreements, contracts, or transactions forward rate agreements) under the II. Scope of Definitions of Swap and are indeed subject to the Title VII definitions of the terms ‘‘swap’’ and Security-Based Swap regulatory regime, and, if so, the costs ‘‘security-based swap.’’ Finally, the to assess whether such Title VII A. Introduction Commissions are providing instrument is subject to the regulatory regime of the SEC or the CFTC.19 Title VII of the Dodd-Frank Act 22 See CEA section 1a(47)(A), 7 U.S.C. 1a(47)(A). Title VII created a jurisdictional applies to a wide variety of agreements, This swap definition is also cross-referenced in new division between the CFTC and SEC. contracts, and transactions classified as section 3(a)(69) of the Exchange Act, 15 U.S.C. 78c(a)(69). The costs and benefits flowing from an swaps or security-based swaps. The 23 See CEA section 1a(47)(B), 7 U.S.C. 1a(47)(B), agreement, contract, or transaction being statute lists these agreements, contracts, clauses (i)–(x). subject to the regulatory regime of the and transactions in the definition of the 24 See CEA sections 1a(47)(C)–(F), 7 U.S.C. 1a(47)(C)–(F). 18 The Commissions refer to these costs and 20 See sections 712(a)(1) and (a)(2) of the Dodd- 25 See CEA section 1a(47)(B)(x), 7 U.S.C. benefits as programmatic costs and benefits. Frank Act. 1a(47)(B)(x). 19 The Commissions refer to these costs as 21 See sections 712(a)(7)(A) and (B) of the Dodd- 26 See section 3(a)(68) of the Exchange Act, 15 assessment costs. Frank Act. U.S.C. 78c(a)(68).

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interpretations related to the provides that a swap ‘‘shall not be Provider Test must be regulated as definitions.27 considered to be insurance’’ and ‘‘may insurance under applicable state law or not be regulated as an insurance the laws of the United States. B. Rules and Interpretations Regarding contract under the law of any State.’’ 30 The final rules contain four subparts: Certain Transactions Outside the Scope Accordingly, the Commissions believe of the Definitions of the Terms ‘‘Swap’’ The first subpart addresses the that state or Federally regulated and ‘‘Security-Based Swap’’ agreement, contract, or transaction; the insurance products that are provided by second subpart addresses the person 31 1. Insurance Products persons that are subject to state or providing that agreement, contract, or The statutory definition of the term Federal insurance supervision, that transaction; the third subpart includes a ‘‘swap’’ includes, in part, any otherwise could fall within the list of traditional insurance products agreement, contract or transaction ‘‘that definitions should not be considered that do not have to meet the provides for any purchase, sale, swaps or security-based swaps so long requirements set out in the first subpart; payment or delivery (other than a as they satisfy the requirements of the and the fourth subpart contains the dividend on an equity security) that is Insurance Safe Harbor (as defined Insurance Grandfather exclusion (as dependent on the occurrence, below). At the same time, however, the defined below). nonoccurrence, or the extent of the Commissions are concerned that certain More specifically, with respect to the occurrence of an event or contingency agreements, contracts, or transactions first subpart, the Commissions are associated with a potential financial, that are swaps or security-based swaps adopting paragraph (i)(A) of rule economic, or commercial might be characterized as insurance 1.3(xxx)(4) under the CEA and consequence.’’ 28 As stated in the products to evade the regulatory regime paragraph (a)(1) of rule 3a69–1 under Proposing Release, the Commissions do under Title VII of the Dodd-Frank Act. the Exchange Act (the ‘‘Product Test’’) not interpret this clause to mean that Accordingly, the Commissions are as proposed, with certain modifications products historically treated as adopting final rules that (i) clarify that to respond to commenters’ concerns. As insurance products should be included certain agreements, contracts, or adopted, the Product Test provides that within the swap or security-based swap transactions that satisfy the the terms ‘‘swap’’ and ‘‘security-based definitions.29 The Commissions are requirements of the Insurance Safe swap’’ will not include an agreement, aware of nothing in Title VII to suggest Harbor will not be considered to be contract, or transaction that, by its terms that Congress intended for traditional swaps or security-based swaps, and (ii) or by law, as a condition of insurance products to be regulated as provide an Insurance Grandfather performance: swaps or security-based swaps. exclusion from the swap and security- • Requires the beneficiary of the Moreover, the fact that swaps and based swap definitions for any agreement, contract, or transaction to insurance products are subject to agreement, contract, or transaction have an insurable interest that is the different regulatory regimes is reflected entered into on or before the effective subject of the agreement, contract, or in section 722(b) of the Dodd-Frank Act date of the Product Definitions, transaction and thereby carry the risk of which, in new section 12(h) of the CEA, provided that, when the parties entered loss with respect to that interest into such agreement, contract, or continuously throughout the duration of transaction, it was provided in 27 In response to the ANPR, some commenters the agreement, contract, or transaction; raised concerns regarding the treatment of inter- accordance with the Provider Test (as • Requires that loss to occur and be affiliate swaps and security-based swaps. See, e.g., defined below), including a requirement proved, and that any payment or Letter from Edward J. Rosen, Cleary Gottlieb Steen that an agreement, contract or indemnification therefor be limited to & Hamilton LLP, Sep. 21, 2010 (‘‘Cleary ANPR transaction that is provided in Letter’’); Letter from Coalition for Derivatives End the value of the insurable interest; accordance with the first prong of the Users, Sep. 20, 2010 (‘‘CDEU ANPR Letter’’); Letter • Is not traded, separately from the from Robert Pickel, Executive Vice President, insured interest, on an organized market International Swaps and Derivatives Association, 30 7 U.S.C. 16(h). Moreover, other provisions of Inc. (‘‘ISDA’’), Sep. 20, 2010; Letter from Richard the Dodd-Frank Act address the status of insurance or over the counter; and A. Miller, Vice President and Corporate Counsel, more directly, and more extensively, than Title VII. • With respect to financial guaranty Prudential Financial Inc., Sep. 17, 2010; Letter from For example, Title V of the Dodd-Frank Act requires insurance only, in the event of payment Richard M. Whiting, The Financial Services the newly established Federal Insurance Office to default or insolvency of the obligor, any Roundtable, Sep. 20, 2010. A few commenters conduct a study and submit a report to Congress, suggested that the Commissions should further within 18 months of enactment of the Dodd-Frank acceleration of payments under the define the term ‘‘swap’’ or ‘‘security-based swap’’ to Act, on the regulation of insurance, including the policy is at the sole discretion of the exclude inter-affiliate transactions. See Cleary consideration of Federal insurance regulation. insurer. ANPR Letter and CDEU ANPR Letter. The Notably, the Federal Insurance Office’s authority Commissions are considering whether inter-affiliate under Title V extends primarily to monitoring and The Commissions are also adopting swaps or security-based swaps should be treated information gathering; its ability to promulgate paragraph (i)(B) of rule 1.3(xxx)(4) differently from other swaps or security-based Federal insurance regulation that preempts state under the CEA and paragraph (a)(2) of swaps in the context of the Commissions’ other insurance regulation is significantly restricted. See rule 3a69–1 under the Exchange Act Title VII rulemakings. section 502 of the Dodd-Frank Act (codified in 28 CEA section 1a(47)(A)(ii), 7 U.S.C. 1a(47)(A)(ii). various sections of 31 U.S.C.). Title V also (the ‘‘Provider Test’’) as proposed, with 29 See Proposing Release at 29821. The addressed non-admitted insurance and reinsurance. certain modifications to respond to Commissions continue to believe that it was not the Title X of the Dodd-Frank Act also specifically commenters’ concerns. As adopted, the intent of Congress through the swap and security- excludes the business of insurance from regulation Provider Test requires that an based swap definitions to preclude the provision of by the Bureau of Consumer Financial Protection. insurance to individual homeowners and small See section 1027(m) of the Dodd-Frank Act, 12 agreement, contract, or transaction that businesses that purchase property and casualty U.S.C. 5517(m) (‘‘The [Bureau of Consumer insurance. See section 2(e) of the CEA, 7 U.S.C. 2(e), Financial Protection] may not define as a financial 31 In response to commenters, the Commissions and section 6(l) of the Exchange Act, 15 U.S.C. product or service, by regulation or otherwise, are changing the word ‘‘company’’ from the 78f(l) (prohibiting individuals and small businesses engaging in the business of insurance.’’); section proposal to ‘‘person.’’ Each of the CEA, the that do not meet specified financial thresholds or 1027(f) of the Dodd-Frank Act, 12 U.S.C. 5517(f) Securities Act, and the Exchange Act contains a other conditions from entering into swaps or (excluding persons regulated by a state insurance definition of a ‘‘person.’’ See, e.g., Letter from Carl security-based swaps other than on or subject to the regulator, except to the extent they are engaged in B. Wilkerson, Vice President & Chief Counsel, rules of regulated futures and securities exchanges). the offering or provision of consumer financial American Council of Life Insurers (‘‘ACLI’’), dated Historically, insurance has not been regulated as products or services or otherwise subject to certain July 22, 2011 (‘‘ACLI Letter’’) and Letter from John such under the Federal securities laws or under the consumer laws as set forth in Title X of the Dodd- P. Mulhern, Dewey & LeBoeuf LLP (‘‘D&L’’), dated CEA. See infra note 1283. Frank Act). July 22, 2011 (‘‘D&L Letter’’).

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satisfies the Product Test must be or losses paid by the cedant 37 ((i), (ii), products included in the Enumerated provided: and (iii), collectively, the ‘‘third Product list and provided in accordance • By a person that is subject to prong’’); or with the Provider test do not fall within supervision by the insurance • In the case of non-admitted the swap or security-based swap commissioner (or similar official or insurance 38 by a person who: definitions. An agreement, contract, or agency) of any state 32 or by the United (i) Is located outside of the United transaction that is labeled as States or an agency or instrumentality 33 States and listed on the Quarterly ‘‘reinsurance’’ or ‘‘retrocession’’, but is Listing of Alien Insurers as maintained thereof, and such agreement, contract, executed as a swap or security-based by the International Insurers or transaction is regulated as insurance swap or otherwise is structured to evade under applicable state law 34 or the laws Department of the National Association of Insurance Commissioners; or Title VII of the Dodd-Frank Act, would of the United States (the ‘‘first prong’’); not satisfy the Insurance Safe Harbor, • (i) Directly or indirectly by the (ii) Meets the eligibility criteria for non-admitted insurers 39 under and would be a swap or security-based United States, any state or any of their swap.41 respective agencies or instrumentalities, applicable state law ((i) and (ii) together, or (ii) pursuant to a statutorily the ‘‘fourth prong’’). In order for an agreement, contract, or In response to commenters’ requests authorized program thereof ((i) and (ii) transaction to qualify under the final that the Commissions codify the together, the ‘‘second prong’’); or rules as an insurance product that proposed interpretation regarding • In the case of reinsurance only 35 by would not be a swap or security-based certain enumerated types of traditional a person to another person that satisfies swap: (i) The agreement, contract, or insurance products in the final rules,40 the Provider Test, provided that: transaction must satisfy the criteria in the Commissions are also adopting the Product Test or be one of the (i) Such person is not prohibited by paragraph (i)(C) of rule 1.3(xxx)(4) applicable state law or the laws of the under the CEA and paragraph (a)(3) of Enumerated Products and (ii) the person United States from offering such rule 3a69–1 under the Exchange Act. In providing the agreement, contract or agreement, contract, or transaction to addition, in response to comments, the transaction must satisfy one prong of the such person that satisfies the Provider Commissions are expanding and Provider Test.42 The fact that an Test; revising the enumerated types of agreement, contract, or transaction (ii) The agreement, contract, or traditional insurance products. As satisfies the Product Test or is one of the transaction to be reinsured satisfies the adopted, the rule provides that the Enumerated Products does not exclude Product Test or is one of the terms ‘‘swap’’ and ‘‘security-based it from the swap or security-based swap Enumerated Products (as defined swap’’ will not include an agreement, definitions if it is not provided by a below); and contract, or transaction that is provided person that satisfies the Provider Test; (iii) Except as otherwise permitted in accordance with the Provider Test nor does the fact that a product is under applicable state law, the total and is any one of the following provided by a person that satisfies the amount reimbursable by all reinsurers 36 (collectively, ‘‘Enumerated Products’’): Provider Test exclude the product from for such agreement, contract, or Surety bonds; fidelity bonds; life the swap or security-based swap transaction may not exceed the claims insurance; health insurance; long-term definitions if the agreement, contract, or care insurance; title insurance; property transaction does not satisfy the criteria 32 The term ‘‘State’’ is defined in section 3(a)(16) and casualty insurance; annuities; set forth in the Product Test or is not of the Exchange Act, 15 U.S.C. 78c(a)(16), to mean disability insurance; insurance against ‘‘any State of the United States, the District of one of the Enumerated Products.43 Columbia, Puerto Rico, the Virgin Islands, or any default on individual residential mortgages (commonly known as private other possession of the United States.’’ The CFTC 41 is incorporating this definition into rule 1.3(xxx)(4) For example, if a person uses a weather mortgage insurance, as distinguished derivative or catastrophe swap to assume all or part for purposes of ensuring consistency between the from financial guaranty of mortgage CFTC and SEC rules further defining the terms of the risks contained in a portfolio of property and ‘‘swap’’ and ‘‘security-based swap.’’ pools); and reinsurance (including casualty insurance policies, that weather derivative or catastrophe swap would be a Title VII instrument 33 For purposes of this release, the term retrocession) of any of the foregoing. ‘‘instrumentality’’ includes publicly supported, The Commissions note that the that is subject to regulation under Title VII. 42 state operated or quasi-state operated insurance inclusion of reinsurance (including As was discussed in the Proposing Release, see Proposing Release at 29822 n. 31, certain variable programs that may not be subject to state regulatory retrocession) as an Enumerated Product oversight, such as the Illinois Mine Subsidence life insurance products and annuities are securities Insurance Fund and the Florida Hurricane is meant to apply to traditional and therefore are excluded from the swap and Catastrophe Fund. reinsurance and retrocession contracts. security-based swap definitions regardless of 34 For purposes of this release, the Commissions Specifically, traditional reinsurance and whether they meet the requirements under the final anticipate that the parties to an agreement, contract, retrocession contracts that reinsure risks rules. See section 1a(47)(B)(v) of the CEA, 7 U.S.C. or transaction will evaluate which state law applies 1a(47)(B)(v). These securities would not be swaps prior to entering into such agreement, contract, or ceded under traditional insurance or security-based swaps whether or not required to transaction. The Commissions do not anticipate that be registered under the Securities Act. See SEC v. the parties’ analysis of which state law applies will 37 For purposes of this release, the term ‘‘cedant’’ United Benefit Life Ins. Co., 387 U.S. 202 (1967) change as a result of the adoption of the Insurance means the person writing the risk being ceded or (holding that the accumulation provisions of a Safe Harbor. In addition, the Commissions will transferred to a reinsurer. ‘‘flexible fund’’ annuity contract were not entitled analyze which state law applies (if necessary, in 38 For purposes of this release, the term ‘‘non- to exemption under section 3(a)(8) of the Securities consultation with state insurance regulatory admitted insurance’’ means any property and Act, 15 U.S.C. 77c(a)(8), for insurance and authorities) if and when such issues arise that the casualty insurance permitted to be placed directly annuities); SEC v. Variable Annuity Life Ins. Co., Commissions determine to address. The or through a surplus lines broker with a non- 359 U.S. 65 (1959) (holding that a variable annuity Commissions note that courts routinely determine admitted insurer eligible to accept such insurance. was not entitled to exemption under section 3(a)(8) what is the ‘‘applicable state law’’ when 39 For purposes of this release, the term ‘‘non- of the Securities Act). adjudicating disputes involving insurance. admitted insurer’’ means, with respect to any State, 43 For the purpose of determining whether an 35 For purposes of this release, the term an insurer not licensed to engage in the business of agreement, contract or transaction falls within the ‘‘reinsurance’’ means the assumption by an insurer insurance in such State, but does not include a risk Insurance Safe Harbor, Title VII provides the of all or part of a risk undertaken originally by retention group, as that term is defined in section Commissions with flexibility to address the facts another insurer. 2(a)(4) of the Liability Risk Retention Act of 1986, and circumstances of new products that may be 36 For purposes of this release, the term 15 U.S.C. 3901(a)(4). marketed or sold as insurance, through joint ‘‘reinsurer’’ means any person who provides 40 See infra notes 88, 89, and 90 and interpretations pursuant to section 712(d)(4) of the reinsurance. accompanying text. Dodd-Frank Act.

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Further, in response to commenters’ requirement that the beneficiary be at indemnifying the beneficiary for such concerns,44 the Commissions are risk of loss (which could be an adverse loss. In addition, limiting any payment confirming that the Product Test, the financial, economic, or commercial or indemnification to the value of the Provider Test and the Enumerated consequence) with respect to the insurable interest aids in distinguishing Products represent a non-exclusive safe interest that is the subject of the swaps and security-based swaps (where harbor. None of the Product Test, the agreement, contract, or transaction there is no such limit) from insurance.50 Provider Test, or the Enumerated continuously throughout the duration of Third, the final rules require that the Products (collectively, the ‘‘Insurance the agreement, contract, or transaction insurance product not be traded, Safe Harbor’’) implies or presumes that will ensure that an insurance contract separately from the insured interest, on an agreement, contract, or transaction beneficiary has a stake in the interest on an organized market or over the counter. that does not meet any of their which the agreement, contract, or As the Commissions observed in the respective requirements is a swap or transaction is written.47 Similarly, the Proposing Release, with limited security-based swap. Such an requirement that the beneficiary have exceptions,51 insurance products agreement, contract, or transaction will the insurable interest continuously traditionally have not been entered into require further analysis of the applicable throughout the duration of the on or subject to the rules of an organized facts and circumstances, including the agreement, contract, or transaction is exchange nor traded in secondary form and substance of such agreement, designed to ensure that payment on the market transactions (i.e., they are not contract, or transaction, to determine insurance product is inextricably traded on an organized market or over whether it is insurance, and thus not a connected to both the beneficiary and the counter). While swaps and security- swap or security-based swap. the interest on which the insurance based swaps also generally have not However, future market conditions or product is written. In contrast to been tradable at will in secondary other developments may prompt the insurance, a credit default swap market transactions (i.e., on an Commissions to reconsider whether a (‘‘CDS’’) (which may be a swap or a organized market or over the counter) particular product that satisfies the security-based swap) does not require without counterparty consent, the requirements of the Insurance Safe the purchaser of protection to hold any Commissions understand that all or part Harbor should instead fall within the underlying obligation issued by the of swaps and security-based swaps are swap or security-based swap definition. reference entity on which the CDS is novated or assigned to third parties, Because a determination that such a written.48 One commenter identified the usually pursuant to industry standard product is a swap or security-based existence of an insurable interest as a terms and documents.52 In response to swap could potentially have an material element to the existence of an commenter concerns,53 the unsettling effect on the domestic insurance contract.49 Because neither Commissions are clarifying when insurance or financial markets, the swaps nor security-based swaps require assignments of insurance contracts and Commissions would only consider the presence of an insurable interest at trading on ‘‘insurances exchanges’’ do making a determination that such a all (although an insurable interest may not constitute trading the contract product is a swap or security-based sometimes be present coincidentally), separately from the related insurable swap through a rulemaking 45 process the Commissions continue to believe interest, and thus would not violate the that would provide market participants that whether an insurable interest is Product Test. The Commissions do not with an opportunity to comment.46 present continuously throughout the interpret the assignment of an insurance duration of the agreement, contract, or contract as described by commenters 54 (a) Types of Insurance Products transaction is a meaningful way to Final Rules distinguish insurance from swaps and 50 To the extent an insurance product provides for security-based swaps. such items as, for example, a rental car for use Product Test while the car that is the subject of an automobile Second, the requirement that a loss insurance policy is being repaired, the The Commissions are adopting the occur and be proved similarly ensures Commissions would consider such items as Product Test as proposed, with certain that the beneficiary has a stake in the constituting part of the value of the insurable modifications to respond to insurable interest that is the subject of interest. commenters’ concerns. The Product the agreement, contract, or transaction. 51 See, e.g., ‘‘Life Settlements Task Force, Staff Test sets forth four criteria for an Report to the United States Securities and Exchange If the beneficiary can demonstrate loss, Commission’’ (‘‘In an effort to help make the agreement, contract, or transaction to be that loss would ‘‘trigger’’ performance bidding process more efficient and to facilitate considered insurance. First, the final by the insurer on the agreement, trading of policies after the initial settlement rules require that the beneficiary have contract, or transaction such that, by occurs, some intermediaries have considered or an ‘‘insurable interest’’ underlying the instituted a trading platform for life settlements.’’), making payment, the insurer is available at http://www.sec.gov/news/studies/2010/ agreement, contract, or transaction and lifesettlements-report.pdf (July 22, 2010). thereby carry the risk of loss with 47 Requiring that a beneficiary of an insurance 52 See, e.g., ISDA, 2005 Novation Protocol, respect to that interest continuously policy have a stake in the interest traditionally has available at http://www.isda.org/2005novationprot/ throughout the duration of the been justified on public policy grounds. For docs/NovationProtocol.pdf (2005); ISDA, ISDA example, a beneficiary that does not have a property Novation Protocol II, available at http:// agreement, contract, or transaction. The right in a building might have an incentive to profit www.isda.org/isdanovationprotII/docs/NPII.pdf from arson. (2005); 2003 Definitions, Exhibits E (Novation 44 See infra notes 178 and 179 and accompanying 48 Standard CDS documentation stipulates that Agreement) and F (Novation Confirmation). text. the incurrence or demonstration of a loss may not 53 See infra notes 74 and 75 and accompanying 45 The Commissions can engage in rulemakings in be made a condition to the payment on the CDS or text. a variety of ways including an advanced notice of the performance of any obligation pursuant to the 54 See, e.g., Letter from Kim O’Brien, President & proposed rulemaking, a notice of proposed CDS. See, e.g., ISDA, 2003 ISDA Credit Derivatives CEO, National Association for Fixed Annuities rulemaking, or an interim final rule. Definitions, art. 9.1(b)(i) (2003) (‘‘2003 Definitions’’) (‘‘NAFA’’), dated July 21, 2011 (‘‘NAFA Letter’’); 46 When determining whether a particular (stating that ‘‘the parties will be obligated to Letter from Robert Pickel, Executive Vice Chairman, product is a swap or security-based swap instead of perform * * * irrespective of the existence or ISDA, dated July 22, 2011 (‘‘ISDA Letter’’); ACLI insurance, if such product does not meet the amount of the parties’ credit exposure to a Letter; and Letter from Letter from Stephen E. Roth, requirements set out in the Insurance Safe Harbor, Reference Entity, and Buyer need not suffer any loss Frederick R. Bellamy and James M. Cain, the Commissions will consider prior regulation as nor provide evidence of any loss as a result of the Sutherland Asbill & Brennan LLP on behalf of the an insurance contract as one factor in their occurrence of a Credit Event’’). Committee of Annuity Insurers (‘‘CAI’’), dated July respective facts and circumstances analysis. 49 See D&L Letter. 22, 2011 (‘‘CAI Letter’’).

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to be ‘‘trading’’ as that term is used in For example, under a financial guaranty Finally, in response to comments,61 the Product Test.55 Nor do the policy, the insurer typically is required the Commissions are clarifying that Commissions find that the examples of to make timely payment of any reinsurance and retrocession exchanges offered by commenters,56 shortfalls in the payment of scheduled transactions fall within the scope of the such as Federal Patient Protection and interest to the holders of the underlying Product Test. The Commissions find Affordable Care Act ‘‘exchanges,’’ 57 are guaranteed obligation. Also, for that these transactions have insurable exchanges as that term is used in the particular bonds that are covered by a interests, as the Commissions interpret Product Test, e.g., a national securities financial guaranty policy, the indenture, such interests in this context, if they exchange or designated contract market. related documentation, and/or the have issued insurance policies covering Mandated insurance exchanges are more financial guaranty policy will provide the risks that they wish to insure (and like marketplaces for the purchase of that a default in payment of principal or reinsure). Moreover, the Commissions insurance, and there is no trading of interest on the underlying bond will not find that retrocession transactions are insurance policies separately from the result in acceleration of the obligation of encompassed within the Product Test insured interest on these insurance the insurer to make payment of the full and the Provider Test because exchanges. Thus, the assignment of an amount of principal on the underlying retrocession is reinsurance of insurance contract as permitted or guaranteed obligation unless the reinsurance (provided the retrocession required by state law, or the purchase or insurer, in its sole discretion, opts to satisfies the other requirements of both assignment of an insurance contract on make payment of principal prior to the tests). In addition, reinsurance an insurance exchange or otherwise, final scheduled maturity date of the (including retrocession) of certain types does not constitute trading an underlying guaranteed obligation. of insurance products is included in the agreement, contract, or transaction Conversely, under a CDS, a protection list of Enumerated Products.62 separately from the insured interest and seller frequently is required to make Requiring all of the criteria in the would not violate the trading restriction payment of the relevant settlement Product Test will help to limit the in the Product Test. For the foregoing amount to the protection buyer upon application of the final rules to reasons as clarified, the Commissions demand by the protection buyer after agreements, contracts, and transactions continue to believe that lack of trading any credit event involving the issuer.60 that are appropriately regulated as separately from the insured interest is a As noted in the Proposing Release, the insurance, and help to assure that feature of insurance that is useful in Commissions do not believe that agreements, contracts, and transactions distinguishing insurance from swaps financial guaranty policies, in general, appropriately subject to the regulatory and security-based swaps. should be regulated as swaps or regime under Title VII of the Dodd- Fourth, the final rules provide that in security-based swaps. However, because Frank Act are regulated as swaps or the case of financial guaranty insurance of the close economic similarity of security-based swaps. As a result, the policies, also known as bond insurance financial guaranty insurance policies Commissions believe that these or bond wraps, any acceleration of guaranteeing payment on debt securities requirements will help prevent the final payment under the policy must be at the to CDS, in addition to the criteria noted rules from being used to circumvent the sole discretion of the provider of the above with respect to insurance applicability of the swap and security- financial guaranty insurance policy in generally, the final rules require that, in based swap regulatory regimes under order to satisfy the Product Test.58 order to satisfy the Product Test, Title VII. Although such products can be financial guaranty policies also must economically similar to products such Enumerated Products satisfy the requirement that they not as CDS, they have certain key In the Proposing Release, the permit the beneficiary of the policy to characteristics that distinguish them Commissions proposed an accelerate the payment of any principal from swaps and security-based swaps.59 interpretation that certain enumerated due on the debt securities. This types of insurance products would be requirement further distinguishes 55 The assignment of the benefits or proceeds of outside the scope of the statutory an insurance contract by an owner or beneficiary financial guaranty policies from CDS definitions of swap and security-based does not violate the trading restriction in the because, as discussed above, the latter Product Test. This interpretation does not extend to swap under the Dodd-Frank Act if generally requires payment of the provided in accordance with the ‘‘stranger originated’’ products. The transfer of relevant settlement amount on the CDS obligations for policyholder benefits between two Provider Test and regulated as insurance companies, such as would occur in after demand by the protection buyer. insurance. Based on comments connection with an insurance company merger or 63 acquisition, also does not violate the trading received, the Commissions are adding Insurers on the ANPR, dated Sept. 20, 2010 three products to the list of products as restriction contained in the Product Test. (explaining the differences between financial 56 See Letter from Susan E. Voss, Commissioner guaranty policies and CDS); Letter from James M. proposed (fidelity bonds, disability Iowa Insurance Division & National Association of Michener, General Counsel, Assured Guaranty on insurance and insurance against default Insurance Commissioners (‘‘NAIC’’) President, and the ANPR, dated Dec. 14, 2010 (noting that the on individual residential mortgages), Therese M. Vaughan, NAIC Chief Executive Officer, Financial Accounting Standards Board has issued adding reinsurance (including dated July 22, 2011 (‘‘NAIC Letter’’). separate guidance on accounting for financial 57 See Patient Protection and Affordable Care Act; guaranty insurance and CDS); Letter from Ernest C. retrocession) of any of the traditional Establishment of Exchanges and Qualified Health Goodrich, Jr., Managing Director—Legal insurance products included in the list, Plans, 76 FR 41866 (Jul. 15, 2011) (proposed). Department, Deutsche Bank AG on the ANPR, dated deleting a requirement applicable to 58 Financial guarantee policies are used by Sept. 20, 2010 (noting that financial guaranty annuities, and codifying the entities such as municipalities to provide greater policies require the incurrence of loss for payment, assurances to potential purchasers of their bonds whereas CDS do not). Enumerated Products in the final rules. and thus reduce their interest costs. See ‘‘Report by 60 While a CDS requires payment in full on the The revised list of Enumerated Products the United States Securities and Exchange occurrence of a credit event, the Commissions is: Surety bonds, fidelity bonds, life Commission on the Financial Guarantee Market: recognize that there are other financial instruments, insurance, health insurance, long-term The Use of the Exemption in section 3(a)(2) of the such as corporate guarantees of commercial loans Securities Act for Securities Guaranteed by Banks and letters of credit supporting payments on loans and the Use of Insurance Policies to Guarantee Debt or debt securities, that allow for acceleration of 61 See infra note 105 and accompanying text. Securities’’ (Aug. 28, 1987). payment obligations without such guarantees or 62 See supra note 41 and accompany text. 59 See, e.g., Letter from Sean W. McCarthy, letters of credit being swaps or security-based 63 See infra notes 93 and 94 and accompanying Chairman, Association of Financial Guaranty swaps. text.

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care insurance, title insurance, property Commenters also noted that annuities indemnification for loss and that life and casualty insurance, annuities, and health insurance do not require the insurance products are not constrained disability insurance, insurance against existence of an insurable interest at by the value of the insurable interest.71 default on individual residential all.68 Another commenter suggested that Another argued that many insurance mortgages (commonly known as private the Commissions modify the Product policies pay fixed amounts upon the mortgage insurance, as distinguished Test to indicate that annuities would occurrence of a loss without a from financial guaranty of mortgage not need to satisfy the ‘‘insurable requirement that the loss be tied to the pools), and reinsurance (including interest’’ component, or to use value of an insurable interest.72 retrocession) of any of the foregoing.64 terminology other than insurable Disability insurance and long-term care The Commissions believe that the interest to make clear that annuities are insurance are other products that Enumerated Products, as traditional not swaps.69 commenters indicate would not be able insurance products, are not the types of As discussed above, the Commissions to satisfy this requirement of the agreements, contracts, or transactions are retaining the insurable interest Product Test.73 that Congress intended to subject to the requirement of the Product Test. The As discussed above, the Commissions regulatory regime for swaps and Commissions continue to believe that are retaining the requirement in the security-based swaps under the Dodd- this requirement is a useful tool to Product Test that a loss occur and be Frank Act. Codifying the Enumerated distinguish insurance from swaps and proven and that any payment for such Products in the final rules appropriately security-based swaps, because swaps loss be limited to the value of the places traditional insurance products and security-based swaps do not require insurable interest. The Commissions outside the scope of the swap and the presence of an insurable interest (or continue to believe that this security-based swap definition so long require either counterparty to bear any requirement is a useful tool to as such Enumerated Products are risk of loss) at any time during the term distinguish insurance from swaps and provided in accordance with the of the agreement, contract, or security-based swaps, because payments Provider Test, including a requirement transaction. While the Commissions under swaps and security-based swaps that an Enumerated Product that is acknowledge commenters who argued may be required when neither party provided in accordance with the first that products such as life insurance, incurs a loss, nor is the amount of prong of the Provider Test must be property and casualty insurance, and payment limited by any such loss. regulated as insurance under applicable annuities may fail the Product Test While the Commissions acknowledge state law or the laws of the United because of the insurable interest commenters who identified various States. requirement, the Commissions do not products that may fail this part of the interpret any such failure to mean that Product Test, the Commissions do not Comments life insurance, property and casualty interpret any such failure to mean that Insurable Interest insurance, and annuities are not products such as annuities, disability Six commenters objected to the insurance products. To the contrary, as insurance, and long-term care insurance requirement in the Product Test that the discussed above, these products are are not insurance products. To the beneficiary have an insurable interest included in the list of Enumerated contrary, as discussed above, these continuously throughout the duration of Products that are excluded from the products are included in the list of the contract.65 These commenters noted swap and security-based swap Enumerated Products that are excluded that, under state law, an insurable definitions so long as they are provided from the swap and security-based swap interest may not always be required to in accordance with the Provider Test. If definitions so long as they are provided be present continuously throughout the a life insurance, property and casualty in accordance with the Provider Test. If duration of the policy. For example, insurance, or annuity is provided in long-term care insurance, disability commenters noted that life insurance accordance with the Provider Test, such insurance, or an annuity is provided in may only require an insurable interest at product is not a swap or security-based accordance with the Provider Test, such the time the policy is executed; 66 and swap, whether or not an insurable product is not a swap or a security- some property and casualty or liability interest is present at all times during the based swap, whether or not a loss insurance may only require an insurable term of the contract. occurs, is proven, or indemnification for 67 loss is limited to the value of the interest at the time a loss occurs. Indemnification for Loss insurable interest. Five commenters objected to the 64 See supra note 41 and accompanying text. Not Traded Separately 65 See ACLI Letter; CAI Letter; ISDA Letter requirement in the Product Test that a (objecting to the requirement that the risk of loss be loss occur and be proven, and that any Six commenters stated that the held continuously throughout the contact); NAFA payment be limited to the value of the proposed requirement that the Letter; NAIC Letter; and Letter from Kenneth F. insurable interest, because payment agreement, contract, or transaction not Spence III, Executive Vice President & General Counsel, The Travelers Companies, Inc. under many insurance products may not be traded, separately from the insured (‘‘Travelers’’), dated Nov. 14, 2011 (‘‘Travelers be directly based upon actual losses interest, on an organized market or over Letter’’). incurred.70 Two commenters argued the counter, is not an effective criterion 66 See ACLI Letter; CAI Letter; ISDA Letter; NAIC that annuities do not provide in determining whether a product is Letter; and Travelers Letter. The Commissions insurance.74 According to commenters, understand that some states may define what constitutes an insurable interest with reference to Counsel, Financial Policy, The Property Casualty this criterion is ineffective and should personal or emotional consequence in addition to Insurers Association of America, dated July 22, be deleted from the Product Test the financial, economic, or commercial 2011. because many conventional insurance consequence mentioned in the statutory swap 68 See CAI Letter; ISDA Letter; NAFA Letter; and definition. NAIC Letter. 71 67 See NAIC Letter and Travelers Letter. However, 69 See Letter from Nicholas D. Latrenta, Executive See ACLI Letter and Travelers Letter. one commenter noted that the Product and Provider Vice President and General Counsel, Metropolitan 72 See Travelers Letter. Tests, as proposed, should be an effective means of Life Insurance Companies and its insurance 73 See, e.g., ACLI Letter and CAI Letter. helping to distinguish between those contracts that affiliates (‘‘MetLife’’), dated July 22, 2011 (‘‘MetLife 74 See ACLI Letter; Letter from Chris Barnard qualify for exclusion from the definition of swap Letter’’). (‘‘Barnard’’), dated June 28, 2011 (‘‘Barnard Letter’’); and security-based swap from those contracts that 70 See ACLI Letter; CAI Letter; ISDA Letter; NAFA CAI Letter; NAFA Letter; NAIC Letter; and ISDA will not. See Letter from Michael A. Bell, Senior Letter; and Travelers Letter. Letter.

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products, such as annuities, are market.80 Mandated insurance commenter also stated that this assignable (and therefore tradable), exchanges are more like marketplaces uncertainty will impose significant which may violate the trading for the purchase of insurance, and there burdens on financial guaranty insurers restriction.75 Two commenters observed is no trading of insurance policies that insure municipal bonds.86 that the trading of insurance policies separately from the insured interest on The Commissions are retaining the has already occurred and is expected to these insurance exchanges. Thus, the requirement that acceleration be at the increase.76 One commenter stated that a assignment of an insurance contract as sole option of the provider of the number of states have ‘‘insurance permitted or required by state law, or financial guaranty insurance policy in exchanges’’ that sell reinsurance and the purchase or assignment of an the Product Test. In response to excess or surplus lines, and that the insurance contract on an insurance commenter concerns, the Commissions Patient Protection and Affordable Care exchange or otherwise, does not are clarifying that they plan to interpret Act requires states or the Federal constitute trading an agreement, the acceleration limitation in government to establish health benefit contract, or transaction separately from accordance with applicable state law to ‘‘insurance exchanges’’ through which the insured interest and would not the extent that it does not contradict the insurers will sell health insurance to violate the trading restriction in the Commissions’ rules, interpretations individuals and small groups.77 One Product Test. and/or guidance regarding what is a commenter recommended that the 87 Acceleration swap or security-based swap. The trading restriction apply only to trading Commissions continue to believe that, by the policyholder or beneficiary of an Three commenters believed that the for purposes of further defining swaps insurance policy.78 proposed requirement that, in the event and security-based swaps, this criterion The Commissions are retaining the of payment default or insolvency of the is useful to distinguish between requirement in the Product Test that the obligor, any acceleration of payments financial guaranty insurance on the one agreement, contract, or transaction not under a financial guaranty insurance hand, and swaps and security-based be traded separately from the insured policy be at the sole discretion of the swaps, such as CDS, on the other interest, on an organized market or over insurer, is not an effective criterion in because, as discussed above, the latter the counter, and as discussed above determining whether financial guaranty generally requires payment of the have provided a clarification regarding insurance falls outside the swap and relevant settlement amount on the CDS assignments and trading on insurance security-based swap definitions and after demand by the protection buyer. exchanges. The Commissions continue should be deleted from the Product to believe that using this criterion is an Test.81 However, one commenter Enumerated Products effective way to distinguish insurance supported its inclusion, observing that The Commissions proposed an from swaps and security-based swaps the proposed requirement is ‘‘firmly interpretation that certain enumerated because swaps and security-based based on substantive business types of insurance products would be swaps are traded on organized markets realities.’’ 82 Two commenters believed outside the scope of the statutory and over the counter. that the acceleration of payments definitions of swap and security-based As stated above, the Commissions do requirement is not useful in swap. Several commenters stated that not interpret the assignment of an distinguishing between financial the list of enumerated insurance insurance contract as described by guaranty insurance and swaps or products should be codified in order to commenters to be ‘‘trading’’ as that term security-based swaps because it is enhance legal certainty.88 In particular, is used in the Product Test.79 Nor do the designed to protect financial guaranty one commenter stated that it is 83 Commissions find that the examples of insurers from insolvency. They noted important for the Commissions to codify exchanges offered by commenters, such that the criterion is a regulatory the interpretation because the as Federal Patient Protection and requirement imposed by state insurance traditional insurance products included Affordable Care Act ‘‘exchanges,’’ are commissioners that is subject to change, in the enumerated list may not satisfy exchanges as that term is used in the and that a state could not change this the Product Test.89 The commenter also Product Test, e.g., a national securities regulatory requirement without expressed concern that insurance exchange or designated contract converting the financial guaranty policy companies and state insurance into a swap or security-based swap.84 75 Id. ACLI stated that many conventional One commenter stated that the 86 Id. The commenter argued that these burdens insurance products, particularly annuities, can be acceleration of payments criterion has would (a) increase instability in the currently fragile assigned by the owner, and often state insurance been the subject of significant analysis municipal bond market and (b) decrease the law requires such assignability as a condition for and interpretation by state insurance availability or attractiveness of bond insurance to approval of the product for sale under applicable municipal issuers that would otherwise save money insurance law. ACLI also stated that insurance regulators, and including the by employing bond insurance. The Commissions policies are frequently assigned among family requirement in the rules could result in understand that only one member of AFGI is members, to third parties as collateral for loans, and conflicting interpretations and currently active in the municipal bond insurance in a host of other situations, and does not believe additional legal uncertainty.85 This market. that these common kinds of assignment should 87 One commenter noted that ‘‘financial cause an insurance product to be characterized as guarantors, for some time and in full compliance 80 a swap. See supra notes 56 and 57. with state insurance laws, have issued insurance 76 See Barnard Letter and NAIC Letter. 81 See Letter from Bruce E. Stern, Chairman, policies that contemplate acceleration upon events 77 See NAIC Letter. The commenter explained Association of Financial Guaranty Insurers unrelated to an issuer default, e.g., upon the that the ‘‘insurance exchanges’’ mandated by the (‘‘AFGI’’), dated July 20, 2011 (‘‘AFGI Letter’’); downgrade of the insurer.’’ See AFGI Letter. In Patient Protection and Affordable Care Act would ISDA Letter; and Letter from Kimberly M. Welsh, response to this comment, the Commissions note be marketplaces for insurance policies. The Vice President and Assistant General Counsel, that the acceleration requirement in the Product commenter described them as ‘‘cooperatives’’ where Reinsurance Association of America (‘‘RAA’’), Test refers only to ‘‘payment default or insolvency people could go to buy insurance policies with dated July 22, 2011 (‘‘RAA Letter’’). of the obligor’’ (emphasis added), without standardized terms/actuaries. The commenter noted 82 See Letter from Dennis M. Kelleher, President precluding other triggers. that the insurable interest would not ‘‘trade’’ & CEO, Better Markets Inc., dated July 22, 2011 88 See ACLI Letter; NAIC Letter; RAA Letter; AIA separately from the insurance policy in these (‘‘Better Markets Letter’’). Letter; NAFA Letter; and Letter from Mark R. cooperatives. 83 See ISDA Letter and RAA Letter. Thresher, Executive Vice President, Nationwide, 78 See Travelers Letter. 84 Id. dated July 19, 2011 (‘‘Nationwide Letter’’). 79 See supra notes 54 and 55. 85 See AFGI Letter. 89 See Travelers Letter.

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regulators would face the possibility types of insurance products,94 with one deposit administration contracts, that the Commissions could revise or suggesting that the Commissions’ immediate participation guaranty withdraw the interpretation in the interpretation cover all transactions contracts, industry loss warrants, and future, with or without undergoing a currently reportable as insurance in the catastrophe bonds.99 These products do formal rulemaking process.90 As noted provider’s regulatory and financial not receive the benefit of state insurance above, in response to commenters’ reports under a state’s or a foreign guaranty funds; their providers are not concerns, the Commissions are jurisdiction’s insurance laws.95 One limited to insurance companies. The codifying the Enumerated Products in commenter noted that the list of Commissions received little detail on the final rules. enumerated types of insurance products sales of these other products, and do not One commenter further argued that does not include other state-regulated believe it is appropriate to determine the enumerated types of insurance products such as service contracts, that whether particular complex, novel or 96 products included in the list should not may not satisfy the Product Test. In still evolving products are swaps or have to additionally satisfy the response to requests to expand the list security-based swaps in the context of a requirements that the person offering of enumerated products, the general definitional rulemaking. Rather Commissions are adding fidelity these products should be considered in such product be a U.S. domiciled 97 insurer and that the product be bonds, disability insurance, and a facts and circumstances analysis. With regulated in the U.S. as insurance.91 The insurance against default on individual respect to GICs, the Commissions have commenter argued that this additional residential mortgages (commonly published a request for comment requirement would result in the known as private mortgage insurance, as regarding the study of stable value distinguished from financial guaranty of contracts. 100 Insurance Safe Harbor not applying to mortgage pools) to the list of traditional insurance products offered Reliance on State Law Concepts Enumerated Products. The Commissions by insurers domiciled outside of the agree that these are traditional insurance Two commenters noted that the U.S. or by insurers that are not products, and thus their inclusion in the Product Test relies on concepts derived organized as insurance companies. The list of Enumerated Products is from state law, such as ‘‘insurable Commissions are retaining the appropriate. The Commissions have also interest’’ and ‘‘indemnification for loss,’’ requirement that the Enumerated added reinsurance (including which do not have uniform Products be provided in accordance 101 retrocession) of any of the traditional definitions. This would require the with the Provider Test. The insurance products to the list of Commissions also note that, in response Enumerated Products.98 However, the 99 See, e.g., RAA Letter; CAI Letter; Letter from to commenters’ concerns, the Ian K. Shepherd, Managing Director, Alice Corp. Commissions decline at this time to Pty Ltd (‘‘Alice Corp.’’), dated July 22, 2011. Alice Commissions have revised the first expand the list of Enumerated Products prong of the Provider Test so that it is Corp. stated that industry loss warrants are a to include other types of contracts such contingent instrument with a somewhat illiquid not limited to insurance companies or to as, guaranteed investment contracts secondary market but ‘‘are currently treated as a entities that are domiciled in the U.S. A (‘‘GICs’’), synthetic GICs, funding reinsurance product and require an insurable product that need not satisfy the interest.’’ Alice Corp. also stated that ‘‘[c]atastrophe agreements, structured settlements, bonds may reference a specific insured portfolio or Product Test must be provided in a set of parameters and may be traded in a accordance with the Provider Test, 94 See ACLI Letter; AIA Letter; CAI Letter; D&L secondary market and behave like a coupon bond including a requirement that products Letter; NAIC Letter; Letter from Michael A. Bell, if there is no triggering event but have a contingent provided in accordance with the first Senior Counsel, Financial Policy, RAA Letter; and element since some or all of the principal may be Letter from Robert J. Duke, The Surety & Fidelity lost if the referenced event or loss occurs.’’ Id. The prong of the Provider Test must be Commissions note that catastrophe bonds are 92 Association of America (‘‘SFAA’’), dated July 13, regulated as insurance. 2011 (‘‘SFAA Letter’’). ACLI, CAI and RAA ‘‘securities’’ under the Federal securities laws and decline to provide an interpretation regarding requested the addition of other types of annuity and Five commenters addressed the industry loss warrants because it is inappropriate to pension plan products, such as group annuity determine whether a complex and novel product is treatment of annuities in the proposed contracts, guaranteed investment contracts, funding a swap or a security-based swap in a general interpretive guidance, with all agreements, structured settlements, deposit definitional rulemaking. recommending that all annuities be administration contracts, and immediate 100 See Acceptance of Public Submissions excluded from the swap and security- participation guarantee contracts. D&L requested the addition of reinsurance of any of the Regarding the Study of Stable Value Contracts, 76 based definitions regardless of their enumerated types of traditional insurance products. FR 53162 (Aug. 25, 2011). status under the tax laws.93 In response NAIC requested the addition of mortgage guaranty, 101 See ACLI Letter and AFGI Letter. Some states to the comments, the Commissions are accident, and disability insurance. SFAA request define concepts such as ‘‘insurable interest’’ in statute; in other states definitions have developed eliminating the proposed requirement the addition of surety and fidelity bonds. 95 See Letter from J. Stephen Zielezienski, Senior through common law. The Commissions recognize that annuities comply with section 72 of Vice President & General Counsel, American that the terms denoting such concepts may vary the Internal Revenue Code in order to Insurance Association (‘‘AIA’’), dated July 22, 2011 from state to state; for instance, what one state calls qualify as an Enumerated Product. The (‘‘AIA Letter’’). an ‘‘insurable interest’’ may be referred to as a ‘‘material interest’’ in another. See, e.g., New York 96 See NAIC Letter. The Commissions note that Commissions are persuaded that the Insurance Law Section 1101 (‘‘material interest’’). service contracts, although regulated as insurance proposed reference to the Internal The Commissions believe, however, that both the in some states, comprise consumer warranties, Revenue Code is unnecessarily limiting concepts and their labels are well understood by extended service plans, and buyer protection plans insurance professionals and that any such and does not help to distinguish of the sort purchased with major appliances, variations would not impede market participants insurance from swaps and security- electronics, and the like. The Commissions are from interpreting or applying the final rules. based swaps. addressing these contracts in their interpretation Indeed, one commenter acknowledged this and regarding consumer/commercial transactions. See applied the concepts, labeled differently, to Other commenters suggested adding infra part II.B.3. particular products. ‘‘The terms used in the rule’s other products to the list of enumerated 97 SFAA requested that the Commissions issue criteria are different from the terms used with specific guidance that surety and fidelity bonds are respect to a surety bond. For example, the bond is insurance products rather than swaps, noting that generally not referred to as a ‘policy.’ In addition, 90 Id. all states include surety and fidelity bonds as lines the beneficiary of a bond typically is known as the 91 See D&L Letter. of insurance subject to state oversight. Surety bonds ‘obligee.’ Further, the bond’s limit is referred to as 92 See infra notes 147 and 148 and accompanying were already included in the list of enumerated the ‘penal sum.’ Nevertheless, the criteria can be text. insurance products contained in the Proposing applied to surety bonds and fidelity bonds, and 93 See ACLI Letter; CAI Letter; MetLife Letter; Release. such application would exclude bonds from the Nationwide Letter; and RAA Letter. 98 See supra note 41 and accompanying text. statutory definition of swaps.’’ See SFAA Letter.

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Commissions to analyze state insurance Enumerated Products. Reinsurance or Test of the criterion that payment not be law, as well as to determine which state retrocession of these Enumerated based on the price, rate, or level of a law should apply.102 One of these Products will fall within the Insurance financial instrument, asset, or interest or commenters also requested that such Safe Harbor so long as such reinsurance any commodity would contribute to concepts be applied consistently with or retrocession is provided in greater legal uncertainty.109 the historical interpretation by the accordance with the Provider Test.106 Two commenters agreed that such a applicable state.103 requirement should be included in the State law differences regarding these Payment Based on the Price, Rate, or final rules.110 One commenter argued concepts should not impede the ability Level of a Financial Instrument that any insurance instrument that of market participants from interpreting In the Proposing Release, the provides for payment based on the or applying the final rules to Commissions requested comment on price, rate, or level of a financial distinguishing between insurance and whether, in order for an agreement, instrument, asset, or interest in any swaps or security-based swaps, and thus contract, or transaction to be considered commodity is in substance a swap or the Commissions are retaining these insurance under the Product Test, the security-based, regardless of its label, concepts in the Product Test. The Commissions should require that and should be regulated as such.111 One Commissions intend to interpret these payment not be based on the price, rate, of these commenters further concepts consistently with the existing or level of a financial instrument, asset, recommended that the Commissions and developing laws of the relevant or interest or any commodity. The exclude annuity and variable universal state(s) governing the agreement, Commissions also requested comment life insurance from this requirement contract, or transaction in question. on whether variable annuity contracts because these products were However, the Commissions note their (where the income is subject to tax investments with some minimal level of authority to diverge from state law if the treatment under section 72 of the life insurance cover or investment Commissions become aware of evasive Internal Revenue Code) and variable life guarantee rider on top.112 conduct.104 insurance should be excepted from such The Commissions are not adopting an a requirement, if adopted.107 additional requirement for the Product Inclusion of Reinsurance and Eight commenters stated that it is Test that payment not be based on the Retrocession Transactions inappropriate to include such a price, rate, or level of a financial Several commenters suggested that requirement in the final rules because a instrument, asset, or interest or any the Commissions amend the Product number of traditional insurance commodity because the Commissions Test to explicitly address reinsurance products would not satisfy the find the requirement to be unsuitable for and retrocession (i.e., reinsurance of requirement and suggested that the distinguishing insurance from swaps reinsurance) transactions.105 Commissions should instead consider and security-based swaps. While the In response to these comments, the whether the agreement, contract, or provision might work for property and Commissions are clarifying that transaction transfers risk and argued casualty insurance, as many reinsurance and retrocession that such a requirement is not a useful commenters noted, it is not an effective transactions may fall within the marker for distinguishing insurance distinction for a number of other Insurance Safe Harbor, thus, it is from swaps and security-based traditional insurance products. swaps.108 Several commenters also unnecessary for the Product Test to be Accounting Standards modified as suggested by these believed that the addition to the Product commenters. In addition, the In the Proposing Release, the Commissions have modified the final 106 See supra note 41 and accompanying text. Commissions requested comment on rules to include reinsurance (including 107 See Proposing Release at 29824. See also id. whether the proposed rules relating to at 29825, Request for Comment 7. insurance should include a provision retrocession) of certain types of 108 See ACLI Letter; AIA Letter; AFGI Letter; CAI insurance products in the list of Letter; ISDA Letter; NAFA Letter; NAIC Letter; and related to whether a product is Nationwide Letter (concurring with ACLI’s recognized at fair value on an ongoing 102 See ACLI Letter and AFGI Letter. comments). basis with changes in fair value 103 See AFGI Letter. Commenters cited several examples of products reflected in earnings under U.S. that would fail a requirement that payment not be 104 The Commissions may also diverge from generally accepted accounting based on the price, rate, or level of a financial 113 interpretations or determinations of state law based instrument, asset, or interest or any commodity. principles. on an analysis of applicable facts and circumstances ACLI, CAI and NAFA cited registered and Three commenters argued that the when determining whether a particular product is unregistered variable annuities and variable life proposed rules should not include a a swap or security-based swap. insurance, and certain fixed annuities and equity 105 provision that an insurance product is See ACLI Letter; CAI Letter; D&L Letter; ISDA indexed annuities, stating that these could be Letter; NAFA Letter; Nationwide Letter; and RAA construed as being based on, or related to, a price, recognized at fair value under generally Letter. ACLI noted that the Product Test does not rate or level of a financial asset. ACLI also cited accepted accounting principles.114 One include a reference to reinsurance and that the financial guaranty insurance, and replacement commenter argued that the determinants ‘‘insurable interest’’ requirement under state value property and casualty insurance, where the of what is an insurance product should insurance law generally does not apply to insurer’s payment obligation may be based on the reinsurance products which, therefore, would not current price of the insured property or adjusted to be the existence of an insurable interest, satisfy the Product Test. ACLI and CAI state that reflect inflation. ACLI and ISDA cited crop transfer of risk, and indemnification of reinsurance in a chain of reinsurance also should insurance, because it could call for payment to be covered loss.115 Another argued that not be considered a swap or security-based swap. based in some way on the market price of the factoring accounting standards into the In addition to expressly referencing reinsurance and covered crop on the date of loss. ISDA and RAA retrocession transactions, ACLI believes that the cited ‘‘dual trigger’’ insurance (such as replacement analysis of whether a product is a swap Product Test should be expanded to include power insurance); property and casualty policies reinsurance and retrocession of insurance risks purchased by some commodity producers (e.g., oil 109 See AIA Letter and AFGI Letter. ceded by non-U.S. insurance companies to refineries, copper mines) with deductibles that 110 See Barnard Letter and Better Markets Letter. domestic insurance companies. RAA recommended increase or decrease based on the price of the 111 See Better Markets Letter. adding a new clause to the Product Test to provide commodity that the company produces; event 112 that ‘‘[a]ny agreement, contract, or transaction cancellation insurance that uses commodity indices See Barnard Letter. 113 which reinsures any agreement, contract, or to determine claims; and weather insurance and See Proposing Release at 29827, Request for transaction meeting the criteria of paragraph malpractice insurance. NAIC cited guaranteed Comment 17. (xxx)(4)(i)(A)–(C) of this section is also an insurance investment contracts, financial guaranty insurance, 114 See AFGI Letter; D&L Letter; and ISDA Letter. product.’’ and mortgage guaranty insurance 115 See D&L Letter.

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or insurance will introduce unnecessary contract, or transaction be provided by pursuant to a statutorily authorized complexity in most cases but that the a person that is subject to state or program thereof. Accordingly, the examination of accounting standards Federal insurance supervision should Commissions have revised the second would be useful in cases where the help prevent regulatory gaps that prong of the Provider Test to provide classification of a product as insurance otherwise might exist between that products meeting the Product Test or swap is unclear.116 insurance regulation and the regulation are excluded from the swap and After considering these comments, the of swaps and security-based swaps by security-based swap definitions if they Commissions are not including a ensuring that products provided by are provided (i) directly or indirectly by reference to accounting standards in the persons that are not subject to state or the Federal government or a state or (ii) Product Test. Federal insurance supervision are not pursuant to a statutorily authorized able to be offered by persons that avoid program of either.127 (b) Providers of Insurance Products regulation under Title VII of the Dodd- As stated in the Proposing Release, Under the first prong of the Provider Frank Act as well. the Commissions believe that where an Test, the agreement, contract, or The first prong of the Provider Test agreement, contract, or transaction transaction must be provided by a also requires that the agreement, qualifies for the safe harbor and person that is subject to supervision by contract, or transaction being provided therefore is considered insurance the insurance commissioner (or similar is ‘‘regulated as insurance’’ under excluded from the swap and security- official or agency) of any state117 or by applicable state law or the laws of the based swap definitions, the lawful the United States.118 In addition, such United States. As stated in the reinsurance of that agreement, contract, agreement, contract, or transaction also Proposing Release, the purpose of this or transaction similarly should be must be regulated as insurance under requirement is that an agreement, excluded.128 Accordingly, the applicable state law119 or the laws of the contract, or transaction that satisfies the Commissions are adopting the third United States. other conditions of the final rules must prong of the Provider Test as proposed, The Commissions have revised the be subject to regulatory oversight as an with certain modifications, to provide first prong of the Provider Test from the insurance product. The Commissions that an agreement, contract, or proposal. As proposed, the first prong of believe that this condition will help transaction of reinsurance will be the Provider Test could only be satisfied prevent products that are not regulated excluded from the swap and security- by a company that was organized as an as insurance in the states in which they based swap definitions, provided that: insurance company whose primary and are offered, and that are swaps or (i) The person offering such reinsurance predominant business activity was the security-based swaps, from being is not prohibited by applicable state law writing of insurance or the reinsuring of characterized as insurance products in or the laws of the United States from risks underwritten by insurance order to evade the regulatory regime offering such reinsurance to a person companies.120 The Commissions have under Title VII of the Dodd-Frank Act. that satisfies the Provider Test; (ii) the revised this prong of the Provider Test As noted by commenters,123 the agreement, contract, or transaction to be to address commenters’ concerns that Commissions recognize that the reinsured meets the requirements under the proposed rules would exclude ‘‘regulated as insurance’’ limitation the Product Test or is one of the insurers that were not organized as means that it is possible that a particular Enumerated Products; and (iii) except as ‘‘insurance companies,’’ as well as product that may not be regulated as otherwise permitted under applicable insurers that were domiciled outside of insurance in a particular state may not state law, the total amount reimbursable the United States.121 As adopted, the qualify for the Insurance Safe Harbor.124 by all reinsurers for such insurance first prong of the Provider Test can be As stated in the Proposing Release, product cannot exceed the claims or satisfied by any person that is subject to the Commissions believe that it is losses paid by the cedant. state or Federal insurance supervision, appropriate to exclude, from regulation In response to commenters’ regardless of that person’s corporate under Title VII, insurance that is issued concerns,129 the Commissions have structure or domicile. The Commissions by the United States or any of its revised the third prong of the Provider understand that, with the exception of agencies or instrumentalities, or Test from that contained in the non-admitted insurers,122 foreign pursuant to a statutorily authorized Proposing Release. As adopted, the third insurers are subject to supervision in the program thereof, from regulation as prong of the Provider Test encompasses 125 states in which they offer insurance swaps or security-based swaps. Such all reinsurers wherever incorporated or products. The treatment of non- insurance includes, for example, organized, and not just those based admitted insurers is addressed in the Federal insurance of funds held in outside of the United States. The fourth prong of the Provider Test. banks, savings associations, and credit Commissions also have revised the third The Commissions believe that the unions; catastrophic crop insurance; prong of the Provider Test to clarify that requirement that the agreement, flood insurance; Federal insurance of the total amount reimbursable by all certain pension obligations; and reinsurers may not exceed the claims or 116 See ISDA Letter. terrorism risk insurance. At the request losses paid by the cedant, unless 117 See supra note 32, regarding the definition of of commenters,126 the Commissions are otherwise permitted by applicable state ‘‘State’’ contained in the Proposing Release. persuaded that it is also appropriate to law. It is not the Commissions’ intent to 118 This requirement in the final rules is provide a similar exclusion to insurance substantially similar to the requirement included in that is issued by a state or any of its 127 The Commissions understand that certain section 3(a)(8) of the Securities Act, 15 U.S.C. agencies or instrumentalities, or types of Federal and State insurance programs, 77c(a)(8). including crop insurance, are administered by third 119 See supra note 34. parties; as a result, the Commissions have added 120 See Proposing Release at 29824. 123 See infra notes 145 and 146 and ‘‘directly or indirectly’’ to the second prong of the 121 See infra notes 139, 140, and 141 and accompanying text. Provider Test to clarify that it can be satisfied even accompanying text. 124 See infra notes 147 and 148 and if the agreement, contract, or transaction is not 122 The Commissions understand that the surplus accompanying text. provided directly by the federal government or a lines brokers who place insurance on behalf of non- 125 See Proposing Release at 29824. state. See Id. admitted insurers are subject to supervision in the 126 See Ex Parte Communication between NAIC 128 See Proposing Release at 29825. states in which they offer non-admitted insurance and CFTC and SEC Staff on October 5, 2011, at 129 See infra notes 150, 151, 152, and 153 and products. http://sec.gov/comments/s7-16-11/s71611-61.pdf. accompanying text.

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impose requirements that conflict with • It meets the eligibility criteria for remove the ‘‘insurance company’’ state law regarding the calculation of non-admitted insurers under applicable limitation and to clarify that any person amounts reimbursable under state law. that is subject to state or Federal reinsurance contracts. insurance supervision will qualify Comments The Commissions have added a fourth under the first prong of the Provider prong to the Provider Test to address General Test. As noted above, the Commissions commenters’ concerns that the proposed The Commissions received ten also believe that this revision should Provider Test excluded entities issuing comment letters that addressed the address commenters’ concerns that the insurance products on a non-admitted Provider Test.135 A few commenters proposed rules could have excluded basis through surplus lines brokers.130 recommended that the Commissions some foreign insurers since the revised Non-admitted insurance is typically retract the Provider Test.136 These test does not require that a person be property and casualty insurance that is commenters argued that if a product is domiciled in the United States; it only permitted to be placed through a subject to regulation as insurance in the requires that the person be subject to surplus lines broker 131 by an insurer United States, the regulated status of the state or Federal insurance supervision. that is not licensed to do business in the insurer is irrelevant.137 The Several commenters suggested that state where the product is offered.132 In Commissions are retaining the Provider the proposed Provider Test would practice, a provider of non-admitted Test with modifications as discussed permit an insurer that is not organized insurance may not satisfy the first prong above. The Commissions believe that as an insurance company to evade state of the Provider Test because it may not insurance products should fall outside insurance oversight by deliberately be subject to state or Federal insurance the swap or security-based swap failing the exemption for insurance supervision. The Commissions definitions only if they are offered by products (that is, by issuing a contract understand that non-admitted insurance persons subject to state or Federal that would fail the proposed rules plays a very important role in the insurance supervision or by certain because it would not be issued by an insurance marketplace. In addition, reinsurers.138 The Provider Test will insurance company).142 These Congress has explicitly recognized non- help to prevent products that are swaps commenters were concerned that if a admitted insurance products as or security-based swaps from being product were to be considered a swap insurance and specified that a state characterized as insurance in order to merely because it was not issued by an cannot prohibit certain types of entities evade the regulatory regime under Title insurance company, this would render from offering non-admitted insurance VII of the Dodd-Frank Act. Other the regulation of such products outside products.133 Because Congress commenters suggested various of the scope of state insurance laws due recognized that certain persons qualify modifications to the Provider Test and to the Federal preemption of swaps as non-admitted insurers, the those comments are discussed in more regulation.143 Commenters noted that a Commissions find that it is appropriate detail below. likely consequence of this preemption to add the fourth prong to the Provider ‘‘Insurance Company’’ Limitation would be that the same product would Test. be subject to substantially different A person will qualify under the fourth Several commenters recommended regulation within a state’s jurisdiction prong of the Provider Test if it satisfies that the Commissions expand the first based solely on the nature of the issuing any one of the following two prong of the Provider Test so that it is person.144 requirements: not limited to ‘‘insurance companies,’’ The Commissions have revised the • It is located outside of the United but to all insurers because not all first prong of Provider Test to address States and listed on the Quarterly insurers are organized as ‘‘insurance commenters’ concerns that providers of Listing of Alien Insurers that is companies,’’139 to accommodate insurance products could evade state compiled and maintained by the insurers and reinsurers that are insurance regulation by intentionally International Insurers Department of the domiciled outside of the United failing the Provider Test, i.e., marketing National Association of Insurance States,140 and to cover domestic and the insurance products as swaps or Commissioners;134 or foreign insurance companies and other security-based swaps in order to avoid entities that issue insurance products on state insurance supervision. As adopted, 130 See infra note 146 and accompanying text. a non-admitted basis through surplus any person that provides insurance 141 131 For the purposes of this release, the term lines brokers. products (and therefore should be ‘‘surplus lines broker’’ means an individual, firm, The Commissions have revised the subject to state or Federal insurance or corporation that is licensed in a state to sell, first prong of the Provider Test to solicit, or negotiate insurance on properties, risks, supervision) must, in fact, be subject to or exposures located or to be performed in a state state or Federal insurance supervision with non-admitted insurers. representatives, and details of U.S. trust accounts with the NAIC’s International Insurers Department in order to satisfy the first prong of the 132 See supra note 39. With respect to domestic and, based upon those documents and other Provider Test. Persons that are reinsurance, state insurance regulators do retain the information, appear to fulfill the criteria set forth in authority to prevent or allow a non-admitted organized as insurance companies or the International Insurers Department Plan of company from participating in a state market. Some whose business activity is Operation for Listing of Alien Nonadmitted states compile a list of companies that may sell as Insurers. predominantly insurance or non-admitteds; other states list non-admitted 135 reinsurance, but who are not in fact companies that may not sell. See ACLI Letter; AIA Letter; CAI Letter; D&L Letter; ISDA Letter; NAIC Letter; NAFA Letter; 133 See Subtitle B of Title V of the Dodd-Frank subject to state or Federal insurance Nationwide Letter; RAA Letter; and Travelers supervision, would not satisfy the first Act. Letter. 134 prong of the Provider Test. Section 524 of the Nonadmitted and 136 See AIA Letter; D&L Letter; and ISDA Letter. Reinsurance Reform Act of 2010 (15 U.S.C. 8204) 137 Id. Finally, as discussed below, the provides that a state cannot prohibit a surplus lines 138 Commissions have added a fourth prong broker from placing non-admitted insurance with a See infra notes 147 and 148 and non-admitted insurer that is listed on the Quarterly accompanying text. Listing of Alien Insurers. According to the NAIC the 139 See AIA Letter; D&L Letter; ISDA Letter; RAA 142 See ACLI Letter; CAI Letter; NAFA Letter; non-admitted alien insurers whose names appear in Letter; NAIC Letter; and Travelers Letter. Nationwide Letter; RAA Letter; and Travelers the Quarterly Listing of Alien Insurers have filed 140 See AIA Letter; D&L Letter; RAA Letter; and Letter. financial statements, copies of auditors’ reports, the Travelers Letter. 143 Id. names of their U.S. attorneys or other 141 See RAA Letter and Travelers Letter. 144 Id.

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to the Provider Test to provide relief for regulation.148 Title insurance sold in a state-based insurance receivership persons that provide insurance products state that does not regulate title law.153 on a non-admitted basis through surplus insurance as insurance would be in the As noted above, the Commissions lines brokers. list of Enumerated Products but would have revised the third prong of the Provider Test to remove the limitation ‘‘Regulated as Insurance’’ Limitation not satisfy the Provider Test and, thus would not qualify for the Insurance Safe that a reinsurance provider has to be Two commenters recommended that Harbor. However, this does not mean located outside of the United States, and the Commissions remove the provision that title insurance sold in a state that thereby address commenters’ concerns in the first prong of the Provider Test does not regulate title insurance as that domestic reinsurers would not that states ‘‘and such agreement, insurance is a swap or security-based qualify under the reinsurance prong. In contract, or transaction is regulated as addition, in response to commenters’ swap. The title insurance may not insurance under the laws of such state concerns, the Commissions have satisfy the Insurance Safe Harbor, but it or of the United States.’’145 These clarified the third prong of the Provider commenters argued that the provision would be subject to a facts and Test so that it does not prohibit a should be deleted because it was circumstances analysis. The reinsurer from offering a product in a redundant with the Product Test and Commissions anticipate that many state where it is permitted, even if that may exclude certain reinsurers and non- factors would militate against a product is prohibited in another state, admitted insurers, as well as products determination that such a surety bond and have revised the portion of the third that may not be specifically ‘‘regulated or title insurance that fails the Provider prong of the Provider Test that as insurance’’ in all states.146 Test, because it cannot meet the addresses a cedant’s reimbursable losses The Commissions have retained the ‘‘regulated as insurance’’ requirement, is to make it subject to applicable state law requirement in the first prong of the a swap or security-based swap rather so that it does not conflict with state- Provider Test that an insurance product than insurance. based insurance receivership law. must be regulated as insurance, but have The Commissions agree that the revised the provision to clarify that an (c) Grandfather Provision for Existing inclusion of the ‘‘regulated as insurance product must be regulated as Insurance Transactions insurance’’ requirement in the first insurance under applicable state law or In the Proposing Release, the prong of the Provider Test will have the the laws of the United States. As Commissions asked whether the discussed above, the Commissions effect of causing non-admitted proposed rules should include a believe that this condition will help insurance products to fall within the provision similar to section 302(c)(1) of prevent products that are not regulated swap and security-based swap the Gramm-Leach-Bliley Act that any as insurance and are swaps or security- definitions. In response to commenters’ product regulated as insurance before based swaps from being characterized as concerns about the ability of non- the date the Dodd-Frank Act was signed insurance products in order to evade the admitted insurers to qualify under the into law and provided in accordance regulatory regime under the Dodd-Frank Provider Test, the Commissions have with the Provider Test would be Act. added a fourth prong to the Provider considered insurance and not fall The Commissions have received Test to address providers of non- within the swap or security-based swap conflicting comments regarding whether admitted insurance products.149 definitions. surety bonds are currently offered by In response to comments,154 the persons who do not satisfy the Provider Providers of Reinsurance Commissions are adding a new Test, in particular the ‘‘regulated as Several commenters recommended paragraph (ii) to rule 1.3(xxx)(4) under 147 insurance’’ requirement. If a person that the Commissions expand the third the CEA and new paragraph (b) to rule who does not satisfy the Provider Test prong of the Provider Test to include 3a69–1 under the Exchange Act that sells a surety bond incidental to other domestic reinsurers.150 One commenter provides that an agreement, contract, or business activity and is not subject to requested that the Commissions remove transaction entered into on or before the state or Federal insurance supervision, the third prong of the Provider Test effective date of the Product Definitions will be considered insurance and not it does not mean that such surety bond from the final rules because it appears is a swap or security-based swap. The fall within the swap and security-based to prohibit a reinsurer from offering a surety bond may not satisfy the swap definitions, provided that, at such product in a state where it is permitted Insurance Safe Harbor, but it would be time it was entered into, such if any other state prohibits that subject to a facts and circumstances agreement, contract, or transaction was product.151 Two commenters requested analysis. Similarly, one commenter provided in accordance with the indicated that title insurance is not revisions to the portion of the third Provider Test (the ‘‘Insurance always subject to state insurance prong of the Provider Test that Grandfather’’). addresses a cedant’s reimbursable As stated in the Proposing Release, 152 145 See RAA Letter and Travelers Letter. losses. One commenter argued this the Commissions are aware of nothing 146 Id. These commenters also recommended the portion of the third prong of the in Title VII to suggest that Congress addition of a new prong to the Provider Test to Provider Test may conflict with the intended for traditional insurance cover domestic or foreign entities that issue products to be regulated as swaps or insurance products on a non-admitted basis through 148 155 surplus lines brokers. See discussion below. The See ACLI Letter. security-based swaps. The Commissions note that the first prong of the 149 See supra notes 130, 131, and 132 and Provider Test does not apply to reinsurance accompanying text. 153 See RAA Letter. RAA stated that in an contracts and the third prong of the Provider Test, 150 See ACLI Letter; CAI Letter; NAIC Letter; and insurance receivership reinsurers are required to which does apply to reinsurance contracts, does not RAA Letter. comply with the reinsurance contract and pay all contain the ‘‘regulated as insurance’’ limitation. 151 See RAA Letter. The commenter argued that amounts due and owing to the estate of the 147 See SFAA Letter. SFAA stated that all states one state’s prohibition on a reinsurance product insolvent cedant even if the estate of the cedant include surety and fidelity bonds as lines of should not affect the ability of the reinsurer to offer may not necessarily pay the full amount of the insurance subject to state oversight. However, the product in a state where it is permitted. underlying claims to the applicable policyholders. Travelers stated that surety bonds may not be 152 See RAA Letter and Travelers Letter. Both 154 See infra notes 157, 158, 159, and 160 and ‘‘specifically’’ regulated as insurance. See Travelers commenters suggested specific edits to the accompanying text. Letter. proposed rules. 155 See Proposing Release at 29821.

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Commissions have designed the definitions.157 Two commenters insurance before the Dodd-Frank Act Insurance Safe Harbor to provide greater suggested that a grandfather provision was signed into law, as recommended assurance to market participants that for all products that were regulated as by some commenters,161 is unnecessary traditional insurance products that were insurance before the Dodd-Frank Act because non-grandfathered regulated regulated as insurance prior to the was signed into law would be insurance transactions generally should Dodd-Frank Act will fall outside the appropriate, stating that it would reduce fall within the Insurance Safe Harbor. swap and security-based swap confusion and uncertainty in applying The Commissions believe that market definitions. Nevertheless, after the swap and security-based swap participants could be incentivized to considering comments received, the definitions to products that are use such a broader grandfather Commissions believe that it is traditionally regulated as insurance provision to create new swap or appropriate to adopt the Insurance while addressing the Commissions’ security-based swap products with Grandfather in order to assure market stated concern that products might be characteristics similar to those of participants that those agreements, structured as insurance products to existing categories of regulated contracts, or transactions that meet the evade Dodd-Frank Act requirements.158 insurance contracts for the purpose of conditions set out in the Insurance These commenters also stated that it is evading the Dodd-Frank Act regulatory Grandfather will not fall within the necessary to add an effective date-based regime. The Commissions also believe swap or security-based swap grandfather provision to the final rule that a broader grandfather provision definitions. providing that any contract or would be contrary to the explicit In order to qualify for the Insurance transaction subject to state insurance direction of sections 722(b) and 767 of Grandfather an agreement, contract, or regulation and entered into prior to any the Dodd-Frank Act which provide that transaction must meet two final rules necessary to implement Title swaps and security-based swaps may requirements. First, it must be entered VII, including the Product Definitions, not be regulated as insurance contracts into on or before the effective date of the are not swaps or security-based by any state.162 Product Definitions. The Commissions swaps.159 These commenters noted that One commenter argued that the are linking the Insurance Grandfather to a grandfather provision based on Provider Test should not apply to the effective date of the Product effective date of all the Title VII rules grandfathered contracts. The commenter Definitions, rather than the date that the was needed to address product stated that it should be enough that the Dodd-Frank Act was signed into law, in development and variation that product is regulated as insurance.163 As order to avoid unnecessary market occurred between the date the Dodd- described above, the grandfather disruption.156 Second, such agreement, Frank Act was enacted and the effective provision will apply only to agreements, contract, or transaction must be date of the rules mandated under that contracts, and transactions that are provided in accordance with the statute.160 entered into prior to the effective date Provider Test. In other words, the The Commissions believe that the of the Product Definitions if they were provider must be subject to state or combination of the Insurance provided in accordance with the Federal insurance supervision or be a Grandfather along with the Insurance Provider Test, including a requirement non-admitted insurer or a reinsurer that Safe Harbor provides market that an agreement, contract or satisfies the conditions for non-admitted participants with increased legal transaction that is provided in insurers and reinsurers that are set out certainty with respect to existing accordance with the first prong of the in the Provider Test. The Commissions agreements, contracts, transactions, and Provider Test must be regulated as note that an agreement, contract or products. In addition, the fact that the insurance under applicable State law or transaction that is provided in Commissions are linking the Insurance the laws of the United States. As the accordance with the first prong of the Grandfather to the effective date of the Commissions discussed in the Provider Test must also be regulated as Product Definitions, rather than the date Proposing Release, and above in insurance under applicable state law or that the Dodd-Frank Act was signed into describing the Provider Test, the the laws of the United States. law, takes into account product Commissions believe the requirement By adopting the Insurance development and innovation that may that the agreement, contract, or Grandfather and the Insurance Safe have occurred between the date the transaction be provided in accordance Harbor, the Commissions are excluding Dodd-Frank Act was signed into law at with the Provider Test should help agreements, contracts, and transactions the effective date of the Product ensure that persons who are not subject for which the Commissions have found Definitions. Further, the Commissions to state or Federal insurance supervision no evidence that Congress intended believe that a grandfather provision that are not able to avoid the oversight them to be regulated as swaps or would exclude all products regulated as security-based swaps, and are providing 161 See ACLI Letter; AGFI Letter; and CAI Letter. 162 greater certainty regarding the treatment 157 See ACLI Letter; AFGI Letter; CAI Letter; and Section 722(b) of the Dodd-Frank Act of agreements, contracts, and D&L Letter. provides, (B) Regulation of Swaps Under Federal and State Law.—Section 12 of the Commodity 158 See ACLI Letter and CAI Letter. ACLI and CAI transactions currently regulated as Exchange Act (7 U.S.C. 16) is amended by adding argued that products that were regulated as insurance. at the end the following: ‘‘(h) Regulation of Swaps insurance prior to the effective date of the Dodd- as Insurance Under Federal and State Law.—A Comments Frank Act clearly were not characterized as swap—(1) Shall not be considered to be insurance; insurance to avoid the Title VII regulatory regime. and (2) may not be regulated as an insurance Four commenters addressed whether See also AFGI Letter; AFGI argued that all contract under the law of any State.’’ Section 767 the final rules should include a insurance contracts issued by state-regulated of the Dodd-Frank Act amended section 28(a) of the grandfather provision that would insurance companies should be excluded from the Exchange Act, 15 U.S.C. 78bb(a), to provide, ‘‘A exclude certain insurance products from swap definition but in the alternative, all insurance security-based swap may not be regulated as an products regulated as insurance before July 21, 2010 insurance contract under any provision of State the swap or security-based swap should be grandfathered. See also D&L Letter. D&L law.’’ stated that prior regulation of insurance products 163 See CAI Letter. CAI suggested that for a 156 The Commissions believe that 60 days after before July 21, 2010 could be a consideration, but product to be regulated as insurance it means that publication of this release should be sufficient time not an absolute determinant for exclusion from the it was provided by an insurance company. See for market participants to enter into pending swap or security-based swap definitions. supra part II.B.1.b) for a discussion of the need for agreements, contracts, or transactions for which the 159 See ACLI Letter and CAI Letter. the Provider Test portion of the Insurance Safe Insurance Grandfather may provide relief. 160 Id. Harbor.

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provided for under Title VII of the would be excluded from the swap • Where such payment is related to a Dodd-Frank Act. definition.169 One commenter argued loss occurring as a result of a that ‘‘Section 3(a)(8) has long been contingency or specified event.172 (d) Alternative Tests recognized as the definitive provision as The Commissions do not find this A number of commenters proposed to where Congress intends to separate alternative preferable to the that the Commissions adopt alternative securities products that are subject to Commissions’ proposal for two reasons. tests to distinguish insurance from SEC regulation from ‘insurance’ and First, the requirements of a specified swaps and security-based swaps.164 ‘annuity’ products that are to be left to term and the promise to make payments After considering each of these state insurance regulation’’ and that the are present in both insurance products alternatives, the Commissions are not section 3(a)(8) criteria are well and in agreements, contracts, or adopting them. understood and have a long history of transactions that are swaps or security- Several commenters suggested that interpretation by the SEC and the based swaps and therefore do not help the sole test for determining whether an courts.170 Other commenters suggest to distinguish between them. A test agreement, contract, or transaction is that because section 3(a)(8) includes based solely on these requirements, insurance should be whether it is both a product and a provider then, could be over-inclusive and subject to regulation as insurance by the requirement, if the Commissions exclude from the Dodd-Frank Act insurance commissioner of the include it in their final rules, it should regulatory regime agreements, contracts, applicable state(s).165 The Commissions be a requirement separate from the and transactions that have not find this alternative to be unworkable Product Test and the Provider Test, and traditionally been considered insurance. because it does not provide a sufficient should extend to insurance products Further, the third and fourth means to distinguish agreements, that are securities.171 requirements of this alternative test contracts and transactions that are While the Commissions agree that the collapse into the Product Test’s insurance from those that are swaps or section 3(a)(8) criteria have a long requirement that the loss must occur security-based swaps. Section 712(d) of history of interpretations by the SEC and be proved, and any payment or the Dodd-Frank Act directs the and the courts, the Commissions find indemnification therefor must be Commissions to ‘‘further define’’ the that it is inappropriate to apply the limited to the value of the insurable terms swap and security-based swap. section 3(a)(8) criteria in this context. interest. Neither swaps nor security-based swaps Although section 3(a)(8) contains some One commenter suggested a three-part may be regulated as insurance contracts conditions applicable to insurance test in lieu of the Product and Provider under the laws of any state.166 While providers that are similar to the prongs Tests. Under this test, the terms ‘‘swap’’ insurance contracts have long been of the Provider Test, it does not contain and ‘‘security-based swap’’ would subject to state regulation, swaps and any conditions that are similar to the exclude any agreement, contract, or security-based swaps were largely prongs of the Product Test. Moreover, transaction that: • unregulated. Since the Dodd-Frank Act section 3(a)(8) provides an exclusion Is issued by a person who is or is created a new regulatory regime for from the Securities Act and the CFTC required to be organized as an insurance swaps and specifically provides that has no jurisdiction under the Federal company and subject to state insurance ‘‘swaps may not be regulated as an regulation; securities laws. Congress directed both • insurance contract under the law of any agencies to further define the terms Is the type of contract issued by state,167 the Commissions believe that it insurance companies; and ‘‘swap’’ and ‘‘security-based swap.’’ As • is important to have a test that Is not of the type that the such, the Commissions find that it is 173 distinguishes insurance from swaps and more appropriate to have a standalone Commissions determine to regulate. This commenter stated that its security-based swaps without relying rule that incorporates features that approach does not contain a definition entirely on the regulatory environment distinguish insurance products from of insurance, and believes that is prior to the enactment of the Dodd- swaps and security-based swaps and preferable to the Commissions’ Frank Act. The Product Test is an over which both Commissions will have approach, which it believes creates legal important element of the Insurance Safe joint interpretative authority. Harbor. One commenter suggested yet another uncertainty because any attempted Several commenters suggested an definition of insurance has the potential approach, recommending that insurance 174 approach in which insurance products be defined as an agreement, contract, or to be over- or under- inclusive. As that qualify for the exclusion contained transaction that by its terms: discussed above, the Commissions’ in section 3(a)(8) of the Securities Act168 • Exists for a specified period of time; rules and interpretations are not • Where the party (the ‘‘insured’’) to intended to define insurance. Rather, 164 See ACLI Letter; AIA Letter; AFGI Letter; CAI the contract promises to make one or they provide a safe harbor for certain Letter; MetLife Letter; NAFA Letter; NAIC Letter; more payments such as money, goods or types of traditional insurance products Nationwide Letter; and Travelers Letter. by reference to factors that may be used 165 services; See ACLI Letter; AIA Letter; AFGI Letter; to distinguish insurance from swaps and MetLife Letter; and Travelers Letter. • In exchange for another party’s 166 See section 12(h) of the CEA, 7 U.S.C. 16(h) promise to provide a benefit of security-based swaps, and a list of (regarding swaps) and section 28(a)(4) of the pecuniary value for the loss, damage, Exchange Act, 15 U.S.C. 78bb(a)(4) (regarding injury, or impairment of an identified 172 See NAIC Letter. security-based swaps). 173 See ACLI Letter (Appendix 1). See also CAI 167 See section 12(h)(2) of the CEA, 7 U.S.C. interest of the insured as a result of the Letter. CAI stated that it believes that the approach 16(h)(2). occurrence of a specified event or and test recommended by ACLI is a fundamentally 168 Section 3(a)(8) of the Securities Act excludes contingency outside of the parties’ sound method for determining those insurance the following from all provisions of the Securities control; and products that are not swaps or security-based swaps Act: Any insurance or endowment policy or and that should remain subject to state regulation, annuity contract or optional annuity contract, and is more appropriate than the Commissions’ issued by a corporation subject to the supervision See infra note 1283 and accompanying text. proposals. Nationwide suggested a three-part test to of the insurance commissioner, bank commissioner, 169 See ACLI Letter; CAI Letter; NAFA Letter; and differentiate insurance products from swaps and or any agency or officer performing like functions, Nationwide Letter. security-based swaps similar to the test proposed by of any State or Territory of the United States or the 170 See NAFA Letter. ACLI. See also Nationwide Letter. District of Columbia. 171 See ACLI Letter and CAI Letter. 174 See ACLI Letter.

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products that do not have to satisfy a (e) ‘‘Safe Harbor’’ (g) Guarantees portion of the safe harbor factors. In the Proposing Release, the Agreements, contracts, and transactions Five commenters recommended that the Product Test, the Provider Test, and Commissions requested comment on that do not qualify for the Insurance whether insurance of an agreement, related interpretations should be Safe Harbor may or may not be contract, or transaction that falls within structured as a ‘‘safe harbor’’ so that insurance, depending upon the facts the swap or security-based swap and circumstances regarding such they do not raise any presumption or definitions should itself be included in agreements, contracts and transactions. inference that products that do not meet the swap or security-based swap The Commissions find the first two the Product Test, Provider Test and definition. The Commissions also requirements of the commenter’s three- related interpretations are necessarily requested comment on whether the 178 part test to be tautologous, and the third swaps or security-based swaps. One Commissions should provide guidance provides no greater certainty than the commenter suggested that this safe as to whether swap or security-based Commissions’ facts and circumstances harbor approach could be modeled after swap guarantees offered by non- approach. In addition, the Commissions Rule 151 under the Securities Act.179 insurance companies should be find that this alternative test could As discussed above, the Commissions considered swaps or security-based exclude from the Dodd-Frank Act do not intend to create a presumption swaps.182 regulatory regime agreements, contracts, that agreements, contracts, or and transactions that have not Guarantees of Swaps.183 transactions that do not fall within the traditionally been considered insurance. Insurance Safe Harbor are necessarily No commenter identified any product Another commenter proposed swaps or security-based swaps. As that insures swaps (that are not security- based swaps or mixed swaps) other than different approaches for existing stated above, the Commissions are 175 financial guaranty insurance. The CFTC products and new products. instead adopting final rules that clarify finds that insurance of an agreement, Specifically, if an existing type of that certain agreements, contracts, or agreement, contract or transaction is contract, or transaction that falls within transactions meeting the requirements currently reportable as insurance in the the swap definition (and is not a of a non-exclusive ‘‘safe harbor’’ provider’s regulatory and financial security-based swap or mixed swap) is established by such rules will not be reports under a state or foreign functionally or economically similar to considered to be swaps or security- jurisdiction’s insurance laws, then that a guarantee of a swap (that is not a based swaps. An agreement, contract, or agreement, contract, or transaction security-based swap or mixed swap) would be insurance rather than a swap transaction that does not fall within the offered by a non-insurance company.184 or security-based swap. On the other Insurance Safe Harbor will require Therefore, the CFTC is treating financial hand, for new products, if this approach further analysis of the applicable facts guaranty insurance of swaps (that are were inconclusive, this commenter and circumstances to determine not security-based swaps or mixed recommended that the Commissions use whether it is insurance, and thus not a swaps) the same way it is treating all the Product Test of the Commissions’ swap or security-based swap. other guarantees of swaps (that are not rules only.176 As discussed above, rather (f) Applicability of Insurance Exclusion security-based swaps or mixed swaps), 185 than treating existing products and new to Security-Based Swaps as discussed below. products differently, the Commissions The CFTC is persuaded that when a are providing ‘‘grandfather’’ protection Four commenters expressed concerns swap has the benefit of a guarantee,186 for agreements, contracts, and that the proposed rules were unclear in the guarantee is an integral part of that transactions entered into prior to the their application to both swaps and swap. The CFTC finds that a guarantee effective date of the Products security-based swaps.180 These of a swap (that is not a security-based Definitions.177 Moreover, this commenters argued that the proposed swap or mixed swap) is a term of that commenter’s test would eliminate the rules do not directly exclude insurance swap that affects the price or pricing Provider Test for new products, which products from the term ‘‘security-based attributes of that swap.187 When a swap the Commissions believe is important to swap’’ because the rules explicitly state 182 help prevent products that are swaps or that ‘‘[t]he term ‘swap’ does not See Proposing Release at 29827. security-based swaps from being 183 The discussion in this subsection relates only include’’ the products that meet the to swaps that are not security-based swaps or mixed characterized as insurance. Product and Provider Tests, but do not swaps and has no effect on the laws or regulations In sum, the Commissions find that make the same statement as to the term applicable to security-based swaps or mixed swaps. each of the alternatives proposed by ‘‘security-based swap.’’ 181 184 The Commissions did not express a view commenters could exclude from the regarding whether financial guaranty insurance is a The Commissions have revised rule swap or security-based swap in the Entities Release. Dodd-Frank Act regulatory regime 1.3(xxx)(4) under the CEA and rule See Entities Release at 30689, n.1132. agreements, contracts, and transactions 3a69–1 under the Exchange Act to 185 Subsequent references to ‘‘guarantees’’ in this that have not historically been discussion shall thus be deemed to include clarify that the exclusion contained considered insurance, and that should, ‘‘financial guaranty insurance policies.’’ therein applies to both swaps and 186 in appropriate circumstances, be For purposes of this release, the CFTC views security-based swaps. a guarantee of a swap to be a collateral promise by regulated as swaps or security-based a guarantor to answer for the debt or obligation of swaps. Accordingly, the Commissions a counterparty obligor under a swap. A guarantee 178 do not find these alternatives to be See ACLI Letter; CAI Letter; NAFA Letter of a swap does not include for purposes of this (concurring with ACLI and CAI); Nationwide Letter; release: (i) A ‘‘guarantee agreement’’ as defined in appropriate for delineating the scope of and Travelers Letter. CFTC regulation § 1.3(nn), 17 CFR 1.3(nn); (ii) any the Insurance Safe Harbor from the 179 See ACLI Letter. assumption by a clearing member of financial or swap and security-based swap 180 See ACLI Letter; CAI Letter; NAFA Letter performance responsibility to a derivatives clearing definitions. (concurring with ACLI and CAI); and Nationwide organization (‘‘DCO’’) for swaps cleared by a DCO; Letter (concurring the ACLI and CAI). or (iii) any guarantee by a DCO with respect to a 181 Id. The commenters suggested that this swap that it clears. 175 See AIA Letter. ambiguity could be resolved by making it clear in 187 E.g., a swap counterparty may specify that a 176 Id. the final rules that an excluded product is neither guarantee is a Credit Support Document under an 177 See supra part II.B.1.c) a swap nor a security-based swap. Continued

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counterparty typically provides a ‘‘full recourse’’ guarantee would have a One commenter supported treating guarantee as credit support for its swap greater effect on the price of a swap than financial guaranty insurance of a swap obligations, the market will not trade a ‘‘limited’’ or ‘‘partial recourse’’ or security-based swap as itself a swap with that counterparty at the same price, guarantee; nevertheless, the CFTC is or a security-based swap. This on the same terms, or at all without the determining that the presence of any commenter argued that financial guarantee. The guarantor’s resources are guarantee with recourse, no matter how guaranty insurance of a swap or added to the analysis of the swap; if the robust, is price forming and an integral security-based swap transfers the risk of guarantor is financially more capable part of a guaranteed swap. counterparty non-performance to the than the swap counterparty, the analysis The CFTC’s interpretation of the term guarantor, making it an embedded and of the swap becomes more dependent ‘‘swap’’ to include guarantees of swaps essential feature of the insured swap or on the creditworthiness of the does not limit or otherwise affect in any security-based swap. This commenter guarantor. Therefore, the CFTC is way the relief provided by the Insurance further argued that the value of such interpreting the term ‘‘swap’’ (that is not Grandfather. In a separate release, the swap or security-based swap is largely a security-based swap or mixed swap) to CFTC will address the practical determined by the likelihood that the include a guarantee of such swap, to the implications of interpreting the term proceeds from the financial guaranty extent that a counterparty to a swap ‘‘swap’’ to include guarantees of swaps insurance policy will be available if the position would have recourse to the (the ‘‘separate CFTC release’’).189 counterparty does not meet its 193 guarantor in connection with the Comments obligations. This commenter position.188 The CFTC anticipates that a maintained that financial guaranty Three commenters provided insurance of swaps and security-based ISDA Master Agreement. If the guarantor fails to comments regarding the treatment of swaps serves a very similar function to comply with or perform under such guarantee, such guarantees. Two commenters 190 credit default swaps in hedging guarantee expires or terminates, or if such guarantee opposed treating insurance or 194 ceases to be in full force and effect, the ‘‘Credit counterparty default risk. Support Default’’ Event of Default under the ISDA guarantees of swaps as swaps. The CFTC is persuaded that when a Master Agreement would generally be triggered, Suggesting that the products are not swap (that is not a security-based swap potentially bringing down the entire swap trading economically similar, one commented or mixed swap) has the benefit of a relationship between the parties to the ISDA Master that insurance wraps of swaps do not guarantee, the guarantee and related Agreement. See generally the standard 1992 ISDA ‘‘necessarily replicate the economics of Master Agreement and 2002 ISDA Master guaranteed swap must be analyzed Agreement. However, the CFTC finds the presence the underlying swap, and only together. The events surrounding the of a guarantee to be an integral part of a swap and following default could the wrap failure of AIG Financial Products that affects the price or pricing attributes of a swap provider end up with the same payment (‘‘AIGFP’’) highlight how guarantees can whether or not such guarantee is a Credit Support obligations as a wrapped defaulting Document under an ISDA Master Agreement. cause major risks to flow to the 191 195 188 This interpretation is consistent with the swap counterparty.’’ This commenter guarantor. The CFTC finds that the interpretations of the Commissions in the Entity also stated that the non-insurance regulation of swaps and the risk Definitions Release. See, e.g., Entity Definitions guarantees are not swaps because the exposures associated with them, which Release at 30689 (‘‘[A]n entity’s swap or security- result of most guarantees is that the is an essential concern of the Dodd- based swap positions in general would be attributed to a parent, other affiliate or guarantor for purposes guarantor is responsible for monetary Frank Act, would be less effective if the of major participant analysis to the extent that claims against the defaulting party, CFTC did not interpret the term ‘‘swap’’ counterparties to those positions would have which in this commenter’s view is a to include a guarantee of a swap. recourse to that other entity in connection with the different obligation than the Two commenters cautioned against position. Positions would not be attributed in the arrangement provided by the underlying absence of recourse.’’). A swap backed by a partial unnecessary and duplicative regulation. 192 or limited recourse guarantee will include the swap itself. One commented that, because the guarantee to the extent of such partial or limited underlying swap, and the parties to it, recourse; a blanket guarantee that supports both with major swap participants, the CFTC will not will be regulated and reported to the swap and non-swap obligations will be treated as deem holding companies to be swap dealers as a extent required by Title VII, there is no part of the guaranteed swap only to the extent that result of guarantees to certain U.S. entities that are such guarantee backstops obligations under a swap already subject to capital regulation. It may, need for regulation of non-insurance or swaps. however, be appropriate to regulate as a swap guarantees.196 The other commented In the Entity Definitions Release, the dealer a parent or other guarantor who guarantees that an insurance policy on a swap Commissions stated, ‘‘we do not believe that it is swap positions of persons who are not already would be subject to state regulation; necessary to attribute a person’s swap or security- subject to capital regulation by the CFTC (i.e., who based swap positions to a parent or other guarantor are not swap dealers, major swap participants or without addressing non-insurance if the person is already subject to capital regulation FCMs). The CFTC is addressing guarantees guarantees, this commenter stated that by the CFTC or SEC (i.e., swap dealers, security- provided to non-U.S. entities, and guarantees by additional Federal regulation would be based swap dealers, major swap participants, major non-U.S. holding companies, in its proposed duplicative.197 The CFTC disagrees with security-based swap participants, FCMs and broker- interpretive guidance and policy statement dealers) or if the person is a U.S. entity regulated regarding the cross-border application of the swaps these arguments. As stated above, the as a bank in the United States. Positions of those provisions of the CEA, 77 FR 41214 (Jul. 12, 2012). CFTC is treating financial guaranty regulated entities already will be subject to capital 189 Briefly, in the separate CFTC release the CFTC insurance of swaps and all other and other requirements, making it unnecessary to anticipates proposing reporting requirements with guarantees of swaps in a similar manner separately address, via major participant respect to guarantees of swaps under Parts 43 and because they are functionally or regulations, the risks associated with guarantees of 45 of the CFTC’s regulations and explaining the those positions.’’ Id. In a footnote, the Commissions extent to which the duties and obligations of swap continued, ‘‘As a result of this interpretation, dealers and major swap participants pertaining to 193 See Better Markets Letter. holding companies will not be deemed to be major guarantees of swaps, as an integral part of swaps, 194 See Better Markets Letter. swap participants as a result of guarantees to certain are already satisfied to the extent such obligations 195 ‘‘AIGFP’s obligations were guaranteed by its U.S. entities that are already subject to capital are satisfied with respect to the related guaranteed highly rated parent company * * * an arrangement regulation.’’ Id. swaps. The CFTC also anticipates addressing in the that facilitated easy money via much lower interest As a result of interpreting the term ‘‘swap’’ (that separate CFTC release the effect, if any, of the rates from the public markets, but ultimately made is not a security-based swap or mixed swap) to interpretation regarding guarantees of swaps on it difficult to isolate AIGFP from its parent, with include a guarantee of such swap, to the extent that position limits and large trader reporting disastrous consequences.’’ Congressional Oversight a counterparty to a swap position would have requirements. Panel, The AIG Rescue, Its Impact on Markets, and recourse to the guarantor in connection with the 190 See AFGI Letter and ISDA Letter. the Government’s Exit Strategy 20 (2010). position, and based on the reasoning set forth above 191 ISDA Letter. 196 See ISDA Letter. from the Entity Definitions Release in connection 192 Id. 197 See AFGI Letter.

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economically similar products. If a swap transaction itself. In addition, the Interpretation.’’ 207 In addition, while guarantee of a swap is not treated as an SEC will consider issues involving the CFTC is withdrawing its 1993 integral part of the underlying swap, cross-border guarantees of security- ‘‘Energy Exemption’’ 208 as proposed, it price forming terms of swaps and the based swaps in a separate release is clarifying that certain alternative risk exposures associated with the addressing the cross-border application delivery procedures will not disqualify guarantees may remain hidden from of Title VII. The SEC notes that security- a transaction from the forward contract regulators and may not be regulated based swaps are included in the exclusion. In response to comments, the appropriately. Moreover, treating definition of ‘‘security’’ contained in the CFTC is providing a new interpretation guarantees of swaps as part of the Securities Act and the Exchange Act.200 regarding book-out documentation, as underlying swaps ensures that the CFTC Under the Securities Act, a guarantee of well as additional factors that may be will be able to take appropriate action a security also is a ‘‘security.’’ 201 considered in its ‘‘facts and if, after evaluating information collected Therefore, a guarantee of a security- circumstances’’ analysis of whether a with respect to the guarantees and the based swap is a security subject to particular contract is a forward. underlying swaps, such guarantees of Federal securities law regulation.202 swaps are revealed to pose particular (i) Forward Exclusion From the Swap 2. The Forward Contract Exclusion problems in connection with the swaps and Future Delivery Definitions markets. In the separate CFTC release, As the Commissions explained in the (A) Consistent Interpretation Proposing Release, the definitions of the the CFTC will clarify the limited The wording of the forward contract practical effects of the CFTC’s terms ‘‘swap’’ and ‘‘security-based swap’’ do not include forward exclusion from the swap definition with interpretation, which should address respect to nonfinancial commodities is concerns regarding duplicative contracts.203 These definitions exclude similar, but not identical, to the forward regulation. ‘‘any sale of a nonfinancial commodity exclusion from the definition of the One commenter also argued that or security for deferred shipment or regulating financial guaranty of swaps delivery, so long as the transaction is term ‘‘future delivery’’ that applies to as swaps would cause monoline intended to be physically settled.’’ 204 futures contracts, which excludes ‘‘any The Commissions provided an sale of any cash commodity for deferred insurers to withdraw from the market, 209 which could adversely affect the U.S. interpretation in the Proposing Release shipment or delivery.’’ and international public finance, regarding the applicability of the In the Proposing Release, the CFTC infrastructure and structured finance exclusion from the swap and security- proposed an interpretation clarifying the markets, given that insuring a related based swap definition for forward scope of the exclusion of forward swap often is integral to the insurance contracts with respect to nonfinancial contracts for nonfinancial commodities of municipal bonds and other commodities 205 and securities. The from the swap definition and from the securities.198 The CFTC finds this Commissions are restating this ‘‘future delivery’’ definition in a number argument unpersuasive. The CFTC interpretation as set forth in the of respects. After considering the understands that the 2008 global Proposing Release with certain comments received, the CFTC is financial crisis severely affected most modifications in response to restating substantially all of its monolines and only one remains active commenters. interpretation regarding these forward in U.S. municipal markets. Thus, it exclusions set forth in the Proposing (a) Forward Contracts in Nonfinancial Release, but with several clarifications appears that the monolines have, for the Commodities most part, already exited these markets. in response to commenters. In addition, as stated above, the CFTC The CFTC provided an interpretation The CFTC is restating from the will clarify in the separate CFTC release in the Proposing Release regarding the Proposing Release that the forward the limited practical effects of the forward contract exclusion for exclusion for nonfinancial commodities CFTC’s interpretation, which should nonfinancial commodities and is in the swap definition will be address these concerns. restating this interpretation with certain interpreted in a manner consistent with modifications in response to the CFTC’s historical interpretation of Guarantees of Security-Based Swaps commenters. These clarifications the existing forward exclusion with The SEC believes that a guarantee of include that the CFTC will interpret the respect to futures contracts, consistent an obligation under a security-based forward contract exclusion consistent with the Dodd-Frank Act’s legislative swap, including financial guaranty with the entire body of CFTC history.210 In addition, in response to a insurance of a security-based swap, is precedent.206 The CFTC is also not a separate security-based swap. clarifying what ‘‘commercial 207 Statutory Interpretation Concerning Forward Further, the SEC is not adopting an participant’’ means under the ‘‘Brent Transactions, 55 FR 39188 (Sep. 25, 1990) (‘‘Brent Interpretation’’). interpretation that a guarantee of a 208 Exemption for Certain Contracts Involving 200 security-based swap is part of the See sections 768(a)(1) and 761(a)(2) of the Energy Products, 58 FR 21286–02 (Apr. 20, 1993) security-based swap. Instead, the SEC Dodd-Frank Act (amending sections 2(a)(1) of the (‘‘Energy Exemption’’). Securities Act, 15 U.S.C. 77b(a)(1), and 3(a)(10) of 209 CEA section 1a(27), 7 U.S.C. 1a(27). will consider requiring, as part of its the Exchange Act, 15 U.S.C. 78c(a)(10), 210 rulemaking relating to the reporting of respectively). See 156 Cong. Rec. H5248–49 (June 30, 2010) security-based swaps,199 the reporting of 201 See section 2(a)(1) of the Securities Act, 15 (introducing into the record a letter authored by U.S.C. 77b(a)(1). Senator Blanche Lincoln, Chairman of the U. S. information about any guarantees and Senate Committee on Agriculture, Nutrition and 202 The SEC has previously addressed the the guarantors of obligations under Forestry, and Christopher Dodd, Chairman U. S. treatment of financial guaranty insurance under the Senate Committee on Banking, Housing, and Urban security-based swaps in connection Federal securities laws. See supra note 58. Affairs, stating that the CFTC is encouraged ‘‘to with the reporting of the security-based 203 See Proposing Release at 29827. clarify through rulemaking that the exclusion from 204 CEA section 1a(47)(B)(ii), 7 U.S.C. the definition of swap for ‘any sale of a nonfinancial 198 See AFGI Letter. Of the members of AFGI, 1a(47)(B)(ii). commodity or security for deferred shipment or only Assured Guaranty (or its affiliates) is currently 205 The discussion in subsections (a) and (b) of delivery, so long as the transaction is intended to writing financial guaranty insurance policies on this section applies solely to the exclusion of be physically settled’ is intended to be consistent U.S. municipal obligations. nonfinancial commodity forwards from the swap with the forward contract exclusion that is 199 See Regulation SBSR Proposing Release infra definition in the CEA. currently in the [CEA] and the CFTC’s established note 1231. 206 See infra part II.B.2(a)(i)(F). Continued

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commenter, the CFTC is clarifying that element of the CFTC’s analysis of the crude oil contracts in that case could the entire body of CFTC precedent whether a particular contract is a individually negotiate cancellation regarding forwards should apply to the forward contract.214 In assessing the agreements, or ‘‘book-outs,’’ with other forward exclusions from the swap and parties’ expectations or intent regarding parties.217 In describing these future delivery definitions.211 delivery, the CFTC consistently has transactions, the CFTC stated: The CFTC’s historical interpretation applied a ‘‘facts and circumstances’’ It is noteworthy that while such [book-out] has been that forward contracts with test.215 Therefore, the CFTC reads the agreements may extinguish a party’s delivery respect to nonfinancial commodities are ‘‘intended to be physically settled’’ obligation, they are separate, individually ‘‘commercial merchandising language in the swap definition with negotiated, new agreements, there is no transactions.’’ 212 The primary purpose respect to nonfinancial commodities to obligation or arrangement to enter into such of a forward contract is to transfer reflect a directive that intent to deliver agreements, they are not provided for by the ownership of the commodity and not to a physical commodity be a part of the terms of the contracts as initially entered transfer solely its price risk. As the into, and any party that is in a position in analysis of whether a given contract is a distribution chain that provides for the CFTC has noted and reaffirms today: a forward contract or a swap, just as it The underlying postulate of the [forward] opportunity to book-out with another party is a part of the CFTC’s analysis of or parties in the chain is nevertheless entitled exclusion is that the [CEA’s] regulatory whether a given contract is a forward scheme for futures trading simply should not to require delivery of the commodity to be apply to private commercial merchandising contract or a futures contract. made through it, as required under the contracts.218 transactions which create enforceable (B) Brent Interpretation obligations to deliver but in which delivery Thus, in the scenario at issue in the is deferred for reasons of commercial In this interpretation, the CFTC is Brent Interpretation, the contracts 213 convenience or necessity. restating, with certain clarifications in created a binding obligation to make or As noted in the Proposing Release, response to commenters, its take delivery without providing any because a forward contract is a interpretation from the Proposing right to offset, cancel, or settle on a commercial merchandising transaction, Release that the principles underlying payment-of-differences basis. The intent to deliver historically has been an the CFTC’s ‘‘Brent Interpretation’’ ‘‘parties enter[ed] into such contracts regarding book-outs developed in with the recognition that they may be policy and orders on this subject, including connection with the forward exclusion 219 situations where commercial parties agree to ‘book- required to make or take delivery.’’ out’ their physical delivery obligations under a from futures apply to the forward On these facts, the Brent forward contract.’’). See also 156 Cong. Rec. H5247 exclusion from the swap definition as Interpretation concluded that the (June 30, 2010) (colloquy between U. S. House well. Book-out transactions meeting the contracts were forward contracts, not Committee on Agriculture Chairman Collin requirements specified in the Brent Peterson and Representative Leonard Boswell futures contracts: during the debate on the Conference Report for the Interpretation that are effectuated through a subsequent, separately Under these circumstances, the [CFTC] is Dodd-Frank Act, in which Chairman Peterson of the view that transactions of this type stated: ‘‘Excluding physical forward contracts, negotiated agreement qualify for the safe which are entered into between commercial including book-outs, is consistent with the CFTC’s harbor under the forward exclusions. longstanding view that physical forward contracts participants in connection with their in which the parties later agree to book-out their As was noted in the Proposing business, which create specific delivery delivery obligations for commercial convenience Release, the issue of book-outs first obligations that impose substantial economic are excluded from its jurisdiction. Nothing in this arose in 1990 in the Brent risks of a commercial nature to these legislation changes that result with respect to Interpretation 216 because the parties to participants, but which may involve, in commercial forward contracts.’’). 211 See Letter from Craig Donahue, Chief Executive Officer, CME Group Inc. (‘‘CME’’), dated 214 The CFTC observed in its decision in In re (Bermuda) Ltd. v. BP N. Am. Petroleum, 738 F. July 22, 2011 (‘‘CME Letter’’) (requesting this Wright that ‘‘it is well-established that the intent to Supp. 1472 (S.D.N.Y. 1990). The Brent clarification). But see below regarding the CFTC’s make or take delivery is the critical factor in Interpretation provided clarification that the 15-day response to CME’s comment concerning the Brent determining whether a contract qualifies as a Brent system crude oil contracts were forward Interpretation that it may be inconsistent, in CME’s forward.’’ In re Wright, CFTC Docket No. 97–02, contracts that were excluded from the CEA view, with more recent CFTC adjudicatory 2010 WL 4388247 at *3 (CFTC Oct. 25, 2010) (citing definition of ‘‘future delivery,’’ and thus were not decisions. In re Stovall, et al., [1977–1980 Transfer Binder] futures contracts. See Brent Interpretation, supra Comm. Fut. L. Rep. (CCH) 20,941 (CFTC Dec. 6, note 207. 212 See, e.g., Brent Interpretation, supra note 207. 1979); Brent Interpretation, supra note 207). In 217 The Brent Interpretation described these 213 See Brent Interpretation, supra note 207. The Wright, the CFTC noted that ‘‘[i]n distinguishing ‘‘book-outs’’ as follows: ‘‘In the course of entering CFTC has reiterated this view in more recent futures from forwards, the [CFTC] and the courts into 15-day contracts for delivery of a cargo during adjudicative orders. See, e.g., In re Grain Land have assessed the transaction as a whole with a a particular month, situations often arise in which Coop., [2003–2004 Transfer Binder] Comm. Fut. L. critical eye toward its underlying purpose. Such an two counterparties have multiple, offsetting Rep. (CCH) ¶ 29,636 (CFTC Nov. 25, 2003); In re assessment entails a review of the overall effect of positions with each other. These situations arise as Competitive Strategies for Agric., Ltd., [2003–2004 the transaction as well as a determination as to a result of the effectuation of multiple, independent Transfer Binder] Comm. Fut. L. Rep. (CCH) ¶ 29,635 what the parties intended.’’ Id. at *3 (quoting Policy commercial transactions. In such circumstances, (CFTC Nov. 25, 2003). Courts have expressed this Statement Concerning Swap Transactions, 54 FR rather than requiring the effectuation of redundant view as well. See, e.g., Salomon Forex, Inc. v. 30694 (Jul. 21, 1989) (‘‘Swap Policy Statement’’) deliveries and the assumption of the credit, delivery Tauber, 8 F.3d 966, 971 (4th Cir. 1993) (‘‘[C]ash (citations and internal quotations omitted)). and related risks attendant thereto, the parties may, forwards are generally individually negotiated sales 215 In Wright, the CFTC applied its facts and but are not obligated to and may elect not to, * * * in which actual delivery of the commodity circumstances test in an administrative enforcement terminate their contracts and forego such deliveries is anticipated, but is deferred for reasons of action involving hedge-to-arrive contracts for corn, and instead negotiate payment-of-differences commercial convenience or necessity.’’); CFTC v. and observed that ‘‘[o]ur views of the pursuant to a separate, individually-negotiated Int’l Fin. Serv. (N.Y.), 323 F. Supp. 2d 482, 495 appropriateness of a multi-factor analysis remain cancellation agreement referred to as a ‘book-out.’ (S.D.N.Y. 2004). See also CFTC v. Co Petro Mktg. unchanged.’’ Wright, note 214, supra, n.13. The Similarly, situations regularly arise when Grp., Inc., 680 F.2d 573, 579–580 (9th Cir. 1982); CFTC let stand the administrative law judge’s participants find themselves selling and purchasing CFTC v. Noble Metals Int’l, Inc., 67 F.3d 766, 772– conclusion that the hedge-to-arrive contracts at oil more than once in the delivery chain for a 773 (9th Cir. 1995; CFTC v. Am. Metal Exch. Corp., issue in the case were forward contracts. Id. at **5– particular cargo. The participants comprising these 693 F. Supp. 168, 192 (D.N.J. 1988); CFTC v. 6. See also Grain Land, supra note 213; Competitive ‘circles’ or ‘loops’ will frequently attempt to Morgan, Harris & Scott, Ltd., 484 F. Supp. 669, 675 Strategies for Agric., supra note 213. negotiate separate cancellation agreements among (S.D.N.Y. 1979) (forward contract exclusion does 216 See Brent Interpretation, supra note 207. The themselves for the same reasons and with the same not apply to speculative transactions in which CFTC issued the Brent Interpretation in response to effect described above.’’ Brent Interpretation, supra delivery obligations can be extinguished under the a Federal court decision that held that certain 15- note 207, at 39190. terms of the contract or avoided for reasons other day Brent system crude oil contracts were illegal 218 Id. at 39192. than commercial convenience or necessity). off-exchange futures contracts. See Transnor 219 Id. at 39189.

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certain circumstances, string or chain Interpretation.223 By contrast, were the activity is not commercial activity deliveries of the type described * * * are investment vehicle, for example, to own within the CFTC’s longstanding view of within the scope of the [forward contract] a gold mine and sell the output of the the Brent Interpretation. exclusion from the [CFTC’s] regulatory gold mine for forward delivery, or own In addition, the CFTC is expanding 220 jurisdiction. a chain of jewelry stores that produces the Brent Interpretation, which applied Although the CFTC did not expressly its own jewelry from raw materials and only to oil, to all nonfinancial 225 discuss intent to deliver, the Brent purchase a supply of gold from another commodities, as proposed. As a Interpretation concluded that entity’s gold mine in order to provide result, book-outs are permissible (where transactions retained their character as raw materials for its jewelry stores, such the conditions of the Brent commercial merchandising transactions, contracts could qualify as forward Interpretation are satisfied) for all notwithstanding the practice of contracts under the Brent nonfinancial commodities with respect terminating commercial parties’ Interpretation—provided that such to the exclusions from the definition of delivery obligations through ‘‘book- contracts otherwise satisfy the terms the term ‘‘swap’’ and the definition of the term ‘‘future delivery’’ under the outs’’ as described. At any point in the thereof. In sum, the CFTC is interpreting the CEA.226 chain, one of the parties could refuse to term ‘‘commercial’’ in the context of the enter into a new contract to book-out the (C) Withdrawal of the Energy Exemption Brent Interpretation in the same way it transaction and, instead, insist upon has done since 1990: ‘‘related to the Because the CFTC has expanded the delivery pursuant to the parties’ business of a producer, processor, Brent Interpretation to nonfinancial obligations under their contract. fabricator, refiner or merchandiser.’’ 224 commodities in this final interpretation, The CFTC also is clarifying that While a market participant need not be the CFTC also has determined to commercial market participants that solely engaged in ‘‘commercial’’ activity withdraw the Energy Exemption as regularly make or take delivery of the to be a ‘‘commercial market participant’’ proposed. In response to comments referenced commodity in the ordinary within the meaning of the Brent received, the CFTC is clarifying that course of their business meet the Interpretation under this interpretation, certain alternative delivery procedures commercial participant standard of the the business activity in which it makes discussed in the Energy Exemption 227 Brent Interpretation.221 The CFTC notes or takes delivery must be commercial will not disqualify a transaction from that the Brent Interpretation applies to activity for it to be a commercial market the Brent Interpretation safe harbor. ‘‘commercial participants in connection participant. A hedge fund’s investment In the Proposing Release, the CFTC with their business.’’ 222 The CFTC proposed to withdraw the Energy intends that the interpretation in this 223 See CME Letter. In connection with its Exemption, which, among other things, release be consistent with the Brent comment regarding ‘‘market participants’’ described Interpretation, and accordingly is above, see supra note 221, the CME further requests 225 See infra part II.B.2(a)(ii), with respect to the confirmation that the CFTC intends to apply the CFTC’s interpretation concerning nonfinancial adding ‘‘commercial’’ before ‘‘market Brent Interpretation to market participants who can commodities. participants’’ in this final interpretation. demonstrate that they meet the standard in the 226 The CFTC reminds market participants that Such entities qualify for the forward guidance as proposed, but are not themselves this does not mean, as was noted in the Brent exclusion from both the future delivery commercial actors: Interpretation, that these transactions or persons Because the Commission‘s interpretation does not who engage in them are wholly outside the reach and swap definitions for their forward explicitly refer to commercial market participants, of the CEA for all purposes. See, e.g., CEA section transactions in nonfinancial it would seem to cover financial players as long as 8(d), 7 U.S.C. 12(d), which directs the CFTC to commodities under the Brent those entities regularly make or take delivery of the investigate the marketing conditions of Interpretation even if they enter into a underlying commodity in connection with their commodities and commodity products and business. Examples of such entities would be hedge byproducts, including supply and demand for these subsequent transaction to ‘‘book out’’ funds or other investment vehicles that regularly commodities, cost to the consumer, and handling the contract rather than make or take make or take delivery of commodities (e.g. gold) in and transportation charges; CEA sections 6(c), 6(d), delivery. Intent to make or take delivery conjunction with their line of business—that is, as and 9(a)(2), 7 U.S.C. 9, 13b, and 13(a)(2), which can be inferred from the binding part of their investment strategies. [CME] asks that proscribe any manipulation or attempt to the [CFTC] confirm that the Brent safe harbor would manipulate the price of any commodity in interstate delivery obligation for the commodity be available to these types of market participants commerce; and CEA section 6(c) as amended by referenced in the contract and the fact that technically are not ‘‘commercial’’ actors. section 753 of the Dodd-Frank Act, which contains that the parties to the contract do, in See CME Letter. prohibitions regarding manipulation and false fact, regularly make or take delivery of 224 Brent Interpretation, supra note 207, at 39191. reporting with respect to any commodity in See also dissent of Commissioner Fowler West interstate commerce, including prohibiting any the referenced commodity in the (stating that commercial means ‘‘in the traditional person to (i) ‘‘use or employ, or attempt to use or ordinary course of their business. sense of those who produce, process, use or * * * employ * * * any manipulative or deceptive handle the underlying commodity.’’). Note that device or contrivance’’ (section 6(c)(1)); (ii) ‘‘to Further, in this final interpretation, being a commercial market participant with respect make any false or misleading statement of material the CFTC clarifies, in response to a to an agreement, contract or transaction in one fact’’ to the CFTC or ‘‘omit to state in any such comment received, that an investment commodity, or grade of a commodity, neither makes statement any material fact that is necessary to vehicle taking delivery of gold as part of an entity, nor precludes an entity from being, a make any statement of material fact made not commercial market participant with respect to an misleading in any material respect’’ (section its investment strategy would not be agreement, contract or transaction in a different 6(c)(2)); and (iii) ‘‘manipulate or attempt to engaging in a commercial activity grade of the commodity or a different commodity. manipulate the price of any swap, or of any within the meaning of the Brent For example, a West Texas Intermediate oil commodity in interstate commerce * * * (section producer may or may not also be a commercial with 6(c)(3)). See also Rule 180.1(a) under the CEA, 17 respect to Brent. Similarly, that same West Texas CFR 180.1(a) (broadly prohibiting in connection 220 Id. at 39192. Intermediate oil producer may or may not have with a commodity in interstate commerce 221 See CME Letter (noting that, although the commercial corn operations. In determining manipulation, false or misleading statements or Brent Interpretation applies to ‘‘commercial market whether an entity is a commercial market omissions of material fact to the Commission, fraud participants,’’ the proposed guidance in the participant with respect to an agreement, contract or deceptive practices or courses of business, and Proposing Release was described as applying to or transaction in a commodity, the CFTC will false reporting). ‘‘market participants’’ (omitting the word consider the facts and circumstances, though it is 227 These include pre-transaction netting ‘‘commercial’’) who ‘‘regularly make or take not unlikely that an entity that is a commercial agreements that result in offsetting physical delivery of the referenced commodities * * * in the market participant with respect to one commodity delivery obligations, ‘‘bona fide termination rights,’’ ordinary course of business.’’ See also Proposing may also be a commercial market participant with and certain other methods by which parties may Release at 29829. respect to either a different grade of the commodity settle their delivery obligations. See Energy 222 Brent Interpretation, supra note 207, at 39192. or a closely related commodity. Exemption, supra note 208, at 21293.

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expanded the Brent Interpretation to such right must be bona fide and not for (D) Book-Out Documentation energy commodities other than oil, on the purpose of evasion. In this regard, The CFTC has taken into the basis that the exemption was no the CFTC further clarifies, consistent consideration comments regarding the longer necessary in light of the with the Energy Exemption, that a bona documentation of book-outs.237 Under extension of the Brent Interpretation to fide termination right must be triggered 228 the Brent Interpretation, what is nonfinancial commodities. The by something not expected by the relevant is that the book out occur Energy Exemption, like the Brent parties at the time the contract is through a subsequent, separately Interpretation, requires binding delivery 233 entered into. negotiated agreement. While the CFTC obligations at the outset, with no right The Energy Exemption also discussed is sensitive to existing recordkeeping to cash settle or offset transactions.229 a number of methods by which parties practices for book-outs, in order to Each requires that book-outs be to energy contracts settle their prevent abuse of the safe harbor, the undertaken pursuant to a subsequent, obligations, including: The seller’s CFTC clarifies that in the event of an separately negotiated agreement. passage of title and the buyer’s payment As discussed above, the CFTC is oral agreement, such agreement must be and acceptance of the underlying followed in a commercially reasonable extending the Brent Interpretation to the commodity; taking delivery of the swap definition and applying it to all timeframe by a confirmation in some commodity in some instances and in type of written or electronic form. nonfinancial commodities for both the others instead passing title to another swap and future delivery definitions, intermediate purchaser in a chain; and (E) Minimum Contract Size and Other but is withdrawing the Energy physically exchanging (i.e., delivering) Contextual Factors Exemption. With regard to netting one quality, grade or type of physical agreements that were expressly In the Proposing Release, the CFTC commodity for another quality, grade or requested comment about potentially permitted by the Energy Exemption,230 type of physical commodity.234 The the CFTC clarifies that a physical imposing additional conditions (such CFTC clarifies that these settlement as, for example, a minimum contract netting agreement (such as, for example, methods generally 235 are not the Edison Electric Institute Master size) in order for a transaction to qualify inconsistent with the Brent as a forward contract under the Brent Power Purchase and Sale Agreement) Interpretation.236 that contains a provision contemplating Interpretation with respect to the future delivery and swap definitions.238 The the reduction to a net delivery amount 233 Id. CFTC has determined that a minimum of future, unintentionally offsetting 234 Id. delivery obligations, is consistent with 235 The CFTC will carefully scrutinize whether contract size should not be required in the intent of the book out provision in market participants are legitimately relying on the order for a contract to qualify as a the Brent Interpretation—provided that Brent Interpretation safe harbor. For example, if forward contract under the Brent non-commercial market participants are Interpretation.239 However, as suggested the parties had a bona fide intent, when intermediate purchasers in a delivery chain, then entering into the transactions, to make the transaction is not actually a commercial or take delivery (as applicable) of the merchandising transaction, and the parties cannot circumstances, be viewed as outside the Brent rely on the Brent Interpretation safe harbor. Interpretation safe harbor or evasion. The CFTC commodity covered by those expects that the limitation of counterparties eligible 236 By definition, if two parties exchange (i.e., transactions. to rely on the Brent Interpretation to those with a physically deliver) one physical commodity for commercial purpose for entering into the The CFTC also has determined that, another physical commodity in settlement of the transaction should limit the development of such notwithstanding the withdrawal of the parties’ delivery obligations, each seller has markets to those with commercial reasons for such delivered the commodity that is the subject of its Energy Exemption, a failure to deliver as a delivery structure. delivery obligation under the relevant agreement, a result of the exercise by a party of a 237 contract or transaction. Depending on the See Letter from R. Michael Sweeney, Jr., ‘‘bona fide termination right’’ does not settlement timing, such transactions, which Hunton & Williams LLP, on behalf of the Working render an otherwise binding delivery resemble barter transactions, would be spot Group of Commercial Energy Firms (‘‘WGCEF’’), obligation as non-binding.231 In the transactions or forward transactions. While the dated July 22, 2011 (‘‘WGCEF Letter’’). 238 Energy Exemption, the CFTC provided most common forward transaction involves an See Proposing Release at 29831, Request for exchange of a physical commodity for cash, neither Comment 27. the following examples of bona fide the Brent Interpretation nor any other CFTC 239 Most commenters opposed adding a minimum termination rights: force majeure authority requires payment for a forward delivery contract size or other conditions to the CFTC’s provisions and termination rights to be made in cash. Thus, a physical exchange of interpretation of the forward exclusion. One triggered by events of default, such as one quality, grade or type of physical commodity commenter argued that such an approach would be counterparty insolvency, default or for another quality, grade, or type of physical inconsistent with CFTC precedent, citing the fact commodity does not affect the characterization of that neither the Brent Interpretation nor subsequent 232 other inability to perform. The CFTC the transaction as a spot or forward transaction. As CFTC precedent interpreting the forward exclusion confirms that market participants who for the sellers passing title and buyers, instead of mention contract size. See CME Letter. Another otherwise qualify for the forward taking delivery of the commodity, passing title to commenter pointed out that Congress did not exclusion may continue to rely on the another intermediate purchaser in a chain, this is impose such a requirement, and thus believes that consistent with the description of Brent the CFTC should not do so. See Letter from David bona fide termination right concept as transactions in the Brent Interpretation, provided M. Perlman, Partner, Bracewell & Giuliani LLP, set forth in this interpretation, although, that, as set forth therein, delivery is required and Counsel to the Coalition of Physical Energy as was stated in the Energy Exemption, ‘‘the delivery obligations create substantial Companies (‘‘COPE’’), dated July 22, 2011 (‘‘COPE economic risk of a commercial nature to the parties Letter’’). Similarly, a third commenter argued that required to make or take delivery * * * includ[ing, the only condition Congress placed on the forward 228 See Proposing Release at 29829. The CFTC without limitation,] demurrage, damage, theft or exclusion is intent to physically settle, and contract also noted that, to avoid any uncertainty, the Dodd- deterioration.’’ That description was based on the size is not relevant to such intent. See Letter from Frank Act supersedes the Swap Policy Statement. industry delivery structure as it existed prior to the Natural Gas Supply Association/National Corn Id. at 29829 n. 74. The CFTC reaffirms that such is Brent Interpretation. To the extent other industries Growers Association (‘‘NGSA/NCGA’’), dated July the case. are similarly structured for commercial reasons, the 22, 2011 (‘‘NGSA/NCGA Letter’’). 229 Compare Energy Exemption, supra note 208, delivery-by-title-and-related-bill-of-lading-transfer Two commenters questioned the reasonableness at 21293 with Brent Interpretation, supra note 207, delivery method would be able to rely on the Brent in instituting a minimum contract size below which at 39192. Interpretation if it otherwise satisfied the terms a transaction would become regulated, but 230 See Energy Exemption, supra note 208, at thereof. However, to the extent persons seek to otherwise would not. See Letter from Craig G. 21293. establish such a delivery structure for new products Goodman, Esq., President, The National Energy 231 See also infra part II.B.2(b)(v) for a discussion and markets (e.g., not actually delivering the Marketers Association (‘‘NEMA’’), dated July 21, of liquidated damages. commodity to most of the participants in a chain), 2011, (‘‘NEMA Letter’’) and Letter from Phillip G. 232 Energy Exemption, supra note 208, at 21293. that could, depending on the applicable facts and Lookadoo on behalf of the International Energy

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by a commenter, the CFTC may consider nonfinancial commodity forward with respect to the forward contract contract size as a contextual factor in contract exclusion from the swap exclusion from the swap and future determining whether a particular definition is intended to be consistent delivery definitions.248 The CFTC also contract is a forward.240 Moreover, the with the forward contract exclusion believes that the interpretation provides CFTC may consider other contextual from the term ‘‘future delivery.’’242 The sufficient notice to the public regarding factors when determining whether a commenter also stated its view that the how the forward exclusions from the contract qualifies as a forward, such as interpretation as proposed does not swap and future delivery definitions a demonstrable commercial need for the provide notice to the electricity industry will be interpreted. As noted above, the product, the underlying purpose of the as to how to determine whether a CFTC’s historical approach to the contract (e.g. whether the purpose of the nonfinancial commodity agreement is a forward contract exclusion from the claimed forward was to sell physical swap or a nonfinancial commodity future delivery definition developed on commodities, hedge risk, or speculate), forward contract, nor as to which factors a case-by-case basis, not by rule. the regular practices of the commercial the CFTC would consider in Commenters generally supported entity with respect to its general distinguishing between swaps and applying the Brent Interpretation to the commercial business and its forward nonfinancial forward contracts.243 forward exclusion from the swap and swap transactions more specifically, Moreover, another commenter suggested definition and expanding it to all or whether the absence of physical that the CFTC should include in nonfinancial commodities for purposes settlement is based on a change in regulatory text a representative, non- of the forward exclusion from both the commercial circumstances. These exhaustive list of the kinds of contracts definitions of the terms ‘‘future contextual factors are consistent with that are excluded from the swap delivery’’ and ‘‘swap.’’ 249 However, in the CFTC’s historical facts-and- definition.244 addition to the requests for clarification circumstances approach to the forward The CFTC has determined not to to which the CFTC has responded in its contract exclusion outside of the Brent codify its interpretation in rule text. The final interpretation provided above, Interpretation safe harbor. CFTC has never codified its prior commenters raise other requests for interpretations of the forward contract clarification. One commenter,250 for Comments exclusion with respect to the future example, believed that the CFTC’s Several commenters believed that the delivery definition as a rule or adjudicatory decisions in Grain Land 251 CFTC should codify its proposed regulation;245 thus, providing an and Wright 252 should be construed to interpretation regarding the Brent interpretation is consistent with the have expanded the Brent Interpretation in rule text to provide manner in which the CFTC has Interpretation’s safe harbor. This greater legal certainty.241 One interpreted the forward exclusion in the commenter stated its view that in Grain commenter further commented that the past, which in turn is consistent with Land, the CFTC recognized that Dodd-Frank Act’s legislative history the Dodd-Frank Act legislative cancellation provisions or an option to expressly directed the CFTC to clarify history.246 Moreover, Congress did not roll the delivery date within flexible through rulemaking that the direct the CFTC to write rules regarding hedge-to-arrive contracts did not render the forward exclusion. The Dodd- the transactions futures contracts, as Credit Association (‘‘IECA’’), dated July 28, 2011 Lincoln letter, cited by a commenter in opposed to forwards. As such, this (‘‘IECA Letter’’). Two commenters believed that support of its argument, ‘‘encourages’’ commenter believed this case may be at such an approach would be contrary to the purposes of Dodd-Frank in regulating transactions the CFTC to clarify the forward odds with the literal terms of the Brent that would affect systemic risk. See NEMA Letter exclusion ‘‘through rulemaking’’ in the Interpretation regarding book-outs, and Letter from Dan Gilligan and Michael Trunzo, generic sense of that term (i.e., through which required that, to be a forward Petroleum Marketers Association of America and New England Fuel Institute (‘‘PMAA/NEFI’’), dated the rulemaking process of notice and contract, any cancellation of delivery July 22, 2011 (‘‘PMAA/NEFI Letter’’). One comment), not specifically through rule must be effected through a subsequent, commenter urged that the Brent Interpretation be text.247 Similarly, the CFTC is not separately negotiated agreement. The applied with minimal restrictive overlay. It believed providing in rule text a representative commenter argued that cases that contract size is a ‘‘contextual factor’’ that may be considered in evaluating the existence of intent list of contracts in nonfinancial subsequent to the Brent Interpretation, to deliver, but should not be viewed as an commodities that are excluded from the such as Grain Land and Wright, independent determinant. See ISDA Letter. swap definition as forwards. recognized the need for flexibility and One commenter argued that the forward The CFTC believes that its innovation in the commercial exclusion should be strengthened with additional interpretation provides sufficient clarity conditions to preclude evasion. Its suggested merchandising transactions that are conditions include defining the required regularity eligible for the forward exclusion. of delivery (such as a predominance, or ‘‘more often 242 See ETA Letter (citing the ‘‘Lincoln-Dodd Therefore, this commenter requested than not’’ standard); providing a quantitative test of Letter’’ printed at 156 Cong. Rec. H5248–249). that the CFTC consider the body of bona fide intent to deliver (such as a demonstrable 243 See ETA Letter. The commenter requests that commercial need for the product and justifying the CFTC ‘‘further define the statutory term ‘swap’ non-physical settlement based on a change in by defining relevant terms in the Dodd-Frank Act, 248 This is particularly true given that the CFTC commercial circumstances); and re-evaluating the reconciling the wording used in the various intends to interpret the forward exclusion from the book-outs aspect of the Brent Interpretation. See provisions in the CEA as amended by the Dodd- swap definition consistently with its interpretation Better Markets Letter. Frank Act, and setting forth in the [CFTC’s] rules of the forward exclusion from the term ‘‘future 240 See ISDA Letter. the factors that are determinative in drawing the delivery,’’ with which market participants have had decades of experience. 241 See Letter from Lisa Yoho, Director, distinction between a ‘swap’ and a ‘nonfinancial 249 Regulatory Affairs, BGA, dated July 22, 2011) commodity forward contract.’’’ The commenter See BGA Letter; COPE Letter; ISDA Letter; (‘‘BGA Letter’’); COPE Letter; Letter from Michael suggests rule text to codify the CFTC’s IECA Letter; Letter from Stuart J. Kaswell, Executive Bardee, General Counsel, Federal Energy Regulatory interpretation regarding the exclusion of Vice President & Managing Director, Managed Commission (‘‘FERC’’), dated July 22, 2011 (‘‘FERC nonfinancial commodity forward contracts. Id. Funds Association (‘‘MFA’’), dated July 22, 2011 244 Staff Letter’’); Letter from Stephanie Bird, Chief See FERC Staff Letter. (‘‘MFA Letter’’); NGSA/NCGA Letter; Letter from Financial Officer, Just Energy, dated July 22, 2011 245 See, e.g. Brent Interpretation, supra note 207; Charles F. Conner, President and CEO, National (‘‘Just Energy Letter’’); Letter from the Electric Trade Energy Exemption, supra note 208; Characteristics Council of Farmer Cooperatives (‘‘NCFC’’), dated Associations (the Electric Power Supply Distinguishing Cash and Forward Contracts and July 22, 2011 (‘‘NCFC Letter’’); NEMA Letter; Association, National Rural Electric Cooperative ‘‘Trade’’ Options, 50 FR 39656 (Sep. 30, 1985) PMAA/NEFI Letter; WGCEF Letter. Association, Large Public Power Council, Edison (‘‘1985 CFTC OGC Interpretation’’). 250 See CME Letter. Electric Institute and American Power Association) 246 See supra note 210 and accompanying text. 251 Grain Land, supra note 213. (‘‘ETA Letter’’), dated July 22, 2011. 247 See 156 Cong. Rec. H5248–49 (June 30, 2010). 252 Wright, supra note 214.

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forward contract precedent as a whole rationale for withdrawing the Energy impracticable.261 The CFTC has and extend the Brent Interpretation’s Exemption or the possible consequences provided an interpretation above safe harbor to situations like those for energy market participants. This regarding the documentation of book- presented in Grain Land, commenter sought confirmation that, outs in response to this commenter’s notwithstanding the absence of a despite the withdrawal of the Energy concerns. subsequent, separately-negotiated Exemption, market participants will be (ii) Nonfinancial Commodities agreement.253 permitted to rely on the Brent While, as noted above, the CFTC has Interpretation, as expanded by the In response to commenters,262 the clarified that the entire body of its Energy Exemption, particularly as it CFTC is providing an interpretation precedent applies to its interpretation of relates to alternative delivery regarding the scope of the term the forward exclusion for nonfinancial procedures.257 This commenter ‘‘nonfinancial commodity’’ in the commodities in the swap definition, the expressed concern that by withdrawing forward exclusion from the swap CFTC does not believe that there is a the Energy Exemption, the CFTC would definition.263 conflict between the Brent be revoking the ability of market The CFTC interprets the term Interpretation and the Grain Land or participants to rely on pre-transaction ‘‘nonfinancial commodity’’ to mean a Wright cases. In Grain Land, the CFTC netting agreements to offset physical commodity that can be physically concluded that the fact that a contract delivery obligations as an alternative to delivered and that is an exempt includes a termination right, standing separately negotiating book-outs after commodity 264 or an agricultural alone, is not determinative of whether entering into the transactions.258 As commodity.265 Unlike excluded the contract is a forward. Rather, as the discussed above, the CFTC has commodities, which generally are CFTC has always interpreted the determined to withdraw the Energy financial,266 exempt and agricultural forward exclusion, it looks to the facts Exemption as proposed, but has commodities by their nature generally and circumstances of the transaction. provided certain clarifications to are nonfinancial. The requirement that Similarly in Wright, which cited Grain address commenters’ concerns. the commodity be able to be physically Land with approval, the CFTC stated One commenter suggested the delivered is designed to prevent market that ‘‘[i]n assessing the parties’ deletion of ‘‘commercial merchandising participants from relying on the forward expectations or intent regarding transaction’’ as a descriptive term in the exclusion to enter into swaps based on delivery, the Commission applies a interpretation. Although recognizing its indexes of exempt or agricultural ‘facts and circumstances’ test rather provenance from the Brent commodities outside of the Dodd-Frank than a bright-line test focused on the Interpretation, this commenter believed Act and settling them in cash, which contract’s terms * * * .’’ In contrast, the that the phrase was anachronistic at that would be inconsistent with the Brent Interpretation is a safe harbor that time, and that it is misleading and historical limitation of the forward assures commercial parties that book- narrow in the current evolving exclusion to commercial merchandising out their contracts through a commercial environment.259 Contrary to transactions. However, to the extent that subsequent, separately negotiated this commenter’s suggestion, the CFTC a transaction is intended to be agreement that their contracts will not has determined to retain the phrase physically settled, otherwise meets the fall out of the forward exclusion. The ‘‘commercial merchandising terms of the forward contract exclusion CFTC’s conclusion that application of transaction’’ in its final interpretation and uses an index merely to determine its facts-and-circumstances approach regarding forward contracts. The CFTC the price to be paid for the nonfinancial demonstrated that the particular characterized forward transactions in commodity intended to be delivered, contracts at issue in Grain Land and this manner in the Brent Interpretation, Wright were forwards did not expand as well as in its subsequent 261 See WGCEF Letter. the scope of the safe harbor afforded by adjudications. Courts also have 262 The Commissions requested comment in the 254 Proposing Release on whether they should provide the Brent Interpretation. characterized forwards as commercial guidance regarding the scope of the term Several commenters suggested that merchandising transactions or cited the ‘‘nonfinancial commodity’’ and, if so, how and the Energy Exemption should not be CFTC’s characterization with where the line should be drawn between financial withdrawn. One commenter noted that approval.260 Accordingly, the CFTC and nonfinancial commodities. See Proposing the Energy Exemption, along with the believes that ‘‘commercial Release at 29832. 263 As noted above, the CEA definition of the term Brent Interpretation, should inform the merchandising transaction’’ continues ‘‘swap’’ excludes ‘‘any sale of a nonfinancial CFTC’s interpretation of the forward to be an accurate descriptive term for commodity or security for deferred shipment or exclusion.255 Another commenter characterizing forward transactions. delivery, so long as the transaction is intended to believed that the Energy Exemption Another commenter requested that be physically settled.’’ CEA section 1a(47)(B)(ii), 7 U.S.C. 1a(47)(B)(ii). Thus, the forward exclusion appears entirely consistent with the the CFTC clarify that a subsequent, from the swap definition is limited to transactions Dodd-Frank Act and should be included separately-negotiated agreement to in nonfinancial commodities. To the extent the in the rules as a non-exclusive effectuate a book-out under the Brent CFTC uses the term ‘‘nonfinancial commodity’’ in exemption to ensure continued Interpretation may be oral or written. other contexts in this release, such as in connection 256 with the Brent Interpretation (including as it clarity. A third commenter requested This commenter noted that the pace at applies with respect to the ‘‘future delivery’’ clarification that revoking the Energy which certain energy markets transact definition), the term will have the same meaning as Exemption will not harm market and the frequency with which book-outs discussed in this section in those contexts. participants, stating that the Proposing may sometimes occur, makes formal 264 The CEA defines an ‘‘exempt commodity’’ as Release did not sufficiently explain the written documentation of all book-outs ‘‘a commodity that is not an excluded commodity or an agricultural commodity.’’ CEA section 1a(20), 7 U.S.C. 1a(20). A security is an excluded 253 See CME Letter. 257 See MFA Letter. commodity as discussed below, and therefore is not 254 As described above in the interpretation, the 258 Ex Parte Communication between MFA and an exempt commodity. CFTC has addressed CME’s other comments on the CFTC Staff on September 15, 2011, at http:// 265 The CFTC has defined the term ‘‘agricultural forward exclusion, including the interpretation’s comments.cftc.gov/PublicComments/ViewExParte. commodity’’ in its regulations at Rule 1.3(zz) under applicability to commercial market participants and aspx?id=387&SearchText= . the CEA, 17 CFR 1.3(zz). See Agricultural CME’s hedge fund example. 259 See ISDA Letter. Commodity Definition, 76 FR 41048 (Jul. 13, 2011). 255 See COPE Letter Appendix. 260 See, e.g., In re Bybee, 945 F.2d 309, 315 (9th 266 The CEA defines an ‘‘excluded commodity’’ at 256 See IECA Letter. Cir. 1991). CEA section 1a(19), 7 U.S.C. 1a(19).

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the transaction may qualify for the (iii) Environmental Commodities interpretation regarding nonfinancial forward exclusion from the swap The Commissions requested comment commodities discussed in subsection definition. on whether environmental commodities (ii) above are nonfinancial commodities In addition, the CFTC is providing an should fall within the forward exclusion and, therefore, a sale for deferred shipment or delivery in such a interpretation that an intangible from the swap definition and, if so, commodity, so long as the transaction is commodity (that is not an excluded subject to what parameters.270 In response to commenters, the CFTC is intended to be physically settled, may commodity) which can be physically qualify for the forward exclusion from delivered qualifies as a nonfinancial providing an interpretation regarding the circumstances under which the swap definition. commodity if ownership of the The intangible nature of commodity can be conveyed in some agreements, contracts or transactions in environmental commodities will satisfy environmental, or other, commodities manner and the commodity can be the forward exclusion from the swap does not disqualify contracts based on consumed. One example of an definition.271 The CFTC did not propose such commodities from the forward intangible nonfinancial commodity that a definition of the term ‘‘environmental exclusion from the swap definition, qualifies under this interpretation, as commodity’’ in the Proposing Release notwithstanding that the core of the discussed in greater detail below, is an 272 forward exclusion is intent to deliver and is not doing so in this release. 275 environmental commodity, such as an The CFTC believes it is not necessary to the underlying commodity. As emission allowance, that can be define the term ‘‘environmental commenters noted, securities are physically delivered and consumed commodity’’ because any intangible intangible (with the exception of the (e.g., by emitting the amount of commodity—environmental or rare certificated security) and yet they pollutant specified in the allowance).267 are expressly permitted by CEA section otherwise—that satisfies the terms of the 276 The interpretation provided herein interpretation provided herein is a 1a(47)(B)(ii) to be the subject of the recognizes that transactions in nonfinancial commodity, and thus an forward exclusion; this reflects recognition by Congress that the forward intangible commodities can, in agreement, contract or transaction in exclusion can apply to intangible appropriate circumstances, qualify as such a commodity is eligible for the 277 forward exclusion from the swap commodities. forwards, while setting forth certain The CFTC understands that market definition.273 The forward exclusion conditions to assure that the forward participants often engage in from the swap definition does not apply exclusion may not be abused with environmental commodity transactions to commodities themselves, but to respect to intangible commodities. in order to transfer ownership 278 of the certain types of agreements, contracts or environmental commodity (and not Comments transactions in a specified type of solely price risk),279 so that the buyer commodity (i.e., a ‘‘nonfinancial’’ Several commenters believed that the commodity).274 Environmental 275 See supra part II.B.2.a)i)(A). CFTC should provide an interpretation commodities that meet the regarding the meaning of the term 276 7 U.S.C. 1a(47)(B)(ii). 277 As commenters also note, each Commission or ‘‘nonfinancial commodity’’ to provide 270 See Proposing Release at 29832, Request for its staff has previously indicated that environmental clarity to market participants on the Comment 32, asked: Should the forward contract commodities, in the CFTC’s case, and securities, in applicability of the forward exclusion from the swap definition apply to the SEC’s case, can be physically settled. See Letter environmental commodities such as emissions 268 from Kyle Danish, Van Ness Feldman, P.C., on exclusion. The CFTC is providing the allowances, carbon offsets/credits, or renewable behalf of Coalition for Emission Reduction Policy interpretation discussed above to energy certificates? If so, please describe these (‘‘CERP’’), dated July 18, 2011 (‘‘CERP Letter’’) and address these commenters’ concerns commodities, and explain how transactions can be 3Degrees Letter. Also, the recent Carbon Report physically settled where the commodity lacks a suggested that the forward exclusion could apply to but, contrary to one commenter’s physical existence (or lacks a physical existence agreements, contracts or transactions in request, declines to adopt a other than on paper)? Would application of the environmental commodities. See Interagency regulation.269 forward contract exclusion to such environmental Working Group for the Study on Oversight of commodities permit transactions that should be Carbon Markets (‘‘Interagency Working Group’’), subject to the swap regulatory regime to fall outside Report on the Oversight of Existing and Prospective 267 See supra part II.B.2.a)iii), regarding the Dodd-Frank Act? Carbon Markets (January 2011) (‘‘Carbon Report’’). environmental commodities. An emission 271 Because the CFTC has determined, as The Carbon Report specifically stated that—[n]o set allowance buyer also can consume the allowance by discussed elsewhere in this release, to interpret the of laws currently exist that apply a comprehensive retiring it without emitting the permitted amount of forward exclusion from the swap definition regulatory regime—such as that which exists for pollutant. consistently with the forward exclusion from the derivatives—specifically to secondary market 268 See Letter from Steven J. Mickelsen, Counsel, ‘‘future delivery’’ definition, the discussion in this trading of carbon allowances and offsets. Thus, for 3Degrees Group, Inc., dated July 22, 2011 section applies equally to the forward exclusion the most part, absent specific action by Congress, (‘‘3Degrees Letter’’); ETA Letter; and Letter from from future delivery. a secondary market for carbon allowances and Kari S. Larsen, General Counsel, Chief Regulatory 272 See also Letter from Gene Grace, Senior offsets may operate outside the routine oversight of Officer, Green Exchange LLC, dated July 22, 2011 Counsel, American Wind Energy Association any market regulator. (‘‘GreenX Letter’’). Each of these commenters (‘‘AWEA’’), dated July 22, 2011 (‘‘AWEA Letter’’) 278 One commenter maintains that a transaction proposed its own definition of ‘‘nonfinancial (providing a general description of renewable in an environmental allowance represents a commodity.’’ The interpretation above incorporates energy credits (‘‘RECs’’), emission allowances, and physically-settled transaction because its primary many of their suggestions. offsets, which the commenter collectively termed purpose is to transfer ownership of the right to emit 269 See ETA Letter. This is consistent with CFTC ‘‘environmental commodities’’ for purposes of its a specified unit of pollution. See Letter from practice in providing an interpretation rather than letter). Andrew K. Soto, American Gas Association regulations where warranted. In this context, the 273 Thus, market participants should apply the (‘‘AGA’’), dated July 22, 2011 (‘‘AGA Letter’’). CFTC is providing an interpretation rather than rule interpretation to their facts to determine whether Compare to Proposing Release at 29828 (stating that text because the CFTC is not limiting the definition their specific circumstances support reliance on the ‘‘[t]he primary purpose of the contract is to transfer of ‘‘nonfinancial commodity’’ to exempt and forward exclusion from the swap definition. ownership of the commodity’’). agricultural commodities (the latter category 274 Several commenters appear to have confused 279 Another commenter states that, from a includes agricultural commodity indexes (see 17 these concepts. The term ‘‘commodity’’ is defined practical standpoint, the buyer must take delivery CFR 1.3(zz)(4))). The definition also requires in CEA section 1a(9), 7 U.S.C. 1a(9). The forward to satisfy a compliance obligation, which typically physical deliverability and, with respect to exclusion in CEA section 1a(47)(B)(ii), 7 U.S.C. requires surrender of allowances and offset credits, intangible commodities, ownership transferability 1a(47)(B)(ii), excludes from the swap definition and likens such transactions to forward sales of and consumability. Whether a commodity has these ‘‘any sale of a nonfinancial commodity or security more tangible commodities, noting they are not features may require interpretation. In any case, for deferred shipment or delivery, so long as the devices for transferring price risk. See CERP Letter. courts can rely on agency interpretations. transaction is intended to be physically settled.’’ Continued

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can consume the commodity in order to or contractual attestation. Therefore, an via a tracking system, registry or comply with the terms of mandatory or agreement, contract or transaction in an contractual attestation, in exchange for voluntary environmental programs.280 environmental commodity may qualify a cash payment.’’ 286 One commenter Those two features—ownership transfer for the forward exclusion from the swap stated that this form of settlement and consumption—distinguish such definition if the transaction is intended demonstrates that the lack of physical environmental commodity transactions to be physically settled. existence of a commodity is not relevant from other types of intangible to whether a transaction in the Comments commodity transactions that cannot be commodity physically settles for delivered, such as temperatures and Several commenters responded to the purposes of the forward exclusion.287 interest rates. The ownership transfer Commission’s request for comment Another commenter contended that title and consumption features render such regarding the applicability of the transfer constitutes physical delivery environmental commodity transactions forward exclusion from the swap because the settlement results in the similar to tangible commodity definition for agreements, contracts and environmental commodity being transactions that clearly can be transactions in environmental consumed to meet an environmental delivered, such as wheat and gold.281 commodities.285 obligation or goal, which occurs through For such transactions, in addition to Most commenters responding to the ‘‘retirement’’ of the environmental the factors discussed above, intent to Commissions’ request for comment commodity.288 Other commenters deliver is readily determinable,282 concerning the appropriate treatment of compared the settlement of a transaction delivery failures generally result from agreements, contracts or transactions in in an environmental commodity frustration of the parties’ intentions,283 environmental commodities asserted through an electronic registry system to and cash-settlement is insufficient that emission allowances, carbon a warehouse receipt that represents title because delivery of the commodity is offsets/credits, or RECs should be able to a physical commodity.289 necessary for compliance purposes.284 to qualify for the forward exclusion For the foregoing reasons, from the swap definition. In support of 286 See 3Degrees Letter. See also WGCEF Letter environmental commodities can be this view, several commenters (advising that ‘‘physical delivery takes place the nonfinancial commodities that can be explained that the settlement process for moment that title and ownership in the delivered through electronic settlement environmental commodity itself is transferred from environmental commodity transactions the seller to the buyer[,] whether through the generally involves ‘‘the transfer of title execution of a legally binding contract or Compare to Proposing Release at 29828 (stating that attestation, or submission of records to a centralized ‘‘[t]he primary purpose of the contract is * * * not 285 One commenter provided a general data base, such as a registry’’); Letter from the Hons. to transfer solely * * * price risk’’). This description of renewable energy credits (‘‘RECs’’), Jeffrey A. Merkley, Sherrod Brown and Jeanne commenter also advises that delivery of RECs and emission allowances, offsets, (which the commenter Shaheen, U.S. Senators, dated January 13, 2012 offsets is typically deferred for commercial collectively termed ‘‘environmental commodities’’ (‘‘Senators Letter’’) (relaying that ‘‘[t]he purchase or convenience, consistent with the Brent for purposes of its letter), and related transactions. sale of a REC is settled through the transfer of title Interpretation, because ‘‘not all of the purchased See AWEA Letter. According to the commenter, to the REC, either electronically over a tracking RECs and offsets are generated at the time of the RECs are created by state regulatory bodies in system or via a paper attestation’’); Letter from transaction’’ and ‘‘long-term contracts with deferred conjunction with the production of electricity from Harold Buchanan, Chief Executive Officer, CE2 delivery are important for renewable energy a qualifying renewable energy facility. The forward Carbon Capital, LLC (‘‘CE2’’), dated July 22, 2011 projects to ensure a consistent revenue stream over sale of a REC transfers ownership of the REC from (‘‘CE2 Letter’’); Letter from Jason M. Rosenstock, ML a long period of time.’’ See CERP Letter. the producing entity to another entity that can use Strategies LLC on behalf of The Business Council 280 Consumption also can be part of a commercial the REC for compliance with an obligation to sell for Sustainable Energy (‘‘BCSE’’), dated January 24, merchandising transaction in the chain of a certain percentage of renewable energy. Many 2012 (‘‘BCSE Letter’’); NEMA Letter (stating that commerce. See, e.g., Brent Interpretation, supra times, this forward sale takes place prior to the RECs must be physically settled through a REC note 207 (dissent of Commissioner Fowler West) construction of a project to enable developers to registry, which ‘‘ensures that there is a physical (citing the 1985 CFTC OGC Interpretation and cases secure related project financing. See AWEA Letter. megawatt hour from a green generator behind the cited therein for the proposition that ‘‘parties to See also Letter from Mary Anne Mason, REC’’). forward contracts * * * seek to profit in their HoganLovells LLP on behalf of Southern California 287 See 3Degrees Letter. See also GreenX Letter businesses from producing, processing, distributing, Edison Company, Pacific Gas and Electric Company (stating that environmental commodities share the storing, or consuming the commodity’’). and San Diego Gas and Electric Company same characteristics as tangible physical 281 Similarly, the settlement method for the types (‘‘California Utilities’’), dated July 22, 2011 commodities ‘‘in all key respects,’’ including that of environmental commodity transactions described (‘‘California Utilities Letter’’) (stating that the they are in limited supply). by commenters such as RECs, emission allowances, California Utilities transact in allowances, under 288 See CRS Letter. CRS explains that retirement and offsets are equivalent to that of physical the EPA’s and anticipated California cap-and-trade occurs through a registry or electronic tracking commodities where ownership is transferred by programs, as well as in RECs, in order to comply system by transfer into a retirement account (or, delivering a warehouse receipt from the seller to the with or participate in various regulatory and alternatively, an exchange of paperwork) and that, buyer, thereby indicating the presence in the voluntary programs). once retired, an environmental commodity cannot warehouse of the contracted for commodity volume. The CFTC understands that, in the United States, be resold. The CRS also argues that such See GreenXLetter. See also REMA letter (averring emission allowances and offsets are issued by the environmental commodity transactions are that ‘‘[i]n effect, the REC is an intangible contract U.S. Environmental Protection Agency (‘‘EPA’’), commercial merchandising transactions, and thus right or interest in that specific quantity of energy; state government entities and private entities. may be forward contracts, because the primary thus, it is quite analogous to a warehouse receipt Emission allowances and offsets are transferred purpose of the transactions is to transfer ownership that represents title to a physical commodity’’). between counterparties, often through forward so that the purchaser may comply with an Another similarity between these environmental contracts, with the purchasing party obtaining the applicable environmental program. See also commodity transactions and tangible commodities ability to use the allowances or offsets for 3Degrees Letter and AWEA Letter. is that it is possible to manipulate the deliverable compliance with clean air or greenhouse gas 289 See Letter from Josh Lieberman, General supply of an environmental commodity just as it is regulations. The forward sale of allowances and Manager, Renewable Energy Markets Association for a tangible commodity. The CFTC reminds offsets allows market participants to hedge the (‘‘REMA’’), dated July 22, 2011 (‘‘REMA Letter’’) market participants of its continuing authority over compliance obligations associated with expected (distinguishing RECs, which allow the buyer to own forwards under the CEA’s anti-manipulation emissions, or to meet a voluntary emissions environmental attributes, from a pure financial provisions prohibiting manipulation, making false reduction commitment or make an environmental swap, where only price risk is transferred); See also and misleading statements and omissions of claim. See, e.g., AWEA Letter; Letter from Henry GreenX Letter (likening the settlement of an material fact to the CFTC, fraud and deceptive Derwent, President and CEO, International environmental commodity transaction (where practices, and false reporting. See supra note 226. Emissions Trading Association, dated July 22, 2011 delivery typically would take place by electronic 282 See Letter from Jennifer Martin, Executive (defining a carbon offset as a ‘‘credit[] granted by delivery from the registry account of the seller to Director, Center for Research Solutions (‘‘CRS’’), a state or regional governmental body or an the registry account of the buyer) to that of dated July 22, 2011 (‘‘CRS Letter’’). independent standards organization in an amount transactions in many tangible physical 283 See 3Degrees Letter. equal to the generation of electricity from a commodities, such as agricultural commodities and 284 See GreenX Letter. qualifying renewable energy facility.’’). metals, where settlement is evidenced by an

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A few commenters also analogized As discussed above, the CFTC has be swaps because the EPA’s initial environmental commodities to addressed the foregoing concerns of issuance of allowances would be securities, which (with the exception of commenters by providing an excluded from the swap definition certificated securities) are intangible. interpretation that agreements, contracts under CEA section 1a(47)(B)(ix).301 The Some commenters, for example, and transactions in environmental CFTC declines to address the asserted that the language of the forward commodities may qualify for the commenter’s legal conclusion regarding exclusion from the swap definition forward exclusion from the swap the application of CEA section means that non-physical items can be definition. 1a(47)(B)(ix), but agrees that an physically settled because the One commenter stated its view that emission allowance created by the EPA exclusion, which references securities, the forward exclusion from the swap is a nonfinancial commodity and that ‘‘implies that securities—which lack a definition should not be available for agreements, contracts and transactions strict physical existence—may be carbon transactions because they should in such allowances may fall within the physically settled.’’ 290 be standardized and conducted on open, forward exclusion from the swap Some commenters assured the transparent and regulated exchanges.296 definition. Commissions that applying the forward This commenter acknowledged the exclusion to transactions in possibility that carbon transactions can (iv) Physical Exchange Transactions environmental commodities would not be physically settled (as the statute The Commissions received a permit transactions that should be requires of excluded forward contracts) comment letter seeking clarification that subject to the swap regulatory regime to but argued that, in light of the fact that physical exchange transactions are fall outside it. One commenter there is no cost associated with making forward contracts excluded from the submitted that intent to deliver with or taking delivery of carbon, there is no swap definition.302 As described by the respect to environmental commodities cost to store it, and there is no delay in commenter, physical exchange will be readily determinable.291 Another delivering it, a forward exclusion for transactions involve ‘‘a gas utility commenter contended that: carbon transactions may allow financial entering into a transaction with another environmental commodity contracts speculators to escape regulation gas utility or other market participant to almost universally require delivery and otherwise required by the Dodd-Frank take delivery of natural gas at one that failure to do so is an event of Act. The CFTC believes that if a delivery point in exchange for the same default; to the best of its knowledge, it transaction satisfies the terms of the quantity of gas to be delivered at an is rare for such a contract to include the statutory exclusion, the CFTC lacks the alternative delivery point * * * for the right to unilaterally terminate an authority to deprive the transaction of primary purpose of transferring agreement under a pre-arranged the exclusion, absent evasion.297 ownership of the physical commodity in contractual provision permitting One commenter stated that ‘‘[i]n the order to rationalize the delivery of financial settlement; 292 and defaults solar industry, RECs are often traded by physical supplies to where they are generally are the result of something an individual consumer as an needed’’ at a price ‘‘generally reflecting frustrating parties’ intentions.293 Still assignment of a right owned by that the difference in value at the delivery other commenters distinguished consumer.’’ 298 This commenter also points.’’ 303 This commenter stated that environmental commodities from other advised that many individual ‘‘exchange transactions create binding intangible commodities, such as the consumers transact forward contracts obligations on each party to make and nonfinancial commodities (such as through solar REC (‘‘SREC’’) aggregators take delivery of physical commodities interest rates and temperatures) that the at a fixed price. The CFTC notes 299 that [, i]n essence constituting paired CFTC referred to in its Adaptation a transaction entered into by a consumer forward contracts that are intended to go Notice of Proposed Rulemaking,294 cannot be a forward transaction, and to physical delivery.’’ 304 The because RECs and emissions allowances accordingly should not be the subject of commenter added that, to the extent an or offsets can be physically transferred an interpretation of the forward exchange transaction payment is based 300 from one account to another, whereas exclusion. on an index price, such pricing is not ‘‘it is not possible to move and One commenter takes the position severable from the physical physically transfer an interest rate or a that, because EPA emission allowances exchange.305 temperature reading.’’ 295 are issued in transactions with the EPA, The CFTC interprets the exchange only resales of such allowances transactions described by the electronic transfer of a warehouse receipt in the (secondary market transactions) could commenter, to the extent they are for records of the warehouse and the underlying deferred delivery, as examples of commodity does not move—it remains in the 296 See Letter from Michelle Chan, Director, warehouse or vault—but its ownership changes)). Economic Policy Programs, Friends of the Earth, transactions in nonfinancial 290 See CRS Letter. See also CERP Letter (claiming dated July 22, 2011. commodities that are within the forward that Congress did not intend for the phrase 297 While the commenter contended that ‘‘the exclusion from the definition of the ‘‘physically settled’’ in the forward exclusion to be intangible nature of carbon makes it much easier for terms ‘‘swap’’ and ‘‘future delivery.’’ limited to tangible commodities because, like speculators or those simply seeking to hedge carbon environmental commodities, securities only exist price risk to take delivery of the carbon itself rather Based on the information supplied by ‘‘on paper.’’). See also AWEA Letter. than enter into a derivatives transaction,’’ as the the commenter, they are commercial 291 See CRS Letter (‘‘unlike a stock or a bond, CFTC states in section VII.A.2.c), infra, deciding to merchandising transactions, the primary which can be resold for its cash value, purchasers enter into a forward transaction rather than a swap purpose of which is to transfer of environmental commodities intend to take does not constitute evasion. Thus, if the transaction delivery of RECs or carbon offsets for either in question is a forward contract, that is the end of compliance purposes or in order to make an the analysis, absent the presence of other factors 301 See Letter from Lauren Newberry, Jeffrey C. environmental claim regarding their renewable that may indicate evasion. See AWEA Letter. Fort, Jeremy D. Weinstein, and Christopher B. energy use or carbon footprint.’’). See also GreenX 298 See Letter from Katherine Gensler, Director, Berendt, Environmental Markets Association, dated Letter. Regulatory Affairs, SEIA, dated August 5, 2011 July 21, 2011. 292 Such a provision would preclude reliance on (‘‘SEIA Letter’’). 302 See AGA Letter. the forward exclusion. 299 See Proposing Release at 29832 n.104. 303 Id. This commenter noted that gas utilities 293 See 3Degrees Letter. 300 However, in section II.B.3., infra, the often can receive gas at more than one 294 See Adaptation of Regulations to Incorporate Commissions provide an interpretation regarding interconnection or delivery point on a pipeline. Swaps, 76 FR 33066, June 7, 2011. the applicability of the swap definition to consumer 304 Id. 295 See California Utilities Letter. transactions. 305 Id.

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ownership of natural gas between two natural gas supplied from the natural as ‘‘a relatively new development,’’ are parties who intend to physically settle gas project. The monthly fee would be that the participants generally are such transactions. That exchange composed of an operating cost fee commercials and a high percentage of transactions may involve, in addition to component, an interstate pipeline contracts go to delivery, gas deliveries at two separate delivery transportation cost fee component and notwithstanding netting of delivery points, a cash payment by one party to an operating reserve cost fee obligations.311 This commenter added the other reflecting the difference in component. The municipal utility’s that, while parties to such contracts value of the gas at different delivery natural gas-fired electric generating intend to go to delivery when they enter points, or that such payment may be facility would be used to supply a into them, their delivery needs may based on an index, does not necessarily portion of its expected retail electric change as time passes. affect the nature of the transactions as load. The CFTC declines to address this forward transactions.306 For an Such agreements are forward request for the 50/100 Forward Safe exchange transaction to fall within the transactions if they otherwise meet the Harbor, which raises policy issues that forward exclusion, though, the parties to interpretation set forth in this release are beyond the scope of this rulemaking. the transaction must intend for the regarding the forward exclusions (e.g., Should the CFTC consider the transaction to be physically settled, and no optionality other than as permitted implications of the requested 50/100 the exchange transaction must satisfy all by the interpretation). Monthly or other Forward Safe Harbor, including possible applicable interpretations set forth fees that are not in the nature of option additional conditions for relief, it would herein, including that relating to book- premiums do not convert the be appropriate for the CFTC to obtain outs.307 transactions from forwards to options. further comment from the public on this Because the transactions as described (v) Fuel Delivery Agreements discrete proposal. For the same reasons, above do not appear to exhibit the CFTC declines to address at this The CFTC understands that fuel optionality as to delivery, and no other time the comment requesting that the delivery agreements can generally be aspect of the transactions as described CFTC take the view that cleared described as agreements whereby two or above seem to exhibit optionality, the forwards between commercial more parties agree to divide the cost of fees would not seem to resemble option participants fall within the scope of the acquiring fuel for generation facilities premiums.308 forward contract exclusion. based on some formula or factors, which can include, for example, their (vi) Cleared/Exchange-Traded Forwards (b) Commodity Options and Commodity respective financial contributions to In the Proposing Release, the Options Embedded in Forward developing the source of the fuel (e.g., Commissions requested comment Contracts a natural gas field). One example of a regarding whether forwards executed on (i) Commodity Options 312 fuel delivery agreement could involve a trading platforms should fall within the forward exclusion from the swap The CFTC noted in the Proposing joint power agency providing to a 313 municipal utility a long-term supply of definition and, if so, subject to what Release that the statutory swap natural gas from a natural gas project parameters.309 One commenter definition explicitly provides that developed by the joint power agency requested that the CFTC adopt a non- commodity options are swaps, that it and other entities to provide fuel for, exclusive safe harbor providing that had proposed revisions to its existing exchange-traded contracts with respect options rules in parts 32 and 33 of its among others, the joint power agency’s 314 and the municipal utility’s natural gas- to which more than 50 percent of regulations with respect to the fired electric generating facilities. The contracts, on average on a rolling three- treatment of commodity options under municipal utility would pay the joint month basis, go to delivery and where the Dodd-Frank Act, and that it had power agency through direct capital 100 percent of the counterparties are requested comment on those proposed commercial counterparties, are neither revisions in that rulemaking contributions to the entity formed to 315 develop the natural gas project for the futures nor swaps (‘‘50/100 Forward proceeding. Accordingly, the CFTC cost of developing it. In addition, the Safe Harbor’’).310 This commenter did not propose an additional municipal utility would pay the joint further requested that the CFTC provide interpretation in the Proposing Release power agency a monthly fee for the an appropriate transition period once with respect to commodity options. those thresholds are breached. This The CFTC reaffirms that commodity 306 However, if such payment stems from an commenter contended that two options are swaps under the statutory embedded option, the interpretation set forth in the hallmarks of the exchange-traded swap definition, and is not providing an embedded option section of this release, see infra forward markets, which it characterized additional interpretation regarding part II.B.2(b)(v), also would be relevant to commodity options in this release. The determining whether an exchange transaction were covered by the forward exclusion from the swap 308 This interpretation is limited to the facts and CFTC recently addressed commodity definition. circumstances described herein; the CFTC is not options in the context of a separate final 307 While the commenter also states that ‘‘[g]as opining on different facts or circumstances, which rulemaking and interim final utilities contract with interstate pipelines for could change the CFTC’s interpretation. rulemaking, under its plenary options 309 capacity rights to have their gas supplies delivered See Proposing Release at 29831–29832, authority in CEA section 4c(b).316 There, to specific delivery points,’’ its discussion of Request for Comment 30. exchange transactions appears unrelated to such 310 See Letter from Peter Krenkel, President and the CFTC adopted a modified trade capacity rights. Therefore, the CFTC’s guidance on CEO, NGX, dated Nov. 4, 2010, resubmitted by option exemption, and has invited exchange transactions does not address exchange email to CFTC staff on Sept. 14, 2011 (‘‘NGX transactions with capacity elements, which, Letter’’). One other commenter addressed a related 311 Id. depending on their structures, may be covered by issue, asserting that the Commissions should clarify 312 As used in this release, the term ‘‘commodity the guidance set forth in the embedded option that cleared forwards between commercial option’’ refers to an option that is subject to the section of this release or by the CFTC’s recent participants should be permitted under the forward CEA. Commodity Options release. See infra note 317. contract exclusion. See Ex Parte Communication 313 Conversely, that parties to an exchange transaction among Evolution Markets Inc. (‘‘Evolution’’), Ogilvy See Proposing Release at 29829–30. separately enter into a capacity transaction with a Government Relations (‘‘Ogilvy’’) and CFTC staff on 314 17 CFR Parts 32 and 33. pipeline operator to transport natural gas delivered May 18, 2011 at http://comments.cftc.gov/Public 315 See Commodity Options and Agricultural via an exchange transaction is not relevant to Comments/ViewExParte.aspx?id=197& Swaps, 76 FR 6095 (Feb. 3, 2011) (proposed). today’s guidance regarding exchange transactions. SearchText=. 316 7 U.S.C. 6c(b).

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public comment on the interim final term ‘‘future delivery,’’ 321 which the secondary trading.328 As was stated in rules.317 CFTC has determined above to apply to the Proposing Release, these same the forward exclusion from the swap principles can be applied with respect Comments definition as well.322 Further, the CFTC to the forward contract exclusion from Several commenters in response to notes that it has recently issued final the swap definition for nonfinancial the Proposing Release argued that and interim final rules adopting a commodities in the Dodd-Frank Act, commodity options should not be modified version of the CFTC’s existing too.329 Utilizing these principles, the regulated as swaps.318 In general, these trade option exemption.323 CFTC is providing a final interpretation commenters believed that commodity that a forward contract that contains an (ii) Commodity Options Embedded in options should qualify for the forward embedded commodity option or Forward Contracts exclusion from the swap definition, options 330 will be considered an emphasizing similarities between The CFTC is restating the excluded nonfinancial commodity commodity options and forward interpretation regarding forwards with forward contract (and not a swap) if the contracts on nonfinancial embedded options from the Proposing embedded option(s): commodities.319 Release, but with certain modifications 1. May be used to adjust the forward The CFTC is not providing an based on comments received. The CFTC contract price,331 but do not undermine interpretation that commodity options is providing additional interpretations the overall nature of the contract as a qualify as forward contracts in regarding forwards with embedded forward contract; nonfinancial commodities. Such an volumetric optionality, optionality in 2. Do not target the delivery term, so approach would be contrary to the plain the form of evergreen and renewal that the predominant feature of the language of the statutory swap provisions, and optionality with respect contract is actual delivery; and definition, which explicitly provides to delivery points and delivery dates. 3. Cannot be severed and marketed that commodity options are swaps.320 As was noted in the Proposing separately from the overall forward This approach also would be a Release, the question of the application contract in which they are embedded.332 departure from the CFTC’s and its staff’s of the forward exclusion from the swap In evaluating whether an agreement, longstanding interpretation of the definition with respect to nonfinancial contract, or transaction qualifies for the forward exclusion with respect to the commodities, where commodity options forward contract exclusions from the are embedded in forward contracts swap definition for nonfinancial 317 See Commodity Options, 77 FR 25320 (Apr. (including embedded options to cash commodities, the CFTC will look to the 27, 2012). settle such contracts), is similar to that specific facts and circumstances of the 318 See Letter from Brian Knapp, Policy Advisor, arising under the CEA’s existing forward transaction as a whole to evaluate American Petroleum Institute (‘‘API’’), dated contract exclusion from the definition of whether any embedded optionality January 31, 2012 (‘‘API Letter’’); BGA Letter; COPE 324 Letter; ETA Letter; Just Energy Letter; NGSA/NCGA the term ‘‘future delivery.’’ The operates on the price or delivery term of Letter; and WGCEF Letter. CFTC’s Office of General Counsel the contract, and whether an embedded 319 For example, one commenter asserted that, addressed forward contracts that commodity option is marketed or traded similar to a forward contract on a nonfinancial contained embedded options in the separately from the underlying commodity, a commodity option conveys no ability 325 333 for a party to unilaterally require a financial 1985 CFTC OGC Interpretation, contract. Such an approach will help settlement. Reasoning that both commodity options which recently was adhered to by the and forward contracts on nonfinancial commodities CFTC in its adjudicatory Order in the 328 Wright, supra note 214, at n.5. In Wright, the are intended to settle by physical delivery, this Wright case.326 While both were issued CFTC affirmed the Administrative Law Judge’s commenter contended that they should have the holding that an option embedded in a hedge-to- same regulatory treatment. See COPE Letter. prior to the effective date of the Dodd- arrive contract did not violate CFTC rules regarding Similarly, another commenter argued that the Frank Act, the CFTC believes that, as the sale of agricultural trade options. The CFTC first forward exclusion ‘‘plainly covers’’ commodity was stated in the Proposing Release, it concluded that the puts at issue operated to adjust options because they are: (i) Contracts for the sale is appropriate to apply this the forward price and did not render the farmer’s of physical, nonfinancial commodities, (ii) for overall obligation to make delivery optional. Then, deferred delivery, and (iii) intended to be interpretation to the treatment of turning to the next step of the analysis, the CFTC physically settled, given that purchasers have an forward contracts in nonfinancial explained that ‘‘the put and [hedge-to-arrive absolute right to physical delivery and sellers have commodities that contain embedded contract] operated as a single contract, and in most an absolute obligation to physically deliver the options under the Dodd-Frank Act.327 cases were issued simultaneously * * *. We do not find that any put was severed from its forward or amounts called for by the purchasers if the option In Wright, the CFTC stated that it is exercised. See NGSA/NCGA Letter. A third that either of [the put or the hedge-to-arrive commenter recommended that the CFTC interpret traditionally has engaged in a two-step contract] was traded separately from the other. We the forward exclusion ‘‘broadly’’ to include options analysis of ‘‘embedded options’’ in hold that in these circumstances, no freestanding that, if exercised, become forwards in nonfinancial which the first step focuses on whether option came into being * * *.’’ Id. at *7. 329 commodities in light of the particular the option operates on the price or the See Proposing Release at 29830. circumstances of the electricity industry, where 330 Options in the plural would include, for electric companies use commodity options to delivery term of the forward contract example, a situation in which the embedded efficiently meet the demands of electric customers and the second step focuses on optionality involves option combinations, such as by hedging or mitigating commercial risks due to costless collars, that operate on the price term of the agreement, contract, or transaction. seasonal and geographically unique weather and 321 See 1985 CFTC OGC Interpretation, supra note 331 load patterns and fluctuations. See ETA letter. In 245. In this regard, an option cannot be a forward For example, a forward with an embedded the alternative, a fourth commenter requested that under the CFTC’s precedent, because under the option with a formulaic strike price based on an the CFTC exercise its plenary options authority terms of the contract the optionee has the right, but index value that may not be known until after under CEA section 4c(b), 7 U.S.C. 6c(b), to establish not the obligation, to make or take delivery, while exercise would be a forward if it meets the rest of a separate regulatory regime for commodity options under a forward contract, both parties must have the 3 components of this interpretation. Triggering analogous to the trade option exemption under binding delivery obligations: one to make delivery an option to buy or sell one commodity based on former CFTC Rule 32.4. See WGCEF Letter. See 17 and the other to take delivery. the price of a different commodity reaching a CFR 32.4 (2011). specified level, such as in a cross-commodity 322 See supra part II.B.2(a)(i)(A). 320 See CEA section 1a(47)(A)(i), 7 U.S.C. transaction, does not constitute an adjustment to 323 See supra note 317. 1a(47)(A)(i) (defining a swap as, among other the forward contract price within the meaning of 324 things, ‘‘a put, call * * * or option of any kind See Proposing Release at 29830. this 3-part interpretation. * * * for the purchase or sale * * * of * * * 325 See 1985 CFTC OGC Interpretation, supra note 332 See Wright, supra note 214, at **6–7. commodities’’) and CEA section 1a(47)(B), 7 U.S.C. 245. 333 This facts and circumstances approach to 1a(47)(B) (not excluding commodity options from 326 Wright, supra note 214. determining whether a particular embedded option the swap definition). 327 See Proposing Release at 29830. Continued

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assure that commodity options that embedded volumetric optionality, outside the control of the parties and are should be regulated as swaps do not when: influencing demand for, or supply of, circumvent the protections established 1. The embedded optionality does not the nonfinancial commodity.341 in the Dodd-Frank Act through the undermine the overall nature of the The first two elements of the forward contract exclusion for agreement, contract, or transaction as a interpretation for embedded volumetric nonfinancial commodities instead. forward contract; optionality, which mirror the CFTC’s The CFTC also is providing an 2. The predominant feature of the historical embedded option interpretation, in response to agreement, contract, or transaction is interpretation discussed above, have commenters,334 with respect to forwards actual delivery; been modified to reflect that embedded with embedded volumetric 3. The embedded optionality cannot volumetric optionality relates to optionality.335 Several commenters be severed and marketed separately delivery rather than price. As noted asserted that agreements, contracts, and from the overall agreement, contract, or above, the predominant feature of a transactions that contain embedded transaction in which it is embedded; 337 forward contract is a binding, albeit ‘‘volumetric options,’’ and that 4. The seller of a nonfinancial deferred, delivery obligation. It is otherwise satisfy the terms of the commodity underlying the agreement, essential that any embedded option in a forward exclusions, should qualify as contract, or transaction with embedded forward contract as to volume must not excluded forwards, notwithstanding volumetric optionality intends, at the undermine a forward contract’s overall their embedded optionality.336 The time it enters into the agreement, purpose.342 The CFTC recognizes that CFTC believes that agreements, contract, or transaction to deliver the the nature of commercial operations are contracts, and transactions with underlying nonfinancial commodity if such that supply and demand embedded volumetric optionality may the optionality is exercised; requirements cannot always be satisfy the forward exclusions from the 5. The buyer of a nonfinancial accurately predicted and that forward swap and future delivery definitions commodity underlying the agreement, contracts that allow for some optionality under certain circumstances. contract or transaction with embedded as to the amount of a nonfinancial Accordingly, the CFTC is providing an volumetric optionality intends, at the commodity actually delivered offer a interpretation that an agreement, time it enters into the agreement, great deal of value to commercial contract, or transaction falls within the contract, or transaction, to take delivery forward exclusion from the swap and of the underlying nonfinancial peak-hourly forecast load plus a 15–17 percent commodity if it exercises the embedded reserve margin. The California Utilities enter into future delivery definitions, resource adequacy agreements to procure electric notwithstanding that it contains volumetric optionality; power generating capacity to meet these 6. Both parties are commercial requirements. The ability to call on the additional 338 takes a transaction out of the forward contract parties; and 15 to 17% reserve reflected in such an agreement exclusion for nonfinancial commodities is 7. The exercise or non-exercise of the is covered by the regulatory requirements part of consistent with the CFTC’s historical approach to embedded volumetric optionality is this element. To the extent the California Utilities determining whether a particular embedded option may have a business need to procure additional based primarily on physical factors,339 capacity resources beyond the foregoing regulatory takes a transaction out of the forward contract 340 requirement (e.g., because they wish to maintain a exclusion from the definition of the term ‘‘future or regulatory requirements, that are slightly larger reserve margin than required due to delivery’’ in the CEA. See id. at *5 (‘‘As we have a recent upswing in unscheduled plant outages due held since Stovall, the nature of a contract involves 337 When a forward contract includes an to aging plants), that may be covered under the a multi-factor analysis * * *.’’). embedded option that is severable from the forward interpretation if the additional capacity is required 334 contract, the forward can remain subject to the The CFTC requested comment on, among due to physical factors beyond the control of the forward contract exclusion, if the parties document other things: whether there are other factors that parties (i.e., the unscheduled outage, in the the severance of the embedded option component should be considered in determining how to foregoing example). characterize forward contracts with embedded and the resulting transactions, i.e. a forward and an 341 In other words, the predominant basis for option. Such an option would be subject to the options with respect to nonfinancial commodities; failing to exercise the option would be that the CFTC’s regulations applicable to commodity and whether there are provisions in forward demand or supply (as applicable) that the options. contracts with respect to nonfinancial commodities, optionality was intended to satisfy, if needed, never 338 other than delivery and price, containing embedded See discussion in section II.B.2.(a)(i)(B), supra. materialized, materialized at a level below that for optionality. See Proposing Release at 29832. 339 See, e.g., BGA Letter (advising that which the parties contracted or changed due to 335 One commenter characterized ‘‘volumetric ‘‘[v]ariability associated with an energy customer’s physical factors or regulatory requirements outside optionality’’ as the optionality in a contract settling physical demand is influenced by factors outside the parties’ control. Such failure to exercise, or an by physical delivery and used to meet varying the control of * * * energy suppliers (and exercise for a reduced amount of the underlying customer demand for a commodity.’’ See WGCEF sometimes * * * consumers) * * * including, but commodity, could, for example, be due to colder Letter. See also BGA Letter (stating that ‘‘it is not limited to, load growth, weather and certain than expected weather during the summer commonplace for energy suppliers to enter into operational considerations (e.g., available decreasing demand for air conditioning, in turn commercial transactions with customers (local transportation capacity to deliver physical natural decreasing demand for power to run the air distribution companies, electric utility companies, gas purchased on the spot market)’’). conditioning. The Commission does not interpret industrial, commercial and residential customers, 340 Volumetric optionality in this category would this to mean that absolutely all factors involved in power plants, etc.), which provide volumetric, price include, for example, a supply contract entered into the decision to exercise an option must be beyond and delivery-related flexibility and variability’’). to satisfy a regulatory requirement that a supplier the parties’ control, but rather the decision must be BGA claims that commercial transactions procure, or be able to provide upon demand, a predominantly driven by factors affecting supply containing embedded volumetric optionality specified volume of commodity (e.g., electricity). To and demand that are beyond a parties control. This ‘‘include, but are not limited to, full requirements the extent the optionality covers an amount of the also means that the forward contract with contracts, interruptible load agreements, capacity commodity in excess of the regulatory requirement, embedded volumetric optionality needs to be a contracts, tolling agreements, energy management such optionality would not necessarily be covered commercially appropriate method for securing the agreements, natural gas transportation contracts and by this aspect of the guidance, though it may purchase or sale of the nonfinancial commodity for natural gas storage contracts.’’ Id. nevertheless be covered by the guidance if such deferred shipment at the time it is entered into. The 336 See, e.g., WGCEF Letter (submitting that excess volumetric optionality is based on physical CFTC cautions market participants that, to the ‘‘‘volumetric optionality’ is [a] separate and distinct factors within the meaning of the guidance. For extent a party relies on the forward exclusion from concept from ‘deliverability optionality’’’); BGA example, the California Utilities explained that the the swap or future delivery definitions, Letter; AGA Letter; Letter from Jeffrey Perryman, California Public Utilities Commission (‘‘CPUC’’) notwithstanding that there is volumetric Director, Contracts and Compliance, Atmos Energy requires them to file a supply plan with the CPUC optionality, if that volumetric optionality is Holdings, Inc. (‘‘Atmos’’), dated July 22, 2011 demonstrating that they have procured sufficient inconsistent with the seventh element of the (‘‘Atmos Letter’’); NGSA/NCGA Letter; Letter from capacity resources (including reserves) needed to interpretation, the agreement, contract or Paul M. Architzel, Wilmer Hale LLP on behalf of serve their aggregate system load on a monthly and transaction may be an option. ONEOK, Inc. (‘‘ONEOK’’), dated July 22, 2011 yearly basis. See California Utilities Letter. Each 342 See discussion in part II.B.2.(a)(i)(B), supra. (‘‘ONEOK Letter’’); COPE Letter. utility’s system requirement is 100 percent of its See also supra note 321.

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participants. Where an agreement, The seventh element is based on point.’’ 346 According to another contract, or transaction requires delivery comments stating that parties to commenter, ‘‘[a] full requirements of a non-nominal volume of a agreements, contracts, and transactions contract * * * is a well-established nonfinancial commodity, even if an with embedded volumetric optionality concept in contract law’’ and ‘‘[i]n a embedded volumetric option is intend to make or take delivery (as requirements contract, the purchaser exercised, the CFTC believes that the applicable) of a commodity, and that it * * * deals exclusively with one predominant feature of the contract, is merely the volume of a commodity supplier.’’ 347 This commenter added notwithstanding the embedded that would be required to be delivered that, while the amount of commodity volumetric optionality, is actual if the option is exercised, that varies. It delivered can vary, it is based on an delivery. This is the case in many is designed to ensure that the objective need and that the Uniform forward contracts that have an volumetric optionality is primarily Commercial Code imposes on the buyer embedded option that allows a party to driven by physical factors or regulatory ‘‘an obligation to act in good faith with buy or sell an additional amount of a requirements that influence supply and respect to the varying amount that is commodity beyond the fixed amount demand and that are outside the parties’ called for delivery.’’ 348 Based upon this called for in the underlying forward control, and that the optionality is a contract. For instance, a forward commercially reasonable way to address description, the CFTC believes that a contract could call for the delivery of uncertainty associated with those going commercial concern with an 10,000 bushels of wheat and include an factors.345 Element seven must be exclusive supply contract has no option option for an additional 5,000 bushels of interpreted with the other elements set but to get its supply requirements met wheat.343 forth here. For instance, even if the through that exclusive supplier The third element is substantially the optionality is consistent with element consistent with the terms of the same as the third element of the seven, such optionality cannot contract. Any instance where nominal interpretation above with respect to undermine the overall nature of the or zero delivery occurred would have to commodity options embedded in contract as a forward contract as be because the commercial requirements forward contracts generally. discussed above. changed or did not materialize. The fourth and fifth elements are As discussed in the interpretation Furthermore, any variability in delivery designed to ensure that both parties regarding forwards with embedded amounts under the contract appears to intend to make or take delivery (as optionality discussed above, in be driven directly by the buyer’s applicable), subject to the relevant evaluating whether an agreement, commercial requirements and is not physical factors or regulatory contract or transaction with embedded requirements, which may lead the dependent upon the exercise of any volumetric optionality qualifies for the commodity option by the contracting parties to deliver more or less than forward exclusions, the CFTC will look originally intended. This distinguishes a parties. to the relevant facts and circumstances forward contract from a commodity Accordingly, full requirements of the transaction as a whole to evaluate option, where only the option seller whether the transaction qualifies for the contracts, as described above, appear must at all times be prepared to deliver forward exclusions from the definitions not to contain embedded volumetric during the term of the option. The sixth of the terms ‘‘swap’’ and ‘‘future options. Therefore, a full requirements element is intended to ensure that the delivery.’’ contract may qualify for the forward interpretation is not abused by market The CFTC is providing further exclusion under the same facts and participants not engaged in a interpretations to explain how it would circumstances analysis applicable to all commercial business involving the treat some of the specific contracts other agreements, contracts, and nonfinancial commodity underlying the transactions that might be forwards. The embedded volumetric optionality.344 described in the comment letters. According to one commenter, a ‘‘full same analysis would apply to an output 343 In evaluating whether the predominant feature requirements contract’’ can be described of a transaction is actual delivery, the CFTC will as a ‘‘contract where the seller agrees to 346 See Letter from Keith M. Sappenfield, II, look at the contract as a whole. Thus, with respect provide all requirements for a specific Director, US Regulatory Affairs, Encana Marketing to this contract, the CFTC would consider the intent customer’s location or delivery (USA) Inc. (‘‘Encana’’), dated July 22, 2011 element of the forward exclusions to be satisfied (‘‘Encana Letter’’). because the contract requires the seller to deliver 347 See ONEOK Letter. The CFTC notes that this 345 a non-nominal volume of a commodity (i.e., 10,000 See, e.g., AGA Letter (advising that ‘‘[i]n commenter discussed full requirements contracts in bushels of wheat), viewing the contract as a whole. general, retail demand for natural gas is weather the context of supply agreements between one of its As a result, if the other elements of the guidance driven * * * as a result [of which], a gas utility’s affiliates and retail customers. If such customers are above are satisfied, this contract would be a forward peaking supplies must have significant flexibility non-commercial customers, such contracts are not contract, even if the party did not exercise the * * * [and g]as utilities * * * use a variety of forwards, but nevertheless they may not be swaps option for the additional 5,000 bushels. contracts with gas suppliers to physically deal with under the Commissions’ guidance regarding the 344 peak periods of demand’’); BGA Letter (citing gas The fact that the CFTC is expressly including non-exhaustive list of consumer transactions, or supply curtailment due to a pipeline outage and the fourth through sixth elements in the embedded otherwise if they have characteristics or factors power generation curtailment by an Independent optionality guidance for volumetric options but not described under the consumer transaction System Operator for operational reasons as factors elsewhere does not mean that intent to deliver and interpretation, see infra part II.B.3. the ability to make or take delivery expressed in outside the control of energy suppliers and which 348 See, e.g., NY UCC § 2–306(1) (stating that ‘‘[a] these elements are not part of the facts and could impact the amount of a commodity term which measures the quantity by the output of circumstances the CFTC will consider in the delivered). The CFTC understands BGA’s comment context of determining whether other agreements, to address involuntary curtailments, but also the seller or the requirements of the buyer means contracts, and transactions qualify for the forward recognizes that power buyers may agree in advance such actual output or requirements as may occur in exclusions. Intent to deliver and the ability to make that the relevant Regional Transmission good faith.* * *’’). This commenter cited Corbin on or take delivery have long been a part of the CFTC’s Organization or Independent System Operator may, Contracts for the proposition that the mere fact that facts-and-circumstances approach to making that in order to maintain system reliability, curtail the quantity term of the contract is ‘‘the buyer’s determination, and they remain so. The CFTC is power deliveries to the buyers. While voluntary needs or requirements’’ does not render the emphasizing these elements in this guidance curtailments are within the control of the power requirements contract ‘‘a mere options contract’’ because the CFTC has not previously expressed the buyer, the potential system reliability issue is not. because ‘‘the buyer’s promise is not illusory * * * view that an agreement, contract, or transaction Therefore, such voluntary curtailments would be [but] is conditional upon the existence of an with embedded volumetric optionality which within the guidance because, if triggered, they objective need for the commodity.’’ See ONEOK affects the delivery term may qualify as a forward would be based on a physical factor (e.g., supply Letter (citing Corbin on Contracts § 6.5 at 240–53 if these facts and circumstances are present. constraints). (1995)).

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contract satisfying the terms of this cash settlement alternative. If the definitions.359 When the Proposing interpretation.349 purchaser does not exercise the right to Release stated that a forward contract With respect to capacity contracts, purchase, then the right is terminated. containing an embedded option that transmission (or transportation) services The seller under the transaction must does not ‘‘target the delivery term’’ is an agreements, and tolling agreements, the deliver the entire quantity of gas that the excluded forward contract,360 it meant CFTC understands that: (i) Capacity purchaser specifies, or pay liquidated that the embedded option does not contracts are generally products damages. Moreover, the option is not affect the delivery amount.361 designed to ensure that sufficient severable and cannot be marketed Also, in response to a commenter,362 physical generation capacity is available separately from the supply agreement the CFTC clarifies that embedded to meet the needs of an electrical itself.355 Similarly, another commenter system;350 (ii) transmission (or said that there is no ability to sever an optionality as to delivery points and transportation) services agreements are embedded option from a natural gas delivery dates will not cause a generally agreements for the use of forward contract. Moreover, it stated transaction that otherwise qualifies as a electricity transmission lines (or gas that the ability for a gas purchaser to forward contract to be considered a pipelines) that allow a power generator specify a quantity of gas for a certain swap. The CFTC emphasizes, however, to transmit electricity (or gas supplier to day is not to encourage speculative that delivery must occur at some transport gas) to a specific location;351 activity; rather, it is because the exact delivery point and on some date, or the and (iii) tolling agreements, as described quantity of gas to be needed on that lack of delivery must be due to the by commenters, provide a purchaser the future day is unknown, and many gas transaction being booked out or right to the capacity, energy, ancillary purchasers have weather-dependent otherwise be consistent with the CFTC’s services and any other product derived needs that cannot accurately be interpretation regarding the forward from a specified generating unit, all predicted in advance.356 exclusions from the swap and future based upon a delivered fuel price and Depending on the relevant facts and delivery definitions. agreed heat rate.352 circumstances, these types of Comments Such agreements, contracts and agreements, contracts, and transactions, may have features that will transactions—capacity contracts, Commenters generally supported the satisfy the ‘‘forwards with embedded transmission (or transportation) services volumetric optionality’’ interpretation CFTC’s proposed interpretation agreements, tolling agreements, and regarding forwards with embedded discussed above, or, like full peaking supply contracts—may satisfy requirements contracts, may not contain options, but many believed that it the elements of the ‘‘forwards with should be modified or expanded. As embedded volumetric options and may embedded volumetric options’’ satisfy other portions of the forward noted above, several commenters interpretation set forth above, or may believed that forward contracts with interpretations herein. For example, satisfy other portions of this according to one commenter, the embedded options that contain interpretation. If they do, they would optionality as to the quantity/volume of delivery obligations in some tolling fall within the forward exclusions from the nonfinancial commodity to be agreements are not optional which is the swap and future delivery delivered should qualify as forwards, indicative that the predominant feature definitions. and that the CFTC’s proposed of such tolling agreements is actual In addition, the CFTC is providing an 353 interpretation (which only mentions delivery. It is also possible, based on interpretation in response to a comment descriptions provided to the CFTC, that price optionality) should be modified that contracts with evergreen or 363 tolling agreements could fit within the extension terms should be considered accordingly. In this regard, several interpretation concerning certain forwards.357 The CFTC is clarifying that commenters focused on forwards with physical agreements, contracts, or an extension term in a commercial embedded volumetric options in the 354 364 transactions, or other interpretations contract, such as a renewal term in a natural gas industry. One commenter herein. five year power purchase agreement noted that, although the 1985 CFTC Some commenters focused on (which, due to the renewal, would OGC Interpretation distinguishes forwards with embedded volumetric require additional deliveries), is not an forward contracts from trade options, it optionality in the natural gas industry. option on the delivery term within the is based on a limited number of For example, one commenter stated that meaning of the CFTC’s interpretation, agricultural contract examples, so ‘‘peaking supply’’ natural gas contracts and consequently would not render additional guidance is needed, do not render delivery optional. such a contract ineligible for the particularly in light of the wide range of Although the purchaser has the option forward exclusions from the definitions cash market and commercial to specify when and if the quantity of of the terms ‘‘swap’’ and ‘‘future merchandising contracting practices in gas will be delivered on any given day, delivery.’’ Similarly, an evergreen this commenter asserted that there is no provision, which automatically renews 359 Using extension or evergreen provisions to avoid delivery, however, as was the case with the 349 a contract (and, as such, would require See Letter from Phillip g. Lookadoo, Esq., Reed 358 ‘‘rolling spot’’ contracts at issue in CFTC v. Zelener, Smith LLP and Jeremy D. Weinstein, Esq. on behalf additional deliveries) absent the 373 F.3d 861 (7th Cir. 2004), could constitute of IECA dated May 23, 2012 (suggesting that output parties affirmatively terminating it, evasion or violate other provisions of the CEA (e.g., contracts, in addition to full requirements contracts, would not render such a contract CEA section 4(a), 7 U.S.C. 6(a)). This interpretation should be within the forward exclusion). An output ineligible for the forward exclusions does not limit the CFTC’s other interpretations in contract has been defined as ‘‘a contract pursuant this release regarding when delivery does not occur to which the obligor’s duty to supply the promised from the swap or future delivery (e.g., the Brent Interpretation). commodity is quantified (and therefore limited) by 360 See NGSA/NCGA Letter (requesting reference to its production thereof.’’ See Boyd v. 355 See AGA Letter. clarification of the phrase ‘‘target the delivery Kmart Corp., 110 F.3d 73 (10th Cir. 1997). 356 See Atmos Letter. term.’’). 350 See California Utilities Letter. 357 See IECA Letter. 361 See Proposing Release at 29830, n.81. 351 See NEMA Letter. 358 The CFTC refers in this and the prior sentence 362 See COPE Letter. 352 See California Utilities Letter. to ‘‘additional deliveries’’ because the IECA’s 363 See AGA Letter; API Letter; Atmos Letter; 353 Id. example involves an agreement calling for delivery ONEOK Letter; NGSA/NCGA Letter; WGCEF Letter. 354 See infra part II.B.2.(b)(iii). of a physical nonfinancial commodity. 364 See AGA Letter; Atmos Letter.

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which delivery terms and amounts Another commenter urged the CFTC response to the commenter’s concerns. vary.365 to broadly exempt commercial forward 373 In addition, another commenter contracting from swap regulation by Request for Comment requested more generally that any generally excluding from the swap embedded option (for example, price, definition any forward contract with The CFTC’s interpretation regarding quantity, delivery point, delivery date, embedded optionality between end forwards with volumetric options is an contract term) that does not permit a users ‘‘whose primary purpose is interpretation of the CFTC and may be unilateral election of financial consistent with that of an ‘end user’, relied upon by market participants. settlement based upon the value change and in which any embedded option is However, the CFTC believes that it in an underlying cash market should not directly related to ‘end use.’ ’’ 369 The would benefit from public comment render the contract a swap.366 CFTC believes that this interpretation is about its interpretation, and therefore As discussed above, the CFTC has vague and overbroad, and declines to requests public comment on all aspects provided an additional interpretation adopt it. of its interpretation regarding forwards with respect to forwards with embedded Another commenter believed that the with embedded volumetric options,374 volumetric options to address CFTC’s ‘‘facts and circumstances’’ and on the following questions: commenters’ concerns. The CFTC also approach to forwards with embedded 1. Are the elements set forth in the has provided an interpretation above, options does not provide the legal interpretation to distinguish forwards regarding price optionality, optionality certainty required by nonfinancial with embedded volumetric optionality with respect to delivery points and entities engaging in commercial from commodity options appropriate? delivery dates specifically in response contracts in the normal course of Why or why not? to this commenter, and optionality as to business.370 This commenter further 2. Are there additional elements that certain contract terms (such as argued that many option-like contract would be appropriate? Please describe evergreen and renewal provisions) to terms could be determined to ‘‘target the and provide support for why such address particular concerns raised by delivery term’’ under a facts and elements would serve to distinguish commenters. The CFTC declines to circumstances analysis.371 forwards with embedded volumetric adopt a more expansive approach with The CFTC has long applied a facts- optionality from commodity options. respect to ‘‘any’’ embedded option. and-circumstances approach to the 3. Is the seventh element that, to One commenter requested that an forward exclusion, including with ensure that an agreement, contract, or option to purchase or sell a physical respect to forwards with embedded transaction with embedded volumetric commodity, whether embedded in a options, and thus it is an approach with optionality is a forward and not an forward contract or stand alone, should which market participants are familiar. option, the volumetric optionality is either (i) fall within the statutory That approach balances the need for based primarily on physical factors, or forward exclusion from the swap legal certainty against the risk of regulatory requirements, that are outside definition, or (ii) alternatively, if providing opportunities for evasion.372 the control of the parties and are deemed by the CFTC to be a swap, The CFTC’s additional interpretation influencing demand for, or supply of, should be exempt from the swap noted above, including clarification the nonfinancial commodity, necessary definition pursuant to a modified trade about the meaning of the phrase ‘‘target and appropriate? Why or why not? Is option exemption pursuant to CEA the delivery term,’’ and forwards with the statement of this element section 4c(b).367 The CFTC has modified embedded volumetric optionality, sufficiently clear and unambiguous? If its proposed interpretation regarding provides enhanced legal certainty in not, what adjustments would be forwards with embedded options as appropriate? discussed above; contracts with Letter. To the extent that Encana’s comment goes 4. Are there circumstances where beyond volumetric optionality, commodity options embedded options that are swaps under are discussed supra in section II.B.2(b). volumetric optionality is based on other this final interpretation may 369 See Letter from Roger Cryan, Vice President factors? Please describe. Would such nevertheless qualify for the modified for Milk Marketing and Economics, National Milk factors, if made a part of the trade option exemption recently Producers Federation (‘‘NMPF’’), dated July 22, interpretation, serve to distinguish adopted by the CFTC and discussed 2011 (‘‘NMPF Letter’’). 370 forwards with embedded volumetric 368 See ETA Letter. Similarly, COPE comments above. that a nonfinancial commodity forward contract optionality from commodity options? If that, ‘‘by its terms,’’ is intended to settle physically so, how? 365 See ONEOK Letter. This commenter noted that should be permitted to contain optionality without 5. Does the interpretation provide it offers its customers a number of types of contracts being transformed into a swap unless such sufficient guidance as to whether for delivery of natural gas under which the amount optionality negates the physical settlement element called for delivery may vary. In each of these types of the contract. That is, if one party can exercise an agreements, contracts, or transactions of contracts, this commenter stated that both parties option to settle the contract financially based upon intend the contracts to result in delivery of the the value change in an underlying cash market, 373 See also Commodity Options, 77 FR 25320, commodity, as needed. The purpose of these then the intent for physical settlement is not 25324 n. 25 (Apr. 27, 2012) (discussing the CFTC’s contracts is to ensure that customers, most of which contained in ‘‘the four corners of the contract’’ and conclusion that an ‘‘option[] to redeem’’ under the are gas or electric utilities, have an adequate supply may render the contract a swap. See COPE Letter. USDA Commodity Credit Corporation’s marketing of natural gas regardless of day-to-day changes in As discussed elsewhere in this release, the CFTC loan program constitutes a cotton producer’s demand that may be caused by variation in weather, historically has eschewed approaches to the contractual right to repay its marketing loan and operational considerations, or other factors. They forward exclusion that rely on the ‘‘four corners of ‘‘redeem’’ the collateral (cotton) to sell in the open are not designed for one-way price protection as the contract,’’ which can provide a roadmap to market). would be the case with an option. See ONEOK evasion of statutory requirements. 374 Separately, it is expected that CFTC staff will Letter. 371 Accordingly, this commenter believed that the be issuing no-action relief with respect to the 366 See COPE Letter, Appendix. CFTC should provide in its rules that an embedded conditions of the modified trade option exemption 367 See WGCEF Letter; 7 U.S.C. 6c(b). option or embedded optionality will not result in (except the enforcement provisions retained in 368 77 FR 25320 (Aug. 27, 2012). Encana believed a nonfinancial forward being a swap unless: (i) § 32.3(d)) until December 31, 2012. This extension that the guidance on forwards with embedded Delivery is optional; (ii) financial settlement is will afford the CFTC an opportunity to review and options should include embedded physical delivery allowed; and (iii) transfer and trading of the option evaluate the comments received on both the options because it asserted that many of the separately from the forward is permitted. See ETA interpretation above regarding embedded contracts currently used by participants in the Letter. volumetric optionality, and the modified trade wholesale natural gas market contain an option for 372 See also NCFC Letter (supporting the CFTC’s option exemption, in order to determine whether the physical delivery of natural gas. See Encana guidance because it provides legal certainty). any changes thereto are appropriate.

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with embedded volumetric optionality regarding certain physical commercial while there is optionality as to whether permitting a nominal amount, or no agreements for the supply and the person uses the specified facility, amount, of a nonfinancial commodity to consumption of energy that provide the person’s right to do so is legally be delivered are forwards or options, flexibility, such as tolls on power established, does not depend upon any viewing the agreements, contracts, or plants, transportation agreements on further exercise of an option and merely transactions as a whole, if they satisfy natural gas pipelines, and natural gas represents a decision to use that for the seven elements of the interpretation? storage agreements.375 Commenters which the lessor already has paid. In Why or why not? Does this recognized that these types of this context, the CFTC would not interpretation encourage evasion, or do agreements, contracts or transactions consider actions such as scheduling the seven elements sufficiently may have option-like features, but electricity transmission, gas distinguish forwards from agreements, analogized them to leases and transportation or injection of gas into contracts, and transactions that may concluded that they were forwards storage to be exercising an option if all evade commodity options regulation? rather than swaps. One commenter, for three elements of the interpretation 6. Is the interpretation sufficiently example, characterized taking power above are satisfied. As with the clear with respect to capacity contracts, produced pursuant to a physical tolling interpretation regarding forwards with transmission (or transportation) services agreement—which can involve one embedded options generally, discussed agreements, peaking supply contracts, party thereto providing fuel for a above, in evaluating whether flexible or tolling agreements? Why or why not? generation plant and having the physical commercial agreements that Do capacity contracts, transmission (or exclusive right to take the power meet the 3-part test qualify for the transportation) services agreements, produced by that plant from the fuel forward exclusions, the CFTC will look peaking supply contracts, or tolling provided—thus, in effect, ‘‘renting’’ the to the specific facts and circumstances agreements generally have features that plant to the extent the plant is used to of the agreement, contract or transaction satisfy the forwards with volumetric produce power from the fuel provided— as a whole to evaluate whether the options interpretation included in this as more akin to a lease than to an agreement, contract or transaction release? If so, which ones? If not, why option.376 qualifies for the forward exclusions not? Could these types of agreements, The CFTC will interpret an from the definitions of ‘‘swap’’ and contracts, and transactions qualify for agreement, contract or transaction not to ‘‘future delivery.’’ the forward exclusions under other be an option if the following three However, in the alternative, if the parts of the interpretation set forth elements are satisfied: (1) The subject of right to use the specified facility is only above? Are there material differences in the agreement, contract or transaction is obtained via the payment of a demand the structure, operation, or economic usage of a specified facility or part charge or reservation fee, and the effect of these types of agreements, thereof rather than the purchase or sale exercise of the right (or use of the contracts, and transactions as compared of the commodity that is to be created, specified facility or part thereof) entails to full requirements contracts that are transported, processed or stored using the further payment of actual storage relevant to whether such agreements, the specified facility; (2) the agreement, fees, usage fees, rents, or other contracts, and transactions are options contract or transaction grants the buyer analogous service charges not included under the CEA? Please explain. If so, the exclusive use of the specified in the demand charge or reservation fee, what are the material differences? facility or part thereof during its term, such agreement, contract or transaction 7. Do the agreements, contracts, and and provides for an unconditional is a commodity option subject to the transactions listed in question No. 6 obligation on the part of the seller to swap definition. above have embedded optionality in the grant the buyer the exclusive use of the Comments first instance? Based on descriptions by specified facility or part thereof; 377 and Two commenters addressed ‘‘lease- commenters, it appears that they may (3) the payment for the use of the like’’ physical agreements, contracts or have a binding obligation for delivery, specified facility or part thereof transactions.378 One of these but have no set amount specified for represents a payment for its use rather commenters asserted that there are delivery. Instead, delivery (including than the option to use it. In such many physical commercial agreements the possibility of nominal or zero agreements, contracts and transactions, delivery) is determined by the terms and for the supply and consumption of energy that effectively provide leases on conditions contained within the 375 See BGA Letter and California Utilities Letter. agreement, contract, or transaction This interpretation also may apply to firm flexible energy assets, such as tolls on (including, for example, the satisfaction transmission agreements pursuant to which power plants, transportation agreements of a condition precedent to delivery, transmission service may not be interrupted for any on natural gas pipelines and natural gas reason except during an emergency when continued storage agreements.379 According to this such as a commodity price or delivery of power is not possible. See http:// temperature reaching a level specified www.interwest.org/wiki/index.php?title=Firm_ commenter, these assets have the in the agreement, contract, or transmission_service. capability to be turned on and off to transaction). That is, the variation in 376 See California Utilities Letter. meet fluctuating demand due to weather delivery is not driven by the exercise of 377 In this regard, the usage rights offered for sale and other factors; physical contracts should be limited to the capacity of the specified around these assets transfer that embedded optionality by the parties. Do facility. While overselling such capacity would not the agreements, contracts, and per se be inconsistent with satisfying the terms of delivery flexibility to the contract transactions listed in question No. 6 this interpretation, the CFTC cautions market holder. The commenter believed that exhibit these kinds of characteristics? If participants that overselling not based on these types of commercial arrangements reasonable commercial expectations of the use of should not be considered commodity so, should the CFTC consider them in the specified facility could lead the contract to be some manner other than its forward deemed evasion and lead to an agreement, contract options, but rather should be excluded interpretation? Why or why not? or transaction being considered a swap, as it would forwards. The other commenter undermine the ‘‘right’’ being offered. For example, described tolling agreements as having (iii) Certain Physical Commercial given physical constraints of the power grid and gas the characteristics of a lease, in that the Agreements, Contracts or Transactions pipelines, overselling transmission or transportation capacity would be per se The CFTC is providing an inconsistent with satisfying the terms of this 378 See BGA Letter and California Utilities Letter. interpretation in response to comments interpretation. 379 See BGA Letter.

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purchasing entity obtains the exclusive contracts that are actually exchanges of to support that conclusion.388 They also right to the use of the power plant cash flows based on referenced values did not provide a working definition of during the term of the agreement.380 and that have no relevant characteristics EMAs. The CFTC understands that This commenter asserted that such of physical delivery.384 EMAs can cover a number of services agreements should not be considered With the exception of energy and transactions, which can include commodity options, but rather forwards management agreements, which are spot, forward and swap transactions. because the obligations are not discussed below, the interpretations that EMAs can include services such as: (i) contingent. The CFTC is providing the the CFTC has already provided above Acting as a financial intermediary by may apply to such types of agreements, above interpretation that these types of substituting one party’s credit and agreements, contracts and transactions contracts and transactions. Specifically, liquidity for those of a less credit are not commodity options if the above to the extent that such types of worthy owner of illiquid energy conditions are satisfied, but may qualify agreements, contracts and transactions for the forward exclusions under the are forwards with embedded volumetric producing assets (i.e. the other party to facts and circumstances, in response to options, the CFTC has provided an the EMA) to facilitate the owner’s 389 these commenters’ concerns. additional interpretation in section purchase of fuel and sale of power; II.B.2.b(iii) above. To the extent such (ii) providing market information to (iv) Effect of Interpretation on Certain types of agreements, contracts or assist the owner in developing and Agreements, Contracts and Transactions transactions are physical commercial refining a risk-management plan for the In the Proposing Release,381 the CFTC agreements, contracts or transactions plant; 390 and (iii) procuring fuel, requested comment regarding how its discussed in section II.B.2.b(iii), supra, arranging delivery and storage, selling proposed interpretation concerning the the CFTC has provided an interpretation excess power not needed to serve load forward contract exclusion would affect in that section. To the extent such types for another party.391 The entity carrying full requirements contracts, reserve of agreements, contracts and out these activities may receive a sharing agreements, tolling agreements, transactions are considered commodity portion of the revenue generated from energy management agreements and options, the CFTC has addressed such activities as compensation for its ancillary services. The CFTC asked commodity options under the separate efforts. Because commenters did not whether such agreements, contracts or rulemaking establishing a modified provide a working definition of EMAs, transactions have optionality as to 385 trade option exemption. And to the the CFTC cannot state categorically that delivery and, if so, whether they, or any extent that such types of agreements, EMAs are or are not swaps. However, if other agreement, contract or transaction contracts, and transactions, such as the fuel acquisition, sales of excess in a nonfinancial commodity, should be ancillary services, occur in Regional 382 generation and any other transactions excluded from the swap definition. Transmission Organizations or Commenters generally believed that executed under the auspices of an EMA Independent System Operators, or are not swaps, nothing about the fact such types of agreements, contracts and entered into between entities described that the transactions are executed as a transactions, although they may contain in section 201(f) of the Federal Power result of or pursuant to an EMA delivery optionality, should be Act,386 they may be addressed through transforms the transactions into swaps. considered forwards rather than swaps the public interest waiver process in 383 or commodity options. By contrast, CEA section 4(c)(6).387 For example, if one party hires another one commenter believed that traded With regard to Energy Management party to enter into spot or forward power markets involve many types of Agreements (‘‘EMAs’’), in general, transactions on its behalf, the fact that commenters expressed the view that their relationship is governed by an 380 See California Utilities Letter. EMAs are forwards, and not swaps, EMA does not render those transactions 381 See Request for Comment 35, which stated: swaps.392 Conversely, were swaps to be How would the proposed interpretive guidance set although they did not provide analysis forth in this section affect full requirements executed by one party on behalf of contracts, capacity contracts, reserve sharing 384 See Better Markets Letter. This commenter another party as a result of, or pursuant agreements, tolling agreements, energy management stated that ancillary services are in substance swaps to, an EMA, the parties thereto would agreements, and ancillary services? Do these based on congestion costs between two agreements, contracts, or transactions have transmission points, measured by the difference need to consider their respective roles optionality as to delivery? If so, should they—or between actual prices assigned at those points by thereunder (e.g. principal versus agent) any other agreement, contract, or transaction in a the grid operator. Capacity contracts are often and whether commodity trading nonfinancial commodity that has optionality as to documented using trading agreements for advisor, introducing broker, futures delivery—be excluded from the swap definition? If transactions in physicals, but this commenter so, please provide a detailed analysis of such believed that they constitute swaps that are used to commission merchant, or other agreements, contracts, or transactions and how they hedge the price risk associated with periodic registration or other elements of the can be distinguished from options that are to be auctions of the contracts to provide reliable Dodd-Frank Act regime were regulated as swaps pursuant to the Dodd-Frank Act. capacity to the grid operator. This commenter To what extent are any such agreements, contracts, asserted that such contracts do not meet the CFTC’s implicated. At a minimum, the fact that or transactions in the electric industry regulated by appropriate tests to exclude them, which should be a swap was executed would implicate the Federal Energy Regulatory Commission made explicit in the guidance. This commenter (‘‘FERC’’), State regulatory authorities, regional stated that basic power contracts often do not meet 388 transmission organizations (‘‘RTOs’’), independent the intent to deliver test because power buyers and See, e.g., Encana Letter and BGA Letter. system operators (‘‘ISOs’’) or market monitoring sellers each schedule delivery to/from the grid, and 389 See, e.g., The Royal Bank of Scotland Group units associated with RTOs or ISOs? such transactions can be settled based on readily plc, Order Approving Notice To Engage in See Proposing Release at 29832. available price differentials rather than scheduling Activities Complementary to a Financial Activity, 382 Id. capacity and load as a pair. At a minimum, this 2008 Federal Reserve Bulletin volume 94. 390 383 See Atmos Letter; BGA Letter; California commenter believed that guidance should be Id. Utilities Letter; COPE Letter; ETA Letter; Encana provided to require that, in order to demonstrate 391 See, e.g., Energy Management Agreement Letter; FERC Staff Letter; IECA Letter; NEMA Letter; intent to deliver, secondary delivery-related costs between Long Island Lighting Company and Long ONEOK Letter; and Letter from Kenneth R. Carretta, (e.g., congestion charges and penalties to which Island Power Authority, available at http:// General Regulatory Counsel—Markets, PSEG those scheduling capacity and load on the grid are www.lipower.org/pdfs/company/papers/contract/ Services Corp., on behalf of the Public Service subject) must be allocated by contract. Id. energy.pdf. Electric and Gas Company, PSEG Power LLC, and 385 See supra note 317. 392 Similarly, using an EMA would not render PSEG Energy Resources & Trade LLC (‘‘PSEG 386 16 U.S.C. 824(f). swaps entered as a result of or pursuant to an EMA Companies’’), dated July 22, 2011 (‘‘PSEG Letter’’). 387 7 U.S.C. 6(c)(6). spot or forward transactions.

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reporting and recordkeeping involving a nonfinancial commodity The CFTC generally agrees with these requirements.393 may provide that the remedy for a comments regarding liquidated damages failure to make or take delivery is the provisions, and has provided the final (v) Liquidated Damages Provisions payment of a market-rate replacement interpretation described above to The Commissions also received price, a payment on a performance address them. several comments discussing guaranty, or ‘‘cover damages’’ to (c) Security Forwards 402 contractual liquidated damages compensate the non-breaching party for provisions. The CFTC is clarifying that the failure of the other party to fulfill its As the Commissions stated in the the presence, in an agreement, contract, contractual obligations.397 Such a Proposing Release, the Commissions or transaction involving physical contractual damages or remedy believe it is appropriate to address how settlement of a nonfinancial commodity, provision, this commenter contended, is the exclusions from the swap and of a liquidated damages provision not analogous to a financial settlement security-based swap definitions apply to (which may be referred to by another option in a trading instrument.398 This security forwards and other purchases name, such as a ‘‘cover costs’’ or ‘‘cover commenter further asserted that one and sales of securities.403 The damages’’ provision) does not party or the other may be unable to Commissions are restating the necessarily render such an agreement, perform, or excused or prevented for interpretation set out in the Proposing contract, or transaction ineligible for the commercial reasons from performing, its Release without modification. 394 forward exclusion. Such a provision contractual obligations to make or take The Dodd-Frank Act excludes in an agreement, contract, or transaction delivery of a nonfinancial commodity, purchases and sales of securities from is consistent with the use of the forward and therefore may be liable to the other the swap and security-based swap exclusion, provided that the parties party for a monetary payment, definitions in a number of different intend the transaction to be physically calculated in accordance with the clauses.404 Under these exclusions, 395 settled. However, liquidated damages contract.399 purchases and sales of securities on a provisions can be used to mask a lack Another commenter noted that fixed or contingent basis 405 and sales of 396 of intent to deliver. In light of the physically settled gas contracts, securities for deferred shipment or possibility for evasion of the Dodd- including peaking contracts (both for delivery that are intended to be Frank Act, the CFTC will continue to daily and monthly supply), bullet day physically delivered 406 are explicitly utilize its historical facts-and- contracts and weather contracts, use the excluded from the swap and security- circumstances approach in determining NAESB Base Contract, which does not based swap definitions.407 The whether the parties to a particular provide for financial settlement other exclusion from the swap and security- agreement, contract, or transaction with than a liquidated damages provision, based swap definitions of a sale of a a liquidated damage provision have the which would compensate a utility for its security for deferred shipment or requisite intent to deliver. cost of obtaining alternative supply at delivery involves an agreement to Comments the prevailing market price if the seller purchase one or more securities, or fails to deliver.400 This commenter groups or indexes of securities, at a One commenter notes that a future date at a certain price. commercial merchandising arrangement stated its view that the seller has no real opportunity to arbitrage its obligation to As with other purchases and sales of securities, security forwards are 393 This interpretation is limited to the facts and deliver based on changes in price, and circumstances described herein; the CFTC is not the purchaser has no incentive to fail to opining on different facts or circumstances, which take delivery of its specified quantities compensate the purchaser for having to obtain its required natural gas). could change the CFTC’s interpretation. of gas, because they are needed for the 394 402 The discussion above regarding the exclusion With respect to performance guarantees, the 401 fact that a failure to deliver a nonfinancial physical operations of its system. from the swap definition for forward contracts on commodity triggers a payment under a performance nonfinancial commodities does not apply to the guaranty does not excuse the performance, nor 397 See ETA Letter. exclusion from the swap and security-based swap render delivery optional. Accordingly, such a 398 Id. This commenter cited FERC Order No. 890, definitions for security forwards or to the payment trigger would not itself preclude an which recognizes that ‘‘[w]hile any party to any distinction between security forwards and security agreement, contract, or transaction from being contract can choose to fail to perform, that does not futures products. covered by the forward exclusion from the swap or convey a contractual right to fail to perform’’ and 403 See Proposing Release at 29830. future delivery definitions. But see supra part that the Edison Electric Institute Master Power 404 See sections 1a(47)(B)(ii), (v), and (vi) of the II.B.1.g, which provides that the CFTC is Purchase and Sale Agreement (‘‘EEI MPPSA’’) CEA, 7 U.S.C. 1a(47)(B)(ii), (v), and (vi). interpreting the term ‘‘swap’’ (that is not a security- clearly obligates the supplier to provide power, 405 See section 1a(47)(B)(v) of the CEA, 7 U.S.C. based swap or mixed swap) to include a guarantee except in cases of force majeure. As the ETA 1a(47)(B)(v) (excluding from the swap and security- of such swap, to the extent that a counterparty to explains, ‘‘[t]he EEI MPPSA is a master agreement based swap definitions ‘‘any agreement, contract, or a swap position would have recourse to the frequently used to document transactions for transaction providing for the purchase or sale of 1 guarantor in connection with the position. deferred delivery and receipt of nonfinancial 395 or more securities on a fixed basis that is subject See 1985 CFTC OGC Interpretation, supra note electric energy, and the terms of the ISDA North to [the Securities Act and Exchange Act]’’); and 245 (stating generally that while ‘‘[s]ome contracts American Power Annex contain substantially section 1a(47)(B)(vi) of the CEA, 7 U.S.C. provide for a liquidated damages of penalty clause identical master agreement provisions * * *.’’ Id. 1a(47)(B)(vi) (excluding from the swap and security- if the producer fails to deliver, the presence of such 399 According to this commenter, parties typically based swap definitions ‘‘any agreement, contract, or clauses in a contract does not change the analysis include liquidated damages provisions in their transaction providing for the purchase or sale of 1 of the nature of the contract [if] * * * it is intended that delivery of the physical crop occur, absent agreements, contracts and transactions to address or more securities on a contingent basis that is destruction of all or a portion of the crop by forces situations in which ‘‘one party or the other may be subject to [the Securities Act and Exchange Act], which neither party can control’’). See generally unable, excused or prevented for commercial unless the agreement, contract, or transaction Corbin on Contracts § 58.1 (characterizing reasons from performing its contractual obligations predicates the purchase or sale on the occurrence liquidated damages provisions as designed to to deliver or receive [the relevant commodity],’’ not of a bona fide contingency that might reasonably be ‘‘[d]etermin[e] the amount of damages that are to serve as ‘‘a financial settlement ‘option’ expected to affect or be affected by the recoverable for a breach of contract’’). analogous to a financial settlement option in a creditworthiness of a party other than a party to the 396 In that regard, see 1985 CFTC OGC trading instrument.’’ Id. agreement, contract, or transaction’’). Interpretation, supra note 245 (stating that ‘‘a 400 See AGA Letter. 406 See section 1a(47)(B)(ii) of the CEA, 7 U.S.C. contract provision which permitted a producer to 401 Id. See also Atmos Letter (stating that there is 1a(47)(B)(ii). avoid delivery for a reason other than for an no financial incentive for a seller to fail to deliver 407 The Commissions note that calling an intervening condition not in the control of either natural gas under contracts used in the natural gas agreement, contract, or transaction a swap or party could change any conclusion about the nature industry, as the standard remedy for such a failure security-based swap does not determine its status. of the contract’’). to deliver is to pay liquidated damages sufficient to See supra part II.D.1.

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excluded from the swap and security- created at the time the forward contract market.419 The Commissions are not based swap definitions. The sale of the is entered into.414 In a TBA transaction, codifying the interpretation because security in this case occurs at the time the seller and the buyer agree to five codification will create a bright-line test. the forward contract is entered into with terms before entering into the The Commissions note that the analysis the performance of the contract deferred transaction: (i) The type of security, as to whether any product falls within or delayed.408 If such agreement, which will usually be a certain type of the exclusion for sales of securities on contract, or transaction is intended to be MBS guaranteed or sold by Fannie Mae, a deferred settlement or delivery basis physically settled, the Commissions Freddie Mac or Ginnie Mae and the type requires flexibility, including the believe it would be within the security of mortgage underlying the MBS; (ii) the consideration of applicable facts and forward exclusion and therefore outside coupon or interest rate; (iii) the face circumstances. Because the the swap and security-based swap value (the total dollar amount of MBS interpretation regarding forward sales of definitions.409 Moreover, as a purchase the purchaser wishes to purchase); (iv) MBS in the TBA market is based on or sale of a security, the Commissions 415 the price; and (v) the settlement date. particular facts and circumstances, the believe it also would be within the The purchaser will contract to acquire a exclusions for the purchase or sale of Commissions do not believe that a specified dollar amount of MBS, which bright-line test is appropriate. one or more securities on a fixed basis may be satisfied when the seller delivers (or, depending on its terms, a contingent one or more MBS pools at settlement.416 Another commenter suggested that basis) and, therefore, outside the swap the Commissions narrow the exclusion The Commissions are confirming that and security-based swap definitions.410 for contracts for the purchase and sale such forward sales of MBS in the TBA In the Proposing Release, the of securities for subsequent delivery as market would fall within the exclusion Commissions provided the following applied to security-based swaps because specific interpretation in the context of for sales of securities on a deferred settlement or delivery basis even though parties can use the formal forward sales of mortgage-backed characterization of a delivery contract securities (‘‘MBS’’) guaranteed or sold the precise MBS are not in existence at for securities to disguise a transaction by the Federal National Mortgage the time the forward MBS sale is entered into.417 Moreover, as the that is substantively a security-based Association (‘‘Fannie Mae’’), the Federal 420 Home Loan Mortgage Corporation purchase or sale of a security, the swap. This commenter was (‘‘Freddie Mac’’), and the Government Commissions also are confirming that concerned because this commenter National Mortgage Association (‘‘Ginnie such forward sales of MBS in the TBA believes that the securities subject to Mae’’).411 The Commissions are market would fall within the exclusions such a delivery obligation are often restating their interpretation regarding for the purchase or sale of one or more easily convertible into cash, which such forward sales. securities on a fixed basis (or, facilitates cash settlement without MBS guaranteed or sold by Fannie depending on its terms, a contingent actual delivery.421 As such, this Mae, Freddie Mac and Ginnie Mae are basis) and therefore would fall outside commenter suggested that the eligible to be sold in the ‘‘To-Be- the swap and security-based swap Commissions should provide a test for Announced’’ (‘‘TBA’’) market, which is definitions.418 determining whether parties have a essentially a forward or delayed bona fide intent to deliver.422 This Comments delivery market.412 The TBA market has commenter recommended that such test been described as one that ‘‘allows The Commissions received two should prohibit cash settlement options mortgage lenders essentially to sell the comments on the interpretation in contracts for subsequent delivery and loans they intend to fund even before regarding security forwards. One should not consider a party that 413 the loans are closed.’’ In the TBA commenter recommended that the frequently unwinds physical positions market, the lender enters into a forward Commissions codify in the text of the with cash settlements using side contract to sell MBS and agrees to final rules the interpretation regarding agreements as having the requisite deliver MBS on the settlement date in forward sales of MBS in the TBA intent to deliver.423 The Commissions the future. The specific MBS that will be are not providing a test at this time for delivered in the future may not yet be 414 Id. determining whether parties have a 415 Id. bona fide intent to deliver because the 408 A purchase or sale of a security occurs at the 416 Id. The good delivery guidelines, titled analysis as to whether sales of securities time the parties become contractually bound, not at ‘‘Uniform Practices for the Clearance and the time of settlement (regardless of whether cash Settlement of Mortgage-Backed Securities and Other for deferred shipment or delivery are or physically settled). See Securities Offering Related Securities,’’ which govern the mechanics of intended to be physically delivered is a Reform, 70 FR 44722 (Aug. 3, 2005). trading and settling MBS, contain specific facts and circumstances determination 409 See section 1a(47)(B)(ii) of the CEA, 7 U.S.C. guidelines for trading and settling MBS guaranteed 1a(47)(B)(ii). or sold by Fannie Mae, Freddie Mac and Ginnie and a bright-line test will not allow for 410 See sections 1a(47)(B)(v) and (vi) of the CEA, Mae in the TBA market. The good delivery the flexibility needed in such analysis. 7 U.S.C. 1a(47)(B)(v) and (vi). guidelines outline the basic terms and conditions Further, the Commissions note that the 411 The Commissions provided the interpretation for trading, confirming, delivering and settling in the Proposing Release in response to commenters MBS. The good delivery guidelines set forth the purchase and sale of a security occurs on the ANPR. See Proposing Release at 29830. basic characteristics that MBS guaranteed or sold by at the time the forward contract is These commenters requested clarification that Fannie Mae, Freddie Mac and Ginnie Mae must entered into.424 forward sales of MBS guaranteed or sold by Fannie have to be able to be delivered to settle an open Mae, Freddie Mac and Ginnie Mae would not be TBA transaction. Id. The Securities Industry and included in the swap and security-based swap Financial Markets Association (‘‘SIFMA’’) is the definitions in order to provide the certainty needed successor to the Bond Market Association and 419 See Letter from Lisa M. Ledbetter, Vice to avoid unnecessary disruption of this market. Id. publishes the good delivery guidelines, which are President and General Counsel, Legislative & 412 Task Force on Mortgage-Backed Securities available at http://www.sifma.org/services/ Regulatory Affairs, Freddie Mac, Jul. 21, 2011. Disclosure, ‘‘Staff Report: Enhancing Disclosure in standard-forms-and-documentation/securitized- 420 See Better Markets Letter. the Mortgage-Backed Securities Markets,’’ part II.E.2 products/. 421 Id. (Jan. 2003), which is available at http:// 417 See section 1a(47)(B)(ii) of the CEA, 7 U.S.C. 422 www.sec.gov/news/studies/mortgagebacked.htm 1a(47)(B)(ii). Id. (‘‘MBS Staff Report’’). 418 See sections 1a(47)(B)(v) and (vi) of the CEA, 423 Id. 413 Id. 7 U.S.C. 1a(47)(B)(v) and (vi). 424 See supra note 408.

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3. Consumer and Commercial Accordingly, the Commissions • Agreements, contracts, or Agreements, Contracts, and proposed an interpretation in the transactions that provide for an interest Transactions Proposing Release to assist consumers rate cap or lock on a consumer loan or The Commissions noted in the and commercial and non-profit entities mortgage, where the benefit of the rate Proposing Release that ‘‘[c]onsumers in understanding whether certain cap or lock is realized only if the loan agreements, contracts, or transactions or mortgage is made to the consumer; enter into various types of agreements, • contracts, and transactions as part of that they enter into would be regulated Consumer loans or mortgages with 430 their household and personal lives that as swaps or security-based swaps. variable rates of interest or embedded may have attributes that could be The Commissions are adopting the interest rate options, including such viewed as falling within the swap or interpretation set out in the Proposing loans with provisions for the rates to security-based swap definition.425 Release with certain modifications in change upon certain events related to response to commenters.431 the consumer, such as a higher rate of Similarly, businesses and other entities, 435 whether or not for profit, also enter into With respect to consumers, the interest following a default; Commissions have determined that the • Service agreements, contracts, or agreements, contracts, and transactions types of agreements, contracts, or transactions that are consumer product as part of their operations relating to, transactions that will not be considered warranties, extended service plans, or among other things, acquisitions or sales swaps or security-based swaps when buyer protection plans, such as those of property (tangible and intangible), entered into by consumers (natural purchased with major appliances and provisions of services, employment of persons) as principals (or by their electronics; 436 individuals, and other matters that agents)432 primarily for personal, family, • Consumer options to acquire, lease, could be viewed as falling within the 433 or sell real or personal property, such as 426 or household purposes, include: definitions.’’ • Agreements, contracts, or options to lease apartments or purchase Commenters on the ANPR pointed out transactions to acquire or lease real or rugs and paintings, and purchases made a number of areas in which a broad personal property, to obtain a mortgage, through consumer layaway plans; 437 reading of the swap and security-based to provide personal services, or to sell • Consumer agreements, contracts, or swap definitions could cover certain or assign rights owned by such transactions where, by law or consumer and commercial arrangements consumer (such as intellectual property regulation, the consumer may cancel the that historically have not been rights); transaction without legal cause; 438 and considered swaps or security-based • Agreements, contracts, or 427 swaps. Examples of such instruments transactions to purchase products or contracts and transactions with non-ECPs when cited by those commenters included services for personal, family or actual delivery does not occur within 28 days). The evidences of indebtedness with a household purposes at a fixed price or Commissions view consumer agreements, contracts, variable rate of interest; commercial and transactions involving periodic or future a capped or collared price, at a future purchases of consumer products and services as contracts containing acceleration, date or over a certain time period (such transactions that are not swaps. This interpretation escalation, or indexation clauses; as agreements to purchase for personal does not extend to consumer agreements, contracts agreements to acquire personal property use or consumption nonfinancial energy or transactions containing embedded optionality or or real property, or to obtain mortgages; embedded derivatives other than those discussed in commodities, including agreements to the text associated with this footnote. This analysis employment, lease, and service purchase home heating fuel or of consumer contracts is separate from the forward agreements, including those that contain agreements involving residential fuel contract analysis for commercial merchandising contingent payment arrangements; and storage, in either case, where the transactions discussed in supra part II.B.2. The consumer mortgage and utility rate CFTC continues to view the forward contract consumer takes delivery of and uses the exclusion for nonfinancial commodities as limited 428 caps. fuel, and the counterparty is a merchant to commercial merchandising transactions. The Commissions also stated in the that delivers in the service area where 435 An example of a consumer loan with a Proposing Release that they ‘‘do not the consumer resides);434 variable rate of interest is credit card debt that believe that Congress intended to includes a ‘‘teaser’’ rate. The teaser rate is a low, adjustable introductory interest rate that is include these types of customary involving a person that is not an ECP must be temporary. consumer and commercial agreements, entered into on, or subject to the rules of, a board 436 One commenter indicated that such service contracts, or transactions in the swap or of trade designated as a contract market. Id. The agreements, contracts, or transactions may be Commissions note that many consumers and regulated as insurance in some but not all states. security-based swap definition, to limit commercial and non-profit entities may not be the types of persons that can enter into However, the Commissions believe that it is ECPs. See section 1a(18) of the CEA, 7 U.S.C. appropriate to address these agreements, contracts, or engage in them, or to otherwise to 1a(18). Further, if these types of arrangements were or transactions in the context of their guidance subject these agreements, contracts, or subject to Title VII, they would be subject to the full regarding consumer and commercial arrangements. regulatory scheme for swaps and security-based See NAIC Letter. transactions to the regulatory scheme for swaps created by Title VII. These requirements 429 437 The Commissions believe that options entered swaps and security-based swaps.’’ could increase costs for consumers and commercial into by consumers that result in physical delivery and non-profit entities and potentially disrupt their of the commodity, if exercised, are not the type of 425 ability to enter into these arrangements. See Proposing Release at 29832. agreements, contracts or transactions that Congress 430 426 Id. See Proposing Release at 29832–33. intended to regulate as swaps or security-based 427 Id. 431 See infra note 447 and accompanying text. swaps. Conversely, options entered into by 428 Id. 432 For example, a mortgage broker may arrange consumers that cash settle based on the difference 429 Id. If these types of arrangements were subject a rate lock on behalf of a consumer borrower. between the market price and the contract price of to Title VII, the persons that could enter into or 433 The Commissions are not addressing here the a commodity are not within the scope of this engage in them could be restricted because Title VII applicability of any other provisions of the CEA, the interpretation. imposes restrictions on entering into swaps and Federal securities laws or the Commissions’ 438 Examples of these types of transactions security-based swaps with persons who are not regulations to such agreements, contracts or include consumer transactions that may be eligible contract participants (‘‘ECPs’’). See sections transactions. cancelled pursuant to the Federal Reserve Board’s 723(1), 763(e), and 768(b) of the Dodd-Frank Act. 434 These agreements, contracts, or transactions Regulation Z, 12 CFR Part 226 (i.e. certain consumer The Dodd-Frank Act amended the Securities Act require the parties respectively to make and take credit transactions that involve a lien on the and the Exchange Act to require that security-based delivery of the underlying commodity to each other consumer’s principal dwelling), consumer mail/ swap transactions involving a person that is not an directly; delivery may be deferred for convenience telephone orders that may be cancelled when orders ECP must be registered under the Securities Act and or necessity. But see section 2(c)(2)(D) of the CEA, have not been filled under 16 CFR Part 435, and effected on a national securities exchange, and also 7 U.S.C. 2(c)(2)(D), generally prohibiting certain other consumer transactions that have cancellations amended the CEA to require that swap transactions leveraged, margined or financed agreements, rights conferred by statute or regulation.

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• Consumer guarantees of credit card • Mortgage or mortgage purchase that the Commissions do not consider to debt, automobile loans, and mortgages commitments, or sales of installment be swaps or security-based swaps. of a friend or relative. loan agreements or contracts or The Commissions intend for this The Commissions have included in the receivables; interpretation to enable consumers to interpretation above several additional • Fixed or variable interest rate engage in transactions relating to their examples of consumer arrangements commercial loans or mortgages entered households and personal or family that the Commissions do not consider to into by banks 443 and non-banks, activities without concern that such be swaps or security-based swaps. These including the following: arrangements would be considered • additional examples have been included Fixed or variable interest rate swaps or security-based swaps. in response to commenters 439 and the commercial loans or mortgages entered Similarly, with respect to commercial Commissions’ determination that such into by the Farm Credit System business arrangements, this additional examples would assist institutions and Federal Home Loan interpretation should allow commercial Banks; and non-profit entities to continue to consumers in identifying other • agreements, contracts, or transactions Fixed or variable interest rate operate their businesses and operations that they enter into that would not be commercial loans or mortgages with without significant disruption and regulated as swaps or security-based embedded interest rate locks, caps, or provide that the swap and security- swaps.440 floors, provided that such embedded based swap definitions are not read to The types of commercial agreements, interest rate locks, caps, or floors are include commercial and non-profit contracts, or transactions that involve included for the sole purpose of operations that historically have not customary business arrangements providing a lock, cap, or floor on the been considered to involve swaps or (whether or not involving a for-profit interest rate on such loan or mortgage security-based swaps. entity) and will not be considered swaps and do not include additional The types of agreements, contracts, or security-based swaps under this provisions that would provide exposure and transactions discussed above are interpretation include: to enhanced or inverse performance, or not intended to be exhaustive of the • Employment contracts and other risks unrelated to the interest rate customary consumer or commercial retirement benefit arrangements; risk being addressed; • arrangements that should not be • Sales, servicing, or distribution Fixed or variable interest rate considered to be swaps or security- arrangements; commercial loans or mortgages with based swaps. There may be other, • Agreements, contracts, or embedded interest rate options, similar types of agreements, contracts, transactions for the purpose of effecting including such loans or mortgages that and transactions that also should not be a business combination transaction; 441 contain provisions causing the interest considered to be swaps or security- • The purchase, sale, lease, or transfer rate to change upon certain events based swaps. In determining whether of real property, intellectual property, related to the borrower, such as a higher similar types of agreements, contracts, equipment, or inventory; rate of interest following a default, • and transactions entered into by Warehouse lending arrangements in provided that such embedded interest consumers or commercial entities are connection with building an inventory rate options do not include additional swaps or security-based swaps, the of assets in anticipation of a provisions that would provide exposure Commissions intend to consider the securitization of such assets (such as in to enhanced or inverse performance, or characteristics and factors that are a securitization of mortgages, student other risks unrelated to the primary common to the consumer and 442 loans, or receivables); reason the embedded interest rate commercial transactions listed above: option is included; and • They do not contain payment 439 See supra note 96 and accompanying text. See • Commercial agreements, contracts, also infra notes 436, 454 and 455 and obligations, whether or not contingent, and transactions (including, but not that are severable from the agreement, accompanying text. limited to, leases, service contracts, and 440 The additional example regarding consumer contract, or transaction; options to acquire, lease, or sell real or personal employment agreements) containing • They are not traded on an organized property was added in response to a commenter on escalation clauses linked to an market or over-the-counter; and the ANPR. See Letter from White & Case LLP, dated underlying commodity such as an • In the case of consumer September 20, 2010. The Commissions also are interest rate or consumer price index. providing as additional examples consumer arrangements, they: 444 agreements, contracts, or transactions where, by law In response to commenters, the —Involve an asset of which the or regulation, the consumer may cancel the Commissions have included in the transaction without legal cause, and consumer consumer is the owner or beneficiary, interpretation above several additional or that the consumer is purchasing, or guarantees of credit card debt, automobile loans, examples of commercial arrangements and mortgages of a friend or relative. they involve a service provided, or to 441 These business combination transactions be provided, by or to the consumer, or include, for example, a reclassification, merger, representations and warranties about the • In the case of commercial consolidation, or transfer of assets as defined under underlying assets are not satisfied. the Federal securities laws or any tender offer 443 While the Commissions have included fixed arrangements, they are entered into: subject to section 13(e) and/or section 14(d) or (e) or variable interest rate commercial loans entered —By commercial or non-profit entities of the Exchange Act, 15 U.S.C. 78m(e) and/or into by banks, the Commissions understand that the as principals (or by their agents) to 78n(d) or (e). These business combination CEA does not apply to, and the CFTC may not agreements, contracts, or transactions can be exercise regulatory authority over, identified serve an independent commercial, contingent on the continued validity of banking products, and that the definitions of the business, or non-profit purpose, and representations and warranties and can contain terms ‘‘security-based swap’’ and ‘‘security-based —Other than for speculative, hedging, earn-out provisions and contingent value rights. swap agreement’’ do not include identified banking or investment purposes. 442 The Commissions believe that such lending products. See infra note 488, regarding identified arrangements included in this category are banking products. However, such loans and Two of the key components reflected traditional borrower/lender arrangements mortgages provided by certain banks may not in these characteristics that distinguish documented using, for example, a loan agreement qualify as identified banking products because these agreements, contracts, and or indenture, as opposed to a synthetic lending those banks may not satisfy the definition of ‘‘bank’’ transactions from swaps and security- arrangement documented in the form of, for for purposes of the ‘‘identified banking products’’ example, a total return swap. The Commissions also definition. See 7 U.S.C. 27(a). based swaps are that: (i) The payment note that securitization transaction agreements also 444 See infra notes 456 and 461 and provisions of the agreement, contract, or may contain contingent obligations if the accompanying text. transaction are not severable; and (ii)

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the agreement, contract, or transaction is most commenters supported the swaps.450 The Commissions believe it is not traded on an organized market or proposed interpretation, these appropriate to provide the interpretation over-the-counter, and therefore such commenters suggested certain changes. to allow consumers and commercial and agreement, contract, or transaction does Four commenters recommended that non-profit entities to engage in such not involve risk-shifting arrangements the Commissions codify the proposed transactions without concern that such with financial entities, as would be the interpretation regarding consumer and arrangements would be considered case for swaps and security-based commercial arrangements.448 The swaps or security-based swaps. swaps.445 In response to commenters,446 Commissions are not codifying the One commenter requested that the the Commissions clarify that merely interpretation. The interpretation is Commissions remove the term because an agreement, contract, or intended to provide guidance to assist ‘‘customary’’ from the description of transaction is assignable does not mean consumers and commercial and non- consumer and commercial arrangements that it is ‘‘traded’’ or that the agreement, profit entities in evaluating whether in the interpretation.451 The contract, or transaction is a swap or certain arrangements that they enter into Commissions note that the use of the security-based swap. An assignment of will be regulated as swaps or security- term ‘‘customary’’ was not intended to a contractual obligation must be based swaps. The interpretation is limit the interpretation, but rather was analyzed to assure that the result is not intended to allow the flexibility used to describe certain types of to sever the payment obligations. necessary, including the consideration arrangements that consumers and This interpretation is not intended to of the applicable facts and businesses may normally or generally be the exclusive means for consumers circumstances by the Commissions, in enter into. The Commissions also note and commercial or non-profit entities to evaluating consumer and commercial that the term ‘‘customary’’ is itself not determine whether their agreements, arrangements to ascertain whether they a separate representative characteristic contracts, or transactions fall within the may be swaps or security-based swaps. or factor for purposes of the swap or security-based swap definition. The representative characteristics and interpretation. If there is a type of agreement, contract, factors taken together are indicators that This commenter also requested that or transaction that is not enumerated a consumer or commercial arrangement specific examples of consumer and above, or does not have all the is not a swap or security-based swap commercial arrangements that are not characteristics and factors that are listed and the Commissions have provided swaps or security-based swaps include above (including new types of specific examples demonstrating how ‘‘any other similar agreements, 452 agreements, contracts, or transactions these characteristics and factors apply to contracts, or transactions.’’ The that may be developed in the future), some common types of consumer and specific examples are not intended to be the agreement, contract, or transaction commercial arrangements. However, as an exhaustive list and the Commissions will be evaluated based on its particular the interpretation is not intended to be do not believe that it is necessary to facts and circumstances. Parties to such a bright-line test for determining include a general catchall provision. an agreement, contract or transaction whether a particular consumer or The interpretation also includes a list of may also seek an interpretation from the commercial arrangement is a swap or representative characteristics and Commissions as to whether the security-based swap, if the particular factors to be used to analyze other agreement, contract or transaction is a arrangement does not meet all of the consumer and commercial swap or security-based swap. identified characteristics and factors, arrangements. Several commenters suggested the arrangement will be evaluated based Comments additional examples of consumer and on its particular facts and commercial arrangements that the Eleven commenters provided circumstances. Commissions should not consider to be comments on the proposed One commenter was concerned that swaps or security-based swaps.453 One interpretation set forth in the Proposing the interpretation itself implicitly commenter suggested that the Release regarding consumer and suggests that many types of consumer 447 Commissions should expand the commercial arrangements. While and commercial arrangements could be example of ‘‘consumer agreements, swaps, although none of these 445 contracts, or transactions to purchase There also are alternative regulatory regimes arrangements historically has been that have been enacted as part of the Dodd-Frank products or services at a fixed price or considered a swap.449 The Commissions Act specifically to provide enhanced protections to a capped or collared price, at a future consumers relating to various consumer do not intend to suggest that many types transactions. See, e.g., the Consumer Financial date or over a certain time period (such of consumer and commercial as agreements to purchase home heating Protection Act of 2010, Public Law 111–203, tit. X, arrangements that historically have not 124 Stat. 1376 (Jul. 21, 2010) (establishing the fuel)’’ to include all nonfinancial energy Bureau of Consumer Financial Protection to been considered swaps are within the commodities in the parenthetical regulate a broad category of consumer products and swap or security-based swap example.454 The Commissions have amending certain laws under the jurisdiction of the definitions. The Commissions provided Federal Trade Commission); the Mortgage Reform modified the identified consumer and Anti-Predatory Lending Act, Public Law 111– the interpretation in response to example to include all nonfinancial 203, tit. XIV, 124 Stat. 1376 (Jul. 21, 2010) comments received on the ANPR. energy commodities. The parenthetical (amending existing laws, and adding new Commenters on the ANPR identified example was not intended to be limited provisions, related to certain mortgages). Some of areas in which a broad reading of the these agreements, contracts, or transactions are to agreements to purchase home heating subject to regulation by the Federal Trade swap and security-based swap fuel. Commission and other Federal financial regulators definitions could cover certain One commenter suggested that the and state regulators. consumer and commercial arrangements Commissions should include as an 446 See infra note 470. that historically have not been 447 See BGA Letter; Letter from The Coalition for considered swaps or security-based 450 Derivatives End-Users, Jul. 22, 2011, (‘‘CDEU See Proposing Release at 29832. 451 Letter’’); ETA Letter; Letter from Robbie Boone, Vice See ISDA Letter. President, Government Affairs, Farm Credit Letter’’); IECA Letter; ISDA Letter; Just Energy 452 Id. Council, Jul. 22, 2011 (‘‘FCC Letter’’); FERC Staff Letter; PMAA/NEFI Letter; and SEIA Letter. 453 See CDEU Letter; FCC Letter; FERC Letter; Letter; Letter from Warren N. Davis, Of Counsel, 448 See ETA Letter; FERC Letter; IECA Letter; and FHLB Letter; ISDA Letter; Just Energy Letter; Sutherland Asbill & Brennan LLP, on behalf of the Just Energy Letter. PMAA/NEFI Letter; and SEIA Letter. Federal Home Loan Banks, Jul. 22, 2011 (‘‘FHLB 449 See IECA Letter. 454 See Just Energy Letter.

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additional example residential fuel Federal Reserve and trust companies, it provide exposure to leverage, inverse storage contracts.455 The Commissions does not include certain other financial performance, or other risks unrelated to agree that these arrangements should institutions that provide commercial the primary reason the embedded not be considered swaps or security- loans or mortgages, such as government- interest rate option is included in the based swaps, provided that they are sponsored enterprises (including the commercial loan or mortgage. residential fuel storage contracts where Federal Home Loan Banks) and certain Four commenters suggested the consumer takes delivery of and cooperatives (including the Farm Credit additional examples of commercial consumes the fuel, and the counterparty System institutions). arrangements that relate to nonfinancial is a merchant (or agent of a merchant) Three commenters suggested that the energy commodities.463 These that delivers in the service area where Commissions should include as arrangements are more appropriately the consumer’s residence is located. additional examples commercial rate addressed in the context of the forward Although the consumer may not lock agreements and commercial loans contract exclusion for nonfinancial immediately consume the fuel with interest rate caps, floors, or commodities 464 or the trade option contracted for, because it will ultimately options.461 The Commissions agree that exemption.465 consume the fuel for personal, family, or these arrangements should not be One commenter supported the household purposes, such a transaction considered swaps or security-based representative characteristics and is a type of customary consumer swaps, provided that the interest rate factors the Commissions set forth to transaction excluded from the swap and locks, caps, or floors, or interest rate distinguish consumer and commercial security-based swap definitions. options are embedded in the arrangements from swaps and security- Three commenters requested commercial loans or mortgages and not based swaps.466 Two commenters were clarification that commercial loans and entered into separately from the concerned with certain of these mortgages would fall within the commercial loans and mortgages, and characteristics and factors because these interpretation regardless of whether are including these arrangements as commenters believed that such 456 entered into by a bank or non-bank. examples in the interpretation. characteristics and factors are common Two of these commenters were However, the Commissions are limiting in a wide variety of consumer and concerned that the specific example was the interpretation to embedded interest commercial arrangements.467 Both limited to commercial loans and rate locks, caps, or floors, and interest commenters suggested that the mortgages entered into by non-banks rate options because interest rate locks, Commissions remove ‘‘for other than and did not address commercial loans caps, or floors, or interest rate options speculative, hedging or investment and mortgages entered into by financial that are entered into separately from the purposes’’ from the interpretation institutions that are banks but whose commercial loans and mortgages fall because many of the types of 462 loans and mortgages do not qualify as within the swap definition. In order transactions listed as examples may be 457 identified banking products. The to further distinguish these undertaken for speculative, hedging or Commissions are revising the example arrangements from swaps and security- investment purposes and because all to clarify that it includes fixed or based swaps, the interpretation provides commercial merchandising transactions variable interest rate commercial loans the following: (i) The embedded interest are ‘‘risk-shifting’’ of commercial or mortgages entered into by both banks rate lock, cap, or floor must be included obligations and risks, and ‘‘hedge’’ the and non-banks, including such loans for the sole purpose of providing a lock, enterprise’s commercial risks.468 The and mortgages entered into by the Farm cap, or floor on the interest rate on such Commissions are not revising the Credit System institutions and Federal loan or mortgage and may not include interpretation to remove or otherwise Home Loan Banks. The Commissions additional provisions that would modify this representative characteristic understand that the CEA does not apply provide exposure to enhanced or and factor. The Commissions believe to, and the CFTC may not exercise inverse performance, or other risks that commercial arrangements regulatory authority over, and the unrelated to the interest rate risk being undertaken for speculative, hedging or definitions of the terms ‘‘security-based addressed, and (ii) the embedded investment purposes may be a swap or swap’’ and ‘‘security-based swap interest rate option may not include a security-based swap depending on the agreement’’ do not include, any fixed or additional provisions that would particular facts and circumstances of the variable interest rate commercial loan or arrangement. mortgage entered into by a bank that is 461 See CDEU Letter; FCC Letter; and FHLB Letter. an identified banking product.458 These commenters indicated that such However, loans and mortgages provided arrangements are similar to the arrangements 463 See BGA Letter (commercial physical included in the list of examples of consumer transactions in the natural gas and electric power by certain banks may not qualify as arrangements that the Commissions would not markets should also fall under the category of identified banking products because consider to be swaps or security-based swaps. exemptions from the swap definition); FERC Letter those banks do not satisfy the definition 462 See section 1a(47)(A)(i) of the CEA, 7 U.S.C. (commercial transactions executed or traded on of ‘‘bank’’ for purposes of the 1a(47)(A)(i). Similarly, with respect to consumer RTOs/ISOs should be included in the agreements, contracts and transactions providing interpretation); Just Energy Letter (commercial ‘‘identified banking products’’ for an interest rate cap or an interest rate lock on arrangements to purchase products or services at a definition.459 According to a consumer loan or mortgage, the Commissions are fixed price or a capped or collared price, at a future commenters,460 while this definition of limiting this example to interest rate caps and date or over a certain time period); and PMAA/NEFI ‘‘bank’’ includes insured depository interest rate locks entered into in connection with Letter (petroleum fuel and gas storage contracts the consumer loan or mortgage and prior to closing between bona fide commercial market participants institutions, certain foreign banks, credit on the loan or mortgage. For this purpose, both or entities other than financial entities). unions, institutions regulated by the because obtaining a consumer loan or mortgage can 464 See supra part II.B.2. The Commissions note involve a great deal of documentation, which can that they provided the interpretation regarding be entered into at different times during the 455 See PMAA/NEFI Letter. consumer arrangements because the CFTC in the process, and because consumers may have some 456 past has not interpreted the forward contract See CDEU Letter; FCC Letter; and FHLB Letter. flexibility as to their deadline for deciding when to 457 exclusion for nonfinancial commodities to apply to See FCC Letter and FHLB Letter. include or exclude an interest rate cap or lock in 458 See infra note 488, regarding identified consumer arrangements. See supra note 434. their consumer loans or mortgages, the 465 banking products. Commissions will consider an interest rate cap or See supra note 317 and accompanying text. 459 See 7 U.S.C. 27(a). See also FCC Letter and lock to be entered into in connection with a 466 See FCC Letter. FHLB Letter. consumer loan or mortgage if it is included in the 467 See ETA Letter and ISDA Letter. 460 See supra note 457. final terms of the loan at closing. 468 Id.

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One of these commenters also together are indicators that a consumer description, REP transactions do not suggested the Commissions remove ‘‘do or commercial arrangement is not a appear to be among the types of not contain payment obligations that are swap or security-based swap. These transactions historically considered severable’’ from the interpretation representative characteristics and swaps or security-based swaps. because assignment of rights and factors also do not imply or presume Although the REP transactions delegation of obligations are common in that a consumer or commercial described by the commenter share some a wide variety of consumer and arrangement that does not meet all of features with spread options (e.g., they commercial transactions.469 The these characteristics and factors is a settle in cash based on the difference Commissions are not revising the swap or security-based swap. As noted between two price sources),475 in both interpretation to remove or otherwise above, if a particular arrangement does swaps and security-based swaps, each modify this representative characteristic not meet all of these characteristics and party assumes market risk.476 By and factor. The Commissions believe factors, the parties will need to evaluate contrast, neither party assumes or that the severability of payment the arrangement based on the particular hedges risk in an REP transaction.477 obligations could be indicative of a facts and circumstances. Moreover, as Instead, the Commissions view an REP consumer or commercial arrangement noted above, if there is a type of transaction essentially as a subsidy that may be a swap or a security-based consumer or commercial arrangement provided to residential and small farm swap depending on the particular facts that does not meet all of these utility customers.478 Accordingly, the and circumstances of the arrangement characteristics and factors, a party to the Commissions do not consider the REP because the severability of payment arrangement can seek an interpretation transactions described by the obligations could be indicative of an from the Commissions as to whether the commenter to be swaps or security- instrument that is merely an exchange arrangement is outside the scope of the based swaps. of payments, such as is the case with swap and security-based swap Loan Participations swaps and security-based swaps. definitions. One of these commenters also The Commissions provided an suggested that the Commissions remove Residential Exchange Program interpretation in the Proposing Release ‘‘not traded on an organized market or One commenter requested that the regarding the treatment of loan over the counter’’ from the CFTC further define the term ‘‘swap’’ to participations.479 The Commissions are interpretation because many of the types exclude consumer benefits under the of contracts listed as examples are Pacific Northwest Electric Power And, as required under the Residential Exchange assignable and frequently assigned or Statute, the entire monetary benefit Bonneville Planning and Conservation Act of 1980 provides to the REP exchanging utilities is in turn 470 472 traded. The other commenter did not (‘‘Northwest Power Act’’) and passed through to the residential and small farm suggest removing this factor, but transactions under the ‘‘Residential power consumers of that utility.’’ Id. requested that the factor be modified to Exchange Program’’ (‘‘REP’’).473 475 A spread option is ‘‘an option in which the provide that the arrangement is not payout is based on the difference in performance According to this commenter, the REP between two assets.’’ Superderivatives, ‘‘Spread traded on a ‘‘registered entity’’ in order was established by Congress ‘‘[t]o option in EQ’’ definition, available at http:// not to include transactions on organized extend the benefits of low cost Federal www.sdgm.com/Support/Glossary.aspx?letter=S. wholesale electricity markets.471 The System hydro power to residential and See also S.J. Denga and S.S. Oren, Electricity Commissions are not revising the derivatives and risk management, Science Direct at small farm electric power consumers 945 (2006), available at http://www.ieor. interpretation to remove or otherwise throughout the Pacific Northwest berkeley.edu/∼oren/pubs/Deng%20and%20Oren- modify this representative characteristic Region.’’ 474 Based on the commenter’s 86.pdf (defining a spark spread options as ‘‘cross- and factor. The Commissions believe commodity options paying out the difference between the price of electricity sold by generators 472 that the trading of an instrument on an 16 U.S.C. Chapter 12H. and the price of the fuels used to generate it’’); organized market or over the counter 473 Letter from Virginia K. Schaeffer, Attorney, Chicago Mercantile Exchange, Soybean-Corn Price could be indicative of a consumer or Office of General Counsel, Bonneville Power Ratio Options Fact Card (describing its soybean- commercial arrangement that may be a Administration, Jul. 22, 2011 (‘‘BPA Letter’’). This corn price ratio option contract as ‘‘an option on the commenter refers to the implementation of Section ratio between the price of the referencing Soybean swap or a security-based swap 5(c) of the Northwest Power Act, 16 U.S.C. 839c(c), futures contract and the price of the referencing depending on the particular facts and as the ‘‘Residential Exchange Program.’’ See Id. Corn futures contract * * *’’), available at http:// circumstances of the arrangement. 474 See BPA Letter. This commenter explained www.cmegroup.com/trading/agricultural/files/AC- However, as noted above, the that, under the REP: ‘‘A Pacific Northwest electric 440-Soybean-CornRatioOptionsFC.pdf. utility has a right to * * * sell power to Bonneville 476 Even a hedging party assumes the risk that the Commissions are clarifying that merely at the utility’s average system cost (ASC) of market can move against its hedging position, because an arrangement is assignable providing that power * * * Bonneville[] is required causing the hedge to reduce the profit it otherwise does not mean that it is ‘‘traded’’ or that to purchase that power at the utility’s ASC, and would have made on an unhedged position. the arrangement is a swap or security- then sell an equivalent amount of power back to the 477 The fact that the Commissions are relying in utility at Bonneville’s rates[,] which are based in part on this aspect of REP transactions to interpret based swap. An assignment of a substantial part on low cost Federal hydro power. such transactions to be neither swaps nor security- contractual obligation must be analyzed As required by the Residential Exchange Statute, based swaps does not mean that market participants to assure that the result is not to sever the amount of such power ‘‘exchanged’’ is based on should conclude, in other contexts, that a lack of the payment obligations. the related utility’s residential and small farm market risk removes an agreement, contract, or customer’s power needs (also known as ‘‘loads’’) in transaction from the swap and security-based swap Further, as noted above, the the Pacific Northwest Region. Under this definitions. The Commissions’ conclusion as to REP representative characteristics and ‘‘exchange,’’ no actual power is transferred to or transactions is based on the unique facts and factors are not intended to be a bright- from Bonneville. Instead, consistent with circumstances presented by the commenter. line test for determining whether a Congressional intent, the exchange transaction is 478 See, e.g., Paul M. Murphy, Northwest Public implemented as an accounting device that avoids Power Association, Background and Summary of particular consumer or commercial the costs and burdens associated with a physical the Residential Exchange Program Settlement arrangement is a swap or security-based exchange of power and that results in the payment Agreement, March 16, 2011, available at http:// swap. These representative of funds by Bonneville to the REP exchanging www.nwppa.org/cwt/external/wcpages/wcmedia/ characteristics and factors taken utilities. Reduced to the essentials, the Residential documents/background_and_summary_of_rep_ Exchange Statute as implemented in * * * REP settlement_agreement.pdf (characterizing the REP contracts results in Bonneville making cash as ‘‘require[ing] BPA to subsidize the residential 469 See ISDA Letter. payments for the positive difference between the and small farm consumers of the higher cost 470 Id. utility’s ASC and Bonneville’s lower rate multiplied utilities in the Pacific Northwest’’). 471 See ETA Letter. by the qualifying residential and small farm loads. 479 See Proposing Release at 29834.

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restating the interpretation set out in the sale of a security on a fixed or financing to the participant or if such Proposing Release with certain contingent basis.487 In addition, participant levers its purchase, modifications in response to depending on the facts and including by posting collateral to secure commenters.480 circumstances, a loan participation may a future payment obligation. Loan participations arise when a be an identified banking product and, as • The loan participation provides the lender transfers or offers a participation such, would be excluded from CFTC participant all of the economic benefit in the economic risks and benefits of all jurisdiction and from the security-based and risk of the whole or part of the loan or a portion of a loan or commitment it swap and security-based swap or commitment that is the subject of the has entered into with a borrower to agreement definitions.488 loan participation. another party as an alternative or The Commissions believe it is These characteristics, which were precursor to assigning to such person important to provide further guidance as identified by commenters,489 are the loan or commitment or an interest to the other circumstances in which intended to distinguish loan in the loan or commitment.481 The certain loan participations would not participations from swaps and security- Commissions understand that two types fall within the swap and security-based based swaps based on loans. The first of loan participations exist in the market swap definitions. Consistent with the characteristic above addresses the today,482 LSTA-style participations483 proposal, the Commissions do not ownership of the underlying loan or and LMA-style participations.484 LSTA- interpret the swap and security-based commitment. Swaps and security-based style participations transfer a beneficial swap definitions to include loan swaps may be created using a synthetic ownership interest in the underlying participations that reflect an ownership or derivative structure that does not loan or commitment to the interest in the underlying loan or require ownership of the underlying participant.485 LMA-style participations commitment. The Commissions believe loan.490 The second characteristic above do not transfer a beneficial ownership that for a loan participation to not be addresses the ratio of the participation interest in the underlying loan or considered a swap or security-based to the underlying loan or commitment. commitment to the participant, but swap, the loan participation must Swaps and security-based swaps based rather create a debtor-creditor represent a current or future direct or on loans may involve synthetic relationship between the grantor and the indirect ownership interest in the loan exposure to a loan that is a multiple of participant under which a future or commitment that is the subject of the the principal amount.491 The third beneficial ownership interest is loan participation. characteristic above addresses leverage 486 conveyed. In evaluating whether the loan in the financing of a loan participation. Depending on the facts and participation represents such an Leverage could be indicative of an circumstances, a loan participation may ownership interest, the Commissions instrument that is merely an exchange be a security under the Federal believe the following characteristics of payments and not a transfer of the securities laws and, as such, the loan should be present: ownership of the underlying loan or participation would be excluded from • The grantor of the loan commitment, such as may be the case the swap definition as the purchase and participation is a lender under, or a 492 participant or sub-participant in, the with a swap or security-based swap. The fourth characteristic above 480 See infra note 504 and accompanying text. loan or commitment that is the subject addresses the level of participation in 481 See Loan Market Association, ‘‘Guide to of the loan participation. Syndicated Loans,’’ section 6.2.4 (‘‘A [loan] • The aggregate participation in the the economic benefits and risks of the participation * * * is made between the existing loan or commitment that is the subject underlying loan or commitment. This lender and the participant. This creates new characteristic is indicative of ownership contractual rights between the existing lender and of the loan participation does not the participant which mirror existing contractual exceed the principal amount of such when analyzed with the other rights between the existing lender and the borrower. loan or commitment. Further, the loan characteristics and, as noted above, However this is not an assignment of those existing participation does not grant, in the swaps and security-based swaps may be rights and the existing lender remains in a direct created using a synthetic or derivative contractual relationship with the borrower.’’), aggregate, to the participant in such loan available at http://www.lma.eu.com/uploads/files/ participation a greater interest than the structure that does not require Introductory_Guides/Guide_to_Par_Syndicated grantor holds in the loan or commitment ownership of the underlying loan. _ Loans.pdf. that is the subject of the loan The Commissions agree with 482 See Letter from R. Bram Smith, Executive participation. commenters that the loan participation Director, The Loan Syndications and Trading • Association, Jan. 25, 2011 (‘‘January LSTA Letter’’); The entire purchase price for the does not have to be a ‘‘true Letter from Elliot Ganz, General Counsel, The Loan loan participation is paid in full when participation,’’ as the Commissions had Syndications and Trading Association, Mar. 1, 2011 acquired and not financed. The stated in their interpretation in the (‘‘March LSTA Letter’’); and Letter from Clare Commissions believe a purchase price Proposing Release,493 in order for the Dawson, Managing Director, The Loan Market Association, Feb. 23, 2011. The Commissions would not be paid in full if the grantor loan participation to fall outside the understand that neither type of loan participation of the loan participation extends swap and security-based swap is a ‘‘synthetic’’ transaction. See March LSTA definitions.494 The Commissions note Letter. Both types of loan participations are merely 487 See sections 1a(47)(B)(v) and (vi) of the CEA, that the ‘‘true participation’’ analysis is transfers of cash loan positions and the ratio of 7 U.S.C. 1a(47)(b)(v) and (vi), as amended by underlying loan to participation is always one to used to determine whether a transaction section 721(a)(21) of the Dodd-Frank Act (excluding has resulted in the underlying assets one. Id. purchases and sales of a security on a fixed or 483 The LSTA is The Loan Syndications and contingent basis, respectively from the swap being legally isolated from a transferor’s Trading Association. definition). creditors for U.S. bankruptcy law 484 The LMA is The Loan Market Association. 488 See section 403(a) of the Legal Certainty for 485 See Letter from Clare Dawson, Managing Bank Products Act of 2000, 7 U.S.C. 27a(a), as 489 See infra note 504 and accompanying text. See Director, The LMA, Jul. 22, 2011 (‘‘July LMA amended by section 725(g)(2) of the Dodd-Frank also infra notes 490, 491, and 492 and Letter’’). Act (providing that, under certain circumstances, accompanying text. 486 See Id. The participant may exercise an the CEA shall not apply to, and the CFTC shall not 490 See July LMA Letter. ‘‘elevation’’ right and request that the grantor use exercise regulatory authority over, identified 491 commercially reasonable efforts to cause the banking products, and the definitions of the terms Id. participant to become the legal owner, by ‘‘security-based swap’’ and ‘‘security-based swap 492 Id. assignment, of the underlying loan or commitment. agreement’’ shall not include identified banking 493 Proposing Release at 29834. Id. products). 494 See infra note 503 and accompanying text.

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purposes.495 This analysis is unrelated direct or indirect ownership interest in are revising the interpretation as noted to and does not inform whether a loan the loan or commitment that is the above. participation is a swap or security-based subject of the loan participation.502 One commenter also indicated that swap. This analysis also may be subject However, commenters disagreed with loan participations are entered into both to varying interpretations.496 Further, the proposal that a loan participation with respect to outstanding loans and the Commissions understand that this should be required to be a ‘‘true with respect to a lender’s commitments analysis could result in certain loan participation’’ in order for the loan to lend and fund letters of credit (e.g., participations that reflect an ownership participation to fall outside the swap under a revolving credit facility).505 interest in the underlying loan or and security-based swap definitions This commenter requested that the commitment being included in the swap because LMA-style participations do not Commissions revise the proposed and security-based swap definitions, represent a beneficial ownership in the interpretation to reflect both which the Commissions do not underlying loan or commitment such outstanding loans and a lender’s intend.497 506 that they would be considered a true commitments. The Commissions Rather, as noted above, the agree and are revising the interpretation participation.503 Commenters requested Commissions believe that the analysis to reflect both outstanding loans and that the Commissions remove this factor as to whether a loan participation is loan commitments as noted above. outside the swap and security-based and instead recognize additional swap definitions should be based on factors.504 The Commissions agree that C. Final Rules and Interpretations whether the loan participation reflects a loan participation does not have to be Regarding Certain Transactions Within an ownership interest in the underlying a true participation in order for the loan the Scope of the Definitions of the loan or commitment. The Commissions participation to fall outside the swap Terms ‘‘Swap’’ and ‘‘Security-Based understand that the characteristics and security-based swap definitions and Swap’’ noted above are indicative, based on 1. In General 498 comments received, of whether a 502 See FSR Letter; July LMA Letter; July LSTA loan participation represents such an Letter; MFA Letter; and SIFMA Letter. Commenters In light of provisions in the Dodd- ownership interest. Further, in response indicated that both LSTA-style participations and Frank Act that specifically address to commenters,499 the Commissions are LMA-style participations represent a current or certain foreign exchange products, the future direct or indirect ownership interest in the Commissions in the Proposing Release clarifying that the interpretation applies related loan or commitment. Id. to loan participations that are entered 503 See July LMA Letter; July LSTA Letter; MFA proposed rules to clarify the status of into both with respect to outstanding Letter; and SIFMA Letter. These commenters products such as foreign exchange loans and with respect to a lender’s indicated that neither LMA-style participations nor forwards, foreign exchange swaps, commitments to lend and fund letters of certain LSTA-style participations are true foreign exchange options, non- participations. See July LMA Letter; July LSTA deliverable forwards involving foreign credit (e.g., under a revolving credit Letter; and SIFMA Letter. Further, according to the facility). July LSTA Letter, ‘‘[l]oan market participants in the exchange (‘‘NDFs’’), and cross-currency The Commissions believe that the United States will likely interpret the ‘true swaps. The Commissions also proposed interpretation will prevent disruption in participation’ requirement as a requirement that a rule to clarify the status of forward loan participations must qualify for ‘true sale’ rate agreements and provided the syndicated loan market for loan treatment in order to avoid classification as a participations. Loan participations ‘swap.’ A ‘true sale’ or ‘true participation’ analysis interpretations regarding: (i) facilitate a lender’s diversification of its is a test aimed at determining whether a transaction Combinations and permutations of, or portfolio holdings, provide a key has resulted in the underlying assets being legally options on, swaps or security-based isolated from the transferor’s creditors for U.S. swaps; and (ii) contracts for differences component of the efficient settlement bankruptcy law purposes. Its underlying purpose is process, and enhance liquidity in the to distinguish between a sale and a financing, not (‘‘CFDs’’). global syndicated loan market.500 The between a sale and a swap.’’ If this is the case, The Commissions are adopting the interpretation will enable this market to certain LSTA-style participations, which typically rules as proposed without modification are offered in the United States, could be and are restating the interpretations continue operating as it did prior to the determined under a ‘‘true sale’’ analysis to be a enactment of Title VII. financing and not a true participation. See July provided in the Proposing Release LSTA Letter. without modification. In addition, the Comments 504 See July LMA Letter; July LSTA Letter; MFA Commissions are providing additional Commenters supported the Letter; and SIFMA Letter. Commenters interpretations regarding foreign recommended that the Commissions revise the interpretation that certain loan interpretation by providing that the Commissions exchange spot transactions and retail participations should not be included in do not interpret the swap and security-based swap foreign currency options. the swap and security-based swaps definitions to include loan participations in which As adopted, rule 1.3(xxx)(2) under the definitions.501 Commenters agreed with (1) the participant is acquiring a current or future CEA and rule 3a69–2 under the direct or indirect ownership interest in the related the proposal that a loan participation loan or commitment, and (2) the agreement Exchange Act explicitly define the term should represent a current and future pursuant to which the participant is acquiring such ‘‘swap’’ to include certain foreign an interest (i) is a participation agreement that is, exchange-related products and forward 495 Id. or any similar agreement of a type that has been, rate agreements unless such products 496 Id. is presently, or in the future becomes, customarily entered into in the primary or secondary loan are excluded by the statutory exclusions 497 Id. markets, (ii) requires the grantor to represent that in subparagraph (B) of the swap 498 See supra note 482. See infra note 501. it is a lender under, or a participant or sub- definition.507 In adopting these rules, 499 See infra note 506 and accompanying text. participant in, the loan or commitment, (iii) the Commissions do not mean to suggest 500 See January LSTA Letter. provides that the participant is entitled to receive 501 See FCC Letter; Letter from Richard M. from the grantor all of the economic benefit of the that the list of agreements, contracts, Whiting, Executive Director and General Counsel, whole or part of a loan or commitment to the extent and transactions set forth in rule Financial Services Roundtable, Jul. 22, 2011 (‘‘FSR of payments received by the grantor in respect of 1.3(xxx)(2) under the CEA and rule Letter’’); July LMA Letter; Letter from R. Bram such loan or commitment, and (iv) requires that Smith, Executive Director, The LSTA, Jul. 22, 2011 100% of the purchase price calculated with respect (‘‘July LSTA Letter’’); MFA Letter; and Letter from to the loan or commitment is paid on the settlement 505 See July LMA Letter. Kenneth E. Bentsen, Jr., Executive Vice President, date. See id. The characteristics identified by these 506 Id. Public Policy and Advocacy, SIFMA, Jul. 22, 2011 commenters are reflected in the Commission’s 507 See section 1a(47)(B) of the CEA, 7 U.S.C. (‘‘SIFMA Letter’’). revised interpretation. 1a(47)(B).

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3a69–2(b) under the Exchange Act is an transactions.511 Specifically, those his final determination about whether to exclusive list. transactions still would be subject to exempt them.517 One commenter certain requirements for reporting 2. Foreign Exchange Products believed that finalizing the swaps, and swap dealers and major Commissions’ proposal prior to the (a) Foreign Exchange Products Subject swap participants engaging in such Secretary’s final determination would to the Secretary’s Swap Determination: transactions still would be subject to be ‘‘premature.’’ 518 The other Foreign Exchange Forwards and Foreign certain business conduct standards.512 commenter believed that the industry Exchange Swaps The Commissions are adopting the will be ‘‘better positioned’’ to assess the The CEA, as amended by the Dodd- rules as proposed to explicitly define by need to clarify the scope of the swap Frank Act, provides that ‘‘foreign rule the term ‘‘swap’’ to include foreign definition with respect to foreign exchange forwards’’ and ‘‘foreign exchange forwards and foreign exchange exchange derivatives after the Secretary exchange swaps’’ shall be considered swaps (as those terms are defined in the has made his determination.519 The 513 swaps under the swap definition unless CEA), in order to include in one rule Commissions understand that, if the the Secretary of the Treasury the definitions of those terms and the final rules are effective before the (‘‘Secretary’’) issues a written related regulatory authority with respect Secretary issues a written determination that either foreign to foreign exchange forwards and determination, market participants 514 exchange swaps, foreign exchange foreign exchange swaps. The final entering into foreign exchange forwards forwards, or both: (i) Should not be rules incorporate the provision of the and foreign exchange swaps might incur regulated as swaps; and (ii) are not Dodd-Frank Act that foreign exchange costs in order to comply with the structured to evade the Dodd-Frank Act forwards and foreign exchange swaps requirements of the CEA (as amended in violation of any rule promulgated by will no longer be considered swaps if by the Dodd-Frank Act) that could be the Secretary issues the written the CFTC pursuant to section 721(c) of rendered unnecessary if the Secretary 508 determination described above to the Dodd-Frank Act. A foreign subsequently were to issue a written exempt such products from the swap exchange forward is defined in the CEA determination to exempt.520 The definition.515 The final rules also reflect as ‘‘a transaction that solely involves the Commissions, however, believe the final the continuing applicability of certain exchange of two different currencies on rules are necessary because in the event reporting requirements and business a specific future date at a fixed rate the Secretary issues a written conduct standards in the event that the agreed upon on the inception of the determination to exempt, certain 509 Secretary makes such a contract covering the exchange.’’ A reporting requirements and business determination.516 foreign exchange swap, in turn, is conduct standards will continue to defined as ‘‘a transaction that solely Comments apply to the exempted instruments, and involves an exchange of 2 different Two commenters recommended that the final rules set forth those currencies on a specific date at a fixed the Commissions defer action on requirements that will continue to rate that is agreed upon on the inception defining foreign exchange swaps and apply. of the contract covering the exchange; foreign exchange forwards in their and a reverse exchange of the 2 Further, the Commissions do not regulations until the Secretary has made currencies described in subparagraph believe that adopting the rules is (A) at a later date and at a fixed rate that premature, as the Secretary may issue a 511 The Secretary’s determination also does not is agreed upon on the inception of the determination at any time, and the affect the CFTC’s jurisdiction over retail foreign Secretary’s authority to do so is contract covering the exchange.’’ 510 currency agreements, contracts, or transactions Under the Dodd-Frank Act, if foreign pursuant to section 2(c)(2) of the CEA, 7 U.S.C. independent of the Commissions’ exchange forwards or foreign exchange 2(c)(2). See section 1a(47)(F)(ii) of the CEA, 7 U.S.C. authority to issue these rules to further 1a(47)(F)(ii). define the term ‘‘swap.’’ 521 The swaps are no longer considered swaps 512 See, e.g., sections 1a(47)(E)(iii) and (iv) of the due to a determination by the Secretary, CEA, 7 U.S.C. 1a(47)(E)(iii) and (iv) (reporting and nevertheless, certain provisions of the business conduct standards, respectively). In 517 See CME Letter and SIFMA Letter. CEA added by the Dodd-Frank Act addition, a determination by the Secretary does not 518 See CME Letter. This commenter also believes exempt any foreign exchange forward or foreign that if the Secretary exempts foreign exchange would continue to apply to such exchange swap traded on a designated contract swaps and foreign exchange forwards from the market or a swap execution facility, or cleared by swap definition, it would create an ‘‘awkward’’ 508 See section 1a(47)(E)(i) of the CEA, 7 U.S.C. a derivatives clearing organization, from any situation both for the CFTC and market 1a(47)(E)(i). The Secretary published in the Federal applicable antifraud or anti-manipulation provision participants, given that options on such products Register a request for comment as to whether an under the CEA. See sections 1a(47)(F)(i) and 1b(c) would be swaps but the products into which they exemption from the swap definition for foreign of the CEA, 7 U.S.C. 1a(47)(F)(i) and 1b(c). exercise would not be swaps, and would result in exchange swaps, foreign exchange forwards, or 513 See rules 1.3(xxx)(3)(iii) and (iv) under the a lack of clarity and consistency for market both, is warranted, and on the application of the CEA and rule 3a69–2(c)(3) and (4) under the participants. Id. statutory factors that the Secretary must consider in Exchange Act. 519 See SIFMA Letter. making a determination regarding whether to 514 See rules 1.3(xxx)(2)(i)(C) and (D) under the 520 These costs market participants may incur exempt these products. See Determinations of CEA and rules 3a69–2(b)(1)(iii) and (iv) under the relate to the upfront and ongoing costs associated Foreign Exchange Swaps and Forwards, 75 FR Exchange Act. The rules further provide that foreign with the regulation of Title VII instruments 66829 (Oct. 28, 2010). Subsequently, the Secretary exchange forwards and forward exchange swaps are generally. See infra parts X and XI, for a discussion published in the Federal Register a proposed not swaps if they fall within one of the exclusions of these costs. The Commissions also note that the determination to exempt both foreign exchange set forth in subparagraph (B) of the statutory swap final rules will reduce (and may eliminate), the swaps and foreign exchange forwards from the definition. See rule 1.3(xxx)(2)(ii) under the CEA costs of determining whether foreign exchange definition of the term ‘‘swap’’ in the CEA. See and rule 3a69–2(b)(2) under the Exchange Act. swaps and foreign exchange forwards are subject to Determination of Foreign Exchange Swaps and 515 See rule 1.3(xxx)(3) under the CEA and rule Title VII, as well as the costs associated with Foreign Exchange Forwards Under the Commodity 3a69–2(c) under the Exchange Act. determining which provisions of the new Title VII Exchange Act, Notice of Proposed Determination, 516 See rule 1.3(xxx)(3)(ii) under the CEA and rule regulatory regime will apply to these instruments. 76 FR 25774 (May 5, 2011) (‘‘Notice of Proposed 3a69–2(c)(2) under the Exchange Act. The exclusion Id. Determination’’). The comment period on the of foreign exchange forwards and foreign exchange 521 Compare section 712(d)(1) of the CEA Secretary’s proposed determination closed on June swaps would become effective upon the Secretary’s (Commissions’ joint rulemaking authority to further 6, 2011. A final determination has not yet been submission of the determination to exempt to the define the term ‘‘swap’’), with section 1a(47)(E) and issued. appropriate Congressional Committees. See sections 1b of the CEA (Secretary’s authority to determine 509 See section 1a(24) of the CEA, 7 U.S.C. 1a(24). 1a(47)(E)(ii) and 1b of the CEA, 7 U.S.C. to exempt foreign exchange swaps and foreign 510 See section 1a(25) of the CEA, 7 U.S.C. 1a(25). 1a(46)(E)(ii) and 1b. exchange forwards from the definition of ‘‘swap.’’).

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Commissions’ final rules are consistent exchange swaps from the swap than foreign currency options traded on with this statutory framework by definition.524 an NSE).529 The rules also state that foreign currency options are not foreign specifically providing that, in the event (i) Foreign Currency Options 525 a determination to exempt is issued, exchange forwards or foreign exchange foreign exchange swaps and foreign As discussed above, the statutory swaps under the CEA.530 exchange forwards will not be swap definition includes options, and it expressly enumerates foreign currency (ii) Non-Deliverable Forward Contracts considered swaps, and will be subject Involving Foreign Exchange only to those CEA requirements that are options. It encompasses any agreement, contract, or transaction that is a put, As explained by the Commissions in specified in the statute.522 As such, the call, cap, floor, collar, or similar option the Proposing Release,531 an NDF final rules accommodate the possibility of any kind that is for the purchase or generally is similar to a forward foreign of (rather than the certainty of) an sale, or based on the value, of 1 or more exchange contract,532 except that at exemptive determination made by the interest or other rates, currencies, maturity the NDF does not require Secretary. commodities, securities, instruments of physical delivery of currencies; rather, Moreover, commenters provided no indebtedness, indices, quantitative the contract typically is settled in a support for the assertion that the measures, or other financial or reserve currency, such as U.S. dollars. situation would be awkward for market economic interests or property of any One of the currencies involved in the participants because options on foreign kind.526 Foreign exchange options transaction, usually an emerging market exchange forwards and foreign exchange traded on a national securities exchange currency, may be subject to capital swaps will be swaps, regardless of (‘‘NSE’’), however, are securities under controls or similar restrictions, and is whether the Secretary determines to the Federal securities laws and not therefore said to be exempt the underlying transactions swaps or security-based swaps.527 ‘‘nondeliverable.’’ 533 If the spot market from the swap definition. The Any determination by the Secretary, exchange rate on the settlement date is Commissions note that Congress drew discussed above, that foreign exchange greater (in foreign currency per dollar the distinction in the statute between forwards or foreign exchange swaps terms) than the previously agreed foreign currency options and foreign should not be regulated as swaps would forward exchange rate, the party to the exchange forwards and foreign exchange not impact foreign currency options contract that is long the nondeliverable swaps. The Commissions conclude that because a foreign currency option is (e.g. emerging market) currency must adopting these final rules would not neither a foreign exchange swap nor a pay its counterparty the difference contribute to a lack of clarity or foreign exchange forward, as those between the contracted forward price consistency for market participants, terms are defined in the CEA. The and the spot market rate, multiplied by the notional amount.534 regardless of any determination the Commissions did not receive any NDFs are not expressly enumerated in Secretary makes. comments either on the proposed rule further defining the term ‘‘swap’’ to the swap definition, but as was stated in (b) Foreign Exchange Products Not include foreign currency options or the the Proposing Release,535 they satisfy Subject to the Secretary’s Swap proposed rule clarifying that foreign clause (A)(iii) of the swap definition Determination currency options are not subject to the because they provide for a future Secretary’s determination to exempt The Commissions are adopting rules foreign exchange swaps and foreign 529 See rule 1.3(xxx)(2)(ii) under the CEA and rule as proposed stating that a determination 528 3a69–2(b)(1) under the Exchange Act. The final exchange forwards. Consequently, rules treat the terms foreign currency options, by the Secretary that foreign exchange the Commissions are adopting rules to currency options, foreign exchange options, and forwards or foreign exchange swaps, or explicitly define the term ‘‘swap’’ to foreign exchange rate options as synonymous. both, should not be regulated as swaps include foreign currency options (other Moreover, for purposes of the final rules, foreign would not affect certain other products currency options include options to enter into or terminate, or that otherwise operate on, a foreign involving foreign currency, such as 524 See rule 1.3(xxx)(2)(i) under the CEA and rule exchange swap or foreign exchange forward, or on foreign currency options, NDFs, 3a69–2(b)(1) under the Exchange Act. The final the terms thereof. As discussed above, foreign currency swaps and cross-currency rules provide, however, that none of these products exchange options traded on an NSE are securities 523 are swaps if they fall within one of the exclusions and therefore are excluded from the swap swaps. The rules explicitly define the set forth in subparagraph (B) of the statutory swap definition. See supra note 527 and accompanying term ‘‘swap’’ to include such products, definition. See rule 1.3(xxx)(2)(ii) under the CEA text. irrespective of whether the Secretary and rule 3a69–2(b)(2) under the Exchange Act. 530 See rule 1.3(xxx)(3)(v) under the CEA and rule makes a determination to exempt Also, the rules do not define the term ‘‘swap’’ to 3a69–2(c)(5) under the Exchange Act. include currency swaps because they are already 531 foreign exchange forwards or foreign See Proposing Release at 29836. included in the statutory definition, but the rules 532 A deliverable forward foreign exchange clarify that currency swaps are not subject to the contract is an obligation to buy or sell a specific 522 See rule 1.3(xxx)(3)(ii) under the CEA and rule Secretary’s determination. See section currency on a future settlement date at a fixed price 3a69–2(c)(2) under the Exchange Act. The statutory 1a(47)(A)(iii)(VII) of the CEA, 7 U.S.C. set on the trade date. See Laura Lipscomb, Federal requirements that remain applicable, 1a(47)(A)(iii)(VII); rule 1.3(xxx)(3)(v)(A) under the Reserve Bank of New York, ‘‘An Overview of Non- notwithstanding a written determination by the CEA; and rule 3a69–2(c)(5)(i) under the Exchange Deliverable Foreign Exchange Forward Markets,’’ 1 Secretary to exempt, are that foreign exchange Act. (May 2005) (citation omitted) (‘‘Fed NDF swaps and foreign exchange forwards shall be 525 This discussion is not intended to address, Overview’’). reported to either a swap data repository, or, if there and has no bearing on, the CFTC’s jurisdiction over 533 See id. at 1–2 (citation omitted). is no swap data repository that would accept such foreign currency options in other contexts. See, e.g., 534 See id. at 2. Being long the emerging market swaps or forwards, to the CFTC pursuant to section CEA sections 2(c)(2)(A)(iii) and 2(c)(2)(B)–(C), 7 currency means that the holder of the NDF contract 4r of the CEA, 7 U.S.C. 6r, within such time period U.S.C. 2(c)(2)(A)(iii) and 2(c)(2)(B)–(C) (off- is the ‘‘buyer’’ of the emerging market currency and as the CFTC may by rule or regulation prescribe, exchange options in foreign currency offered or the ‘‘seller’’ of dollars. Conversely, if the emerging and any party to a foreign exchange swap or entered into with retail customers). market currency appreciates relative to the forward that is a swap dealer or major swap 526 See section 1a(47)(A)(i) of the CEA, 7 U.S.C. previously agreed forward rate, the holder of the participant shall conform to the business conduct 1a(47)(A)(i). contract that is short the emerging market currency standards contained in section 4s(h) of the CEA, 7 527 See section 1a(47)(B)(iv) of the CEA, 7 U.S.C. must pay its counterparty the difference between U.S.C. 6s(h). Section 1a(47)(E)(iii) and (iv) of the 1a(47)(B)(iv). the spot market rate and the contracted forward CEA, 7 U.S.C. 1a(47)(E)(iii) and (iv). 528 A comment regarding the CFTC’s jurisdiction price, multiplied by the notional amount. See id. at 523 See rule 1.3(xxx)(3)(v) under the CEA and rule over retail foreign currency options is discussed 2, n.4. 3a69–2(c)(5) under the Exchange Act. below. 535 See Proposing Release at 29836.

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(executory) payment based on an forward contract exclusion of the swap In addition, commenters believed that exchange rate, which is an ‘‘interest or definition because currency is outside not treating NDFs as foreign exchange other rate[ ]’’ within the meaning of the scope of the forward contract forwards or foreign exchange swaps clause (A)(iii).536 Each party to an NDF exclusion for nonfinancial would be contrary to both domestic and transfers to its counterparty the risk of commodities.540 Nor have NDFs international market practices. As the exchange rate moving against the traditionally been considered specific examples, commenters noted counterparty, thus satisfying the commercial merchandising transactions. that NDFs typically are traded as part of requirement that there be a transfer of Rather, as the Commissions observed in a bank’s or broker’s foreign exchange financial risk associated with a future the Proposing Release,541 NDF markets desk; the Federal Reserve Bank of New change in rate. This financial risk appear to be driven in large part by York has described an NDF in a 1998 transfer in the context of an NDF is not speculation 542 and hedging,543 which publication as an instrument ‘‘similar to accompanied by a transfer of an features are more characteristic of swap an outright forward,’’ except that there ownership interest in any asset or markets than forward markets. is no physical delivery or transfer of the liability. Thus, an NDF is a swap under local currency; the Bank for clause (A)(iii) of the swap definition.537 Comments International Settlements (‘‘BIS’’) Moreover, the Commissions have Commenters who addressed the categorizes NDFs in its ‘‘outright determined that NDFs do not meet the nature of NDFs believed that NDFs forward’’ category; various European definitions of ‘‘foreign exchange should not be considered swaps, but regulations do not distinguish between forward’’ or ‘‘foreign exchange swap’’ rather should be categorized as foreign the two transaction types; standard set forth in the CEA.538 NDFs do not exchange forwards. In general, foreign exchange trading documentation involve an ‘‘exchange’’ of two different commenters maintained that NDFs are includes both net- and physically- currencies (an element of the definition functionally and economically settled foreign exchange transactions in of both a foreign exchange forward and equivalent to foreign exchange forwards, general definitions of foreign exchange a foreign exchange swap); instead, they and therefore should be treated in the transactions; and special rules under the are settled by payment in one currency same manner for regulatory purposes.544 U.S. tax code apply equally to (usually U.S. dollars).539 In support of this view, commenters physically settled and cash settled Notwithstanding their ‘‘forward’’ 546 made several arguments, including that foreign exchange forwards. label, NDFs also do not fall within the Commenters also raised potential both NDFs and foreign exchange negative consequences to certain U.S. forwards require the same net value to 536 See section 1a(47)(A)(iii) of the CEA, 7 U.S.C. market participants if NDFs are not be transferred between counterparties; 1a(47)(A)(iii) (providing that a swap is an considered to be foreign exchange agreement, contract, or transaction ‘‘that provides the purpose for using them is the forwards. For example, one commenter on an executory basis for the exchange, on a fixed same—to cover foreign currency or contingent basis, of 1 or more payments based argued that treating NDFs as swaps will exchange risk; both are typically short on the value or level of 1 or more interest or other put U.S. corporations doing business in term transactions; and both may be rates, currencies, commodities, securities, emerging markets at a disadvantage instruments of indebtedness, indices, quantitative cleared by CLS Bank.545 measures, or other financial or economic interests relative to U.S. corporations doing or property of any kind, or any interest therein or business solely in developed markets.547 540 based on the value thereof, and that transfers, as Currency is an excluded commodity under the This commenter stated that NDFs are between the parties to the transaction, in whole or CEA. See section 1a(19)(i) of the CEA, 7 U.S.C. in part, the financial risk associated with a future 1a(19)(i). In accordance with the interpretation widely used by U.S. corporations that change in any such value or level without also regarding nonfinancial commodities, which as do business in emerging markets to conveying a current or future direct or indirect discussed above, see supra part II.B.2(a), are exempt hedge their exposure to the currencies ownership interest in an asset (including any and agricultural commodities that can be physically of those markets, and that regulating enterprise or investment pool) or liability that delivered, currency does not qualify as a incorporates the financial risk so transferred * * * nonfinancial commodity for purposes of the NDFs as swaps would significantly .’’). forward exclusion from the swap definition. increase the cost of hedging those 537 In addition, as was noted in the Proposing 541 See Proposing Release at 29836. exposures.548 Release, at least some market participants view 542 See Fed NDF Overview at 5 (‘‘[E]stimates vary With respect to the Commissions’ NDFs as swaps today, and thus NDFs also may fall but many major market participants estimate as legal conclusion that NDFs are not within clause (A)(iv) of the swap definition as ‘‘an much as 60 to 80 percent of NDF volume is agreement, contract, or transaction that is, or in the generated by speculative interest, noting growing foreign exchange forwards, and thus are future becomes, commonly known to the trade as participation from international hedge funds.’’) and not subject to the Secretary’s a swap.’’ See Proposing Release at 29836. See also 4 (‘‘[D]ealers note that much of the volume in determination, one commenter stated section 1a(47)(A)(iv) of the CEA, 7 U.S.C. Chinese yuan NDFs is generated by speculative that the Commissions’ reading of the 1a(47)(A)(iv). Cf. rule 35.1(b)(1)(i) under the CEA, positioning based on expectations for an alteration 17 CFR 35.1(b)(1)(i) (providing that the definition in China’s current, basically fixed exchange rate.’’) definition of the term ‘‘foreign exchange of ‘‘swap agreement’’ includes a ‘‘forward foreign (italics in original). forward’’ as not including NDFs is ‘‘too exchange agreement,’’ without reference to 543 See id. at 4 (noting that ‘‘[much of the] Korean restrictive.’’ 549 In this regard, this convertibility or delivery). won NDF volume[,] * * * estimated to be the commenter believed that the term 538 In the Notice of Proposed Determination, the largest of any currency, * * * is estimated to ‘‘exchange’’ should be read to include Secretary stated that his authority to issue a originate with international investment portfolio determination ‘‘is limited to foreign exchange managers hedging the currency risk associated with ‘‘the economic exchange that occurs in swaps and forwards and does not extend to other their onshore investments’’). net settlement rather than being foreign exchange derivatives’’ and noted that ‘‘NDFs 544 See CDEU Letter; Letter from The Committee narrowly read as the physical ‘exchange’ may not be exempted from the CEA’s definition of on Investment of Employee Benefit Assets, dated of two different currencies.’’ ‘‘swap’’ because they do not satisfy the statutory Jul. 22, 2011 (‘‘CIEBA Letter’’); Letter from Bruce C. definitions of a foreign exchange swap or forward.’’ Bennett, Covington & Burling LLP, dated Jul. 22, One commenter, in contrast, agreed See Notice of Proposed Determination. 2011 (‘‘Covington Letter’’); and Letter from Karrie with the Commissions’ interpretation 539 Likewise, the Commissions have determined McMillan and Cecelia Calaby, the Investment that NDFs are not encompassed within that a foreign exchange transaction, which initially Company Institute/American Bar Association the definition of the term ‘‘foreign is styled as or intended to be a ‘‘foreign exchange Securities Association, dated Jul. 22, 2011 (‘‘ICI/ forward,’’ and which is modified so that the parties ABASA Letter’’). 546 settle in a reference currency (rather than settle 545 See Covington Letter and ICI/ABASA Letter. See Covington Letter and ICI/ABASA Letter. through the exchange of the 2 specified currencies), CLS Bank operates the largest multi-currency cash 547 See Covington Letter. does not conform with the definition of ‘‘foreign settlement system to eliminate settlement risk in the 548 See supra note 520. exchange forward’’ in the CEA. See infra note 626. foreign exchange market. 549 See ICI/ABASA Letter.

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exchange forward.’’ 550 This commenter thereof) [that meet certain reduce borrowing costs, to hedge requested, though, that the CFTC requirements]’’. If the phrase ‘‘exchange currency exposure, and to create exempt NDFs from the swap definition, of 2 different currencies’’ had been synthetic assets 558 and are viewed as an using its exemptive authority under intended to include economic important tool, given that they can be section 4(c) of the CEA.551 exchanges of value, as suggested by this used to hedge currency and interest rate While commenters raised a number of commenter, that phrase would have risk in a single transaction. objections to the Commissions’ proposal included language similar to ‘‘based on Currency swaps and cross-currency to define NDFs as swaps, these the value thereof’’ to indicate that other swaps are not foreign exchange swaps as objections primarily raise policy mechanisms of transferring value may defined in the CEA because, although arguments. No commenter has provided occur in these particular types of they may involve an exchange of foreign a persuasive, alternative interpretation transactions. Instead, as noted above, currencies, they also require contingent of the statute’s plain language in the Congress limited the scope of each of or variable payments in different definition of the term ‘‘foreign exchange these particular transactions by using currencies. Because the CEA defines a forward’’ to overcome the Commissions’ the words ‘‘solely involves the exchange foreign exchange swap as a swap that conclusion that, under the CEA, NDFs of 2 different currencies’’. The ‘‘solely’’ involves an initial exchange of are swaps, not foreign exchange Commissions conclude that the use of currencies and a reversal thereof at a forwards. the word ‘‘solely’’ provides further later date, subject to certain parameters, One commenter believed that the support for the Commissions’ currency swaps and cross-currency Commissions’ interpretation of interpretation that exchange means an swaps would not be foreign exchange ‘‘exchange of 2 different currencies’’ as actual interchange of the 2 different swaps. Similarly, currency swaps and used in the foreign exchange forward currencies involved in the cross-currency swaps are not foreign definition is too restrictive, and that the transaction.555 exchange forwards because foreign phrase should be read broadly to mean exchange forwards ‘‘solely’’ involve an (iii) Currency Swaps and Cross- initial exchange of currencies, subject to an economic exchange of value in Currency Swaps addition to physical exchange; the certain parameters, while currency 556 Commissions believe that this A currency swap and a cross- swaps and cross-currency swaps contain 557 contention is misplaced.552 This currency swap each generally can be additional elements, as discussed above. commenter essentially asks the described as a swap in which the fixed Currency swaps are expressly Commissions to interpret the statutory legs or floating legs based on various enumerated in the statutory definition 559 language to mean an exchange of foreign interest rates are exchanged in different of the term ‘‘swap.’’ Cross-currency 560 currencies themselves, as well as an currencies. Such swaps can be used to swaps, however, are not. exchange based on the value of such Accordingly, based on the foregoing 555 currencies. However, only the word This commenter’s request that the CFTC considerations, the Commissions are exempt NDFs from the swap definition using its adopting rules explicitly defining the ‘‘exchange’’ appears in the relevant exemptive authority under section 4(c) of the CEA, definitions, reinforcing the conclusion 7 U.S.C. 6(c), and that the SEC exercise its term ‘‘swap’’ to include cross-currency 561 that Congress intended the definition of exemptive authority under section 36 of the swaps. The rules also state that Exchange Act, 78 U.S.C. 78mm, with respect to ‘‘foreign exchange forward’’ to be neither currency swaps nor cross- NDFs, is beyond the scope of this rulemaking. currency swaps are foreign exchange distinct from other types of transactions 556 A swap that exchanges a fixed rate against a covered by the definition of ‘‘swap’’ in fixed rate is known as a currency swap. See Federal forwards or foreign exchange swaps as the CEA. Moreover, the language of each Reserve System, ‘‘Trading and Capital-Markets those terms are defined in the CEA. The Activities Manual,’’ section 4335.1 (Jan. 2009). Commissions did not receive any definition emphasizes that these 557 Cross-currency swaps with a fixed leg based transactions may ‘‘solely’’ involve an comments either on the rule further on one rate and a floating leg based on another rate, defining the term ‘‘swap’’ to include exchange. The ordinary meaning of the where the two rates are denominated in different cross-currency swaps or the rule verb ‘‘exchange’’ is to ‘‘barter’’ 553 or currencies, are generally referred to as cross- currency coupon swaps, while those with a floating clarifying that cross-currency swaps and ‘‘part with, give or transfer for an leg based on one rate and another floating leg based currency swaps are not subject to the equivalent,’’ 554 i.e., each party is both on a different rate are known as cross-currency Secretary’s determination to exempt giving to and receiving from the other basis swaps. Id. Cross-currency swaps also include foreign exchange swaps and foreign party. This does not occur under an annuity swaps and amortizing swaps. In cross- currency annuity swaps, level cash flows in exchange forwards. NDF, in which only a single party different currencies are exchanged with no makes a payment. exchange of principal; annuity swaps are priced (c) Interpretation Regarding Foreign Elsewhere in the CEA, Congress used such that the level payment cash flows in each Exchange Spot Transactions explicit language that potentially could currency have the same net present value at the inception of the transaction. An amortizing cross- The CEA generally does not confer provide support for a broader currency swap is structured with a declining regulatory jurisdiction on the CFTC interpretation of the type advocated by principal schedule, usually designed to match that with respect to spot transactions.562 In this commenter, but such language is of an amortizing asset or liability. Id. See also Derivatives ONE, ‘‘Cross Currency Swap absent from the definition of the term 558 Valuation’’ (‘‘A cross currency swap is swap of an BMO Capital Markets, ‘‘Cross Currency ‘‘foreign exchange forward.’’ For interest rate in one currency for an interest rate Swaps,’’ available at http://www.bmocm.com/ example, section 2(a)(1)(C)(ii) confers payment in another currency * * * This could be products/marketrisk/intrderiv/cross/default.aspx. exclusive jurisdiction on the CFTC over considered an interest rate swap with a currency 559 See section 1a(47)(A)(iii)(VII) of the CEA, 7 U.S.C. 1a(47)(A)(iii)(VII). ‘‘contracts of sale for future delivery of component.’’), available at http:// www.derivativesone.com/cross-currency-swap- 560 Clause (A)(iii) of the swap definition expressly a group or index of securities (or any valuation/; Financial Accounting Standards Board, refers to a cross-currency rate swap. See section interest therein or based upon the value ‘‘Examples Illustrating Application of FASB 1a(47)(A)(iii)(V) of the CEA, 7 U.S.C. Statement No. 138,’’ Accounting for Certain 1a(47)(A)(iii)(V). Although the swap industry appears to use the term ‘‘cross-currency swap,’’ 550 Derivative Instruments and Certain Hedging See CIEBA Letter. rather than ‘‘cross-currency rate swap’’ (the term 551 Activities, section 2, Example 1, at 3 (‘‘The 7 U.S.C. 6(c). company designates the cross-currency swap as a used in section 1a(47)(A)(iii)(V) of the CEA), the 552 See ICI/ABASA Letter. fair value hedge of the changes in the fair value of Commissions interpret these terms as synonymous. 553 See Webster’s New World Dictionary (3d the loan due to both interest and exchange rates.’’), 561 See rule 1.3(xxx)(2)(i)(A) under the CEA and College Ed. 1988). available at http://www.fasb.org/derivatives/ rule 3a69–2(b)(1)(i) under the Exchange Act. 554 See Black’s Law Dictionary. examples.pdf. 562 But see supra note 227.

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the context of foreign currency, spot Accordingly, the Commissions are of the CEA.568 While it is possible to transactions typically settle within two providing an interpretation that a bona view the fact that the buyer of a business days after the trade date fide foreign exchange spot transaction, currency in such a transaction does not (‘‘T+2’’).563 The accepted market i.e., a foreign exchange transaction that pay for the currency until it is delivered practice of a two-day settlement for spot is settled on the customary timeline of as leverage (in that the buyer puts foreign currency transactions has been the relevant spot market, is not within nothing down until taking delivery, thus recognized by the CFTC 564 and the the definition of the term ‘‘swap.’’ In achieving 100% leverage) or a financing courts.565 general, a foreign exchange transaction arrangement, the CFTC does not interpret it as such for purposes of CEA The Commissions recognize that the will be considered a bona fide spot section 2(c)(2)(C).569 Congress new foreign exchange forward transaction if it settles via an actual recognized that settlement of bona fide definition in the CEA, which was added delivery of the relevant currencies spot foreign exchange transactions by the Dodd-Frank Act and which within two business days. In certain circumstances, however, a foreign typically takes two days.570 The fact that applies to an exchange of two different Congress expressly excluded these types currencies ‘‘on a specific future date,’’ exchange transaction with a longer settlement period concluding with the of bona fide spot foreign exchange could be read to apply to any foreign transactions does not mean that exchange transaction that does not settle actual delivery of the relevant currencies may be considered a bona Congress intended to subject Security on the same day. Such a reading could Conversion Transactions to regulation render most foreign exchange spot fide spot transaction depending on the customary timeline of the relevant under the retail foreign exchange transactions foreign exchange forwards 571 market.566 In particular, as discussed regime. For the foregoing reasons, the under the CEA; as a result, such CFTC will interpret a Securities transactions would be subject to the below, the Commissions will consider a foreign exchange transaction that is Conversion Transaction as not CEA reporting and business conduct leveraged, margined or financed within standards requirements applicable to entered into solely to effect the purchase or sale of a foreign security to be a bona the meaning of section 2(c)(2)(C) of the foreign exchange forwards even if the CEA.572 Secretary determines to exempt foreign fide spot transaction where certain exchange forwards from the definition conditions are met. Comments of ‘‘swap.’’ The Commissions do not The CFTC will consider the following One commenter requested believe that Congress intended, solely to be a bona fide spot foreign exchange clarification regarding the status of with respect to foreign exchange transaction: An agreement, contract or foreign exchange spot transactions.573 transactions, to extend the reach of the transaction for the purchase or sale of an This commenter recommended that the CEA to transactions that historically amount of foreign currency equal to the Commissions clarify that foreign have been considered spot transactions. price of a foreign security with respect exchange spot transactions, which this At the same time, however, the to which (i) the security and related commenter defined as ‘‘transactions of Commissions do not want to enable foreign currency transactions are market participants simply to label as executed contemporaneously in order to 568 7 U.S.C. 2(c)(2)(C). Similarly, a Securities ‘‘spot’’ foreign exchange transactions effect delivery by the relevant securities Conversion Transaction is not an option, option on a futures contract or futures contract and thus that regularly settle after the relevant settlement deadline and (ii) actual would not be subject to CEA section 2(c)(2)(B), 7 foreign exchange spot market settlement delivery of the foreign security and U.S.C. 2(c)(2)(B). Of course, optionality as to deadline, or with respect to which the foreign currency occurs by such settlement would render the transaction an option deadline (such transaction, a ‘‘Securities and is inconsistent with a ‘‘spot’’ characterization. parties intentionally delay settlement, 569 567 Cf. 12 CFR 220.8(b)(1) under Regulation T (12 both of which would be properly Conversion Transaction’’). For CFR Part 220) (generally permits a customer to categorized as foreign exchange Securities Conversion Transactions, the purchase a security (including a foreign security) in forwards, or CEA section 2(c)(2) CFTC will consider the relevant foreign a cash account, rather than a margin account, even transactions (discussed separately exchange spot market settlement if the customer has no collateral in the account, if payment for the security is made within the below), in order to avoid applicable deadline to be the same as the securities appropriate payment period). Similarly, if a foreign foreign exchange regulatory settlement deadline. As noted above, exchange buyer in a Securities Conversion requirements. while the CFTC will look at the relevant Transaction posts no margin or collateral on the trade date, the CFTC does not consider that facts and circumstances, it does not transaction to be ‘‘margined’’ within the meaning of 563 Bank for International Settlements, Triennial expect that an unintentional settlement 7 U.S.C. 2(c)(2)(C)(i)(I)(bb). Central Bank Survey, Report on Global Foreign failure or delay for operational reasons 570 See section 2(c)(2)(C)(i)(II) of the CEA, 7 U.S.C. Exchange Market Activity in 2010 at 32 (Dec. 2010) or due to a market disruption will 2(c)(2)(C) (‘‘[s]ubclause (I) of this clause shall not (defining a foreign exchange spot transaction to undermine the character of a bona fide apply to * * * a contract of sale that * * * results provide for cash settlement within 2 business days); in delivery within 2 days’’). Sam Y. Cross, Federal Reserve Bank of New York, spot foreign exchange transaction as 571 The CFTC notes, for example, that Congress ‘‘All About * * *. The Foreign Exchange Market in such. recognized that settlement in various spot markets the United States’’ at 31–32 (1998). in commodities other than foreign exchange can be 564 See CFTC Division of Trading and Markets, The CFTC also will interpret a longer than two days. See CEA section Report on Exchange of Futures for Physicals at 124– Securities Conversion Transaction as 2(c)(2)(D)(ii)(III)(aa) (disapplying the DCM-trading 127 (1987) (noting that foreign currency spot not leveraged, margined or financed requirement for certain commodity transactions transactions settle in 2 days). within the meaning of section 2(c)(2)(C) with non-ECPs when the contract ‘‘results in actual 565 See CFTC v. Frankwell Bullion, Ltd., 99 F.3d delivery within 28 days or such other longer period 299, 300 (9th Cir. 1996) (‘‘Spot transactions in as the [CFTC] may determine by rule or regulation foreign currencies call for settlement within two 566 In this regard, while the Commissions will based on the typical commercial practice in cash or days.’’); CFTC v. Int’l Fin. Servs. (NewYork), Inc., look at the relevant facts and circumstances, they spot markets for the commodity involved’’). 323 F. Supp. 2d 482, 495 (S.D.N.Y. 2004) (noting will not expect that an unintentional settlement 572 This interpretation is not intended to address, that spot transactions ordinarily call for settlement failure or delay for operational reasons or due to a and has no bearing on, the CFTC’s interpretation of within two days); Bank Brussels Lambert, S.A. v. market disruption will undermine the character of the term ‘‘actual delivery’’ as set forth in section Intermetals Corp., 779 F.Supp. 741, 742 (S.D.N.Y. a bona fide spot foreign exchange transaction as 2(c)(2)(D)(ii)(III)(aa), 7 CFR 2(c)(2)(D)(ii)(III)(aa). See 1991) (same). But the Commissions understand that such. Retail Commodity Transactions under the the settlement cycle for spot transactions 567 The interpretation herein with respect to Commodity Exchange Act, 76 FR 77670, Dec. 14, exchanging Canadian dollars for U.S. dollars (or Security Conversion Transactions is limited to such 2011. vice versa) is T+1. See Cross, supra 563, at 31. transactions. 573 See SIFMA Letter.

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one currency into another that settle transactions described in sections Release stated that the proposal was not within a customary settlement cycle,’’ 2(c)(2)(C) and (D) of the CEA, but not intended to address, and had no bearing are neither foreign exchange forwards those in section 2(c)(2)(B) of the CEA.577 on, the CFTC’s jurisdiction over foreign nor swaps.574 Another commenter Section 2(c)(2)(B) of the CEA applies to currency options in other contexts, indicated that the customary settlement futures, options on futures and options specifically citing section 2(c)(2)(B) of cycle for purchases of most non-U.S. on foreign currency (other than foreign the CEA.581 Nonetheless, the CFTC denominated securities is ‘‘T+3’’ (in currency options executed or traded on acknowledges the ambiguity in the some securities markets, such as South a national securities exchange), and statute regarding the status of off- Africa, the settlement cycle can take up permits such transactions to be entered exchange foreign currency options with to seven days), and requires the buyer into with counterparties who are not non-ECPs that are subject to section to pay for the foreign securities in the ECPs 578 on an off-exchange basis by 2(c)(2)(B) of the CEA. While foreign relevant foreign currency.575 Typically, certain enumerated regulated entities.579 currency options are swaps, they also according to this commenter, a broker- No issue arises with respect to futures are subject to section 2(c)(2)(B) of the dealer or bank custodian acting on or options on futures in foreign currency CEA when entered into off-exchange behalf of the buyer or seller will enter that are covered by section 2(c)(2)(B) of with non-ECPs, and there is no statutory into a foreign currency transaction to the CEA, because they are expressly exclusion from the swap definition for settle on a T+3 basis (or the relevant excluded from the statutory swap section 2(c)(2)(B) transactions. If foreign settlement period) as well. Timing the definition.580 Commodity options, currency options were deemed to be foreign exchange transaction to settle at including options on foreign currency, swaps, then, pursuant to section 2(e) of the same time as the securities however, are not excluded from the the CEA, as added by the Dodd-Frank transaction benefits the customer by swap definition (other than foreign Act,582 they could not be entered into by reducing his or her exposure to currency currency options executed or traded on non-ECP counterparties, except on a risk on the securities transaction a national securities exchange). DCM. This would render the provisions between trade date and settlement date. The CFTC notes that, in further of section 2(c)(2)(B) of the CEA, The Commissions have provided the defining the term ‘‘swap’’ to include permitting off-exchange foreign interpretation described above regarding foreign currency options, the Proposing currency options with non-ECPs by the interplay between the foreign enumerated regulated entities, a nullity. exchange forward definition, the 577 See section 1a(47)(B)(i) of the CEA, 7 U.S.C. The CFTC believes that Congress did meaning of ‘‘leveraged, margined or 1a(47)(B)(i). Sections 2(c)(2)(B), (C), and (D) of the not intend the swap definition to financed’’ under section 2(c)(2)(C) of the CEA, 7 U.S.C. 2(c)(2)(B), (C), and (D), govern certain overrule and effectively repeal another CEA, and bona fide foreign exchange types of off-exchange transactions in commodities, including foreign currency, in which one of the provision of the CEA in such an oblique spot transactions to address these parties to the transaction is not an ECP. fashion.583 Nor is there anything in the commenters’ concerns. 578 ECPs are defined in section 1a(18) of the CEA, 7 U.S.C. 1a(18). legislative history of the Dodd-Frank (d) Retail Foreign Currency Options 579 Section 2(c)(2)(B)(i) of the CEA provides: (i) Act to suggest a congressional intent to The CFTC is providing an This Act applies to, and the Commission shall have prohibit only one type of off-exchange interpretation regarding the status of jurisdiction over, an agreement, contract, or foreign currency transaction with non- transaction in foreign currency that—(I) is a ECPs (out of the three types of off- retail foreign currency options that are contract of sale of a commodity for future delivery described in section 2(c)(2)(B) of the (or an option on such a contract) or an option (other exchange foreign currency transactions CEA.576 As noted above, the than an option executed or traded on a national with non-ECPs that are addressed in Commissions proposed to include securities exchange registered pursuant to section CEA section 2(c)(2)(B)). The omission of 6(a) of the Securities Exchange Act of 1934, 15 section 2(c)(2)(B) of the CEA from the foreign currency options generally U.S.C. 78f(a)); and (II) is offered to, or entered into within the definition of the term with, a person that is not an eligible contract exclusions set forth in the statutory ‘‘swap,’’ subject to the statutory participant, unless the counterparty, or the person swap definition appears to be a exclusions in subparagraph (B) of the offering to be the counterparty, of the person is scrivener’s error.584 Accordingly, the [certain regulated counterparties enumerated in the CFTC is applying the exclusion from the definition. The statutory exclusions statute.] 7 U.S.C. 2(c)(2)(B)(i). Thus, under section from the swap definition encompass 2(c)(2)(B)(i) of the CEA, the CEA’s exchange-trading swap definition to foreign currency requirement generally applies with respect to options described in CEA section 574 Id. In this commenter’s view, such futures, options on futures, and options on foreign 2(c)(2)(B). clarification is necessary to avoid the statutory currency. See section 4(a) of the CEA, 7 U.S.C. 6(a) foreign exchange forward definition ‘‘unwittingly (generally requiring futures contracts to be traded 581 See Proposing Release at 29835 n.125. captur[ing] many typical foreign exchange spot on or subject to the rules of a DCM); section 4c(b) 582 transactions * * * settl[ing] within a customary of the CEA, 7 U.S.C. 6c(b) (prohibiting trading 7 U.S.C. 2(e). settlement cycle,’’ which this commenter stated is options subject to the CEA contrary to CFTC rules, 583 The CFTC notes in this regard that repeals by generally ‘‘T+2’’ in the United States, but can be regulations or orders permitting such trading); Part implication are strongly disfavored by the courts. ‘‘T+3’’ in some other countries. 32 of the CFTC’s rules, 17 CFR Part 32 (generally See, e.g., Village of Barrington, Ill. v. Surface 575 See Letter from Phoebe A. Papageorgiou, prohibiting entering into options subject to the CEA Transp. Bd., 636 F.3d 650, 662 (D.C. Cir. 2011) Senior Counsel, American Bankers Ass’n and James (other than options on futures) other than on or (‘‘Repeals by implication, however, are strongly Kemp, Managing Director, Global Foreign Exchange subject to the rules of a DCM); and CFTC Rule disfavored ‘absent a clearly expressed congressional Division, dated April 18, 2012 (‘‘ABA/Global FX 33.3(a), 17 CFR 33.3(a) (prohibiting entering into intention’ ’’) (quoting Branch v. Smith, 538 U.S. Letter’’). This commenter requested clarification options on futures other than on or subject to the 254, 273, 123 S.Ct. 1429 (2003)); Agri Processor Co., that the purchase, sale or exchange of a foreign rules of a DCM). However, if the counterparty to the Inc. v. N.L.R.B., 514 F.3d 1, 4 (D.C. Cir. 2008) currency by a bank on behalf of a retail customer non-ECP is an enumerated regulated entity (‘‘[a]mendments by implication, like repeals by for the sole purpose of effecting a purchase or sale identified in section 2(c)(2)(B)(i)(II) of the CEA, 7 implication, are not favored’’ and ‘‘will not be of a foreign security or in order to clear or settle U.S.C. 2(c)(2)(B)(i)(II), the CEA’s exchange-trading found unless an intent to repeal [or amend] is ‘clear such purchase or sale, when the settlement period requirement does not apply. Accordingly, an and manifest.’ ’’) (quoting United States v. Welden, for such FX transaction is within the settlement enumerated regulated entity—including a banking 377 U.S. 95, 102 n. 12, 84 S.Ct. 1082 (1964) and cycle for such foreign security, is excluded from the institution regulated by the OCC—can, pursuant to Rodriguez v. United States, 480 U.S. 522, 524, 107 retail foreign exchange under the CEA. The CFTC section 2(c)(2)(B) of the CEA, lawfully enter into a S.Ct. 1391 (1987)). has provided the clarification regarding the future, an option on a future, or an option on 584 See, e.g., Singer and Singer, Sutherland meaning of ‘‘leveraged, margined or financed’’ foreign currency with a non-ECP counterparty on an Statutes and Statutory Construction § 47:38 (7th ed. under section 2(c)(2)(C) of the CEA to address this off-exchange basis. 2011) (‘‘Words may be supplied in a statute * * * commenter’s concern. 580 See section 1a(47)(B)(i) of the CEA, 7 U.S.C. where omission is due to inadvertence, mistake, 576 7 U.S.C. 2(c)(2)(B). 1a(47)(B)(i). accident, or clerical error’’).

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3. Forward Rate Agreements Notwithstanding their ‘‘forward’’ Release.592 The Commissions received The Commissions are adopting rules label, FRAs do not fall within the no comments on the interpretation as proposed to explicitly define the term forward contract exclusion from the provided in the Proposing Release ‘‘swap’’ to include forward rate swap definition. FRAs do not involve regarding combinations and agreements (‘‘FRAs’’).585 The nonfinancial commodities and thus are permutations of, or options on, swaps outside the scope of the forward Commissions did not receive any and security-based swaps and are contract exclusion. Nor is an FRA a comments on the proposed rules restating their interpretation of clause commercial merchandising transaction, regarding the inclusion of FRAs in the (A)(vi) of the swap definition with one as there is no physical product to be swap definition. technical correction and one delivered in an FRA.589 Accordingly, In general, an FRA is an over-the- clarification. the Commissions believe that the Clause (A)(vi) means, for example, counter contract for a single cash forward contract exclusion from the that an option on a swap or security- payment, due on the settlement date of swap definition for nonfinancial based swap (commonly known as a a trade, based on a spot rate (determined commodities does not apply to FRAs.590 ‘‘swaption’’) would itself be a swap or pursuant to a method agreed upon by Based on the foregoing security-based swap, respectively. The the parties) and a pre-specified forward considerations, the Commissions are Commissions also interpret clause rate. The single cash payment is equal adopting rules to provide greater clarity (A)(vi) to mean that a ‘‘forward swap’’ to the product of the present value by explicitly defining the term ‘‘swap’’ would itself be a swap or security-based (discounted from a specified future date to include FRAs. As with the foreign swap, respectively.593 By listing to the settlement date of the trade) of the exchange-related products discussed examples here, the Commissions do not difference between the forward rate and above, the final rules provide that FRAs intend to limit the broad language of the spot rate on the settlement date are not swaps if they fall within one of clause (A)(vi) of the swap definition, multiplied by the notional amount. The the exclusions set forth in subparagraph which is designed to capture those notional amount itself is not (B) of the swap definition. agreements, contracts and transactions exchanged.586 that are not expressly enumerated in the An FRA provides for the future 4. Combinations and Permutations of, or CEA swap definition but that (executory) payment based on the Options on, Swaps and Security-Based nevertheless are swaps.594 transfer of interest rate risk between the Swaps parties as opposed to transferring an Clause (A)(vi) of the swap definition 5. Contracts for Differences ownership interest in any asset or provides that ‘‘any combination or As the Proposing Release notes, the 587 liability. Thus, the Commissions permutation of, or option on, any Commissions have received inquiries believe that an FRA satisfies clause agreement, contract, or transaction over the years regarding the treatment of 588 (A)(iii) of the swap definition. described in any of clauses (i) through CFDs under the CEA and the Federal (v)’’ of the definition is a swap.591 The securities laws.595 A CFD generally is an 585 See rules 1.3(xxx)(2)(i)(E) under the CEA and Commissions provided an interpretation agreement to exchange the difference in rule 3a69–2(b)(1)(v) under the Exchange Act. regarding clause (A)(vi) in the Proposing 586 See generally ‘‘Trading and Capital-Markets value of an underlying asset between Activities Manual,’’ supra note 556, section 4315.1 the time at which a CFD position is (‘‘For example, in a six-against-nine-month (6x9) CEA, 17 CFR 35.1(b)(1)(i); Exemption for Certain established and the time at which it is FRA, the parties agree to a three-month rate that is Swap Agreements, 58 FR 5587 (Jan. 22, 1993). The terminated.596 If the value increases, the to be netted in six months’ time against the CFTC recently repealed that rule and amended Part prevailing three-month reference rate, typically 35 of its rules in light of the enactment of Title VII LIBOR. At settlement (after six months), the present of the Dodd-Frank Act. See Agricultural Swaps, 76 592 See Proposing Release at 29838. value of the net interest rate (the difference between FR 49291 (Aug. 10, 2011). 593 Forward swaps are also commonly known as the spot and the contracted rate) is multiplied by 589 See Regulation of Hybrid and Related forward start swaps, or deferred or delayed start the notional principal amount to determine the Instruments, 52 FR 47022, 47028 (Dec. 11, 1987) swaps. A forward swap can involve two offsetting amount of the cash exchanged between the parties (stating ‘‘[FRAs] do not possess all of the swaps that both start immediately, but one of which ***. If the spot rate is higher than the contracted characteristics of forward contracts heretofore ends on the deferred start date of the forward swap rate, the seller agrees to pay the buyer the delineated by the [CFTC]’’). itself. For example, if a counterparty wants to hedge differences between the prespecified forward rate 590 The Commissions note that Current European its risk for four years, starting one year from today, and the spot rate prevailing at maturity, multiplied Union law includes FRAs in the definition of it could enter into a one-year swap and a five-year by a notional principal amount. If the spot rate is ‘‘financial instruments.’’ See Markets in Financial swap, which would partially offset to create a four- lower than the forward rate, the buyer pays the Instruments Directive (MiFID), ‘‘Directive 2004/39/ year swap, starting one year forward. A forward seller.’’). EC of the European Parliament and of the Council,’’ swap also can involve a contract to enter into a 587 It appears that at least some in the trade view Annex I(C), 4, 5, 10 (Apr. 21, 2004), available at swap or security-based swap at a future date or with FRAs as swaps today. See, e.g., The Globecon http://eur-lex.europa.eu/LexUriServ/LexUri a deferred start date. A forward swap is not a Group, Ltd., ‘‘Derivatives Engineering: A Guide to Serv.do?uri=CONSLEG:2004L0039: nonfinancial commodity forward contract or Structuring, Pricing and Marketing Derivatives,’’ 45 20070921:EN:PDF. European Commission security forward, both of which are excluded from (McGraw-Hill 1995) (‘‘An FRA is simply a one- legislation on derivatives, central clearing, and the swap definition and discussed elsewhere in this period interest-rate swap.’’); DerivActiv, Glossary of trade repositories applies to FRAs that are traded release. Financial Derivatives Terms (‘‘A swap is * * * a over-the-counter and, thus, would subject such 594 This category could include categories of strip of FRAs.’’), available at http://www.derivactiv. transactions to mandatory clearing, reporting and agreements, contracts or transactions that do not yet com/definitions.aspx?search=forward+rate+ other regulatory requirements. See Regulation of the exist as well as more esoteric swaps that exist but agreements. Cf. Don M. Chance, et al., ‘‘Derivatives European Parliament and of the Council on OTC that Congress did not refer to by name in the in Portfolio Management,’’ 29 (AIMR 1998) (‘‘[An derivatives, central counterparties and trade statutory swap definition. FRA] involves one specific payment and is basically repositories, tit. I, art. 2 (1(3b)), 7509/1/12 REV 1 595 See Proposing Release at 29838. a one-date swap (in the sense that a swap is a (Mar. 19, 2012). 596 See Ontario Securities Commission, Staff combination of FRAs[,] with some variations).’’). 591 See section 1a(47)(vi) of the CEA, 7 U.S.C. Notice 91–702, ‘‘Offerings of Contracts for Thus, FRAs also may fall within clause (A)(iv) of 1a(47)(vi). Clause (A)(vi) of the swap definition Difference and Foreign Exchange Contracts to the swap definition, as ‘‘an agreement, contract, or refers specifically to other types of swaps in the Investors in Ontario,’’ at part IV.1 (defining a CFD transaction that is, or in the future becomes, swap definition. However, because section 3(a)(68) as ‘‘a derivative product that allows an investor to commonly known to the trade as a swap.’’ See of the Exchange Act defines a security-based swap obtain economic exposure (for speculative, section 1a(47)(a)(iv) of the CEA, 7 U.S.C. as a swap [with some connection to a security], investment or hedging purposes) to an underlying 1a(47)(a)(iv). clause (A)(vi) of the swap definition is relevant to asset * * * such as a share, index, market sector, 588 See section 1a(47)(A)(iii) of the CEA, 7 U.S.C. determining whether any combination or currency or commodity, without acquiring 1a(47)(A)(iii). CFTC regulations have defined FRAs permutation of, or option on, a security-based swap ownership of the underlying asset’’), available at as swap agreements. See rule 35.1(b)(1)(i) under the is a security-based swap. Continued

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seller pays the buyer the difference; if CFDs.599 These commenters requested swaps and security-based swaps,604 but the value decreases, the buyer pays the that the Commissions determine that it may be a relevant factor.605 The key seller the difference. CFDs can be traded NDFs involving foreign exchange are question is whether the agreement, on a number of products, including not swaps. Given that the Commissions contract, or transaction falls within the treasuries, foreign exchange rates, are defining NDFs as swaps and that statutory definitions of the term ‘‘swap’’ commodities, equities, and stock CFDs involving foreign currency also or ‘‘security-based swap’’ (as further indexes. Equity CFDs closely mimic the would be swaps, there is no need to defined and interpreted pursuant to the purchase of actual shares. The buyer of distinguish NDFs involving foreign final rules and interpretations herein) an equity CFD receives cash dividends exchange from CFDs involving foreign based on its terms and other and participates in stock splits.597 In the exchange. characteristics. Even if one effect of an case of a long position, a dividend agreement is to reduce the risk faced by adjustment is credited to the client’s D. Certain Interpretive Issues the parties (for example, the ‘‘swap’’ of account. In the case of a short position, 1. Agreements, Contracts, or physical delivery obligations described a dividend adjustment is debited from Transactions That May Be Called, or above may reduce the risk of non- the client’s account. CFDs generally are Documented Using Form Contracts delivery), the agreement would not be a traded over-the-counter (though they Typically Used for, Swaps or Security- swap or security-based swap unless it also are traded on the Australian Based Swaps otherwise meets one of those statutory Securities Exchange) in a number of definitions, as further defined by the countries outside the United States. The Commissions are restating the Commissions. If the agreement, contract, The Commissions provided an interpretation provided in the Proposing or transaction satisfies the swap or interpretation in the Proposing Release Release regarding agreements, contracts, security-based swap definitions, the fact regarding the treatment of CFDs. The or transactions that may be called, or that the parties refer to it by another Commissions are restating the documented using form contracts name would not take it outside the interpretation set out in the Proposing typically used for, swaps or security- Dodd-Frank Act regulatory regime. Release without modification. based swaps with one modification in Conversely, if an agreement, contract, or CFDs, unless otherwise excluded, fall response to a commenter.600 transaction is not a swap or security- within the scope of the swap or As was noted in the Proposing based swap, as those terms are defined security-based swap definition, as Release,601 individuals and companies in the CEA and the Exchange Act and applicable.598 Whether a CFD is a swap may generally use the term ‘‘swap’’ to the rules and regulations thereunder, or security-based swap will depend on refer to certain of their agreements, the fact that the parties refer to it, or the underlying product of that particular contracts, or transactions. For example, document it, as a swap or security-based CFD transaction. Because CFDs are they may use the term ‘‘swap’’ to refer swap will not subject that agreement, highly variable and a CFD can contain to an agreement to exchange real or contract, or transaction to regulation as a variety of elements that would affect personal property between the parties or a swap or a security-based swap. its characterization, the Commissions to refer to an agreement for two believe that market participants will companies that produce fungible 604 As noted in the Proposing Release, the CFTC need to analyze the features of the consistently has found that the form of a transaction products and with delivery obligations is not dispositive in determining its nature, citing underlying product of any particular in different locations to perform each Grain Land, supra note 213, at *16 (CFTC Nov. 25, CFD in order to determine whether it is other’s delivery obligations instead of 2003) (holding that contract substance is entitled to a swap or a security-based swap. The their own.602 However, the name or at least as much weight as form); In the Matter of Commissions are not adopting rules or First Nat’l Monetary Corp., [1984–1986 Transfer label that the parties use to refer to a Binder] Comm. Fut. L. Rep. (CCH) ¶ 22,698 at additional interpretations at this time particular agreement, contract, or 30,974 (CFTC Aug. 7, 1985) (‘‘When instruments regarding CFDs. transaction is not determinative of have been determined to constitute the functional equivalent of futures contracts neither we nor the Comments whether it is a swap or security-based 603 courts have hesitated to look behind whatever self- swap. serving labels the instruments might bear.’’); Two commenters requested that the It is not dispositive that the Stovall, supra note 63 (holding that the CFTC ‘‘will Commissions clarify that non- agreement, contract, or transaction is not hesitate to look behind whatever label the deliverable forward contracts are not parties may give to the instrument’’). As also noted documented using an industry standard in the Proposing Release, the form of a transaction form agreement that is typically used for is not dispositive in determining whether an http://www.osc.gov.on.ca/documents/en/Securities- agreement, contract, or transaction falls within the Category9/sn_20091030_91-702_cdf.pdf (Oct. 30, regulatory regime for securities. See SEC v. Merch. 599 2009); Financial Services Authority, Consultation See Covington Letter and ICI/ABASA Letter. Capital, LLC, 483 F.3d 747, 755 (11th Cir. 2007) Paper 7/20, ‘‘Disclosure of Contracts for 600 See infra note 606. (‘‘The Supreme Court has repeatedly emphasized Difference—Consultation and draft Handbook text,’’ 601 See Proposing Release at 29839. that economic reality is to govern over form and at part 2.2 (defining a CFD on a share as ‘‘a 602 For example, a company obligated to deliver that the definitions of the various types of securities derivative product that gives the holder an its product to a customer in Los Angeles would should not hinge on exact and literal tests.’’) economic exposure, which can be long or short, to instead deliver the product in Albany to a different (quoting Williamson v. Tucker, 645 F.2d 404, 418 the change in price of a specific share over the life company’s customer on behalf of that other (5th Cir. 1981)); Robinson v. Glynn, 349 F.3d 166, of the contract’’), available at http:// company. In return, the company with the 170 (4th Cir. 2003) (‘‘What matters more than the www.fsa.gov.uk/pubs/cp/cp07_20.pdf (Nov. 2007). obligation to deliver a product to its customer in form of an investment scheme is the ‘economic 597 See, e.g., Int’l Swaps and Derivatives Ass’n, Albany would deliver the product instead in Los reality’ that it represents. * * *’’) (internal citation ‘‘2002 ISDA Equity Derivatives Definitions,’’ art. 10 Angeles to the customer of the company obligated omitted); Caiola v. Citibank, N.A., New York, 295 (Dividends) and 11 (Adjustments and Modifications to deliver its product to that customer in Los F.3d 312, 325 (2d Cir. 2002) (quoting United Affecting Indices, Shares and Transactions). Angeles. Housing Foundation v. Foreman, 421 U.S. 837, 848 598 In some cases, depending on the facts and 603 See, e.g., Haekel v. Refco, 2000 WL 1460078, (1975) (‘‘In searching for the meaning and scope of circumstances, the SEC may determine that a at *4 (CFTC Sept. 29, 2000) (‘‘[T]he labels that the word ‘security’ * * * the emphasis should be particular CFD on an equity security, for example, parties apply to their transactions are not on economic reality’’)). See Proposing Release at should be characterized as constituting a purchase necessarily controlling’’); Reves v. Ernst & Young, 29839 n. 152. or sale of the underlying equity security and, 494 U.S. 56, 61 (1990) (stating that the purpose of 605 The Commissions note, though, that therefore, be subject to the requirements of the the securities laws is ‘‘to regulate investments, in documentation is not controlling in evaluating Federal securities laws applicable to such whatever form they are made and by whatever whether an agreement, contract or transaction is a purchases or sales. name they are called’’) (emphasis in original). swap, security-based swap, or neither.

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Comments rulemaking to further define the terms authority to exempt FERC-regulated ‘‘swap’’ and ‘‘security-based swap.’’ 608 transactions and other transactions in The Commissions requested comment The CFTC notes that it has been RTOs or ISOs.618 As discussed above, regarding what agreements, contracts, or engaged in discussions with a number section 722(f) of the Dodd-Frank Act transactions that are not swaps or of RTOs and ISOs regarding the added new section 4(c)(6) to the CEA security-based swaps are documented possibility of a petition seeking an specifically addressing how the CFTC using industry standard form exemption pursuant to CEA section should approach certain instruments agreements that are typically used for 4(c)(6) for certain RTO and ISO and transactions regulated by FERC that swaps and security-based swaps, and transactions. The CFTC also notes that also may be subject to CFTC asked for examples thereof and details the status of some RTO and ISO jurisdiction. The CFTC continues to regarding their documentation, transactions may have been addressed believe, as was stated in the Proposing including why industry standard form in the interpretation above regarding Release, that such an approach is the agreements typically used for swaps and embedded options and the forward more appropriate means of considering security-based swaps are used. One exclusion from the swap definition,609 issues relating to the instruments and commenter stated its view that and/or indirectly through the CFTC’s documentation can be a relevant factor recent interim final rulemaking relating transactions specified in CEA section in determining whether an agreement, to trade options.610 4(c)(6). One commenter’s argument that the CEA section 4(c)(6) exemptive contract or transaction is a swap or Comments security-based swap.606 The approach will cause regulatory Commissions are persuaded by the The CFTC received a number of ambiguity is not a convincing basis on commenter and are modifying the comments discussing transactions in which to forego a process specifically 611 interpretation to clarify that in RTOs and ISOs. These commenters designated by Congress for the issue at 619 determining whether an agreement, argued that the CFTC should further hand. The CFTC also believes that contract or transaction is a swap or define the term ‘‘swap’’ to exclude the ability to tailor exemptive relief, transactions executed or traded on RTOs after notice and public comment, to the security-based swap, documentation 612 may be a relevant (but not dispositive) and ISOs. One commenter argued complex issues presented by that the CEA section 4(c)(6) exemptive factor. transactions on RTOs and ISOs, is approach will leave regulatory further reason to favor such an approach 2. Transactions in Regional ambiguity for market participants, since over the more general directive to Transmission Organizations and the CFTC might not grant an exemption, further define the terms ‘‘swap’’ and Independent System Operators later revoke an existing exemption, ‘‘security-based swap’’ that is the grant a partial or conditional exemption, subject of this rulemaking. The CFTC declines to address the or limit an exemption to existing status of transactions in Regional products.613 This commenter also noted In response to one commenter’s Transmission Organizations (‘‘RTOs’’) that FERC has complete regulatory contentions that FERC has complete and Independent System Operators authority over RTOs and ISOs and their regulatory authority over RTOs and (‘‘ISOs’’), including financial transactions, and that Congress expected ISOs and their transactions, and that transmission rights (‘‘FTRs’’) and the CFTC and FERC to avoid Congress expected the CFTC and FERC ancillary services, within this joint duplicative, unnecessary regulation.614 to avoid duplicative, unnecessary definitional rulemaking. As was noted Another commenter argued that the regulation, the CFTC notes that in the Proposing Release, section 722 of CFTC should exclude RTO and ISO Congress addressed this issue not by the Dodd-Frank Act specifically transactions in the same manner as excluding RTO and ISO transactions addresses certain instruments and insurance has been excluded.615 A third from the comprehensive regime for transactions regulated by FERC that also commenter stated that RTO and ISO swap regulation, but rather by enacting may be subject to CFTC jurisdiction. transactions are commercial the exemptive process in CEA section Section 722(f) added CEA section merchandising transactions and thus 4(c)(6). 4(c)(6),607 which provides that, if the forwards or, alternatively, that defining And in response to another CFTC determines that an exemption for them as swaps is inconsistent with the commenter’s contention that the CFTC FERC-regulated instruments or other text, goals, and purpose of the Dodd- should exclude RTO and ISO 616 specified electricity transactions would Frank Act. transactions in the same manner as By contrast, one commenter asserted be in accordance with the public insurance has been excluded, the CFTC that FTRs are in substance swaps and interest, then the CFTC shall exempt notes that Congress provided neither an should be regulated as such.617 such instruments or transactions from exemptive process equivalent to CEA the requirements of the CEA. Given that Two commenters supported the CFTC’s use of its section 722(f) section 4(c)(6) for insurance, nor an specific statutory directive, the energy market-equivalent to the treatment of these FERC-regulated 620 608 McCarran-Ferguson Act. instruments and transactions should be The Commissions note that this approach should not be taken to suggest any finding by the As noted above, FERC staff opines considered under the standards and Commissions as to whether or not FTRs or any procedures specified in section 722 of other FERC-regulated instruments or transactions that defining RTO and ISO transactions the Dodd-Frank Act for a public interest are swaps (or futures contracts). as swaps would be inconsistent with the waiver, rather than through this joint 609 See supra part II.B.2(a). text, goals, and purpose of the Dodd- 610 See supra note 317. Frank Act. The CFTC can consider 611 See COPE Letter; ETA Letter; and FERC Staff 606 concerns of the sort expressed by FERC See IECA Letter. This commenter noted that Letter. ‘‘[e]ven though swaps are commonly documented staff in connection with any petition for 612 Id. on the ISDA Master Agreements without annexes, 613 a CEA section 4(c)(6) exemption that physical transactions under such agreements with See COPE Letter. power or natural gas annexes are not swaps because 614 Id. they are physically settled forward contracts that 615 See ETA Letter. 618 See NEMA Letter and WGCEF Letter. are exempt under 1a47(B)’’). Id. 616 See FERC Staff Letter. 619 See COPE Letter. 607 7 U.S.C. 6(c)(6). 617 See Better Markets Letter. 620 15 U.S.C. 1011–1015.

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may be submitted to the CFTC.621 instrument itself is not amended, market rates.627 The Commissions find Interested parties on all sides of the modified, or otherwise adjusted during that this interpretation is an appropriate issue would receive an opportunity to its term by the parties, its way to address Title VII instruments comment on the scope and other aspects characterization as a swap or security- based on interest rates, other monetary of any proposed exemptive relief at that based swap will not change during its rates, or yields and is designed to time. duration because of any changes that reduce costs associated with may occur to the factors affecting its determining whether such instruments III. The Relationship Between the Swap character as a swap or security-based are swaps or security-based swaps.628 Definition and the Security-Based Swap swap.626 Definition 1. Title VII Instruments Based on Classifying a Title VII instrument as a A. Introduction Interest Rates or Other Monetary Rates swap or security-based swap is That Are Swaps Title VII of the Dodd-Frank Act straightforward for most instruments. defines the term ‘‘swap’’ under the However, the Commissions provided an The Commissions believe that when CEA,622 and also defines the term interpretation in the Proposing Release payments exchanged under a Title VII ‘‘security-based swap’’ under the to clarify the classification of swaps and instrument are based solely on the Exchange Act.623 Pursuant to the security-based swaps in certain areas levels of certain interest rates or other regulatory framework established in and to provide an interpretation monetary rates that are not themselves Title VII, the CFTC has regulatory regarding the use of certain terms and based on one or more securities, the instrument would be a swap and not a authority over swaps and the SEC has conditions in Title VII instruments. The 629 regulatory authority over security-based Commissions are restating the security-based swap. Often swaps on swaps. The Commissions are further interpretation set out in the Proposing interest rates or other monetary rates defining the terms ‘‘swap’’ and Release with certain modifications to require the parties to make payments ‘‘security-based swap’’ to clarify the interpretation regarding TRS. based on the comparison of a specified whether particular agreements, floating rate (such as the London B. Title VII Instruments Based on contracts, or transactions are swaps or Interbank Offered Rate (‘‘LIBOR’’)) to a Interest Rates, Other Monetary Rates, security-based swaps based on fixed rate of interest agreed upon by the and Yields characteristics including the specific parties. A rate swap also may require payments based on the differences terms and conditions of the instrument Parties frequently use Title VII between two floating rates, or it may and the nature of, among other things, instruments to manage risks related to, require that the parties make such the prices, rates, securities, indexes, or or to speculate on, changes in interest payments when any agreed-upon events commodities upon which the rates, other monetary rates or amounts, with respect to interest rates or other instrument is based. or the return on various types of assets. monetary rates occur (such as when a Because the discussion below is Broadly speaking, Title VII instruments specified interest rate crosses a focused on whether particular based on interest or other monetary threshold, or when the spread between agreements, contracts, or transactions rates would be swaps, whereas Title VII two such rates reaches a certain point). are swaps or security-based swaps, the instruments based on the yield or value The rates referenced for the parties’ Commissions use the term ‘‘Title VII of a single security, loan, or narrow- obligations are varied, and examples of instrument’’ in this release to refer to based security index would be security- any agreement, contract, or transaction such rates include the following: based swaps. However, market Interbank Offered Rates: An average that is included in either the definition participants and financial professionals of the term ‘‘swap’’ or the definition of of rates charged by a group of banks for sometimes use the terms ‘‘rate’’ and lending money to each other or other the term ‘‘security-based swap.’’ Thus, ‘‘yield’’ in different ways. The the term ‘‘Title VII instrument’’ is banks over various periods of time, and Commissions proposed an other similar interbank rates,630 synonymous with ‘‘swap or security- interpretation in the Proposing Release based swap.’’ 624 including, but not limited to, LIBOR regarding whether Title VII instruments (regardless of currency); 631 the Euro The determination of whether a Title that are based on interest rates, other VII instrument is either a swap or a monetary rates, or yields would be 627 These secured lending rates are the Eurepo, security-based swap should be made swaps or security-based swaps and are The Depository Trust & Clearing Corporation’s based on the facts and circumstances restating the interpretation, but with a General Collateral Finance Repo Index, the relating to the Title VII instrument prior modification to the list of examples of Repurchase Overnight Index Average Rate and the to execution, but no later than when the Tokyo Repo Rate. reference rates to include certain 628 See supra part I, under ‘‘Overall Economic parties offer to enter into the Title VII secured lending rates under money 625 Considerations’’. instrument. If the Title VII 629 See infra part III.F, regarding the use of certain of the Securities Act. This analysis also would terms and conditions. 621 CEA section 4(c)(6) requires the CFTC to apply with respect to mixed swaps and security- 630 Interbank lending rates are measured by determine that an exemption pursuant to such based swap agreements. With respect to swaps, the surveys of the loan rates that banks offer other section ‘‘is consistent with the public interest and determination also would need to be made no later banks, or by other mechanisms. The periods of time the purposes of th[e CEA].’’ 7 U.S.C. 6(c)(6). than the time that provisions of the CEA and the for such loans may range from overnight to 12 622 See section 1a(47) of the CEA, 7 U.S.C. 1a(47). regulations thereunder become applicable to a Title months or longer. 623 See section 3(a)(68) of the Exchange Act, 15 VII Instrument. For instance, certain duties apply to The interbank offered rates listed here are U.S.C. 78c(a)(68). swaps prior to execution. See Daily Trading frequently called either a ‘‘reference rate,’’ the rate 624 In some cases, the Title VII instrument may be Records under Rule 23.202 under the CEA, 17 CFR of ‘‘reference banks,’’ or by a designation that is a mixed swap. Mixed swaps are discussed further 23.202, and Subpart H of Part 23 of the CFTC’s specific to the service that quotes the rate. For some in section IV below. regulations, 17 CFR Part 23, Subpart H (Business of the interbank offered rates listed here, there is a 625 The determination must be made no later than Conduct Standards for Swap Dealers and Major similar rate that is stated as an interbank bid rate, when the parties offer to enter into the Title VII Swap Participants Dealing with Counterparties, which is the average rate at which a group of banks instrument because persons are prohibited from Including Special Entities). bid to borrow money from other banks. For offering to sell, offering to buy or purchase, or 626 See infra part III.G.5(a), for a discussion example, the bid rate similar to LIBOR is called selling a security-based swap to any person who is regarding the evaluation of Title VII Instruments on LIBID. not an ECP unless a registration statement is in security indexes that move from broad-based to 631 Today, LIBOR is used as a rate of reference for effect as to the security-based swap. See section 5(e) narrow-based or narrow-based to broad-based. the following currencies: Australian Dollar,

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Interbank Offered Rate (‘‘Euribor’’); the Government Target Rates: A rate spread or correlation between LIBOR Canadian Dealer Offered Rate established or determined based on and an OIS. (‘‘CDOR’’); and the Tokyo Interbank guidance established by a central bank As discussed above, the Commissions Offered Rate (‘‘TIBOR’’); 632 including, but not limited to, the believe that when payments under a Money Market Rates: A rate Federal Reserve discount rate, the Bank Title VII instrument are based solely on established or determined based on of England base rate and policy rate, the any of the foregoing, such Title VII actual lending or money market Canada Bank rate, and the Bank of Japan instrument would be a swap. transactions, including, but not limited policy rate (also known as the Mutan Comments to, the Federal Funds Effective Rate; the rate); Euro Overnight Index Average General Lending Rates: A general rate Two commenters believed that (‘‘EONIA’’ or ‘‘EURONIA’’) (which is the used for lending money, including, but constant maturity swaps always should weighted average of overnight not limited to, a prime rate, rate in the be treated as swaps, rather than mixed unsecured lending transactions in the commercial paper market, or any similar swaps, because they generally are Euro-area interbank market); the EONIA rate provided that it is not based on any viewed by market participants as rates Swap Index; the Eurepo (the rate at security, loan, or group or index of trades instead of trades on securities.635 which, at 11.00 a.m. Brussels time, one securities; According to the commenters, the bank offers, in the euro-zone and Indexes: A rate derived from an index ‘‘bulk’’ of constant maturity swaps are worldwide, funds in euro to another of any of the foregoing or following based on exempted securities, but the bank if in exchange the former receives rates, averages, or indexes, including commenters noted that the constant from the latter the best collateral within but not limited to a constant maturity maturity leg may be based on a number the most actively-traded European repo rate (U.S. Treasury and certain other of different rates or yields, including, market); the Australian dollar RBA 30 rates),633 the interest rate swap rates among other things, U.S. Treasury Interbank Overnight Cash Rate; the published by the Federal Reserve in its yields, Treasury auction rates, yields on Canadian Overnight Repo Rate Average ‘‘H.15 Selected Interest Rates’’ debt of foreign governments, and debt (‘‘CORRA’’); The Depository Trust & publication, the ISDAFIX rates, the related to indices of mortgage-backed Clearing Corporation’s General ICAP Fixings, a constant maturity swap, securities.636 As discussed above, the Collateral Finance (‘‘GCF’’) Repo Index or a rate generated as an average Commissions are adopting the (an average of repo rates collateralized (geometric, arithmetic, or otherwise) of interpretation as proposed. The by U.S. Treasury and certain other any of the foregoing, such as overnight statutory language of the swap and securities); the Mexican interbank index swaps (‘‘OIS’’)—provided that security-based swap definitions equilibrium interest rate (‘‘TIIE’’); the such rates are not based on a specific explicitly states that a Title VII NZD Official Cash Rate; the Sterling security, loan, or narrow-based group or instrument that is based on a non- Overnight Interbank Average Rate index of securities; exempted security should be a security- (‘‘SONIA’’) (which is the weighted Other Monetary Rates: A monetary based swap and not a swap.637 rate including, but not limited to, the average of unsecured overnight cash 2. Title VII Instruments Based on Yields transactions brokered in London by the Consumer Price Index (‘‘CPI’’), the rate Wholesale Markets Brokers’ Association of change in the money supply, or an The Commissions proposed an (‘‘WMBA’’)); the Repurchase Overnight economic rate such as a payroll index; interpretation in the Proposing Release Index Average Rate (‘‘RONIA’’) (which and clarifying the status of Title VII is the weighted average rate of all Other: The volatility, variance, rate of instruments in which one of the secured overnight cash transactions change of (or the spread, correlation or underlying references of the instrument brokered in London by WMBA); the difference between), or index based on is a ‘‘yield.’’ The Commissions received Swiss Average Rate Overnight any of the foregoing rates or averages of no comments on the interpretation set (‘‘SARON’’); the Tokyo Overnight such rates, such as forward spread out in the Proposing Release regarding Average Rate (‘‘TONAR’’) (which is agreements, references used to calculate Title VII instruments based on yields based on uncollateralized overnight the variable payments in index and are restating the interpretation average call rates for interbank lending); amortizing swaps (whereby the notional without modification. In cases when a and the Tokyo Repo Rate (average repo principal amount of the agreement is ‘‘yield’’ is calculated based on the price rate of active Japanese repo market amortized according to the movement of or changes in price of a debt security, participants). an underlying rate), or correlation swaps loan, or narrow-based security index, it and basis swaps, including but not is another way of expressing the price 634 Canadian Dollar, Danish Krone, Euro, Japanese Yen, limited to, the ‘‘TED spread’’ and the or value of a debt security, loan, or New Zealand Dollar, Pound Sterling, Swedish narrow-based security index. For Krona, Swiss Franc, and U.S. Dollar. 633 A Title VII instrument based solely on the example, debt securities often are 632 Other interbank offered rates include the level of a constant maturity U.S. Treasury rate quoted and traded on a yield basis following (with the country or city component of would be a swap because U.S. Treasuries are rather than on a dollar price, where the the acronym listed in parentheses): AIDIBOR (Abu exempted securities that are excluded from the Dhabi); BAIBOR (Buenos Aires); BKIBOR security-based swap definition. Conversely, a Title yield relates to a specific date, such as (Bangkok); BRAZIBOR (Brazil); BRIBOR/BRIBID VII instrument based solely on the level of a the date of maturity of the debt security (Btatislava); BUBOR (Budapest); CHIBOR (China); constant maturity rate on a narrow-based index of (i.e., yield to maturity) or the date upon CHILIBOR (Chile); CIBOR (Copenhagen); COLIBOR non-exempted securities under the security-based (Columbia); HIBOR (Hong Kong); JIBAR swap definition would be a security-based swap. which the debt security may be (Johannesburg); JIBOR (Jakarta); KAIBOR 634 The TED spread is the difference between the redeemed or called by the issuer (e.g., (Kazakhstan); KIBOR (Karachi); KLIBOR (Kuala interest rates on interbank loans and short-term U.S. yield to first whole issue call).638 Lumpur); KORIBOR ((South) Korea); MEXIBOR government debt (Treasury bills or ‘‘T-bills’’). The Except in the case of certain exempted (Mexico); MIBOR (Mumbai); MOSIBOR (Moscow); latter are exempted securities that are excluded securities, when one of the underlying NIBOR (Norway); PHIBOR (Philippines); PRIBOR from the statutory definition of the term ‘‘security- (Prague); REIBOR/REIBID (Reykjavik); RIGIBOR/ based swap.’’ Thus, neither any aspect of U.S. 635 RIGIBID (Riga); SHIBOR (Shanghai); SIBOR Treasuries nor interest rates on interbank loans can See CME Letter and SIFMA Letter. (Singapore); SOFIBOR (Sofia); STIBOR (Stockholm); form the basis of a security-based swap. For this 636 Id. TAIBOR (Taiwan); TELBOR (Tel Aviv); TRLIBOR reason, a Title VII instrument on a spread between 637 See supra note 633. and TURKIBOR (Turkey); VILIBOR (Vilnius); interbank loan rates and T-bill rates also would be 638 See, e.g., Securities Confirmations, 47 FR VNIBOR (Vietnam); and WIBOR (Warsaw). a swap, not a security-based swap. 37920 (Aug. 27, 1982).

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references of the Title VII instrument is is commonly known in the trade as, a with determining whether a TRS is a the ‘‘yield’’ of a debt security, loan, or put, call, or other option.’’ 639 swap or a security-based swap.643 narrow-based security index in the As a result of this exclusion in the As was described in the Proposing Release,644 a TRS is a Title VII sense where the term ‘‘yield’’ is used as security-based swap definition for instrument in which one counterparty, a proxy for the price or value of the debt ‘‘exempted securities,’’640 if the only the seller of the TRS, makes a payment security loan, or narrow-based security underlying reference of a Title VII index, the Title VII instrument would be that is based on the price appreciation instrument involving securities is, for and income from an underlying security a security-based swap. And, as a result, example, the price of a U.S. Treasury in cases where the underlying reference or security index.645 A TRS also can security and the instrument does not is a point on a ‘‘yield curve’’ generated overlie a single loan, two or more loans have any other underlying reference from the different ‘‘yields’’ on debt and other underliers. The other involving securities, then the securities in a narrow-based security counterparty, the buyer of the TRS, instrument would be a swap. Similarly, index (e.g., a constant maturity yield or makes a financing payment that is often if the Title VII instrument is based on rate), the Title VII instrument would be based on a variable interest rate, such as a security-based swap. However, where the ‘‘yield’’ of a U.S. Treasury security LIBOR (or other interbank offered rate or certain exempted securities, such as and does not have any other underlying money market rate, as described above), U.S. Treasury securities, are the only reference involving securities, then the as well as a payment based on the price underlying reference of a Title VII instrument also would be a swap, depreciation of the underlying instrument involving securities, the regardless of whether the term ‘‘yield’’ reference. The ‘‘total return’’ consists of Title VII instrument would be a swap. is a proxy for the price of the security. the price appreciation or depreciation, Title VII instruments based on Foreign government securities, by plus any interest or income exempted securities are discussed contrast, were not ‘‘exempted payments.646 Accordingly, where a TRS further below. securities’’ as of the date of enactment is based on a single security or loan, or The above interpretation would not of the Futures Trading Act of 1982 641 a narrow-based security index, the TRS 647 apply in cases where the ‘‘yield’’ and thus do not explicitly fall within would be a security-based swap. In addition, the Commissions are referenced in a Title VII instrument is this exclusion from the security-based providing a final interpretation not based on a debt security, loan, or swap definition. Therefore, if the providing that, generally, the use of a narrow-based security index of debt underlying reference of the Title VII variable interest rate in the TRS buyer’s securities but rather is being used to instrument is the price, value, or payment obligations to the seller is reference an interest rate or monetary ‘‘yield’’ (where ‘‘yield’’ is a proxy for incidental to the purpose of, and the rate as outlined above in subsection one price or value) of a foreign government risk that the counterparties assume in, of this section. In these cases, this security, or a point on a yield curve entering into the TRS, because such ‘‘yield’’ reference would be considered derived from a narrow-based security payments are a form of financing equivalent to a reference to an interest index composed of foreign government reflecting the seller’s (typically a rate or monetary rate and the Title VII securities, then the instrument is a security-based swap dealer) cost of instrument would be, under the security-based swap. financing the position or a related interpretation in this section, a swap (or C. Total Return Swaps hedge, allowing the TRS buyer to mixed swap depending on other receive payments based on the price references in the instrument). The Commissions are restating the appreciation and income of a security or 3. Title VII Instruments Based on interpretation regarding TRS set out in security index without purchasing the Government Debt Obligations the Proposing Release with certain security or security index. As stated in The Commissions provided an changes with respect to quanto and 643 See supra part I, under ‘‘Overall Economic interpretation in the Proposing Release compo equity TRS and loan TRS based on two or more loans, and to reflect that Considerations.’’ regarding instances in which the 644 TRS can overlie reference items other See Proposing Release at 29842. underlying reference of the Title VII 645 Where the underlying security is an equity than securities, loans, and indexes of security, a TRS is also known as an ‘‘equity swap.’’ instrument is a government debt 642 obligation. The Commissions received securities or loans. The Commissions A bond may also be the underlying security of a find that this interpretation is an TRS. no comments on the interpretation 646 If the total return is negative, the seller provided regarding instances in which appropriate way to address TRS and is receives this amount from the buyer. TRS can be the underlying reference of the Title VII designed to reduce the cost associated used to synthetically reproduce the payoffs of a position. For example, two counterparties may instrument is a government debt enter into a 3-year TRS where the buyer of the TRS 639 Section 3(a)(68)(C) of the Exchange Act, 15 obligation and are restating such receives the positive total return on XYZ security, U.S.C. 76c(a)(68)(C). interpretation without modification. if any, and the seller of the TRS receives LIBOR 640 As of January 11, 1983, the date of enactment The security-based swap definition plus 30 basis points and the absolute value of the of the Futures Trading Act of 1982, Public Law 97– negative total return on XYZ security, if any. 444, 96 Stat. 2294, section 3(a)(12) of the Exchange specifically excludes any agreement, 647 However, if the underlying reference of the contract, or transaction that meets the Act, 15 U.S.C. 78c(a)(12), provided that, among TRS is a broad-based security index, it is a swap other securities, ‘‘exempted securities’’ include: (i) (and an SBSA) and not a security-based swap. In definition of a security-based swap only Securities which are direct obligations of, or because it ‘‘references, is based upon, or addition, a TRS on an exempted security, such as obligations guaranteed as to principal or interest by, a U.S. Treasury, under section 3(a)(12) of the settles through the transfer, delivery, or the United States; (ii) certain securities issued or Exchange Act, 15 U.S.C. 78c(a)(12), as in effect on receipt of an exempted security under guaranteed by corporations in which the United the date of enactment of the Futures Trading Act States has a direct or indirect interest as designated of 1982 (other than any municipal security as [section 3(a)(12) of the Exchange Act], as by the Secretary of the Treasury; and (iii) certain in effect on the date of enactment of the defined in section 3(a)(29) of the Exchange Act, 15 other securities as designated by the SEC in rules U.S.C. 78c(a)(29), as in effect on the date of Futures Trading Act of 1982 (other than and regulations. enactment of the Futures Trading Act of 1982), is any municipal security as defined in 641 Public Law 97–444, 96 Stat. 2294 (1983). a swap (and an SBSA), and not a security-based [section 3(a)(29) of the Exchange Act] 642 While this guidance focuses on TRS overlying swap. Similarly, and as discussed in more detail * * *), unless such agreement, contract, securities and loans, TRS also may overlie other below, an LTRS based on two or more loans that commodities. Such TRS may be structured are not securities (‘‘non-security loans’’) are swaps, or transaction is of the character of, or differently due to the nature of the underlying. and not security-based swaps.

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the Proposing Release, the Commissions of such non-U.S. equity index into U.S. chooses to use to hedge the quanto believe that when such interest rate dollars,’’ 653 can be described as: equity swap and is not a direct result of payments act merely as a financing An equity swap in which [(1)] the any expected payment obligations by component in a TRS, or in any other underlying is denominated in a currency (the either party under the quanto equity security-based swap, the inclusion of foreign currency) other than that in which swap.657 such interest rate terms would not cause the equity swap is denominated (the By contrast, in a compo equity swap, the TRS to be characterized as a mixed domestic currency) * * * [and (2) t]he final swap.648 Financing terms may also value of the underlying is denominated in the parties assume exposure to, and the involve adding or subtracting a spread the foreign currency and is converted into the total return is calculated based on, both 649 domestic currency using the exchange rate the performance of specified foreign to or from the financing rate, or prevailing at inception[,] result[ing in] the calculating the financing rate in a stocks and the change in the relevant investor * * * not [being] exposed to exchange rate.658 Because the currency other than that of the currency risk.654 underlying reference security or security counterparty initiating a transaction can index.650 While a quanto equity swap, choose to avoid currency exposure by However, where such payments therefore, effectively ‘‘exposes the entering into a quanto equity swap, the incorporate additional elements that dealer on the foreign leg of the currency exposure obtained via a compo correlation product to a variable create additional interest rate or equity swap is not incidental to the notional principal amount that changes currency exposures that are unrelated to equity exposure for purposes of whenever the exchange rate or the the financing of the security-based determining mixed swap status. In fact, foreign index fluctuates,’’ 655 such swap, or otherwise shift or limit risks investors seeking synthetic exposure to that are related to the financing of the exposure results from the choice of hedges for the quanto equity swap, not foreign securities via a TRS may also be security-based swap, those additional seeking exposure to the exchange rate elements may cause the security-based from the cash flows of the quanto equity swap itself.656 Thus, that exposure between the currencies, as evidenced by swap to be a mixed swap. For example, the fact that a number of mutual funds where the counterparties embed could be viewed as created in the seller exist in both hedged and unhedged interest-rate optionality (e.g., a cap, by the act of entering into the quanto versions to provide investors exposure collar, call, or put) into the terms of a equity swap, rather than as a transfer security-based swap in a manner between the parties, as is required by to the same foreign securities with or designed to shift or limit interest rate the third prong of the statutory swap without the attendant currency exposure, the inclusion of these terms definition. Consequently, the dealer’s would cause the TRS to be both a swap exchange rate exposure could be seen as and a security-based swap (i.e., a mixed incidental to the securities exposure swap). Similarly, if a TRS is also based desired by the party initiating the on non-security-based components quanto equity swap. (such as the price of oil, or a currency), The Commissions view a quanto the TRS would also be a mixed swap.651 equity swap as a security-based swap, The Commissions also are providing and not a mixed swap, where (i) the an additional interpretation regarding a purpose of the quanto equity swap is to quanto equity swap, in response to transfer exposure to the return of a comments raised by one commenter,652 security or security index without and for illustrative purposes, a similar transferring exposure to any currency or but contrasting product, a compo equity exchange rate risk; and (ii) any exchange swap. A quanto equity swap, which rate or currency risk exposure incurred ‘‘can provide a U.S. investor with by the dealer due to a difference in the currency-protected exposure to a non- currency denomination of the quanto U.S. equity index by translating the equity swap and of the underlying percentage equity return in the currency security or security index is incidental to the quanto equity swap and arises 648 See infra part IV. from the instrument(s) the dealer 649 See, e.g., Moorad Chowdry, ‘‘Total Return Swaps: Credit Derivatives and Synthetic Funding 653 Id. Instruments,’’ at 3–4 (noting that the spread to the 654 Handbook of Corporate Equity Derivatives and TRS financing rate is a function of: The credit rating Equity Capital Markets (‘‘Corporate Equity of the counterparty paying the financing rate; the Derivatives Handbook’’), § 1.2.10, at 23, available at amount, value, and credit quality of the reference http://media.wiley.com/product_data/excerpt/05/ asset; the dealer’s funding costs; a profit margin; 11199759/1119975905-83.pdf last visited May 4, and the capital charge associated with the TRS), 2012. available at http://www.yieldcurve.com/ 655 James M. Mahoney, Correlation Products and 657 Mktresearch/LearningCurve/TRS.pdf. Risk Management Issues, FRBNY Economic Policy Although the SIFMA Letter describes quanto 650 For example, a security-based swap on an Review/October 1995 at 2, available at http:// equity swaps in terms of equity indexes, if the equity security priced in U.S. dollars in which www.ny.frb.org/research/epr/95v01n3/ underlying reference of a quanto equity swap is a payments are made in Euros based on the U.S. 9510maho.pdf last visited May 4, 2012. single security, the result would be the same. The dollar/Euro spot rate at the time the payment is 656 While applicable in general, this logic, which Commissions also note that if a security index made would not be a mixed swap. As the merely expands upon the principle that the underlying a quanto equity swap is not narrow- Commissions stated in the Proposing Release, under character of a Title VII instrument as either a swap based, the quanto equity swap is a swap. In that these circumstances, the currency is merely or a security-based swap should follow the event, it is not a mixed swap because no element referenced in connection with the method of underlying factors which are incorporated into the of the quanto equity swap is a security-based swap payment, and the counterparties are not hedging the cash flows of the instrument—a security, yield, and, to be a mixed swap, a Title VII instrument risk of changes in currency exchange rates during loan, or other trigger for SEC jurisdiction or as a the term of the security-based swap See Proposing commodity triggering CFTC jurisdiction (or both for must have both swap and security-based swap Release at 29842, n. 176. joint jurisdiction), should not be extrapolated to components. 651 See Mixed Swaps, infra part IV. other Title VII instruments, for which other 658 See generally Corporate Equity Derivatives 652 See SIFMA Letter. principles may override. Handbook, supra note 654, § 1.2.9, at 21–23.

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exposure.659 Consequently, a compo security index’’ in both the CEA and the exposure that might be construed as equity swap is a mixed swap.660 Exchange Act only applies to securities, extending beyond those purposes.670 In response to comments,661 the and not to non-security loans.663 An The Commissions are clarifying that a Commissions also are providing an LTRS, moreover, is not covered by the quantitative analysis is not necessarily interpretation with respect to the third prong of the security-based swap required in order to determine whether treatment of loan TRS (‘‘LTRS’’) on two definition because it is based on the a TRS is a mixed swap. Any analysis, or more loans. As noted above, the total return of such loans, and not quantitative or qualitative, clearly second prong of the security-based swap events related thereto. Accordingly, an demonstrating the nature of a payment definition includes a swap that is based LTRS on two or more loans that are non- (solely financing-related, unrelated to on ‘‘a single security or loan, including security loans is a swap and not a financing or a combination of the two) any interest therein or on the value security-based swap.664 can suffice.671 thereof.’’ Thus, an LTRS based on a The Commissions also are clarifying single loan, as mentioned above, is a Comments that market participants are not security-based swap. The Commissions The Commissions received three necessarily required to compare their believe, however, that an LTRS based on comments with respect to the financing rates to market financing rates two or more non-security loans are interpretation provided on TRS in the in order to determine whether the swaps, and not security-based swaps.662 Proposing Release.665 One of these financing leg of a TRS is merely a An LTRS on a group or index of such commenters addressed the financing leg or is sufficient to render non-security loans is not covered by the Commissions’ interpretation on the TRS a mixed swap. Because a first prong of the security-based swap security-based TRS.666 The other two number of factors can influence how a definition—swaps based on a narrow- commenters requested that the particular TRS is structured,672 the based security index—because the Commissions clarify the treatment of Commissions cannot provide an definition of the term ‘‘narrow-based LTRS on two or more loans.667 interpretation applicable to all One commenter asserted that the situations. If the financing leg of a TRS 659 See, e.g., Descriptive Brochure: The Tweedy, terms of a TRS that create interest rate reflects the dealer’s financing costs on a Browne Global Value Fund II—Currency Unhedged or currency exposures incidental to the one-to-one basis, the Commissions at 1, available at http://www.tweedy.com/resources/ primary purpose of the TRS should not would view such leg as a financing leg. gvf2/TBGVF-II_verJuly2011.pdf (last visited May 4, 2012) (comparing the Tweedy, Browne Global cause a transaction that otherwise Adding a spread would not alter that Value Fund II—Currency Unhedged and the would be deemed to be a security-based conclusion if the spread is consistent Tweedy, Browne Global Value Fund (which hedges swap to be characterized as a mixed with the dealer’s course of dealing its currency exposure) and stating that ‘‘[t]he only swap.668 This commenter agreed with generally, with respect to a particular material difference [between the funds] is that the Unhedged Global Value Fund generally does not the Commissions that the scope of the type of TRS or with respect to a hedge currency risk [and] is designed for long-term mixed swap category of Title VII particular counterparty. The value investors who wish to focus their investment instruments is intended to be narrow Commissions believe that this would be exposure on foreign stock markets, and their and that, when variable interest rates are the case even if the spread is ‘‘off- associated non-U.S. currencies’’ and ‘‘[b]y establishing the Tweedy, Browne Global Value used for financing purposes incidental market,’’ if the deviance from a market Fund II—Currency Unhedged, we were to counterparties’ purposes, and risks spread is explained by factors unique to acknowledging that many investors may view assumed, in entering into a TRS, the the dealer (e.g., the dealer has high exposure to foreign currency as another form of TRS is a security-based swap and not a financing costs), to the TRS (e.g., the diversification when investing outside the U.S., 669 underlying securities are highly illiquid, and/or may have strong opinions regarding the mixed swap. future direction of the U.S. dollar.’’). See also the This commenter also opined that the so financing them is more costly than PIMCO Foreign Bond Fund (Unhedged) Fact Sheet Commissions’ interpretation that would be reflected in a ‘‘typical’’ market at 1 (stating that ‘‘[t]he fund seeks to capture the ‘‘where such payments incorporate spread for other TRS) or to then-current returns of non-U.S. bonds including potential additional elements that create market conditions (e.g., a share returns due to changes in exchange rates. In a declining dollar environment foreign currency additional interest rate or currency repurchase might make shares harder appreciation may augment the returns generated by exposures * * * unrelated to the investments in foreign bonds.’’), available at financing of the [TRS], or otherwise 670 Id. SIFMA added that such a determination http://investments.pimco.com/Shareholder shift or limit risks that are related to the could require market participants to determine Communications/External%20Documents/Foreign whether a specific interest rate or spread referenced %20Bond%20Fund%20(Unhedged)%20 financing of the [TRS], those additional in the TRS is sufficiently in line with market rates Institutional.pdf last visited May 4, 2012 and the elements may cause the [TRS] to be a to constitute a financing leg of a transaction under PIMCO Foreign Bond Fund (U.S. Dollar-Hedged) mixed swap’’ could be seen as requiring the proposed test. SIFMA continues by noting that INSTL Fact Sheet at 1 (stating that ‘‘[t]he fund seeks a quantitative analysis to determine there are a number of examples where a TRS can to capture the returns of non-U.S. bonds but provide for some interest rate or currency exposure generally hedges out most currency exposure in whether a reference to interest rates or incidental to the primary purpose of the TRS, order to limit the volatility of returns.’’), available currencies in a TRS is solely for describing a quanto equity swap as an example. at http://investments.pimco.com/Shareholder financing purposes or creates additional 671 To the extent a market participant is uncertain Communications/External%20Documents/Foreign as to the results of such an analysis, it may seek %20Bond%20Fund%20(U.S.%20Dollar-Hedged) 663 informal guidance from the Commissions’ staffs or %20Institutional.pdf (last visited May 4, 2012). See CEA section 1a(35), 7 U.S.C. 1a(35), and section 3(a)(55) of the Exchange Act, 15 U.S.C. use the process established in this release, see infra 660 Such swaps are examples of swaps with 78c(a)(55). part VI, for seeking formal guidance from the payments that ‘‘incorporate additional elements Commissions as to the nature of a Title VII 664 The same would be true with respect to swaps that create additional * * * currency exposures instrument as a swap, security-based swap or mixed (e.g., options, CFDs, NDFs), other than LTRS or loan * * * unrelated to the financing of the security- swap. index credit default swaps, on two or more loans based swap * * * that may cause the security- 672 that are not securities. For example, the Commissions would expect based swap to be a mixed swap.’’ See Proposing a dealer perceived by the market to constitute a 665 See July LSTA Letter; Letter from David Release at 29842. higher counterparty risk to have higher funding Lucking, Allen & Overy LLP, dated May 26, 2011 661 See infra note 667 and accompanying text. costs generally, which might affect its TRS (‘‘Allen & Overy Letter’’); and SIFMA Letter. 662 Depending on the facts and circumstances financing costs. To the extent such a dealer passed 666 loans may be notes or evidences of indebtedness See SIFMA Letter. through its higher TRS financing costs to its TRS that are securities. See section 3(a)(10) of the 667 See Allen & Overy Letter and July LSTA counterparty, such a pass-through simply would Exchange Act. In this section, the Commissions Letter. reflect the dealer’s specific circumstances, and address only groups or indexes of loans that are not 668 See SIFMA Letter. would not transform the TRS from a security-based securities. 669 Id. swap into a mixed swap.

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for a dealer to procure in order to hedge swaps, including both LTRS and loan a security is triggered by the occurrence its obligations under a TRS to pay its index credit default swaps.677 of an event relating to that issuer, the counterparty the capital appreciation of The Commissions have provided the CDS is a security-based swap under the a security, resulting in higher financing final interpretation discussed above third prong of the statutory security- costs due to the decrease in shares regarding LTRS based on two or more based swap definition.683 loans that are not securities. The outstanding, assuming demand for the In relation to aggregations of shares does not change). If the spread is Commissions acknowledge that this transactions under a single ISDA Master designed to provide exposure to an interpretation results in different Agreement,684 the Commissions are underlying reference other than treatment for an LTRS on two non- revising the example that was included securities, however, rather than to security loans (a swap), as opposed to a in the Proposing Release referring to reflect financing costs, such a TRS is a Title VII instrument based on two mixed swap. securities (a security-based swap). This single-name CDS to clarify that the result, however, is dictated by the interpretation regarding aggregations of Market participants are better statute. transactions is non-exclusive and thus positioned than are the Commissions to not limited to either CDS or single- D. Security-Based Swaps Based on a determine what analysis, and what reference instruments.685 supporting information and materials, Single Security or Loan and Single- best establish whether the nature of a Name Credit Default Swaps The Commissions believe that each particular payment reflects financing The Commissions provided an transaction under an ISDA Master costs alone, or something more. interpretation in the Proposing Release Agreement would need to be analyzed Moreover, the Commissions expect that regarding security-based swaps based on to determine whether it is a swap or a dealer would know if the purpose of a single security or loan and single- security-based swap. For example, the the payment(s) in question is to cover its name CDS 678 and are restating such Commissions believe that a number of cost of financing a position or a related interpretation with certain Title VII instruments that are executed hedge.673 In such cases, a detailed modifications in response to at the same time and that are analysis should not be necessary. commenters.679 The second prong of the documented under one ISDA Master One commenter noted the nature of statutory security-based swap definition Agreement, but in which a separate quanto equity swaps as TRS and includes a swap that is based on ‘‘a confirmation is sent for each maintained that such a transaction ‘‘is single security or loan, including any instrument, should be treated as an interest therein or on the value aggregation of such Title VII equivalent to a financing of a long 680 position in the underlying non-U.S. thereof.’’ The Commissions believe instruments, each of which must be equity index[]’’ and that the currency that under this prong of the security- analyzed separately under the swap and protection is incidental to the financing based swap definition, a single-name security-based swap definitions.686 The element, which is the primary purpose CDS that is based on a single reference Commissions believe that, as a practical obligation would be a security-based of the TRS.674 As discussed above, the and economic matter, each such Title swap because it would be based on a Commissions have provided a final VII instrument would be a separate and single security or loan (or any interest interpretation regarding the appropriate independent transaction. Thus, such an therein or on the value thereof). classification of Title VII instruments In addition, the third prong of the aggregation of Title VII instruments that are quanto equity swaps and compo security-based swap definition includes would not constitute a Title VII equity swaps. a swap that is based on the occurrence instrument based on one ‘‘index or Two commenters requested that the of an event relating to a ‘‘single issuer group’’ 687 under the security-based Commissions clarify the status of LTRS of a security,’’ provided that such event swap definition but instead would on two or more loans.675 Both ‘‘directly affects the financial constitute multiple Title VII commenters stated that while the statements, financial condition, or instruments. The Commissions find that statutory definition of the term financial obligations of the issuer.’’ 681 this interpretation is an appropriate way ‘‘security-based swap’’ provides that This provision applies generally to to address CDS, TRS or other Title VII swaps based on a single loan are event-triggered swap contracts. With instruments referencing a single security security-based swaps, it does not respect to a CDS, such events could or loan or entity that is documented explicitly provide whether swaps on include, for example, the bankruptcy of under a Master Agreement or Master indexes of loans are security-based an issuer, a default on one of an issuer’s Confirmation and is designed to reduce swaps.676 They requested clarification debt securities, or the default on a non- the cost associated with determining regarding the treatment of loan based security loan of an issuer.682 The Commissions believe that if the 683 The Commissions understand that some 673 The Commissions expect that dealers know payout on a CDS on a single issuer of single-name CDS now trade with fixed coupon their financing costs and can readily explain the payments expressed as a percentage of the notional components of the financing leg paid by their TRS 677 The Commissions address the comments amount of the transaction and payable on a periodic counterparties. regarding loan index credit default swaps below. basis during the term of the transaction. See Markit, 674 Id. SIFMA distinguished quanto equity swaps See infra note 768 and accompanying text. ‘‘The CDS Big Bang: Understanding the Changes to from the examples of mixed swaps that the 678 See Proposing Release at 29843. the Global CDS Contract and North American Commissions provided in the Proposing Release, 679 See infra note 689 and accompanying text. Conventions,’’ 3, available at http:// www.markit.com/cds/announcements/resource/ characterizing them as ‘‘very different.’’ 680 Section 3(a)(68)(A)(ii)(II) of the Exchange Act, cds_big_bang.pdf. The Commissions are restating 675 See Allen & Overy Letter and July LSTA 15 U.S.C. 78c(a)(68)(A)(ii)(II). The first prong of the their view that the existence of such single-name Letter. security-based swap definition is discussed below. CDS does not change their interpretation. 676 See Allen & Overy Letter. Allen & Overy notes See infra part III.G. 684 that a Title VII Instrument that references two 681 Section 3(a)(68)(A)(ii)(III) of the Exchange Act, See Proposing Release at 29843. securities is a security-based swap. It believes that 15 U.S.C. 78c(a)(68)(A)(ii)(III). 685 See infra note 689 and accompanying text. treating an LTRS on two or more loans as a swap 682 The Commissions understand that in the 686 See infra note 691. would result in functionally and potentially context of credit derivatives on asset-backed 687 The security-based swap definition further economically similar products being treated in an securities or MBS, the events include principal defines ‘‘index to include an ‘‘index or group of arbitrarily different way, contrary to the spirit of the writedowns, failure to pay principal and interest securities.’’ See section 3(a)(68)(E) of the Exchange Dodd-Frank Act. shortfalls. Act, 15 U.S.C. 78c(a)(68)(E).

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whether such instruments are swaps or The Commissions are restating the ‘‘exempted security,’’ subject to certain security-based swaps.688 interpretation they provided in the conditions.700 To date, the SEC has Proposing Release without modification. enumerated within rule 3a12–8 the debt Comments The Commissions also discussed in the securities of 21 foreign governments The Commissions received two Proposing Release the unique solely for purposes of futures trading comments regarding the interpretation circumstance involving certain futures (‘‘21 enumerated foreign regarding aggregation of Title VII contracts on foreign government debt governments’’).701 instruments under a single ISDA Master securities and requested comment as to The Commissions recognize that as a Agreement. One commenter requested how Title VII instruments on these result of rule 3a12–8, futures contracts that the Commissions clarify that the futures contracts should be treated.694 In on the debt securities of the 21 interpretation applies to other types of response to commenters,695 the enumerated foreign governments that instruments, such as TRS, in addition to Commissions are adopting a rule satisfy the conditions of rule 3a12–8 are CDS.689 The commenter also stated that regarding the treatment of Title VII subject to the CFTC’s exclusive the interpretation should be helpful instruments on certain futures contracts jurisdiction and are not considered with respect to use of a ‘‘Master on foreign government debt security futures. As a result, applying Confirmation’’ structure, which the securities.696 the interpretation above to a Title VII commenter described as use of general A Title VII instrument that is based on instrument that is based on a futures terms in a ‘‘Master Confirmation’’ that a futures contract will either be a swap contract on the debt securities of these apply to a number of instruments with or a security-based swap, or both (i.e., 21 enumerated foreign governments separate underlying references but for a mixed swap), depending on the nature would mean that the Title VII which a separate ‘‘Supplemental of the futures contract, including the instrument would be a swap.702 The Confirmation’’ is sent for each separate underlying reference of the futures Commissions note, however, that the component.690 contract. Thus, a Title VII instrument conditions in rule 3a12–8 were A second commenter agreed with the where the underlying reference is a established specifically for purposes of Commissions’ interpretation that a security future is a security-based the offer and sale of ‘‘qualifying foreign number of single-name CDS that are swap.697 In general, a Title VII futures contracts’’ (as defined in rule executed at the same time and that are instrument where the underlying 3a12–8) 703 on the debt securities of the documented under one ISDA Master reference is a futures contract that is not 21 enumerated foreign governments,704 Agreement, but in which a separate a security future is a swap.698 As the not Title VII instruments based on confirmation is sent for each CDS, Commissions noted in the Proposing futures contracts on the debt securities should not be treated as a single index Release,699 Title VII instruments CDS and stated that this approach is involving certain futures contracts on 700 Specifically, rule 3a12–8 under the Exchange 691 consistent with market practice. foreign government debt securities Act requires as a condition to the exemption that As discussed above, in response to present a unique circumstance, which is the foreign government debt securities not be comments the Commissions are registered under the Securities Act (or be the discussed below. subject of any American depositary receipt expanding the example so it is clear that Rule 3a12–8 under the Exchange Act 692 registered under the Securities Act) and that futures it applies beyond just CDS. exempts certain foreign government contracts on such foreign government debt debt securities, for purposes only of the securities ‘‘require delivery outside the United E. Title VII Instruments Based on States, [and] any of its possessions or territories, Futures Contracts offer, sale, or confirmation of sale of futures contracts on such foreign and are traded on or through a board of trade, as The Commissions proposed an defined in [section 2 of the CEA, 7 U.S.C. 2].’’ See government debt securities, from all rules 3a12–8(a)(2) and 3a12–8(b) under the interpretation in the Proposing Release provisions of the Exchange Act which Exchange Act, 17 CFR 240.3a12–8(a)(2) and regarding the treatment, generally, of by their terms do not apply to an 240.3a12–8(b). These conditions were ‘‘designed to swaps based on futures contracts.693 minimize the impact of the exemption on securities distribution and trading in the United States. 694 Id. * * *’’ See Exemption for Certain Foreign 688 See supra part I, under ‘‘Overall Economic 695 See infra note 718 and accompanying text. Government Securities for Purposes of Futures Considerations’’. 696 See rule 1.3(bbbb) under the CEA and rule Trading, 49 FR 8595 (Mar. 8, 1984) at 8596–97 689 See July LSTA Letter. 3a68–5 under the Exchange Act. (citing Futures Trading Act of 1982). 690 Id. 697 A security future is defined in both the CEA 701 See rule 3a12–8(a)(1) under the Exchange Act 691 See Letter from Richard M. McVey, Chairman and the Exchange Act as a futures contract on a (designating the debt securities of the governments and Chief Executive Officer, MarketAxess Holdings, single security or a narrow-based security index, of the United Kingdom, Canada, Japan, Australia, Inc. (‘‘MarketAxess’’), July 22, 2011 (‘‘MarketAxess including any interest therein or based on the value France, New Zealand, Austria, Denmark, Finland, Letter’’). thereof, except an exempted security under section the Netherlands, Switzerland, Germany, Ireland, 692 The Commissions believe, based on the July 3(a)(12) of the Exchange Act, 15 U.S.C. 78c(a)(12), Italy, Spain, Mexico, Brazil, Argentina, Venezuela, LSTA Letter, that the ‘‘Master Confirmation’’ as in effect on the date of enactment of the Futures Belgium, and Sweden). structure the commenter described is the same Trading Act of 1982 (other than any municipal 702 The Commissions note, by contrast, that a general structure as the aggregation of single-name security as defined in section 3(a)(29) of the Title VII instrument that is based on the price or CDS the Commissions provided as an example in Exchange Act, 15 U.S.C. 78c(a)(29), as in effect on value of, or settlement into, a futures contract on the Proposing Release, but that a ‘‘Master the date of enactment of the Futures Trading Act the debt securities of one of the 21 enumerated Confirmation’’ structure may not be limited to of 1982). single-reference instruments or to CDS and instead foreign governments and that also has the potential may be used for a broader range of instruments. See The term security future does not include any to settle directly into such debt securities would be July LSTA Letter. The Commissions note that the agreement, contract, or transaction excluded from a security-based swap and, depending on other following are examples of ‘‘Master Confirmation’’ the CEA under sections 2(c), 2(d), 2(f), or 2(g) of the features of the Title VII instrument, possibly a structure to which the interpretive guidance would CEA, 7 U.S.C. 2(c), 2(d), 2(f), or 2(g), as in effect on mixed swap. apply: 2009 Americas Master Equity Derivatives the date of enactment of the Commodity Futures 703 Rule 3a12–8(b) under the Exchange Act Confirmation Agreement, Stand-alone 2007 Modernization Act of 2000 (‘‘CFMA’’) or Title IV of defines ‘‘qualifying foreign futures contracts’’ as Americas Master Variance Swap Confirmation the CFMA. See section 1a(44) of the CEA, 7 U.S.C. ‘‘contracts for the purchase or sale of a designated Agreement, and 2004 Americas Interdealer Master 1a(44), and section 3(a)(55) of the Exchange Act, 15 foreign government security for future delivery, as Equity Derivatives Confirmation Agreement and U.S.C. 78c(a)(55). ‘future delivery’ is defined in 7 U.S.C. 2, provided March 2004 Canadian Supplement to the Master 698 Depending on the underlying reference of the such contracts require delivery outside the United Confirmation. The Commissions believe the broader futures contract, though, such swaps could be States, any of its possessions or territories, and are example in this release provides the clarification SBSAs. For example, a swap on a future on the S&P traded on or through a board of trade, as defined the commenter requested. 500 index would be an SBSA. at 7 U.S.C. 2.’’ 17 CFR 240.3a12–8(b). 693 See Proposing Release at 29843–44. 699 See Proposing Release at 29843. 704 See supra note 700.

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of the 21 enumerated governments. settlement of such Title VII instrument), believe that this condition is Further, the Commissions note that the an affiliate (as defined in the Securities appropriate in order to provide Dodd-Frank Act did not exclude swaps Act and the rules and regulations consistent treatment of Title VII on foreign government debt securities thereunder) 708 of the issuer, or an instruments based on qualifying foreign generally from the definition of the term underwriter with respect to such futures contracts on the debt securities ‘‘security-based swap.’’ Accordingly, a securities. of the 21 enumerated foreign Title VII instrument that is based Under the first condition, the final governments with the Commissions’ directly on foreign government debt rules provide that the futures contract treatment of swaps and security-based securities, including those of the 21 on which the Title VII instrument is swaps generally.711 enumerated governments, is a security- based or referenced must be a qualifying The fifth condition of the final rules based swap or a swap under the same foreign futures contract that satisfies the provides that for a Title VII instrument analysis as any other Title VII conditions of rule 3a12–8 and may only to be a swap under such rules, it cannot instruments based on securities. be based on the debt of any one or more be entered into by the issuer of the The Commissions indicated in the of the enumerated 21 foreign securities upon which the qualifying Proposing Release that they would governments. If the conditions of rule foreign futures contract is based or evaluate whether Title VII instruments 3a12–8 are not satisfied, then there referenced (including any security used based on futures contracts on the debt cannot be a qualifying foreign futures to determine the cash payment due on securities of the 21 enumerated foreign contract, the futures contract is a settlement of such Title VII instrument), governments that satisfy the conditions security future, and a swap on such a an affiliate of the issuer, or an of rule 3a12–8 should be characterized security future is a security-based swap. underwriter of the issuer’s securities. as swaps, security-based swaps, or The second condition of the final The Commissions have included this mixed swaps.705 In response to rules provides that the Title VII condition to address the concerns raised commenters,706 the Commissions are instrument on the qualifying foreign by the SEC in the Proposing Release that adopting rule 1.3(bbbb) under the CEA futures contract must itself be traded on the characterization of a Title VII and rule 3a68–5 under the Exchange or through a board of trade because a instrument that is based on a futures Act, which address the treatment of qualifying foreign futures contract on contract on the debt securities of one of these Title VII instruments. the debt securities of one or more of the the 21 enumerated foreign governments The final rules provide that a Title VII 21 enumerated foreign governments may affect Federal securities law instrument that is based on or references itself is required to be traded on a board provisions relating to the distribution of a qualifying foreign futures contract on of trade. The Commissions believe that the securities upon which the Title VII the debt securities of one or more of the swaps on such futures contracts should instrument is based or referenced.712 21 enumerated foreign governments is a be traded subject to rules applicable to The Dodd-Frank Act included swap and not a security-based swap, such futures contracts themselves. provisions that would not permit provided that the Title VII instrument The third condition of the final rules issuers, affiliates of issuers, or satisfies the following conditions: provides that the debt securities on underwriters to use security-based • The futures contract on which the which the qualifying foreign futures swaps to offer or sell the issuers’ Title VII instrument is based or that is contract is based or referenced and any securities underlying a security-based referenced is a qualifying foreign futures security used to determine the cash swap without complying with the contract (as defined in rule 3a12–8) 707 settlement amount pursuant to the requirements of the Securities Act.713 on the debt securities of any one or fourth condition cannot be registered This provision applies regardless of more of the 21 enumerated foreign under the Securities Act or be the whether the Title VII instrument allows governments that satisfies the subject of any American depositary the parties to physically settle any such conditions of rule 3a12–8; receipt registered under the Securities security-based swap. In addition, the • The Title VII instrument is traded Act. This condition is intended to Dodd-Frank Act provided that any offer on or through a board of trade (as prevent circumvention of registration or sale of security-based swaps to non- defined in section 1a(6) of the CEA); and disclosure requirements of the ECPs would have to be registered under 714 • The debt securities on which the Securities Act applicable to foreign the Securities Act. For example, if a qualifying foreign futures contract is government issuances of their securities. Title VII instrument that is based on a based or referenced and any security This condition is similar to a condition futures contract on the debt securities of used to determine the cash settlement included in rule 3a12–8.709 one of the 21 enumerated foreign amount pursuant to the fourth condition The fourth condition of the final rules governments is characterized as a swap, below are not covered by an effective provides that the Title VII instrument and not a security-based swap, then the registration statement under the must be cash settled. Although, as the provisions of the Dodd-Frank Act Securities Act or the subject of any Commissions recognize, rule 3a12–8 enacted to ensure that there could not American depositary receipt covered by permits a qualifying foreign futures be offers and sales of securities made an effective registration statement under contract to be physically settled so long without compliance with the Securities the Securities Act; as delivery is outside the United States, Act, either by issuers, their affiliates, or • The Title VII instrument may only any of its possessions or territories,710 in underwriters or to non-ECPs, would not be cash settled; and the context of Title VII instruments, apply to such swap transactions. • The Title VII instrument is not only cash settled Title VII instruments Only those Title VII instruments that are based on qualifying foreign futures entered into by the issuer of the based on qualifying foreign futures contracts on the debt securities of the 21 securities upon which the qualifying contracts on the debt securities of the 21 foreign futures contract is based or enumerated foreign governments will be referenced (including any security used 711 See infra part III.H. considered swaps. The Commissions 712 to determine the cash payment due on See Proposing Release at 29844. 713 See section 2(a)(3) of the Securities Act, 15 708 See, e.g., rule 405 under the Securities Act, 17 U.S.C. 77b(a)(3), as amended by the Dodd-Frank 705 See Proposing Release at 29844. CFR 230.405. Act. 706 See infra note 718 and accompanying text. 709 See supra note 700. 714 See section 5 of the Securities Act, 15 U.S.C. 707 See supra note 703. 710 Id. 77e, as amended by the Dodd-Frank Act.

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enumerated foreign governments and foreign government debt security and security, rate, or other commodity that that satisfy these five conditions will be one that is based on a qualifying foreign informed the setting of such fixed term swaps, not security-based swaps. The futures contract on a debt security of or condition should not itself impact the Commissions note that the final rules one of the 21 enumerated foreign determination of whether the Title VII are intended to provide consistent governments. However, the instrument is a swap or a security-based treatment (other than with respect to Commissions note that this is the case swap, provided that the fixed term or method of settlement) of qualifying today (i.e., different treatments) with condition is set at the time of execution foreign futures contracts and Title VII respect to other instruments subject to and the value or level of that fixed term instruments based on qualifying foreign CFTC regulation and/or SEC regulation, or condition may not vary over the life futures contracts on the debt securities such as futures on broad-based security of the Title VII instrument.721 of the 21 enumerated foreign indexes and futures on a single security For example, a Title VII instrument, 715 governments. The Commissions or narrow-based security index. such as an interest rate swap, in which understand that many of the qualifying Comments floating payments based on three-month foreign futures contracts on the debt LIBOR are exchanged for fixed rate Commenters did not address the securities of the 21 enumerated foreign payments of five percent would be a interpretation as it applied to Title VII governments trade with substantial swap, and not a security-based swap, instruments based on futures contracts volume through foreign trading venues even if the five percent fixed rate was generally. Two commenters addressed under the conditions set forth in rule informed by, or quoted based on, the 716 Title VII instruments based on futures 3a12–8 and permitting swaps on yield of a security, provided that the such futures contracts subject to similar contracts on debt securities of the 21 enumerated foreign governments.718 five percent fixed rate was set at the conditions would not raise concerns time of execution and may not vary over that such swaps could be used to Both commenters requested that the 722 Commissions treat these Title VII the life of the Title VII instrument. circumvent the conditions of rule 3a12– Another example would be where a 8 and the Federal securities laws instruments as swaps.719 The Commissions agree that these private sector or government borrower concerns that such conditions are that issues a five-year, amortizing $100 717 instruments should be treated as swaps intended to protect. Further, million debt security with a semi- providing consistent treatment for under certain conditions and, therefore, annual coupon of LIBOR plus 250 basis qualifying foreign futures contracts on are adopting rule 1.3(bbbb) under the points also, at the same time, chooses to the debt securities of the 21 enumerated CEA and rule 3a68–5 under the enter into a five-year interest rate swap foreign governments and Title VII Exchange Act as discussed above to on $100 million notional in which this instruments based on futures contracts treat Title VII instruments based on same borrower, using the same on the debt securities of the 21 qualifying foreign futures contracts on amortization schedule as the debt enumerated foreign governments will the debt securities of the 21 enumerated security, receives semi-annual payments allow trading of these instruments foreign governments as swaps, provided of LIBOR plus 250 basis points in through designated contract markets on such Title VII instruments satisfy exchange for five percent fixed rate which such futures are listed. certain conditions. payments. The fact that the specific The Commissions recognize that the F. Use of Certain Terms and Conditions terms of the interest rate swap (e.g., five- rules may result in a different in Title VII Instruments year, LIBOR plus 250 basis points, $100 characterization of a Title VII million notional, fixed amortization instrument that is based directly on a The Commissions provided an interpretation in the Proposing Release schedule) were set at the time of 715 The Commissions note that the final rules regarding the use of certain fixed terms execution to match related terms of a provide consistent treatment of qualifying foreign in Title VII instruments and are debt security does not cause the interest futures contracts on the debt securities of the 21 restating that interpretation without rate swap to become a security-based enumerated foreign governments and Title VII modification.720 The Commissions are swap. However, if the interest rate swap instruments based on qualifying foreign futures contracts on the debt securities of the 21 aware that market participants’ setting contained additional terms that were in enumerated foreign governments unless the Title of certain fixed terms or conditions of fact contingent on a characteristic of the VII instrument is entered into by the issuer of the Title VII instruments may be informed debt security that may change in the securities upon which the qualifying foreign futures by the value or level of a security, rate, future, such as an adjustment to future contract is based or referenced (including any or other commodity at the time of the security used to determine the cash payment due interest rate swap payments based on on settlement of such Title VII instrument), an execution of the instrument. The the future price or yield of the debt affiliate of the issuer, or an underwriter with respect Commissions believe that, in evaluating security, then this Title VII instrument to such securities. whether a Title VII instrument with would be a security-based swap that 716 For the quarter that ended December 31, 2011, such a fixed term or condition is a swap would be a mixed swap. the trading volume reported to the CFTC of qualifying foreign futures contracts on the debt or security-based swap, the nature of the securities of the 21 enumerated foreign 721 This interpretation relates solely to the governments made available for trading by direct 718 See CME Letter and SIFMA Letter. determination regarding whether a Title VII access from the U.S. on foreign trading venues 719 Id. Both commenters stated their belief that instrument is a swap or security-based swap. The granted direct access no-action relief by the CFTC the range of factors considered by the SEC in Commissions are not expressing a view regarding that exceeded 100,000 contracts per quarter from designating the debt securities of the 21 enumerated whether such Title VII instrument would be a the U.S. were as follows: (i) 7,985,959 contracts for foreign governments as exempted securities security-based swap agreement. 3 Year Treasury Bond Futures on the Australian indicated that there is sufficient disclosure about 722 However, to the extent the fixed term or Securities Exchange’s ASX Trade24 platform; (ii) the 21 enumerated foreign governments and their condition is set at a future date or at a future value 1,872,592 contracts for 10-Year Government of securities such that the further disclosure should or level of a security, rate, or other commodity Canada Bond Futures on the Bourse de Montreal; not be necessary. Both commenters also indicated rather than the value or level of such security, rate, (iii) 47,874,911 contracts for Euro Bund Futures on that subjecting futures contracts on the debt or other commodity at the time of execution of the Eurex Deutschland (‘‘Eurex’’); (iv) 26,434,713 securities of the 21 enumerated foreign Title VII instrument, the discussion above would contracts for Euro Bobl Futures on Eurex; (v) governments to CFTC regulation, while subjecting not apply, and the nature of the security, rate, or 30,489,427 contracts for Euro Schatz Futures on Title VII instruments based on these futures other commodity used in determining the terms or Eurex; and (vi) 8,292,222 contracts for Long Gilt contracts to SEC regulation, would be problematic. conditions would be considered in evaluating Futures on the NYSE LIFFE. Id. whether the Title VII instrument is a swap or 717 See supra note 712 and accompanying text. 720 See Proposing Release at 29845. security-based swap.

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Comments • The meaning of the term ‘‘index’’; $50,000,000 (or in the case of an index • One commenter agreed with the Rules governing the tolerance with more than 15 component Commissions’ interpretation generally, period for Title VII instruments on securities, $30,000,000), except that if but believed that the Commissions security indexes traded on DCMs, SEFs, there are two or more securities with should broaden the interpretation to foreign boards of trade (‘‘FBOTs’’), equal weighting that could be included allow a swap to reflect ‘‘resets,’’ or security-based SEFs, or NSEs, where the in the calculation of the lowest changes in the referenced characteristic security index temporarily moves from weighted component securities of a security, where those ‘‘resets’’ or broad-based to narrow-based or from comprising, in the aggregate, 25 percent narrow-based to broad-based; and of the index’s weighting, such securities changes are ‘‘intended to effect a • purpose other than transmitting the risk Rules governing the grace period for shall be ranked from lowest to highest of changes in the characteristic itself,’’ Title VII instruments on security dollar value of average daily trading without causing a Title VII instrument indexes traded on DCMs, SEFs, FBOTs, volume and shall be included in the that is not a security-based swap to security-based SEFs, or NSEs, where the calculation based on their ranking 723 security index moves from broad-based starting with the lowest ranked become a security-based swap. 728 The Commissions are not expanding to narrow-based or from narrow-based security. the interpretation to allow ‘‘resets’’ of a to broad-based and the move is not The first three criteria apply to the 725 number and concentration of the fixed rate derived from a security. The temporary. ‘‘component securities’’ in the index. interpretation is consistent with the As discussed below, the Commissions The fourth criterion applies to the statutory swap and security-based swap are restating the interpretation set forth average daily trading volume of an definitions. The Commissions believe in the Proposing Release with certain further clarifications and adopting the index’s ‘‘component securities.’’ 729 that a Title VII instrument based on a This statutory narrow-based security rate that follows a security, and that rules as proposed with certain modifications. index definition focuses on indexes may ‘‘reset’’ or change in the future composed of equity securities and based on changes in that security, is a 2. Applicability of the Statutory Narrow- certain aspects of the definition, in security-based swap. Further, any Based Security Index Definition and particular the evaluation of average amendment or modification of a Past Guidance of the Commissions to daily trading volume, are designed to material term of a Title VII instrument Title VII Instruments take into account the trading patterns of would result in a new Title VII The Commissions provided an individual stocks.730 However, the instrument and a corresponding interpretation in the Proposing Release Commissions, pursuant to authority reassessment of the instrument’s status regarding the applicability of the granted in the CEA and the Exchange as either a swap or a security-based statutory definition of the term ‘‘narrow- Act,731 previously have extended the swap.724 based security index’’ and past guidance definition to other categories of indexes G. The Term ‘‘Narrow-Based Security of the Commissions relating to such but modified the definition to take into Index’’ in the Security-Based Swap term to Title VII instruments.726 The account the characteristics of those Definition Commissions are restating the other categories. Specifically, the interpretation set out in the Proposing Commissions have previously provided 1. Introduction Release without modification. guidance regarding the application of As noted above, a Title VII instrument As defined in the CEA and Exchange the narrow-based security index in which the underlying reference of the Act,727 an index is a narrow-based definition to futures contracts on instrument is a ‘‘narrow-based security security index if, among other things, it volatility indexes 732 and debt security index’’ is a security-based swap subject meets any one of the following four indexes.733 Today, then, there exists to regulation by the SEC, whereas a Title criteria: guidance for determining what VII instrument in which the underlying • It has nine or fewer component constitutes a narrow-based security reference of the instrument is a security securities; index. index that is not a narrow-based • A component security comprises Volatility indexes are indexes security index (i.e., the index is broad- more than 30 percent of the index’s composed of index options. The based) is a swap subject to regulation by weighting; Commissions issued a joint order in the CFTC. The Commissions proposed • The five highest weighted an interpretation and rules regarding component securities in the aggregate 728 See section 3(a)(55)(B) of the Exchange Act, 15 U.S.C. 78c(a)(55)(B). See also sections 1a(35)(A) and usage of the term ‘‘narrow-based comprise more than 60 percent of the (B) of the CEA, 7 U.S.C. 1a(35)(A) and (B). security index’’ in the security-based index’s weighting; or 729 The narrow-based security index definition in swap definition, including: • The lowest weighted component the CEA and Exchange Act also excludes from its • The existing criteria for determining securities comprising, in the aggregate, scope security indexes that satisfy certain specified whether a security index is a narrow- 25 percent of the index’s weighting have criteria. See sections 3(a)(55)(C)(i)–(vi) of the Exchange Act, 15 U.S.C. 78c(a)(55)(C)(i)–(vi), and based security index and the an aggregate dollar value of average sections 1a(35)(B)(i)–(vi) of the CEA, 7 U.S.C. applicability of past guidance of the daily trading volume of less than 1a(35)(B)(i)–(vi). Commissions regarding those criteria to 730 See Joint Order Excluding Indexes Comprised Title VII instruments; 725 See Proposing Release at 29845–58. of Certain Index Options From the Definition of • New criteria for determining 726 See Proposing Release at 29845–48. Narrow-Based Security Index, 69 FR 16900 (Mar. whether a CDS where the underlying 727 Sections 3(a)(55)(B) and (C) of the Exchange 31, 2004) (‘‘March 2004 Index Options Joint Act, 15 U.S.C. 78c(a)(55)(B) and (C), include a Order’’). reference is a group or index of entities 731 definition of ‘‘narrow-based security index’’ in the See section 1a(35)(B)(vi) of the CEA, 7 U.S.C. or obligations of entities (typically same paragraph as the definition of security future. 1a(35)(B)(vi), and section 3(a)(55)(C)(vi) of the referred to as an ‘‘index CDS’’) is based See also sections 1a(35)(A) and (B) of the CEA, 7 Exchange Act, 15 U.S.C. 78c(a)(55)(C)(vi). on an index that is a narrow-based U.S.C. 1a(35)(A) and (B). A security future is a 732 See March 2004 Index Options Joint Order. security index; contract for future delivery on a single security or 733 See Joint Final Rules: Application of the narrow-based security index (including any interest Definition of Narrow-Based Security Index to Debt therein or based on the value thereof). See section Securities Indexes and Security Futures on Debt 723 See ISDA Letter. 3(a)(55) of the Exchange Act, 15 U.S.C. 78c(a)(55), Securities, 71 FR 39434 (Jul. 13, 2006) (‘‘July 2006 724 See infra part III.G.5(a). and section 1a(44) of the CEA, 7 U.S.C. 1a(44). Debt Index Release’’).

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2004 to define when a volatility index 2006 (‘‘July 2006 Debt Index Rules’’) to In the Dodd-Frank Act, Congress is not a narrow-based security index. define when an index of debt included the term ‘‘narrow-based Under this joint order, a volatility index securities 736 is not a narrow-based security index’’ in the security-based is not a narrow-based security index if security index. The first three criteria of swap definition, and thus the statutory the index meets all of the following that definition are similar to the definition of the term ‘‘narrow-based criteria: statutory definition for equities and the security index’’ 740 also applies in • The index measures the magnitude order regarding volatility indexes in that distinguishing swaps (on security of changes (as calculated in accordance a debt security index would not be indexes that are not narrow-based, also with the order) in the level of an narrow-based if: known as ‘‘broad-based’’) and security- underlying index that is not a narrow- • It is comprised of more than nine based swaps (on narrow-based security based security index pursuant to the debt securities that are issued by more indexes).741 The Commissions have statutory criteria for equity indexes than nine non-affiliated issuers; determined that their prior guidance discussed above; • The securities of any issuer with respect to what constitutes a • The index has more than nine included in the index do not comprise narrow-based security index in the component securities, all of which are more than 30 percent of the index’s context of volatility indexes 742 and debt options on the underlying index; weighting; and security indexes 743 applies in • No component security of the index • The securities of any five non- determining whether a Title VII comprises more than 30 percent of the affiliated issuers in the index do not instrument is a swap or a security-based index’s weighting; comprise more than 60 percent of the swap, except as the rules the • The five highest weighted index’s weighting. Commissions are adopting provide for component securities of the index in the In the July 2006 Debt Index Rules, other treatment with respect to index aggregate do not comprise more than 60 instead of the statutory average daily CDS as discussed below.744 percent of the index’s weighting; trading volume test, however, the To make clear that the Commissions • The average daily trading volume of Commissions adopted a public are applying the prior guidance and the lowest weighted component information availability requirement. rules to Title VII instruments, the securities in the underlying index (those Under this requirement, assuming the Commissions are adopting rules to comprising, in the aggregate, 25 percent aforementioned number and further define the term ‘‘narrow-based of the underlying index’s weighting) concentration criteria were satisfied, a security index’’ in the security-based have a dollar value of more than debt security index would not be a swap definition. Under paragraph (1) of $50,000,000 (or $30,000,000 in the case narrow-based security index if the debt rule 1.3(yyy) under the CEA and of an underlying index with 15 or more securities or the issuers of debt paragraph (a) of rule 3a68–3 under the component securities), except if there securities in the index met any one of Exchange Act, for purposes of the are 2 or more securities with equal the following criteria: • security-based swap definition, the term weighting that could be included in the The issuer of the debt security is ‘‘narrow-based security index’’ has the calculation of the lowest weighted required to file reports pursuant to same meaning as the statutory definition component securities comprising, in the section 13 or section 15(d) of the 737 set forth in section 1a(35) of the CEA aggregate, 25 percent of the underlying Securities Exchange Act of 1934; and section 3(a)(55) of the Exchange index’s weighting, such securities shall • The issuer of the debt security has Act,745 and the rules, regulations, and be ranked from lowest to highest dollar a worldwide market value of its orders issued by the Commissions value of average daily trading volume outstanding common equity held by relating to such definition. As a result, and shall be included in the calculation non-affiliates of $700 million or more; except as the rules the Commissions are based on their ranking starting with the • The issuer of the debt security has adopting provide for other treatment lowest ranked security; outstanding securities that are notes, • bonds, debentures, or evidence of with respect to index CDS as discussed Options on the underlying index 746 are listed and traded on an NSE indebtedness having a total remaining below, market participants generally registered under section 6(a) of the principal amount of at least $1 billion; may use the Commissions’ past Exchange Act; 734 and • The security is an exempted guidance in determining whether • The aggregate average daily trading security as defined in section 3(a)(12) of certain Title VII instruments based on a volume in options on the underlying the Securities Exchange Act of 1934 738 security index are swaps or security- index is at least 10,000 contracts and the rules promulgated thereunder; based swaps. calculated as of the preceding 6 full or The Commissions also are providing calendar months.735 • The issuer of the security is a an interpretation and adopting With regard to debt security indexes, government of a foreign country or a additional rules establishing criteria for the Commissions issued joint rules in political subdivision of a foreign indexes composed of securities, loans, country.739 or issuers of securities referenced by an 734 15 U.S.C. 78f(a). 740 735 See March 2004 Index Options Joint Order. In 736 Under the rules, debt securities include notes, See sections 3(a)(55)(B) and (C) of the 2009, the Commissions issued a joint order that bonds, debentures or evidence of indebtedness. See Exchange Act, 15 U.S.C. 78c(a)(55)(B) and (C). See provided that, instead of the index options having rule 41.15(a)(1)(i) under the CEA, 17 CFR also sections 1a(35)(A) and (B) of the CEA, 7 U.S.C. to be listed on an NSE, the index options must be 41.15(a)(1)(i) and rule 3a55–4(a)(1)(i) under the 1a(35)(A) and (B). listed on an exchange and pricing information for Exchange Act, 17 CFR 240.3a55–4(a)(1)(i). See also 741 The statutory definition of the term ‘‘narrow- the index options, and the underlying index, must July 2006 Debt Index Release. based security index’’ for equities, and the be computed and disseminated in real time through 737 15 U.S.C. 78m or 78o(d). Commissions’ subsequent guidance as to what major market data vendors. See Joint Order To constitutes a narrow-based security index with 738 15 U.S.C. 78c(a)(12). Exclude Indexes Composed of Certain Index respect to volatility and debt indexes, is applicable 739 Options From the Definition of Narrow-Based See July 2006 Debt Index Rules. The July 2006 in the context of distinguishing between futures Security Index, 74 FR 61116 (Nov. 23, 2009) Debt Index Rules also provided that debt securities contracts and security futures products. in the index must satisfy certain minimum (expanding the criteria necessary for exclusion 742 See March 2004 Index Options Joint Order. under the March 2004 Index Options Joint Order to outstanding principal balance criteria, established 743 See July 2006 Debt Index Rules. apply to volatility indexes for which pricing certain exceptions to these criteria and the public 744 information for the underlying broad-based security information availability requirement, and provided See infra part III.G.3. index, and the options that compose such index, is for the treatment of indexes that include exempted 745 7 U.S.C. 1a(35) and 15 U.S.C. 78c(a)(55). current, accurate, and publicly available). securities (other than municipal securities). 746 See infra part III.G.3.

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index CDS.747 The interpretation and issuers of securities in a narrow-based relates to securities, the Commissions rules also address the definition of an security index (i.e., a broad-based index) are further defining both the term ‘‘index’’ 748 and the treatment of broad- is a swap.752 ‘‘narrow-based security index’’ and the based security indexes that become The statutory definition of the term term ‘‘issuers of securities in a narrow- narrow-based and narrow-based indexes ‘‘narrow-based security index,’’ as based security index’’ in the context of that become broad-based, including rule explained above, was designed with the the security-based swap definition as provisions regarding tolerance and grace U.S. equity markets in mind.753 Thus, applied to index CDS. The Commissions periods for swaps on security indexes the statutory definition is not believe it is important to further define that are traded on CFTC-regulated necessarily appropriate for determining both terms in order to assure consistent trading platforms and security-based whether an index underlying an index analysis of index CDS.756 While the swaps on security indexes that are CDS is broad or narrow-based. Nor is wording of the two definitions as traded on SEC-regulated trading the guidance that the Commissions have adopted differs slightly, the platforms.749 These rules and previously issued with respect to the Commissions expect that they will yield interpretation are discussed below. narrow-based security index definition the same substantive results in discussed above necessarily distinguishing narrow-based and broad- 3. Narrow-Based Security Index Criteria appropriate, because that guidance was based index CDS.757 for Index Credit Default Swaps designed to address and was uniquely (b) Rules Regarding the Definitions of (a) In General tailored to the characteristics of ‘‘Issuers of Securities in a Narrow-Based The Commissions provided an volatility indexes and debt security Security Index’’ and ‘‘Narrow-Based interpretation in the Proposing Release indexes in the context of futures. Security Index’’ for Index Credit Default regarding the narrow-based security Accordingly, the Commissions are Swaps clarifying that the guidance that the index criteria for index CDS and are The Commissions proposed rules to restating it without modification.750 Commissions have previously issued with respect to the narrow-based further define the terms ‘‘issuers of While the Commissions understand that securities in a narrow-based security the underlying reference for most security index definition discussed above does not apply to index CDS. index’’ and ‘‘narrow-based security cleared CDS is a single entity or an index’’ in order to provide appropriate index of entities rather than a single Instead, the Commissions are adopting rules as discussed below that include criteria for determining whether an security or an index of securities, the index composed of issuers of securities underlying reference for CDS also could separate criteria for determining whether an index underlying an index referenced by an index CDS and an be a single security or an index of index composed of securities referenced securities.751 A CDS where the CDS is a narrow-based security index. The Commissions are further defining by an index CDS are narrow-based underlying reference is a single entity security indexes.758 The Commissions (i.e., a single-name CDS), a single the term ‘‘security-based swap,’’ and the use of the term ‘‘narrow-based security are adopting rules 1.3(zzz) and 1.3(aaaa) obligation of a single entity (e.g., a CDS under the CEA and rules 3a68–1a and on a specific bond, loan, or asset-backed index’’ within that definition, to modify the criteria applied in the context of 3a68–1b under the Exchange Act as security, or any tranche or series of any 759 index CDS in assessing whether the proposed with certain modifications. bond, loan, or asset-backed security), or In formulating the criteria in the final an index CDS where the underlying index is a narrow-based security index. The third prong of the security-based rules, and consistent with the guidance reference is a narrow-based security and rules the Commissions have index or the issuers of securities in a swap definition includes a Title VII instrument based on the occurrence of narrow-based security index is a 756 Because they apply only with respect to index security-based swap. An index CDS an event relating to the ‘‘issuers of CDS, the definitions of ‘‘issuers of securities in a where the underlying reference is not a securities in a narrow-based security narrow-based security index’’ and ‘‘narrow-based narrow-based security index or the index,’’ provided that such event security index’’ as adopted do not apply with directly affects the ‘‘financial respect to other types of event contracts, whether analyzed under the first or third prong. 747 Id. statements, financial condition, or 757 For example, if the reference entities included 754 748 See infra part III.G.4. financial obligations of the issuer.’’ in one index are the same as the issuers of securities 749 See infra part III.G.5. The first prong of the security-based included in another index, application of the two 750 See Proposing Release at 29847–48. swap definition includes a Title VII definitions should result in both indexes being 751 See, e.g., Markit, ‘‘Markit CDX’’ (describing the either broad-based or narrow-based. instrument that is based on a narrow- 758 Markit CDX indexes and the number of ‘‘names’’ 755 See Proposing Release at 29848. included in each index), available at http:// based security-index. Because the 759 The discussion throughout this section refers www.markit.com/en/products/data/indices/credit- third prong of the security-based swap to ‘‘reference entities’’ and ‘‘issuers’’ in discussing and-loan-indices/cdx/cdx.page; Markit, ‘‘Markit definition relates to issuers of securities, the final rules. The term ‘‘reference entity’’ is iTraxx Indices,’’ (stating that the ‘‘Markit iTraxx while the first prong of such definition defined in paragraph (c)(3) of rule 1.3(zzz) under indices are comprised of the most liquid names in the CEA and rule 3a68–1a under the Exchange Act the European and Asian markets’’) (emphasis and the term ‘‘issuer’’ is defined in paragraph (c)(3) 752 added), available at http://www.markit.com/en/ Similarly, an option to enter into a single- of rule 1.3(aaaa) under the CEA and rule 3a68–1b products/data/indices/credit-and-loan-indices/ name CDS or a CDS referencing a narrow-based under the Exchange Act. The final rules provide itraxx/itraxx.page . Examples of indexes based on security index as described above would be a that the term ‘‘reference entity’’ includes: (i) An securities include the Markit ABX.HE and CMBX security-based swap, while an option to enter into issuer of securities; (ii) an issuer of securities that indexes. See Markit, ‘‘Markit ABX.HE,’’ (describing a CDS on a broad-based security index or the is an issuing entity of asset-backed securities is a the Markit ABX.HE index as ‘‘a synthetic tradeable issuers of securities in a broad-based security index reference entity or issuer, as applicable; and (iii) an index referencing a basket of 20 subprime mortgage- would be a swap. Index CDS where the underlying issuer of securities that is a borrower with respect backed securities’’), available at http:// reference is a broad-based security index would be to any loan identified in an index of borrowers or www.markit.com/en/products/data/indices/ SBSAs. The SEC has enforcement authority with loans is a reference entity. The final rules provide structured-finance-indices/abx/abx.page; and respect to swaps that are SBSAs, as discussed that the term ‘‘issuer’’ includes: (i) An issuer of Markit, ‘‘Markit CMBX,’’ (describing the Markit further in section V., infra. securities; and (ii) an issuer of securities that is an CMBX index as ‘‘a synthetic tradeable index 753 See July 2006 Debt Index Rules. issuing entity of asset-backed securities is a referencing a basket of 25 commercial mortgage- 754 Section 3(a)(68)(A)(ii)(III) of the Exchange Act, reference entity or issuer, as applicable. See backed securities’’), available at http:// 15 U.S.C. 78c(a)(68)(A)(ii)(III). paragraph (c)(3) of rules 1.3(zzz) and 1.3(aaaa) www.markit.com/en/products/data/indices/ 755 Section 3(a)(68)(A)(ii)(I) of the Exchange Act, under the CEA and rule 3a68–1a and 3a68–1b structured-finance-indices/cmbx/cmbx.page. 15 U.S.C. 78c(a)(68)(A)(ii)(I). under the Exchange Act.

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previously issued and adopted is an event ‘‘relating to’’ the Commissions did not address in the regarding narrow-based security indexes borrower.764 To the extent that the Proposing Release the question of in the context of security futures, the borrower is an issuer of securities, the whether an index composed exclusively Commissions believe that there should index CDS based on such index of loans of loans should be treated as a narrow- be public information available about a will be analyzed under the third prong based security index.769 This predominant percentage of the reference of the security-based swap definition in commenter noted that because the first entities included in the index, or, in the the same manner as any other index and third prongs of the statutory case of an index CDS on an index of CDS. security-based swap definition do not securities, about the issuers of the explicitly reference loans, the statutory Comments securities or the securities underlying definition does not expressly categorize the index, in order to reduce the The Commissions received two Title VII instruments based on more likelihood that non-narrow-based general comments requesting that the than one loan, or contingent on events indexes referenced in index CDS or the proposed rules further defining the that occur with respect to more than one component securities or issuers of terms ‘‘issuers of securities in a narrow- loan borrower, unless such borrowers securities in that index would be readily based security index’’ and ‘‘narrow- are also ‘‘issuers of securities.’’ 770 Based susceptible to manipulation, as well as based security index’’ be simplified.765 on this commenter’s view of the to help prevent the misuse of material One commenter believed that the rules statutory definition, this commenter non-public information through the use were exceedingly complicated.766 requested that the Commissions clarify of CDS based on such indexes. Another commenter thought that the the treatment of indexes composed To satisfy these objectives, the criteria should allow transactions to be exclusively of loans.771 Another Commissions are adopting rules that are readily and transparently classifiable as commenter provided similar comments based on the criteria developed for debt a swap or security-based swap.767 The and also requested clarification indexes discussed above 760 but that commenters did not provide analysis regarding the treatment of CDS based on tailor these criteria to address index supporting their comments or indexes of loans.772 A third commenter CDS.761 These criteria are included recommend language changes. stated its view that the third prong of solely for the purpose of defining the The Commissions are adopting the the statutory security-based swap terms ‘‘narrow-based security index’’ rules regarding index CDS essentially as definition implies that Title VII and ‘‘issuers of securities in a narrow- proposed with certain modifications to instruments on a basket of loans are based security index’’ in the first and address commenters’ concerns. While security-based swaps if the lenders third prongs of the security-based swap the final rules contain a number of would satisfy the criteria for issuers of definition with respect to index CDS elements that are similar or identical to a ‘‘narrow-based security index’’ and and will not affect any other elements contained in the statutory encouraged the Commissions to clarify interpretation or use of the term narrow-based security index definition, this issue.773 The Commissions agree ‘‘narrow-based security index’’ or any in order to enable the narrow-based with commenters that an index CDS other provision of the Dodd-Frank Act, security index definition to apply based on an index of loans that are not the CEA, or the Exchange Act. appropriately to index CDS, the final securities is analyzed under the third Further, in response to rules contain some alternative tests to prong of the statutory security-based commenters,762 the Commissions are those set forth in the statutory swap definition and, therefore, are clarifying that if an index CDS is based definition. clarifying the treatment of these Title on an index of loans that are not The Commissions also recognize the VII instruments above.774 securities,763 an event relating to a loan diversity of Title VII instruments. While in the index, such as a default on a loan, the final rules for index CDS are based (i) Number and Concentration on the July 2006 Debt Index Rules, the Percentages of Reference Entities or 760 See discussion of July 2006 Debt Index Rules. substantive differences between the Securities 761 The Commissions note that the language of the final rules in the index CDS and the The Commissions believe that the first rules is intended, in general, to be consistent with equity or debt security contexts are the criteria developed for debt indexes discussed three criteria of the debt security index above. Certain changes from the criteria developed intended to reflect the particular test (which are based on the statutory for debt indexes are necessary to address characteristics of the CDS marketplace, narrow-based security index definition) differences between futures on debt indexes and in which, for example, index discussed above (i.e., the number and index CDS. Certain other changes are necessary components may be entities (issuers of because the rules for debt indexes define under concentration weighting requirements) what conditions an index is not a narrow-based securities) as well as specific equity and are appropriate to apply to index CDS, security index, whereas the rules for index CDS debt securities. define what is a narrow-based security index. For The Commissions also received three 769 See Allen & Overy Letter. example, an index is not a narrow-based security comments requesting clarification 770 Id. index under the rule for debt indexes if it is not a 771 narrow-based security index under either regarding the applicability of the index Id. subparagraph (a)(1) or paragraph (a)(2) of the rule. CDS rules to CDS based on indexes of 772 See July LSTA Letter. This commenter noted See July 2006 Debt Index Rules. Under the rules for loans.768 One commenter noted that the that prong (III) of the statutory security-based swap index CDS, however, an index is a narrow-based definition does not clearly reference borrowers of security index if it meets the requirements of both loans or indexes of borrowers. However, this 764 of the counterpart paragraphs in the rules regarding An index CDS referencing loans also may be commenter noted that because most borrowers that index CDS (paragraphs (1)(i) and (1)(ii) of rules based on events relating to the borrower, such as are named as reference entities in loan CDS 1.3(zzz) and 1.3(aaaa) under the CEA and paragraph bankruptcy, and to defaults on any obligation of the transactions are corporate entities that issue equity (a)(1) and paragraph (a)(2) of rules 3a68–1a and borrower. interests to one or more shareholders (although they 3a68–1b under the Exchange Act), even though the 765 See ISDA Letter and MarketAxess Letter. may not issue public securities or become subject criteria in the debt index rules and the rules for 766 See MarketAxess Letter. This commenter to public reporting requirements), this commenter index CDS include generally the same criteria and stated that ‘‘The Proposed Rules layout an believes that prong (III) can be interpreted to structure. exceedingly complex process for determining include swaps that reference a single borrower or 762 See infra note 768 and accompanying text. whether an index CDS is broad-based or narrow- borrowers of loans in an index. Id. 763 If the loans underlying the index of loans are based.’’ Id. 773 See SIFMA Letter. securities, the index CDS would be analyzed in the 767 See ISDA Letter. 774 The Commissions also are providing guidance same manner as any other index CDS based on an 768 See Allen & Overy Letter; July LSTA Letter; with respect to TRS based on two or more loans that index of securities. and SIFMA Letter. are not securities. See supra part III.C.

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whether CDS on indexes of securities or the index comprises more than 60 the number of non-affiliated reference indexes of issuers of securities.775 percent of the index’s weighting.780 entities or issuers of securities, or Accordingly, the Commissions are Similarly, the Commissions are securities issued by non-affiliated adopting the first three criteria of rule adopting as proposed the first three issuers, as applicable, included in an 1.3(zzz) under the CEA and rule 3a68– criteria of rule 1.3(aaaa) under the CEA index and the weighting of notional 1a under the Exchange Act as proposed and rule 3a68–1b under the Exchange amounts allocated to the reference with certain modifications in response Act. These three criteria provide that, entities or securities included in the to commenters’ concerns.776 These rules for purposes of determining whether an index, as applicable. These first three contain the same number and index CDS is a security-based swap criteria of the final rules evaluate the concentration criteria as proposed, but under section 3(a)(68)(A)(ii)(I) of the number and concentration of the modify the method of calculating Exchange Act,781 the term ‘‘narrow- reference entities or securities included affiliation among issuers and reference based security index’’ includes an index in the index, as applicable, and ensure entities in response to commenters.777 in which essentially the same criteria that an index with a small number of Further, in response to commenters,778 apply, substituting securities for issuers. reference entities, issuers, or securities the Commissions are providing an Under these criteria, the term ‘‘narrow- or concentrated in only a few reference additional interpretation with respect to based security index’’ would mean an entities, issuers, or securities is narrow- the application of these criteria to two index in which: based, and thus where such index is the • particular types of CDS, commonly Number: There are nine or fewer underlying reference of an index CDS, known as ‘‘nth-to-default CDS’’ and securities, or securities that are issued the index CDS is a security-based swap. ‘‘tranched CDS.’’ by nine or fewer non-affiliated issuers, Further, as more fully described The first three criteria provide that, included in the index, provided that a below,782 the final rules provide that a for purposes of determining whether an security shall not be deemed a reference entity or issuer of securities index CDS is a security-based swap component of the index unless (i) a included in an index and any of that under section 3(a)(68)(A)(ii)(III) of the credit event with respect to the issuer of reference entity’s or issuer’s affiliated such security or a credit event with Exchange Act,779 the term ‘‘issuers of entities (as defined in the final rules) respect to such security would result in securities in a narrow-based security that also are included in the index are a payment by the credit protection seller index’’ includes issuers of securities aggregated for purposes of determining to the credit protection buyer under the identified in an index (including an whether the number and concentration index CDS based on the related notional index referencing loan borrowers) in criteria are met. amount allocated to such security, or (ii) which: Specifically, the final rules provide the fact of such credit event or the that an index meeting any one of certain • Number: There are nine or fewer calculation in accordance with clause (i) identified conditions would be a non-affiliated issuers of securities that above of the amount owed with respect narrow-based security index. The first are reference entities included in the to such credit event is taken into condition in paragraph (1)(i)(A) of rule index, provided that an issuer of account in determining whether to make 1.3(zzz) under the CEA and paragraph securities shall not be deemed a any future payments under the index (a)(1)(i) of rule 3a68–1a under the reference entity included in the index CDS with respect to any future credit Exchange Act is that there are nine or unless (i) a credit event with respect to events; fewer non-affiliated issuers of securities such reference entity would result in a • Single Component Concentration: that are reference entities in the index. payment by the credit protection seller The effective notional amount allocated An issuer of securities counts toward to the credit protection buyer under the to the securities of any issuer included this total only if a credit event with index CDS based on the related notional in the index comprises more than 30 respect to such entity would result in a amount allocated to such reference percent of the index’s weighting; or payment by the credit protection seller entity; or (ii) the fact of such credit • Largest Five Component to the credit protection buyer under the event or the calculation in accordance Concentration: The effective notional index CDS based on the notional with clause (i) above of the amount amount allocated to the securities of any amount allocated to such entity, or if the owed with respect to such credit event five non-affiliated issuers included in fact of such a credit event or the is taken into account in determining the index comprises more than 60 calculation of the payment with respect whether to make any future payments percent of the index’s weighting. to such credit event is taken into under the index CDS with respect to any Thus, the applicability of the final account when determining whether to future credit events; rules depends on conditions relating to make any future payments under the • Single Component Concentration: index CDS with respect to any future The effective notional amount allocated 780 These rules refer to the ‘‘effective notional credit events. to any reference entity included in the amount’’ allocated to reference entities or securities in order to address potential situations in which the Similarly, the first condition in index comprises more than 30 percent means of calculating payout across the reference paragraph (1)(i)(A) of rule 1.3(aaaa) of the index’s weighting; or entities or securities is not uniform. Thus, if one or under the CEA and paragraph (a)(1)(i) of • Largest Five Component more payouts is leveraged or enhanced by the rule 3a68–1b under the Exchange Act structure of the transaction (i.e., 2x recovery rate), provides that a security counts toward Concentration: The effective notional that amount would be the ‘‘effective notional amount allocated to any five non- amount’’ for purposes of the 30 percent and 60 the total number of securities in the affiliated reference entities included in percent tests in paragraphs (1)(i)(B) and (1)(i)(C) of index only if a credit event with respect rules 1.3(zzz) and 1.3(aaaa) and paragraphs (a)(1)(ii) to such security, or the issuer of such and (a)(1)(iii) of rules 3a68–1a and 3a68–1b. 775 security, would result in a payment by See infra notes 792 and 793 and Similarly, if the aggregate notional amount under a accompanying text. CDS is not uniformly allocated to each reference the credit protection seller to the credit 776 See paragraphs (a)(1)(i)–(iii) of rules 1.3(zzz) entity or security, then the portion of the notional and 1.3(aaaa) under the CEA and rules 3a68–1a and amount allocated to each reference entity or 782 See infra part III.G.3(b)(ii), for a discussion of 3a68–1b under the Exchange Act. security (which may be by reference to the product the affiliation definition applicable to calculating 777 See infra note 804 and accompanying text. of the aggregate notional amount and an applicable the number and concentration criteria. As noted 778 See infra notes 795 and 796 and percentage) would be the ‘‘effective notional above, the Commissions are modifying the method accompanying text. amount.’’ of calculating affiliation for purposes of these 779 15 U.S.C. 78c(a)(68)(A)(ii)(III). 781 15 U.S.C. 78c(a)(68)(A)(ii)(I). criteria.

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protection buyer under the index CDS a percentage range of the total notional Exchange Act and the CEA,792 which based on the notional amount allocated amount of the CDS) because the CDS includes the same number and to such security, or if the fact of such payment takes into account a credit concentration percentages as the a credit event or the calculation of the event with respect to an index Commissions are adopting in this payment with respect to such credit component, even if the credit event release. The Commissions are not event is taken into account when itself does not result in such a payment. modifying the statutory definition to determining whether to make any future The second condition, in paragraphs change the percentages. The statutory payments under the index CDS with (1)(i)(B) of rules 1.3(zzz) and 1.3(aaaa) definition included the concentration respect to any future credit events. under the CEA and paragraphs (a)(1)(ii) percentages, which the Commissions These provisions are intended to of rules 3a68–1a and 3a68–1b under the understand are intended to assure that ensure that an index concentrated in a Exchange Act, is that the effective a security index could not be used as a few reference entities or securities, or a notional amount allocated to any surrogate for the underlying securities few reference entities that are affiliated reference entity or security of any issuer in order to avoid application of the (as defined in the final rules) or a few included in the index comprises more Federal securities laws. The securities issued by issuers that are than 30 percent of the index’s Commissions also previously affiliated, are within the narrow-based weighting. determined to retain these statutory security index definition.783 These percentages in connection with rules The third condition, in paragraphs provisions also are intended to ensure relating to debt security indexes in the (1)(i)(C) of rules 1.3(zzz) and 1.3(aaaa) that an entity is not counted as a security futures context.793 The under the CEA and paragraphs (a)(1)(iii) reference entity included in the index, Commissions believe that these of rules 3a68–1a and 3a68–1b under the and a security is not counted as a percentages are similarly appropriate to Exchange Act, is that the effective security included in the index, unless a apply to indexes on which index CDS notional amount allocated to any five credit event with respect to the entity, are based. Moreover, with respect to the non-affiliated reference entities, or to issuer, or security affects payout under number and concentration criteria, as the securities of any five non-affiliated a CDS on the index.784 these are in the statutory definition of issuers, included in the index comprises Further, as this condition is in the the term ‘‘narrow-based security index’’ more than 60 percent of the index’s alternative (i.e., either there must be a applicable to security futures, market weighting. credit event resulting in a payment participants have experience in under the index CDS or a credit event Given that Congress determined that analyzing indexes, including equity, is considered in determining future CDS these concentration percentages are volatility and debt security indexes, to payments), the tests encompass all appropriate to characterize an index as determine compliance with these index CDS. For example, and in a narrow-based security index, and the criteria. As discussed below,794 though, response to a commenter,785 the test Commissions have determined they are the Commissions are modifying the would cover an nth-to-default CDS,786 appropriate for debt security indexes in affiliation definition used in analyzing 789 in which default with respect to a the security futures context, the the number and concentration criteria specified component of an index (such Commissions believe that these for an index. as the first default or fifth default) concentration percentages are Two commenters requested triggers the CDS payment, even if the appropriate to apply to the notional clarification regarding nth-to-default CDS payment is not made with respect amount allocated to reference entities CDS, stating their view that such CDS to such particular credit event. As and securities in order to apply similar should be treated as security-based another example, and in response to standards to indexes that are the swaps to reflect their single-entity another commenter,787 the test applies underlying references of index CDS. triggers.795 Two commenters requested to a tranched CDS 788 if the payments Moreover, with respect to both the clarification regarding tranched index are made on only a tranche, or portion, number and concentration criteria, the CDS, including whether the CDS would of the potential aggregate notional markets have had experience with these be classified based on the underlying amount of the CDS (often expressed as criteria with respect to futures on equity index.796 As discussed above, the indexes, volatility indexes, and debt Commissions are providing an 790 783 This requirement is generally consistent with security indexes. interpretation on the applicability of the the definition of ‘‘narrow-based security index’’ in first three criteria of the rules to nth-to- Comments section 1a(35)(A) of the CEA, 7 U.S.C. 1a(35)(A), default CDS and tranched CDS. As and section 3(a)(55)(B) of the Exchange Act, 15 noted above, the Commissions believe U.S.C. 78c(a)(55)(B), and the July 2006 Debt Index One commenter expressed its view Rules. that the Commissions should increase the rules encompass all index CDS, 784 Id. the percentage test in the largest five regardless of the type or payment 785 See infra note 795 and accompanying text. component concentration.791 The 786 An ‘‘nth-to-default CDS’’ is a CDS in which Commissions are adopting the number 792 See 15 U.S.C. 78c(a)(55)(B) and 7 U.S.C. the payout is linked to one in a series of defaults and concentration criteria as proposed. 1a(35). (such as first-, second- or third-to-default), with the 793 The statutory definition of the term See July 2006 Debt Index Rules. contract terminating at that point. See SIFMA 794 See infra part III.G.3(b)(ii). Letter. ‘‘security-based swap’’ references the 795 See ISDA Letter and SIFMA Letter. One of 787 See infra note 796 and accompanying text. definition of the term ‘‘narrow-based these commenters noted that such an approach also 788 A ‘‘tranched CDS’’ is a CDS in which the security index’’ contained in the made sense for nth-to-default CDS because they are counterparties agree to buy and sell credit typically based on baskets of less than 10 securities. protection on only a portion of the potential losses See ISDA Letter. 789 that could occur on an underlying portfolio of See July 2006 Debt Index Rules. 796 See Markit Letter and SIFMA Letter. One of reference entities. The portion is typically denoted 790 As noted above, the Commissions are these commenters stated that classifying tranches as a specified percentage range of aggregate losses modifying the method of calculating affiliation for underlying index CDS according to attachment or (e.g., 2 percent to 5 percent, meaning the credit purposes of the number and concentration criteria. detachment points is not appropriate because it is protection seller would not make payments until See infra part III.G.3(b)(ii). impossible to know for certain at inception of the aggregate losses exceed 2 percent of the notional of 791 See ISDA Letter. According to this commenter, CDS the number of credit events that will the transaction, and would no longer be obligated the ‘‘operational complexity’’ of the number and ultimately affect actual payments, which typically to make payments after aggregate losses reach 5 concentration criteria will increase costs and depend on the severity of loss associated with each percent). See SIFMA Letter. compliance risks. Id. credit event. See SIFMA Letter.

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structure, such as whether there is a of 20 percent ownership.801 This change that majority ownership is consistent single-entity payment based on credit is based on the Commissions’ with current market practice, including events of other index components or consideration of comments received.802 the definition of affiliate included in the whether the payment is based on a By using a more than 50 percent (i.e., 2003 ISDA Credit Derivatives specific entity. majority ownership) test rather than a Definitions.805 One commenter also 20 percent ownership test for the stated its belief that affiliated entities (ii) Affiliation of Reference Entities and control threshold, there is a greater should only be aggregated where the Issuers of Securities With Respect to likelihood that there will be an reference entities’ credit risks are Number and Concentration Criteria alignment of economic interests of the substantially similar and credit The Commissions are adopting the affiliated entities that is sufficient to decisions are made by the same group 806 affiliation definition that applies when aggregate reference entities or issuers of of individuals. This commenter calculating the number and securities included in an index for stated its view that 20 percent purposes of the number and ownership is too low and that majority concentration criteria with certain 803 modifications from the proposal to concentration criteria. ownership is necessary for credit risk As the affiliation definition is applied address commenters’ concerns.797 The and credit decisions to be aligned to the number criterion, affiliated final rules provide that the terms enough as to warrant collapsing two reference entities or issuers of securities ‘‘reference entity included in the index’’ issuers into one for purposes of the included in an index will be viewed as 807 and ‘‘issuer of the security included in number and concentration criteria. a single reference entity or issuer of As stated above, the Commissions are the index’’ include a single reference securities to determine whether there modifying the affiliation definition that entity or issuer of securities included in are nine or fewer non-affiliated applies when calculating the number an index, respectively, or a group of reference entities included in the index and concentration criteria in response to affiliated reference entities or issuers or securities that are issued by nine or commenters to use an affiliation test included in an index, respectively.798 fewer non-affiliated issuers. Similarly, based on majority ownership. Based on For purposes of the rules, affiliated as the affiliation definition is applied to commenters’ letters, the Commissions reference entities or issuers of securities the concentration criteria, the notional understand that the current standard included in an index or securities amounts allocated to affiliated reference CDS documentation and the current included in an index issued by affiliated entities included in an index or the approach used by certain index issuers will be counted together for securities issued by a group of affiliated providers for index CDS with respect to determining whether the number and issuers of securities included in an the inclusion of affiliated entities in the concentration criteria are met. However, index must be aggregated to determine same index use majority ownership with respect to asset-backed securities, the level of concentration of the rather than 20 percent ownership to the final rules provide that each components of the index for purposes of determine affiliation. The Commissions reference entity or issuer of securities the 30-percent and 60-percent are persuaded by commenters that, in included in an index that is an issuing concentration criteria. the case of index CDS only it is more entity of an asset-backed security is appropriate to use majority ownership considered a separate reference entity or Comments because majority-owned entities are issuer, as applicable, and will not be Three commenters requested that the more likely to have their economic considered affiliated with other Commissions revise the affiliation interests aligned and be viewed by the reference entities or issuers of securities definition that applies when calculating market as part of a group. The included in the index. the number and concentration criteria to Commissions believe that revising the The final rules provide that a increase the control threshold from 20 affiliation definition in this manner for reference entity or issuer of securities percent ownership to majority purposes of calculating the number and included in an index is affiliated with ownership.804 These commenters noted concentration criteria responds to another reference entity or issuer of commenters’ concerns that the securities included in the index if it 801 See Proposing Release at 29849. percentage control threshold may controls, is controlled by, or is under 802 See infra note 804 and accompanying text. inadvertently include entities that are The Commissions note that another alternative not viewed as part of a group. Thus, as common control with, that other would have been to include a requirement that the 799 reference entity or issuer. The final entities satisfy the 20 percent control threshold and revised, the affiliation definition will rules define control, solely for purposes also be consolidated with each other in financial include only those reference entities or of this affiliation definition, to mean statements. The Commissions did not include a issuers included in an index that satisfy requirement that the entities be consolidated with the more than 50 percent (i.e., majority ownership of more than 50 percent of a each other in financial statements because they do reference entity’s or issuer’s equity or not believe that the scope of the affiliation ownership) control threshold. The the ability to direct the voting of more definition should be exposed to the risk of future than 50 percent of a reference entity’s or changes in accounting standards. Further, the use Commissions clarify the application of the 800 of a majority ownership control threshold (more affiliation definition. See Markit Letter. The issuer’s voting equity. The affiliation than 50 percent) is generally consistent with Commissions have provided above and in infra part definition in the final rules differs from consolidation under generally accepted accounting III.G.3(b)(ii), several examples illustrating the the definition included in the proposal, principles. See FASB ASC section 810–10–25, application of the affiliation definition in response which provided for a control threshold Consolidation—Overall—Recognition (stating that to this commenter. consolidation is appropriate if a reporting entity has 805 Id. a controlling financial interest in another entity and 806 See SIFMA Letter. The ISDA Letter provides 797 See infra note 804 and accompanying text. a specific scope exception does not apply). a similar rationale that ‘‘the control threshold was 798 See paragraph (c)(4) of rules 1.3(zzz) and 803 In such a case, as noted by commenters, the too low and potentially disruptive when viewed 1.3(aaaa) under the CEA and rule 3a68–1a and affiliated entities are viewed as part of group for against entities that the swap markets now trade as 3a68–1b under the Exchange Act. which aggregation of these entities is appropriate. separate entities. In the CDS market, for example, 799 See paragraph (c)(1) of rules 1.3(zzz) and See infra note 806 and accompanying text. entities that share ownership ties of substantially 1.3(aaaa) under the CEA and rules 3a68–1a and 804 See ISDA Letter (requesting a threshold of at more than 20 percent trade quite independently. 3a68–1b under the Exchange Act. least 50 percent); Markit Letter (requesting a These entities may have completely disparate 800 See paragraph (c)(2) of rules 1.3(zzz) and threshold of at least 50 percent); and SIFMA Letter characteristics for the purpose of an index grouping 1.3(aaaa) under the CEA and rules 3a68–1a and (requesting a threshold of majority ownership, or 51 of one sort or another.’’ See ISDA Letter. 3a68–1b under the Exchange Act. percent). One commenter also requested that the 807 See SIFMA Letter.

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Commissions believe that determining index would be readily susceptible to Exchange Act 816 and the rules affiliation in this manner for purposes of manipulation. The fourth condition in promulgated thereunder (except a calculating the number and the index CDS rules sets out a similar municipal security); concentration criteria responds to the public information availability test that • The reference entity or the issuer of commenters’ concerns. is intended solely for purposes of the security included in the index is a The Commissions also believe that the determining whether an index government of a foreign country or a modified affiliation definition addresses underlying a CDS is narrow-based.809 political subdivision of a foreign commenters’ concerns noted above 808 The Commissions are adopting the country; or that the rules further defining the terms public information availability test • If the reference entity or the issuer ‘‘issuers of securities in a narrow-based essentially as proposed with certain of the security included in the index is security index’’ and ‘‘narrow-based modifications to address commenters’ an issuing entity of asset-backed security index’’ should be simplified. concerns, including modifications to the securities as defined in section 3(a)(77) The modified affiliation definition definition of affiliation for purposes of of the Exchange Act,817 such asset- enables market participants to make an satisfying certain criteria of the public backed security was issued in a affiliation determination for purposes of information availability test.810 transaction registered under the calculating the number and The Commissions are adopting final Securities Act and has publicly concentration criteria by measuring the rules under which an index CDS will be available distribution reports. more than 50 percent (i.e., majority considered narrow-based (except as However, so long as the effective ownership) control threshold. discussed below) if a reference entity or notional amounts allocated to reference entities or securities included in the (iii) Public Information Availability security included in the index does not meet any of the following criteria: 811 index that satisfy the public information Regarding Reference Entities and • availability test comprise at least 80 Securities The reference entity or the issuer of the security included in the index is percent of the index’s weighting, failure In addition to the number and required to file reports pursuant to the by a reference entity or security concentration criteria, the debt security Exchange Act or the regulations included in the index to satisfy the index test also includes, as discussed thereunder; public information availability test will above, a public information availability • The reference entity or the issuer of be disregarded if the effective notional test. The public information availability the security included in the index is amounts allocated to that reference test is intended as the substitute for the eligible to rely on the exemption entity or security comprise less than five 818 average daily trading volume (‘‘ADTV’’) provided in rule 12g3–2(b) under the percent of the index’s weighting. In provision in the statutory narrow-based Exchange Act; 812 this situation, the public information security index definition. An ADTV test • The reference entity or the issuer of availability test for purposes of the is designed to take into account the the security included in the index has index would be satisfied. trading of individual stocks and, a worldwide market value of its The determination as to whether an because Exchange Act registration of the outstanding common equity held by index CDS is narrow-based is security being traded is a listing non-affiliates of $700 million or conditioned on the likelihood that standard for equity securities, the issuer more; 813 information about a predominant of the security being traded must be • The reference entity or the issuer of percentage of the reference entities or subject to the reporting requirements the security included in the index (other securities included in the index is 819 under the Exchange Act. Based on the than a reference entity or an issuer of publicly available. For example, a provisions of the statutory ADTV test, the security included in the index that reference entity or an issuer of securities the Commissions have determined that is an issuing entity of an asset-backed 816 the ADTV test is not useful for purposes security as defined in section 3(a)(77) of 15 U.S.C. 78c(a)12. 817 15 U.S.C. 78c(a)(77). of determining the status of the index on the Exchange Act 814) has outstanding which the index CDS is based because 818 See paragraph (b) of rules 1.3(zzz) and notes, bonds, debentures, loans, or 1.3(aaaa) under the CEA and rule 3a68–1a and index CDS most commonly reference evidences of indebtedness (other than 3a68–1b under the Exchange Act. entities, which do not ‘‘trade,’’ or debt revolving credit facilities) having a total 819 Most of the thresholds in the public instruments, which commonly are not remaining principal amount of at least information availability test are similar to those the Commissions adopted in their joint rules regarding listed, and, therefore, do not have a $1 billion; 815 significant trading volume. However, the application of the definition of the term • The reference entity included in the ‘‘narrow-based security index’’ to debt security the underlying rationale of such index is an issuer of an exempted indexes and security futures on debt securities. See provision, that there is sufficient trading security, or the security included in the July 2006 Debt Index Rules. The July 2006 Debt in the securities and therefore public index is an exempted security, each as Index Rules also included an additional information and market following of the requirement regarding the minimum principal defined in section 3(a)(12) of the amount outstanding for each security in the index. issuer of the securities, applies to index The Commissions have not included this CDS. 809 See Proposing Release at 29850. requirement in rule 1.3(zzz) under the CEA and rule In general, if an index is not narrow- 810 See infra notes 845, 847, 849 and 867 and 3a68–1a under the Exchange Act. That requirement based under the number and accompanying text. was intended as a substitute criterion for trading volume because the trading volume of debt 811 See paragraphs (a)(1)(iv)(A)–(G) of rules concentration criteria, it will be narrow- securities with a principal amount outstanding 1.3(zzz) and 1.3(aaaa) under the CEA and rule based if one of the reference entities or above that minimum amount was found to be 3a68–1a and 3a68–1b under the Exchange Act. securities included in the index fails to generally larger than debt securities with a 812 17 CFR 240.12g3–2(b). meet at least one of the criteria in the principal amount outstanding below that minimum 813 See July 2006 Debt Index Rules (noting that amount. See July 2006 Debt Index Release. There public information availability test. This issuers having worldwide equity market is no similar criterion that would be applicable in test was designed to reduce the capitalization of $700 million or more are likely to the context of index CDS. The numerical thresholds likelihood that broad-based debt have public information available about them). also are similar to those the SEC adopted in other security indexes or the component 814 15 U.S.C. 78c(a)(77). contexts, including in the existing definitions of 815 See July 2006 Debt Index Rules (noting that ‘‘well-known seasoned issuer’’ and ‘‘large securities or issuers of securities in that issuers having at least $1 billion in outstanding debt accelerated filer.’’ See rule 405 under the Securities are likely to have public information available Act, 17 CFR 230.405, and rule 12b–2 under the 808 See supra note 765 and accompanying text. about them). Exchange Act, 17 CFR 240.12b–2.

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included in the index that is required to As more fully described below,824 for thus index CDS where the underlying file reports pursuant to the Exchange purposes of satisfying one of these references or securities are such indexes Act or the regulations thereunder makes issuer eligibility criteria, the final rules as security-based swaps, should help to regular and public disclosure through provide that a reference entity or an ensure that the index cannot be used to those filings. Moreover, a reference issuer of securities included in an index circumvent the Federal securities laws, entity or an issuer of securities included may rely upon the status of an affiliated including those relating to Securities in the index that does not file reports entity as an Exchange Act reporting Act compliance and the antifraud, with the SEC but that is eligible to rely company or foreign private issuer or antimanipulation and insider trading on the exemption in rule 12g3–2(b) may aggregate the worldwide equity prohibitions with respect to the index under the Exchange Act (i.e., foreign market capitalization or outstanding components or the securities of the private issuers) is required to make indebtedness of an affiliated entity, reference entities. certain types of financial information regardless of whether such affiliated As noted above, if an index is not publicly available in English on its Web entity itself or its securities are included narrow-based under the number and site or through an electronic information in the index. concentration criteria, it will be narrow- delivery system generally available to In the case of indexes including asset- based if one of the reference entities or the public in its primary trading backed securities, or reference entities securities included in the index fails to markets.820 that are issuing entities of asset-backed meet at least one of the criteria in the The Commissions believe that other securities, information about the public information availability test. reference entities or issuers of securities reference entity or issuing entity of the However, even if one or more of the included in the index that do not file asset-backed security will not alone be reference entities or securities included reports with the SEC, but that have sufficient and, consequently, the rules in the index fail the public information worldwide equity market capitalization provide that the public information availability test, the final rules provide of $700 million or more, have at least $1 availability test will be satisfied only if that the index will not be considered billion in outstanding debt obligations certain information also is available ‘‘issuers of securities in a narrow-based (other than in the case of issuing entities about the asset-backed securities. An security index’’ or a ‘‘narrow-based of asset-backed securities), issue issuing entity (whether or not a security index,’’ so long as the exempted securities (other than reference entity) of asset-backed applicable reference entity or security municipal securities), or are foreign securities will meet the public that fails the test represents less than sovereign entities either are required to information availability test if such five percent of the index’s weighting, or are otherwise sufficiently likely, asset-backed securities were issued in a and so long as reference entities or solely for purposes of the ‘‘narrow-based transaction for which the asset-backed securities comprising at least 80 percent security-index’’ and ‘‘issuers of securities issued (which includes all of the index’s weighting satisfy the securities in a narrow-based security tranches) 825 were registered under the public information availability test. index’’ definitions, to have public Securities Act and distribution reports An index that includes a very small information available about them.821 about such asset-backed securities are proportion of reference entities or In response to commenters,822 the publicly available. In response to securities that do not satisfy the public Commissions are modifying the commenters,826 the Commissions note information availability test will be outstanding debt threshold criterion in that distribution reports, which treated as a broad-based security index the public information availability test sometimes are referred to as servicer if the other elements of the definition, to include any indebtedness, including reports, delivered to the trustee or including the five percent and 80 loans, so long as such indebtedness is security holders, as the case may be, are percent thresholds, are satisfied prior to not a revolving credit facility. The filed with the SEC on Form 10–D. In execution, but no later than when the Commissions believe that expanding the addition, because of the lack of public parties offer to enter into the index 828 definition of indebtedness to include information regarding many asset- CDS. The five-percent weighting loans (other than revolving credit) for backed securities, despite the size of the threshold is designed to provide that purposes of the debt threshold outstanding amount of securities,827 the reference entities or securities not determination is consistent with the rules do not permit such reference satisfying the public information view that entities that have significant entities and issuers to satisfy the public availability test comprise only a very outstanding indebtedness likely will information availability test by having at small portion of the index, and the 80- have public information available about least $1 billion in outstanding percent weighting threshold is designed them.823 indebtedness. Characterizing an index to provide that a predominant with reference entities or securities for percentage of the reference entities or 820 17 CFR 240.12g3–2(b). which public information is not likely securities in the index satisfy the public 821 It is important to note that the public to be available as narrow-based, and information availability test. As a result, information availability test is designed solely for these thresholds provide market purposes of distinguishing between index CDS that 824 See infra part III.G.3(b)(iv), for a discussion participants with flexibility in are swaps and index CDS that are security-based regarding the affiliation definition applicable to the constructing an index. The swaps. The proposed criteria are not intended to public information availability test. As noted above, provide any assurance that there is any particular the Commissions are modifying the method of Commissions believe that these level of information actually available regarding a calculating affiliation for purposes of this test. thresholds are appropriate and that particular reference entity or issuer of securities. 825 Under this part of the public information providing such flexibility is not likely to Meeting one or more of the criteria for the limited availability test, all offerings of the asset-backed increase the likelihood that an index purpose here—defining the terms ‘‘narrow-based securities will have to be covered by a registration that satisfies these provisions or the security index’’ and ‘‘issuers of securities in a statement under the Securities Act, including all narrow-based security index’’ in the first and third tranches, so that public information would exist for component securities or issuers of prongs of the security-based swap definition with any tranche included in an index. However, as securities in that index would be readily respect to index CDS—would not substitute for or noted below, CDS that are offered to ECPs only may susceptible to manipulation or that satisfy any other requirement for public disclosure rely on alternatives to satisfy the public information of information or public availability of information test for asset-backed securities. there would be misuse of material non- for purposes of the Federal securities laws. 826 See infra note 849 and accompanying text. public information about the component 822 See infra note 845 and accompanying text. 827 See generally Asset-Backed Securities, 75 FR 823 See July 2006 Debt Index Release. 23328 (May 3, 2010). 828 See supra note 625 and accompanying text.

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securities or issuers of securities in that information availability test applicable participants engaged in swap and index through the use of CDS based on to index CDS entered into solely security-based swap transactions.835 such indexes. between ECPs to clarify that the rule One commenter suggested replacing the The final rules also provide that, for 144A information must either be made public information availability test with index CDS entered into solely between publicly available or otherwise made a volume trading test.836 ECPs, there are alternative means to available to the ECP. In addition, the The Commissions are adopting the satisfy the public information Commissions are clarifying that public information availability test as availability test. Under the final rules, financial information about the proposed with certain modifications solely for index CDS entered into reference entity or the issuer of the described above. As discussed above, between ECPs, an index will be security may otherwise be publicly the public information availability test considered narrow-based if a reference available through an issuer’s Web site, is intended as the substitute for the entity or security included in the index through public filings with other ADTV provision in the statutory does not meet (i) any of the criteria regulators or exchanges, or through narrow-based security index definition, enumerated above or (ii) any of the other electronic means. This method of which the Dodd-Frank Act included as following criteria: 829 satisfying the public information the method for determining whether • The reference entity or the issuer of availability test does not specify the index CDS are swaps or security-based the security included in the index (other precise method by which financial swaps. Based on the reasons discussed than a reference entity or issuer information must be available. above, the Commissions have retained included in the index that is an issuing As with other index CDS, with respect the public information availability test entity of an asset-backed security) to index CDS entered into solely with as the underlying rationale of such makes available to the public or ECPs, if the percentage of the effective provision, that there is sufficient trading otherwise makes available to such ECP notional amounts allocated to reference in the securities and therefore public information about such reference entity entities or securities satisfying this information and market following of the or issuer pursuant to rule 144A(d)(4) expanded public information issuer of the securities, applies to index 830 under the Securities Act; availability test comprise at least 80 CDS. Accordingly, the Commissions • Financial information about the percent of the index’s weighting, then a believe that there should be public reference entity or the issuer of the reference entity or security included in information available about a security included in the index (other the index that fails to satisfy the predominant percentage of the reference than a reference entity or issuer alternative public information test entities or issuers of securities included in the index that is an issuing criteria will be disregarded so long as underlying the index in order to prevent entity of an asset-backed security) is the effective notional amount allocated circumvention of other provisions of the otherwise publicly available; or to that reference entity or security • In the case of an asset-backed Federal securities laws through the use comprises less than five percent of the of CDS based on such indexes, to reduce security included in the index, or a index’s weighting. reference entity included in the index the likelihood that the index, the that is an issuing entity of an asset- Comments component securities, or the named backed security, information of the type The Commissions received a number issuers of securities in the index could and level included in public of general and specific comments be readily susceptible to manipulation, distribution reports for similar asset- regarding the public information and to prevent the misuse of material backed securities is publicly available availability test. non-public information about such an about both the reference entity or A number of commenters believed index, the component securities, or the issuing entity and the asset-backed that the public information availability reference entities. security. test should not be included in the final The Commissions understand that the As more fully described below, for rules for various reasons, including the characterization of an index underlying purposes of satisfying either the rule potential disparate treatment between a CDS as broad-based or narrow-based 144A information criterion or the products based on indexes due to may change because of changes to the financial information otherwise publicly changes in index components,833 the index, such as addition or removal of available criterion, the final rules impact of the migration of indexes from components, or changes regarding the provide that a reference entity or an narrow-based to broad-based and vice- issuer of securities included in an index versa,834 and assertions that the test was 835 See ISDA Letter. This commenter expressed its belief that the public information availability test is may look to an affiliated entity to not needed due to the types of not needed given the largely institutional nature of determine whether it satisfies one of the existing over-the-counter market. Id. See also these criterion, regardless of whether 833 See SIFMA Letter. This commenter expressed July LSTA Letter. such affiliated entity itself or its its concern that transactions on the same or similar 836 See Markit Letter. This commenter expressed 831 indexes may result in differing regulatory treatment its belief that a volume-based classification process securities are included in the index. due to changes in index components as a result of would be preferable to the public information 832 In response to commenters, the component adjustments or as the availability of availability test for several reasons. First, the Commissions are revising the rule 144A information relating to a component issuer changes statutory definition of ‘‘narrow-based security information criterion of the public over time. Id. index’’ includes a volume-based factor. Second, a 834 See Markit Letter. According to this volume-based factor could be applied easily and commenter, determining whether an index of loans transparently because the outstanding notional 829 See paragraph (a)(1)(iv)(H) of rules 1.3(zzz) or borrowers meets the public information volume of CDS referencing each index constituent and 1.3(aaaa) under the CEA and rule 3a68–1a and availability test would be more difficult and more is captured by the Trade Information Warehouse. 3a68–1b under the Exchange Act. costly than making the same determination for an Third, an index classification based on outstanding 830 17 CFR 230.144A(d)(4). index of securities, which ‘‘are generally subject to notional amount as opposed to the public 831 See infra part III.G.3(b)(iv), for a discussion national or exchange-based reporting and disclosure information availability test would result in less regarding the affiliation definition applicable to the regimes’’ and could create regulatory uncertainty. indices migrating from broad- to narrow-based public information availability test applicable to Id. This commenter also expressed its belief that the classifications, and vice versa. This commenter also index CDS entered into solely between ECPs. As public information availability test would cause expressed its belief that a volume-based test would noted above, the Commissions are modifying the indexes to switch between a narrow-based and ensure that broad-based indices are not readily method of calculating affiliation for purposes of this broad-based classification, which could result in susceptible to manipulation because indexes based test. unnecessary cost, confusion, and market disruption. on constituents with high volumes are likely to 832 See infra note 847 and accompanying text. Id. have significant public information available. Id.

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specific components of the index, such index CDS would have to be determined criteria for the public information as a decrease in the amount of before any trading volume could exist availability test,843 the Commissions outstanding common equity for a and, therefore, the index CDS would fail believe that the information tests of the component. However, these types of a volume-based test. The Commissions rule as modified will address these changes are contemplated by the also believe that a volume-based test concerns. The modified rule will add statutory narrow-based security index based either on the CDS components of loans to the categories of instruments to definition, which the Dodd-Frank Act the index or the index itself would not be aggregated for purposes of the used to establish whether index CDS are be an appropriate substitute for or an outstanding indebtedness criterion and, swaps or security-based swaps.837 alternative to a public information as discussed below, will aggregate Moreover, the Commissions have availability test with respect to the outstanding indebtedness of provided that the determination of referenced entity, issuer of securities, or affiliates.844 As a result of these whether a Title VII instrument is a underlying security because such a modifications, the Commissions believe swap, security-based swap or mixed volume-based test would not provide that the indexes the commenter was swap is made prior to execution, but no transparency on such underlying concerned about may be more likely to later than when the parties offer to enter entities, issuers of securities or satisfy the public information into the Title VII instrument,838 and securities.841 availability test. does not change if a security index The Commissions believe that the One commenter agreed with underlying such instrument public information availability test in including an outstanding debt threshold subsequently migrates from broad to the index CDS rules allows more as a criterion in the public information narrow (or vice versa) during its life. flexibility with respect to the types of availability test, but requested that the Accordingly, even if the public components included in indexes Commissions change this criterion to information availability test would underlying index CDS. For many include loans that are not within the cause indexes underlying index CDS to indexes, such as bespoke indexes, definition of security, as well as affiliate migrate as suggested by a commenter, trading volume for CDS on individual debt guaranteed by the issuer of that will not affect the classification of components may not be significant even securities or reference entity, and to outstanding index CDS entered into though the index component would reduce the required outstanding debt prior to such migration. However, if an otherwise have no trouble satisfying one threshold from $1 billion to $100 amendment or change is made to such of the criteria of the public information million.845 As discussed above, the outstanding index CDS that would availability test. The public information Commissions are revising the rules to cause it to be a new purchase or sale of availability test in the index CDS rules expand the types of debt that are such index CDS, that could affect the also is very similar to the test in the counted toward the $1 billion debt classification of such outstanding index rules for debt security indexes, which, CDS. Further, as is true for other threshold to include any indebtedness, as noted above, apply in the context of including loans, so long as such products using the narrow-based Title VII instruments, thus providing a security index definition, the indebtedness is not a revolving credit consistent set of rules under which facility. The Commissions have made no Commissions also believe that the index compilers and market participants effects of changes to an index other changes to the $1 billion debt can analyze the characterization of CDS. threshold. underlying a CDS traded on an One commenter also had concerns organized platform are addressed regarding specific types of indexes and The Commissions believe that the fact through the tolerance period and grace specific types of index components, that an entity has guaranteed the period rules the Commissions are including the applicability of the public obligations of another entity will not adopting, which rules are based on information availability test to indexes affect the likelihood that public tolerance period and grace period rules of loans or borrowers.842 As discussed information is available about either the for security futures to which the above, however, the Commissions borrower on the guaranteed obligation statutory narrow-based security index believe that index CDS based on indexes or on the guarantor entity. However, the definition applies.839 of loans or borrowers should be Commissions note that they are The Commissions are not adopting a analyzed under the third prong of the providing an additional interpretation volume-based test based on the trading statutory security-based swap definition on the affiliation definition of the index of the CDS or the trading of the index, in the same manner as any other index CDS rules, including modifying the either as a replacement for the public CDS. Although this commenter noted method of calculating affiliation, that information availability test or as an such indexes may include a higher should address this commenter’s alternative means of satisfying it, as one proportion of ‘‘private’’ borrowers (those concerns regarding guaranteed affiliate 840 commenter suggested. The borrowers who are not public reporting Commissions believe that using a companies or that do not register 843 Id. volume-based test based on the trading offerings of their securities) and thus 844 As noted above, the Commissions are of the CDS or the trading of the index may themselves not satisfy any of the modifying the method of calculating affiliation for would not work in the index CDS purposes of certain criteria of the public information availability test. See infra part context because the character of the 841 In the context of equity securities indexes to III.G.3(b)(iv). which the ADTV test applies, there likely is 845 See Markit Letter. This commenter suggested 837 The index migration issue exists for all information regarding the underlying entities, that the debt threshold should be reduced to $100 products in which the ‘‘narrow-based security issuers of securities or securities because, as noted million because debt issuances in some debt index’’ definition is used. Thus, as is true for above, Exchange Act registration of the security markets, such as the high yield markets, tend to be security futures, the migration issue exists for debt being traded is a listing standard for equity relatively small. This commenter also suggested security indexes and the statutory definition of the securities and, therefore, the issuer of the security that the debt threshold should include debt term ‘‘narrow-based security index,’’ under which being traded must be subject to the reporting guaranteed by the issuer of the securities or an index’s characterization may be affected by a requirements under the Exchange Act. However, in reference entity because in many cases the issuer change to the index itself or to the components of the context of index CDS, there are no comparable of the securities or reference entity is merely the index. listing standards that would be applicable to guaranteeing debt of its affiliates and not issuing the 838 See supra note 625 and accompanying text. provide transparency on the underlying entities, debt. Finally, this commenter requested 839 See infra part III.G.6. issuers of securities or securities. clarification as to whether the debt threshold 840 See supra note 836 and accompanying text. 842 See July LSTA Letter. included loans and leveraged loans.

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debt.846 The Commissions also believe The Commissions are adopting as reference entity or issuer of the security that the $1 billion debt threshold, which proposed the provisions of the public included in the index is required to file is the same amount as the outstanding information availability test applicable reports pursuant to the Exchange Act or debt threshold in the rules for debt to indexes based on asset-backed the regulations thereunder; 856 (ii) the security indexes, is set at the securities. The Commissions note that reference entity or issuer of the security appropriate level to achieve the there are two possible ways to satisfy included in the index is eligible to rely objective that such entities are likely to the public information availability test on the exemption provided in rule have public information available about for index CDS based on asset-backed 12g3–2(b) under the Exchange Act for them. securities or asset-backed issuers. For foreign private issuers; 857 (iii) the One commenter suggested that the index CDS available to non-ECPs, all reference entity or issuer of the security proposed rule 144A information asset-backed securities in the index or of included in the index has a worldwide criterion of the public information the issuer in the index must have been market value of its outstanding common availability test applicable to index CDS sold in registered offerings under the equity held by non-affiliates of $700 entered into solely between ECPs Securities Act and have publicly million or more; 858 and (iv) the should be satisfied if the issuer made available distribution reports. The reference entity or issuer of the security the rule 144A information available Commissions are clarifying that included in the index has outstanding upon request to the public or to the ECP monthly service reports filed with the notes, bonds, debentures, loans, or in question, rather than being required SEC will satisfy the requirement for evidences of indebtedness (other than to provide the information.847 In publicly available distribution revolving credit facilities) having a total response to this commenter, the reports.853 However, for index CDS remaining principal amount of at least Commissions are revising the rule 144A being sold only to ECPs, the public $1 billion.859 This affiliation definition information criterion of the public information availability test with also applies for purposes of determining information availability test applicable respect to the index components is whether a reference entity or issuer of to index CDS entered into solely satisfied, regardless of whether the securities included in an index satisfies between ECPs to clarify that the rule asset-backed securities have been sold one of the following two criteria of the 144A information must be made in registered offerings under the alternative public information publicly available or otherwise made Securities Act, if information of the type availability test applicable to index CDS available to the ECP. and level included in public entered into solely between ECPs: (i) The Commissions received one distribution reports for similar asset- The reference entity or issuer of the comment regarding the criteria of the backed securities is publicly available security included in the index makes public information availability test that about both the issuing entity and such available rule 144A information; 860 and relate specifically to asset-backed asset-backed securities. The (ii) financial information about the securities.848 The commenter was Commissions believe that requiring reference entity or issuer of the security concerned that the test for asset-backed such information about the asset-backed included in the index is otherwise securities underlying an index may be securities and the assets in the pools publicly available.861 difficult to apply because all asset- underlying such asset-backed securities The final rules provide that the terms backed securities underlying an index is consistent with existing disclosure ‘‘reference entity included in the index’’ are not always registered under the requirements for asset-backed securities and ‘‘issuer of the security included in Securities Act.849 This commenter also and existing practices of ABS issuers. the index’’ include a single reference entity or issuer of securities included in was concerned that the term (iv) Affiliation of Reference Entities and ‘‘distribution reports’’ may not be the an index, respectively, or a group of Issuers of Securities With Respect to 862 same as monthly service reports, which Certain Criteria of the Public affiliated entities. For purposes of the this commenter indicated are available Information Availability Test rules, a reference entity or issuer of through the deal trustee and/or the SEC securities included in an index may rely The Commissions are adopting the Web site.850 This commenter also upon an affiliated entity to satisfy affiliation definition that applies to believed that it was unclear whether certain criteria of the public information certain criteria of the public information these monthly service reports would availability test. However, with respect availability test with certain qualify as ‘‘distribution reports’’ for to asset-backed securities, the final rules modifications from the proposals to purposes of the public information provide that each reference entity or address commenters’ concerns.854 The availability test and whether issuer of securities included in an index Commissions are making modifications information regarding Agency MBS to this affiliation definition that are the 856 pools, which are available on Agency See paragraph (a)(1)(iv)(A) of rules 1.3(zzz) same as the modifications the Web sites, would be sufficient to satisfy and 1.3(aaaa) under the CEA and rule 3a68–1a and Commissions are making to the 3a68–1b under the Exchange Act. the public information availability 857 See paragraph (a)(1)(iv)(B) of rules 1.3(zzz) 851 affiliation definition that applies when test. In addition, this commenter calculating the number and and 1.3(aaaa) under the CEA and rule 3a68–1a and 3a68–1b under the Exchange Act. requested that the Commissions clarify concentration criteria.855 that not all tranches of a transaction 858 See paragraph (a)(1)(iv)(C) of rules 1.3(zzz) This affiliation definition applies for and 1.3(aaaa) under the CEA and rule 3a68–1a and need to be registered under the purposes of determining whether a 3a68–1b under the Exchange Act. Securities Act to satisfy the publicly reference entity or issuer of securities 859 See paragraph (a)(1)(iv)(D) of rules 1.3(zzz) available distribution report included in an index satisfies one of the and 1.3(aaaa) under the CEA and rule 3a68–1a and 852 requirement. following four criteria of the public 3a68–1b under the Exchange Act. 860 See paragraph (a)(1)(iv)(H)(1) of rules 1.3(zzz) information availability test: (i) The and 1.3(aaaa) under the CEA and rule 3a68–1a and 846 See infra part III.G.3(b)(iv). 3a68–1b under the Exchange Act. 847 See SIFMA Letter. 853 Distribution reports, which sometimes are 861 See paragraph (a)(1)(iv)(H)(2) of rules 1.3(zzz) 848 See Markit Letter. referred to as servicer reports, delivered to the and 1.3(aaaa) under the CEA and rule 3a68–1a and 849 Id. trustee or security holders, as the case may be, are 3a68–1b under the Exchange Act. 850 Id. filed with the SEC on Form 10–D. 862 See paragraph (c)(4) of rules 1.3(zzz) and 851 Id. 854 See infra note 867 and accompanying text. 1.3(aaaa) under the CEA and rule 3a68–1a and 852 Id. 855 See supra part III.G.3(b)(ii). 3a68–1b under the Exchange Act.

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that is an issuing entity of an asset- reference entity or issuer of securities to publicly available criteria of the backed security is considered a separate rely upon an affiliated entity to satisfy alternative public information reference entity or issuer, as applicable, one of the criteria of the public availability test applicable to index CDS and will not be considered affiliated information availability test. Further, entered into solely between ECPs, a with any other entities. unlike the affiliation definition that reference entity or an issuer of securities The final rules provide that a applies when calculating the number included in an index that itself does not reference entity or issuer of securities and concentration criteria, the affiliation make available rule 144A information or included in an index is affiliated with definition that applies to certain criteria does not have financial information another entity if it controls, is controlled of the public information availability otherwise publicly available may rely by, or is under common control with, test does not require that the affiliated upon an affiliated entity, regardless of that other entity.863 The final rules entity or its securities be included in the whether that affiliated entity itself or its define control, solely for purposes of index. securities are included in the index, to this affiliation definition, to mean As the affiliation definition applies to satisfy one of these criteria. ownership of more than 50 percent of a the Exchange Act reporting company reference entity’s or issuer’s equity or and foreign private issuer criteria of the Comments the ability to direct the voting of more public information availability test, a reference entity or an issuer of securities One commenter requested that the than 50 percent of a reference entity’s or Commissions revise the affiliation issuer’s voting equity.864 This revision included in an index that itself is not required to file reports pursuant to the definition that applies for purposes of is the same as the modification the the public information availability test Commissions are making to the Exchange Act or the regulations to increase the threshold from 20 affiliation definition that applies when thereunder or is not eligible to rely on percent ownership to majority calculating the number and the exemption provided in rule 12g3– ownership.867 This commenter noted concentration criteria, which is 2(b) under the Exchange Act for foreign that majority ownership is consistent discussed above.865 private issuers may rely upon the status with current market practice, including As the Commissions noted above, this of an affiliated entity as an Exchange the definition of affiliate included in the change is based on the Commissions’ Act reporting company or foreign 2003 ISDA Credit Derivatives consideration of comments received. By private issuer, regardless of whether that Definitions.868 This commenter also using a more than 50 percent (i.e., affiliated entity itself or its securities are noted that the current approach with majority ownership) test rather than a included in the index, to satisfy one of 20 percent ownership test for the these criteria. For example, a majority- respect to the inclusion of affiliated control threshold, there is a greater owned subsidiary included in an index entities in the same index uses majority may rely upon the status of its parent, ownership rather than 20 percent likelihood that there will be information 869 available about the reference entity or which may or may not be included in ownership to determine affiliation. issuer of securities included in the the index, to satisfy the issuer eligibility This commenter also requested that the index because the market likely will criteria if the parent is required to file Commissions clarify the application of view the affiliated entity and the reports under the Exchange Act or is a the affiliation definition to the public 870 reference entity or issuer of securities foreign private issuer. information availability test. Further, Similarly, as the affiliation definition included in the index as a single this commenter requested that the applies to the worldwide equity market company or economic entity.866 worldwide equity market capitalization capitalization and outstanding Accordingly, to the extent information criterion should include all affiliated indebtedness criteria of the public regarding the affiliated entity is publicly entities because the reference entity information availability test, a reference included in the index may not be the available, there may be information entity or an issuer of securities included regarding the reference entity or issuer member of a corporate group that issues in an index that itself does not have a 871 of securities included in the index that public equity. Finally, this worldwide market value of its commenter was concerned that the also is publicly available. This modified outstanding common equity held by control threshold will permit such outstanding indebtedness criterion non-affiliates of $700 million or more or would not include affiliate debt outstanding notes, bonds, debentures, 863 See paragraph (c)(1) of rules 1.3(zzz) and guaranteed by the reference entity or 1.3(aaaa) under the CEA and rule 3a68–1a and loans, or evidences of indebtedness issuer of securities included in the 3a68–1b under the Exchange Act. (other than revolving credit facilities) index.872 Further, as noted above,873 864 See paragraph (c)(2) of rules 1.3(zzz) and having a total remaining principal another commenter was concerned that 1.3(aaaa) under the CEA and rule 3a68–1a and amount of at least $1 billion, may index CDS may include a higher 3a68–1b under the Exchange Act. aggregate the worldwide equity market 865 proportion of ‘‘private’’ borrowers (those See supra part III.G.3(b)(ii). capitalization or outstanding 866 The more than 50 percent (i.e., majority borrowers that are not public reporting ownership) test is generally consistent with indebtedness of an affiliated entity, companies or that do not register consolidation under U.S. generally accepted regardless of whether that affiliated offerings of their securities) and thus accounting principles. See FASB ASC section 810– entity itself or its securities are included may themselves not satisfy each of the 10–25, Consolidation—Overall—Recognition in the index, to satisfy one of these (stating that consolidation is appropriate if a criteria. For example, a majority-owned reporting entity has a controlling financial interest 867 See Markit Letter (requesting a threshold of at in another entity and a specific scope exception subsidiary included in an index may least 50 percent). does not apply). Accordingly, using a more than 50 aggregate the worldwide equity market 868 Id. percent (i.e., majority ownership) test will make it capitalization or outstanding 869 Id. more likely that the reference entity or issuer of 870 securities included in the index and the affiliated indebtedness of its parent and/or other Id. entity will be consolidated with each other in affiliated entities, such as other 871 Id. This commenter provided Kinder Morgan financial statements. Consolidated financial majority-owned subsidiaries of the Kansas Inc. (CDS) and Kinder Morgan Inc. (equity) statements present the financial position and results parent, to satisfy one of these criteria. as an example of where the reference entity and of operations for a parent (controlling entity) and issuer of equity among a corporate group are not the one or more subsidiaries (controlled entities) as if Finally, as the affiliation definition same. Id. the individual entities actually were a single applies to the rule 144A information 872 Id. company or economic entity. and financial information otherwise 873 See supra note 842 and accompanying text.

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criteria for the public information capitalization criterion. Moreover, the securities in the index. The availability test.874 Commissions note that the final rules Commissions are not revising the rules The Commissions note the respond to the commenter’s concerns to exclude from the public information commenters’ concerns. The regarding affiliate debt by providing that availability test any index compiled by Commissions are modifying the method indebtedness of an affiliate can be a third-party index provider. of determining affiliation that applies counted in determining whether the (vi) Treatment of Indexes Including for purposes of satisfying certain criteria reference entity or issuer of securities Reference Entities That Are Issuers of of the public information availability included in the index meets the Exempted Securities or Including test. The final rules provide that a outstanding indebtedness criterion. Exempted Securities reference entity or issuer of securities Finally, the Commissions note that the included in an index may rely upon an affiliation definition as modified The Commissions are adopting the affiliated entity (meeting the more than responds to the commenter’s concerns rules regarding the treatment of indexes 50 percent control threshold) to satisfy regarding ‘‘private’’ borrowers because that include exempted securities or one of the criterion of the public the modified affiliation definition will reference entities that are issuers of information availability test. This allow a reference entity or issuer of exempted securities as proposed modification is similar to the one the securities included in an index to without modification.877 The Commissions are making to the consider the indebtedness, the Commissions believe such treatment is affiliation definition that applies for outstanding equity, and the reporting consistent with the objective and intent purposes of calculating the number and status of an affiliate in determining of the statutory definition of the term concentration criteria. As noted above, whether the public information ‘‘security-based swap,’’ as well as the based on commenters’ letters, the availability test is satisfied. approach taken in the context of Commissions understand that the As noted above, the Commissions also security futures.878 Accordingly, current standard CDS documentation believe that the modified affiliation paragraph (1)(ii) of rules 1.3(zzz) and and the current approach with respect definition responds to commenters’ 1.3(aaaa) under the CEA and paragraph to the inclusion of affiliated entities in concerns noted above that the rules (a)(2) of rules 3a68–1a and 3a68–1b the same index use majority ownership further defining the terms ‘‘issuers of under the Exchange Act provide that, in rather than 20 percent ownership to securities in a narrow-based security the case of an index that includes determine affiliation. The Commissions index’’ and ‘‘narrow-based security exempted securities, or reference agree with commenters that in the case index’’ should be simplified. The entities that are issuers of exempted of index CDS only it is more appropriate modified affiliation definition enables securities, in each case as defined as of to use a more than 50 percent (i.e., market participants to make an the date of enactment of the Futures majority ownership) test rather than a affiliation determination for purposes of Trading Act of 1982 (other than 20 percent ownership test. The the public information availability test municipal securities), such securities or Commissions believe that because criteria by measuring the more than 50 reference entities are excluded from the reference entities or issuers of securities percent (i.e., majority ownership) index when determining whether the included in an index may rely on an control threshold. securities or reference entities in the affiliated entity to help satisfy the index constitute a ‘‘narrow-based (v) Application of the Public public information availability test a security index’’ or ‘‘issuers of securities Information Availability Requirements threshold of majority ownership rather in a narrow-based security index’’ under to Indexes Compiled by a Third-Party than 20 percent ownership will increase the rules. Index Provider the likelihood that there is information Under paragraph (1)(ii) of rules available about the reference entity or The Commissions requested comment 1.3(zzz) and 1.3(aaaa) under the CEA issuer of securities included in the in the Proposing Release as to whether and paragraph (a)(2) of rules 3a68–1a index. The Commissions believe that the public information availability test and 3a68–1b) under the Exchange Act, determining affiliation in this manner should apply to an index compiled by an index composed solely of securities for purposes of the public availability of an index provider that is not a party to that are, or reference entities that are information test responds to the an index CDS (‘‘third-party index issuers of, exempted securities (other commenter’s concerns. provider’’) that makes publicly available than municipal securities) will not be a Further, the Commissions are general information about the providing several illustrative examples construction of the index, index rules, 877 See rules 1.3(zzz)(1)(i) and 1.3(aaaa)(1)(i) of the way in which the affiliation identity of components, and under the CEA and rules 3a68–1a(a)(2) and 3a68– 1b(a)(2) under the Exchange Act; and July 2006 definition works in the context of the predetermined adjustments, and which Debt Index Rules. The Commissions did not receive public availability of information index is referenced by an index CDS any comments on the proposed rules regarding the criteria to address the commenter’s that is offered on or subject to the rules treatment of indexes that include exempted securities or reference entities that are issuers of concerns regarding the application of of a DCM or SEF, or by direct access in exempted securities. the affiliation definition in that context. the U.S. from an FBOT that is registered 878 See section 3(a)(68)(C) of the Exchange Act, 15 The Commissions also note that the with the CFTC.875 Two commenters U.S.C. 78c(a)(68)(C) (providing that ‘‘[t]he term final rules respond to the commenter’s stated that the presence of a third-party ‘security-based swap’ does not include any concerns regarding the applicability of agreement, contract, or transaction that meets the index provider would assure that definition of a security-based swap only because the affiliation definition to the sufficient information is available such agreement, contract, or transaction references, worldwide equity market capitalization regarding the index CDS itself.876 is based upon, or settles through the transfer, criterion by providing that the Neither commenter provided any delivery, or receipt of an exempted security under worldwide market capitalization of an paragraph (12) [of the Exchange Act], as in effect on analysis to explain how or whether a the date of enactment of the Futures Trading Act affiliate can be counted in determining third-party index provider would be of 1982 (other than any municipal security as whether the reference entity or issuer of able to provide information about the defined in paragraph (29) [of the Exchange Act] as securities included in the index meets underlying securities or issuers of in effect on the date of enactment of the Futures Trading Act of 1982), unless such agreement, the worldwide equity market contract, or transaction is of the character of, or is 875 See Proposing Release at 29851–52. commonly known in the trade as, a put, call, or 874 See July LSTA Letter. 876 See ISDA Letter and SIFMA Letter. other option’’).

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‘‘narrow-based security index’’ or an meant by ‘‘predetermined’’ for purposes instrument on that security portfolio is index composed of ‘‘issuers of securities of whether criteria or a self-executing a security-based swap.886 in a narrow-based security index.’’ In formula for adjusting the security index However, not all changes that occur to the case of an index where some, but underlying a Title VII instrument the composition or weighting of a not all, of the securities or reference qualify under the interpretation. The security index underlying a Title VII entities are exempted securities (other Commissions find that this instrument will always result in that than municipal securities) or issuers of interpretation is an appropriate way to security index being treated as a narrow- exempted securities (other than address how to determine when a based security index. Many security municipal securities), the index will be portfolio of securities is a narrow-based indexes are constructed and maintained a ‘‘narrow-based security index’’ or an or broad-based security index, and the by an index provider pursuant to a index composed of ‘‘issuers of securities circumstances in which changes to the published methodology.887 For instance, in a narrow-based security index’’ only composition of a security index the various Standard & Poor’s security if the index is narrow-based when the (including a portfolio of securities) indexes are reconstituted and securities that are, or reference entities underlying a Title VII instrument would rebalanced as needed and on a periodic that are issuers of, exempted securities affect the characterization of such Title basis pursuant to published index (other than municipal securities) are VII instrument, and is designed to criteria.888 Such indexes underlying a disregarded. The Commissions believe reduce costs associated with making Title VII instrument would be broad- this approach should result in such a determination.883 based or narrow-based depending on the consistent treatment for indexes A security index in most cases is composition and weighting of the regardless of whether they include designed to reflect the performance of a underlying security index. securities that are, or issuers of market or sector by reference to In addition, counterparties to a Title securities that are, exempted securities representative securities or interests in VII instrument frequently agree to use as (other than municipal securities) while securities. There are several well-known the underlying reference of a Title VII helping to ensure that exempted security indexes established and instrument a security index based on securities (other than municipal maintained by recognized index predetermined criteria where the securities) and issuers of exempted providers currently in the market.884 security index composition or weighting securities (other than municipal However, instead of using these may change as a result of the occurrence securities) are not included in an index established indexes, market participants of certain events specified in the Title merely to make the index either broad- may enter into a Title VII instrument VII instrument at execution, such as based or narrow-based under the rules. where the underlying reference of the ‘‘succession events.’’ Counterparties to a Title VII instrument also may use a 4. Security Indexes Title VII instrument is a portfolio of securities selected by the counterparties predetermined self-executing formula to The Dodd-Frank Act defines the term or created by a third-party index make other changes to the composition ‘‘index’’ as ‘‘an index or group of provider at the behest of one or both or weighting of a security index securities, including any interest therein counterparties. In some cases, the Title underlying a Title VII instrument. In 879 or based on the value thereof.’’ The VII instrument may give one or both of either of these situations, the Commissions provided an interpretation the counterparties, either directly or composition of a security index may in the Proposing Release regarding how indirectly (e.g., through an investment 886 to determine when a portfolio of adviser or through the third-party index The Commissions understand that a security securities is a narrow-based or broad- portfolio could be labeled as such or could just be provider), discretionary authority to an aggregate of individual Title VII instruments based security index, and the change the composition of the security documented, for example, under a master circumstances in which changes to the portfolio, including, for example, by agreement or by amending an annex of securities composition of a security index adding or removing securities in the attached to a master trade confirmation. If the (including a portfolio of securities) 880 security portfolio were created by aggregating security portfolio on an ‘‘at-will’’ basis individual Title VII instruments, each Title VII underlying a Title VII instrument would during the term of the Title VII instrument must be evaluated in accordance with affect the characterization of such Title instrument.885 Where the the guidance to determine whether it is a swap or 881 VII instrument. The Commissions are counterparties, either directly or a security-based swap. For the avoidance of doubt, restating the interpretation set forth in if the counterparties to a Title VII instrument indirectly (e.g., through an investment exchanged payments under that Title VII the Proposing Release with one adviser or through the third-party index instrument based on a security index that was itself clarification in response to a provider), have this discretionary created by aggregating individual security-based 882 commenter. Specifically, the authority to change the composition or swaps, such Title VII instrument would be a Commissions are clarifying what is security-based swap. See supra part III.D. weighting of securities in a security 887 See, e.g., NASDAQ, ‘‘NASDAQ–100 Index’’ portfolio, that security portfolio will be (‘‘The NASDAQ–100 Index is calculated under a 879 See section 3(a)(68)(E) of the Exchange Act, 15 treated as a narrow-based security modified capitalization-weighted methodology. The U.S.C. 78c(a)(68)(E). index, and therefore a Title VII methodology generally is expected to retain the 880 The Commissions noted in the Proposing economic attributes of capitalization-weighting Release that a ‘‘portfolio’’ of securities could be a while providing enhanced diversification. To group of securities and therefore an ‘‘index’’ for 883 See supra part I, under ‘‘Overall Economic accomplish this, NASDAQ will review the purposes of the Dodd-Frank Act. See Proposing Considerations’’. composition of the NASDAQ–100 Index on a Release at 29854. To the extent that changes are 884 One example is the S&P 500® Index, an index quarterly basis and adjust the weightings of Index made to the securities underlying the Title VII that gauges the large cap U.S. equities market. components using a proprietary algorithm, if certain instrument and each such change is individually 885 Alternatively, counterparties may enter into pre-established weight distribution requirements confirmed, then those substituted securities are not Title VII instruments where a third-party are not met.’’), available at http:// part of a security index as defined in the Dodd- investment manager selects an initial portfolio of dynamic.nasdaq.com/dynamic/ Frank Act, and therefore a Title VII instrument on securities and has discretionary authority to change nasdaq100_activity.stm. each of those substituted securities is a security- the composition of the security portfolio in 888 Information regarding security indexes and based swap. accordance with guidelines agreed upon with the their related methodologies may be widely available 881 Solely for purposes of the discussion in this counterparties. Under the final guidance the to the general public or restricted to licensees in the section, the terms ‘‘security index’’ and ‘‘security Commissions are issuing today, such security case of proprietary or ‘‘private label’’ security portfolio’’ are intended to include either securities portfolios are treated as narrow-based security indexes. Both public and private label security or the issuers of securities. indexes, and Title VII instruments on those security indexes frequently are subject to intellectual 882 See infra note 891 and accompanying text. portfolios are security-based swaps. property protection.

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change pursuant to predetermined as it was proposed, including whether 5. Evaluation of Title VII Instruments on criteria or predetermined self-executing the terms ‘‘predetermined criteria’’ and Security Indexes That Move from Broad- formulas without the Title VII ‘‘predetermined self-executing formula’’ Based to Narrow-Based or Narrow-Based instrument counterparties, their agents, are clear, and whether additional to Broad-Based or third-party index providers having interpretations should be provided with (a) In General any direct or indirect discretionary respect to these terms. The authority to change the security index. The determination of whether a Title Commissions received one comment on VII instrument is a swap, a security- In general, and by contrast to Title VII the interpretation provided in the instruments in which the based swap, or both (i.e., a mixed swap), Proposing Release, in which the counterparties, either directly or is made prior to execution, but no later commenter requested clarification that indirectly (e.g., through an investment than when the parties offer to enter into adviser or through the third-party index criteria affecting the composition of an the Title VII instrument.893 If the provider), have the discretion to change index, when such criteria are agreed security index underlying a Title VII the composition or weighting of the bilaterally, pre-trade, by the instrument migrates from being broad- referenced security index, where there counterparties to a bespoke index trade, based to being narrow-based, or vice is an underlying security index for are ‘‘predetermined’’ for purposes of versa, during the life of a Title VII which there are predetermined criteria determining whether the index is instrument, the characterization of that or a predetermined self-executing treated as narrow-based or broad- Title VII instrument will not change formula for adjusting the security index based.891 from its initial characterization regardless of whether the Title VII that are not subject to change or The Commissions are restating the instrument was entered into bilaterally modification through the life of the Title interpretation set forth in the Proposing or was executed through a trade on or VII instrument and that are set forth in Release with one clarification in the Title VII instrument at execution subject to the rules of a DCM, SEF, response to the commenter’s concerns. FBOT, security-based SEF, or NSE. For (regardless of who establishes the As discussed above, the Commissions criteria or formula), a Title VII example, if two counterparties enter are providing that not all changes that into a swap based on a broad-based instrument on such underlying security occur to the composition or weighting of index is based on a broad-based or security index, and three months into a security index underlying a Title VII narrow-based security index, depending the life of the swap the security index instrument will result in that security on the composition and weighting of the underlying that Title VII instrument index being treated as a narrow-based underlying security index. Subject to migrates from being broad-based to the interpretation discussed below security index. Foremost among these being narrow-based, the Title VII regarding security indexes that may examples is a security index that is instrument will remain a swap for the shift from being a narrow-based security constructed and maintained by an index duration of its life and will not be index or broad-based security index provider pursuant to a published recharacterized as a security-based during the life of an existing Title VII methodology.892 Changes to such an swap. If the material terms of a Title VII instrument, the characterization of a index pursuant to such a methodology instrument are amended or modified Title VII instrument based on a security are not the type of discretionary changes during its life based on an exercise of index as either a swap or a security- that will render an otherwise broad- based security index a narrow-based discretion and not through based swap will depend on the predetermined criteria or a characterization of the security index security index. The Commissions 889 predetermined self-executing formula, using the above interpretation. believe this clarification addresses the the Commissions view the amended or The Commissions are clarifying in commenter’s concerns. modified Title VII instrument as a new response to a commenter that, for Title VII instrument.894 As a result, the purposes of this interpretation, criteria 891 See ISDA Letter. While this commenter agrees characteristics of the underlying or a self-executing formula regarding with the guidance that the predetermined changes security index must be reassessed at the composition of a security index described in this section should not alter the time of such an amendment or underlying a Title VII instrument shall character of an index (or the classification of a Title VII instrument based thereon), this commenter modification to determine whether the be considered ‘‘predetermined’’ if it is security index has migrated from broad- bilaterally agreed upon pre-trade by the disagrees that the ability to make discretionary changes should cause an otherwise broad-based 890 based to narrow-based, or vice versa. If parties to a transaction. In order to security index to be a narrow-based security index. the security index has migrated, then qualify under this interpretation, This commenter requested that the Commissions the characterization of the amended or however, the Commissions reiterate that classify transactions ‘‘at inception and upon actual change in respect of any classification-related the ‘‘predetermined’’ criteria or self- 893 See supra note 625 and accompanying text. characteristic, be that change the product of a executing formula, as described above, 894 For example, if, on its effective date, a Title renegotiation or a unilateral exercise of discretion.’’ must not be subject to change or VII instrument tracks the performance of an index Id. The Commissions note that if material terms of modification through the life of the Title of 12 securities but is amended during its term to a Title VII instrument are amended or modified track the performance of only 8 of those 12 VII instrument and must be set forth in during its life based on an exercise of discretion and securities, the Commissions would view the the Title VII instrument at execution not through predetermined criteria or a amended or modified Title VII instrument as a new (regardless of who establishes the predetermined self-executing formula, the Title VII instrument. Because it is a new Title VII criteria or formula). Commissions view the amended or modified Title instrument, any regulatory requirements regarding VII instrument as a new Title VII instrument. See new Title VII instruments apply. Conversely, if, on Comments infra part III.G.5. its effective date, a Title VII instrument tracks the 892 Indeed, the Commissions specifically performance of an index of 12 securities but is The Commissions requested comment amended during its term to reflect the replacement mentioned in this regard, and have included in the of a departing ‘‘key person’’ of a hedge fund that on a number of issues regarding the final guidance above, the various Standard & Poor’s interpretation contained in this section is a counterparty to the Title VII instrument with security indexes—some of which may be described a new ‘‘key person,’’ the Commissions would not as ‘‘common equity indices’’ as alluded to in ISDA’s view the amended or modified Title VII instrument 889 See supra note 886, regarding the aggregation comment—that are reconstituted and rebalanced as as a new Title VII instrument because the of separate trades. needed and on a periodic basis pursuant to amendment or modification is not to a material 890 See infra note 891 and accompanying text. published index criteria. term of the Title VII instrument.

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modified Title VII instrument will be criteria or a predetermined self- Commissions’ interpretation should determined by evaluating the executing formula. capture as mixed swaps only those Title underlying security index at the time The Commissions are clarifying what VII instruments on indexes that will the Title VII instrument is amended or is meant by whether the pre-determined change with certainty, and not those modified. Similarly, if a security index criteria or pre-determined self-executing that might change given specific market has migrated from broad-based to formula ‘‘would cause’’ the underlying circumstances.899 Moreover, this narrow-based, or vice versa, any new broad-based security index to become or commenter believed that the Title VII instrument based on that assume the characteristics of a narrow- Commissions’ statement that a Title VII security index will be characterized based security index, or vice versa, as instrument on a security index governed pursuant to an evaluation of the noted above in the interpretation. The by a pre-determined self-executing underlying security index at the Commissions believe that, unless the formula that ‘‘would cause’’ a change execution of that new Title VII criteria or formula were intentionally from broad to narrow, or narrow to instrument. designed to change the index from broad, means that the change in The Commissions provided an narrow to broad, or vice versa, Title VII character must be a certainty for the interpretation in the Proposing Release instruments based on indexes that may, instrument to be classified as a mixed regarding circumstances in which the but will not necessarily, change from swap.900 The Commissions have character of a security index on which broad to narrow (or vice versa) under clarified their interpretation in response a Title VII instrument is based changes such criteria or formula should be to this commenter’s concerns as according to predetermined criteria or a considered swaps or security-based discussed above. predetermined self-executing formula swaps, as appropriate, at execution and Another commenter disagreed with set forth in the Title VII instrument (or for the term thereof, and not mixed the Commissions’ proposed in a related or other agreement entered swaps. In such circumstances, it is not interpretation that transactions on into by the counterparties or a third- the case that the criteria or formula indexes under predetermined criteria or party index provider to the Title VII ‘‘would cause’’ the change within the a predetermined self-executing formula instrument) at execution. The meaning of the Commission’s that would change from broad to Commissions are restating this interpretation. narrow, or narrow to broad, should be interpretation with one clarification in The Commissions believe that this classified as mixed swaps at response to a commenter.895 interpretation regarding the use of inception.901 This commenter does not Where at the time of execution such predetermined criteria or a believe that regulatory arbitrage is such criteria or such formula would cause the predetermined self-executing formula a significant concern in this context that underlying broad-based security index will prevent potential gaming of the would justify the challenges to market to become or assume the characteristics Commissions’ interpretation regarding participants if these transactions were of a narrow-based security index or vice security indexes, and prevent potential treated as mixed swaps subject to the versa during the duration of the regulatory arbitrage based on the dual regulatory authority of the 896 instrument, then the Title VII migration of a security index from Commissions.902 instrument based on such security index broad-based to narrow-based, or vice The Commissions believe that is a mixed swap during the entire life of versa. In particular, predetermined regulatory arbitrage is a sufficient the Title VII instrument.897 Although at criteria and predetermined self- concern to justify mixed swap status certain points during the life of the Title executing formulas can be constructed and dual regulatory oversight for Title VII instrument, the underlying security in ways that take into account the VII instruments where the index would index would be broad-based and at characteristics of a narrow-based change from broad to narrow, or narrow other points the underlying security security index and prevent a narrow- to broad, under the pre-determined index would be narrow-based, based security index from becoming criteria or predetermined self-executing regulating such a Title VII instrument as broad-based, and vice versa. formula. Counterparties that are a mixed swap from the execution of the Comments concerned about regulatory burdens Title VII instrument and throughout its associated with mixed swap status can The Commissions received two life reflects the appropriate redesign their formula to avoid the comments on the proposed characterization of a Title VII result, or enter into another swap or interpretation in this section regarding instrument based on a security index security-based swap that is structured to the classification of Title VII that migrates pursuant to predetermined achieve the same economic result Instruments based on security indexes without mixed swap status. 895 See infra note 898 and accompanying text. that change from narrow-based to broad- 896 Thus, for example, if a predetermined self- based, or vice versa, under (b) Title VII Instruments on Security executing formula agreed to by the counterparties predetermined criteria or a Indexes Traded on Designated Contract of a Title VII instrument at or prior to the execution of the Title VII instrument provided that the predetermined self-executing formula, Markets, Swap Execution Facilities, security index underlying the Title VII instrument as mixed swaps. One commenter Foreign Boards of Trade, Security-Based would decrease from 20 to 5 securities after six requested that the Commissions clarify Swap Execution Facilities, and National months, such that the security index would become that a Title VII instrument based on a Securities Exchanges narrow-based as a result of the reduced number of securities, then the Title VII instrument is a mixed security index that may, but will not As was recognized in the Proposing swap at its execution. The characterization of the necessarily, change from narrow-based Release, security indexes underlying Title VII instrument as a mixed swap will not to broad-based, or vice versa, under Title VII instruments that are traded on change during the life of the Title VII instrument. predetermined criteria or a 897 As discussed in section III.G.4., supra, to the DCMs, SEFs, FBOTs, security-based extent a Title VII instrument permits ‘‘at-will’’ predetermined self-executing formula SEFs, or NSEs raise particular issues if substitution of an underlying security index, should be characterized at execution as an underlying security index migrates however, as opposed to the use of predetermined a swap or security-based swap, as criteria or a predetermined self-executing formula, 898 applicable, and not as a mixed swap. 899 the Title VII instrument is a security-based swap at Id. its execution and throughout its life regardless of This commenter believed that the 900 Id. whether the underlying security index was narrow- 901 See ISDA Letter. based at the execution of the Title VII instrument. 898 See SIFMA Letter. 902 Id.

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from broad-based to narrow-based, or trading platforms where the underlying the following 3 calendar months as a vice versa.903 The Commissions are security index migrates from broad- grace period. adopting as proposed their based to narrow-based or narrow-based The Commissions believe that a interpretation clarifying that the to broad-based, so that market similar tolerance period should apply to characterization of an exchange-traded participants will know where such Title swaps traded on DCMs, SEFs, and Title VII instrument based on a security VII instruments may be traded and can FBOTs and security-based swaps traded index at its execution will not change avoid potential disruption of their on security-based SEFs and NSEs. through the life of the Title VII ability to offset or enter into new Title Accordingly, the Commissions are instrument, regardless of whether the VII instruments on trading platforms adopting the rules, as proposed, underlying security index migrates from when such migration occurs.907 providing for tolerance periods for broad-based to narrow-based, or vice As was noted in the Proposing swaps that are traded on DCMs, SEFs, versa. Accordingly, a market participant Release,908 Congress and the or FBOTs 911 and for security-based who enters into a swap on a broad-based Commissions addressed a similar issue swaps traded on security-based SEFs security index traded on or subject to in the context of security futures, where and NSEs.912 the rules of a DCM, SEF or FBOT that the security index on which a future is The final rules provide that to be migrates from broad-based to narrow- based may migrate from broad-based to subject to the tolerance period, a based may hold that position until the narrow-based or vice versa. Congress security index underlying a swap swap’s expiration without any change in provided in the definition of the term executed on or subject to the rules of a regulatory responsibilities, ‘‘narrow-based security index’’ in both DCM, SEF, or FBOT must not have been requirements, or obligations; similarly, a the CEA and the Exchange Act 909 for a a narrow-based security index 913 during market participant who enters into a tolerance period ensuring that, under the first 30 days of trading.914 If the security-based swap on a narrow-based certain conditions, a futures contract on index becomes narrow-based during the security index traded on a security- a broad-based security index traded on first 30 days of trading, the index must based SEF or NSE that migrates from a DCM may continue to trade, even not have been a narrow-based security narrow-based to broad-based may hold when the index temporarily assumes index during every trading day of the 6 that position until the security-based characteristics that would render it a full calendar months preceding a date swap’s expiration without any change in narrow-based security index under the no earlier than 30 days prior to the regulatory responsibilities, statutory definition.910 In general, an commencement of trading of a swap on requirements, or obligations. index is subject to this tolerance period, such index.915 If either of these In addition, the Commissions are and therefore is not a narrow-based alternatives is met, the index will not be adopting, as proposed, final rules security index, if: (i) A futures contract a narrow-based security index if it has providing for tolerance and grace on the index traded on a DCM for at been a narrow-based security index for periods for Title VII instruments on least 30 days as a futures contract on a no more than 45 business days over 3 security indexes that are traded on broad-based security index before the consecutive calendar months.916 These DCMs, SEFs, FBOTs, security-based index assumed the characteristics of a provisions apply solely for purposes of SEFs and NSEs.904 As was noted in the narrow-based security index; and (ii) the swaps traded on or subject to the rules Proposing Release,905 in the absence of index does not retain the characteristics of a DCM, SEF, or FBOT. any action by the Commissions, if a of a narrow-based security index for Similarly, the rules provide a market participant wants to offset a more than 45 business days over 3 tolerance period for security-based swap or enter into a new swap on a consecutive calendar months. Pursuant swaps traded on security-based SEFs or DCM, SEF or FBOT where the to these statutory provisions, if the NSEs. To be subject to the tolerance underlying security index has migrated index becomes narrow-based for more period, a security index underlying a from broad-based to narrow-based, or to than 45 business days over 3 security-based swap executed on a offset a security-based swap or enter consecutive calendar months, the index security-based SEF or NSE must have into a new security-based swap on a is excluded from the definition of the security-based SEF or NSE where the term ‘‘narrow-based security index’’ for 911 See paragraph (2) of rule 1.3(yyy) under the CEA and paragraph (b) of rule 3a68–3 under the underlying security index has migrated Exchange Act. 907 The rules apply only to the particular Title VII from narrow-based to broad-based, the 912 See paragraph (3) of rule 1.3(yyy) under the instrument that is traded on or subject to the rules participant would be prohibited from CEA and paragraph (c) of rule 3a68–3 under the of a DCM, SEF, FBOT, security-based SEF, or NSE. Exchange Act. doing so. That is because swaps may As the Commissions noted in the Proposing 913 trade only on DCMs, SEFs, and FBOTs, Release, to the extent that a particular Title VII For purposes of these rules, the term ‘‘narrow- and security-based swaps may trade instrument is not traded on such a trading platform based security index’’ shall also mean ‘‘issuers of (even if another Title VII instrument of the same securities in a narrow-based security index.’’ See only on registered NSEs and security- class or type is traded on such a trading platform), supra part III.G.3(b), (discussing the rules defining based SEFs.906 The rules being adopted the rules do not apply to that particular Title VII ‘‘issuers of securities in a narrow-based security by the Commissions address how to instrument. See Proposing Release at 29857 n. 259. index’’). treat Title VII instruments traded on 908 See Proposing Release at 29857. 914 This provision is consistent with the 909 CEA section 1a(35)(B)(iii), 7 U.S.C. provisions of the CEA and the Exchange Act applicable to futures contracts on security indexes. 903 1a(35)(B)(iii); section 3(a)(55)(C)(iii) of the Exchange See Proposing Release at 29856. Act, 15 U.S.C. 78c(a)(55)(C)(iii). CEA section 1a(35)(B)(iii)(I), 7 U.S.C. 904 See paragraphs (2), (3) and (4) of rule 1.3(yyy) 910 By joint rules, the Commissions have provided 1a(35)(B)(iii)(I); section 3(a)(55)(C)(iii)(I) of the under the CEA and paragraphs (b), (c) and (d) of that ‘‘[w]hen a contract of sale for future delivery Exchange Act, 15 U.S.C. 78c(a)(55)(C)(iii)(I). rule 3a68–3 under the Exchange Act. on a security index is traded on or subject to the 915 This alternative test is the same as the 905 See Proposing Release at 29857. rules of a foreign board of trade, such index shall alternative test applicable to futures contracts in 906 If a swap were based on a security index that not be a narrow-based security index if it would not CEA rule 41.12, 17 CFR 41.12, and rule 3a55–2 migrated from broad-based to narrow-based, a DCM, be a narrow-based security index if a futures under the Exchange Act, 17 CFR 240.3a55–2. SEF, or FBOT could no longer offer the Title VII contract on such index were traded on a designated 916 These provisions are consistent with the instrument because it is now a security-based swap. contract market * * * .’’ See rule 41.13 under the parallel provisions in the CEA and Exchange Act Similarly, if a security-based swap were based on CEA, 17 CFR 41.13, and rule 3a55–3 under the applicable to futures contracts on security indexes a security index that migrated from narrow-based to Exchange Act, 17 CFR 240.3a55–3. Accordingly, the traded on DCMs. See CEA section 1a(35)(B)(iii)(II), broad-based, a security-based SEF or NSE could no statutory tolerance period applicable to futures on 7 U.S.C. 1a(35)(B)(iii)(II), and section longer offer the Title VII instrument because it is security indexes traded on DCMs applies to futures 3(a)(55)(C)(iii)(II) of the Exchange Act, 15 U.S.C. now a swap. traded on FBOTs as well. 78c(a)(55)(C)(iii)(II).

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been a narrow-based security index rule provides sufficient time for a Title context,924 and the commenter has during the first 30 days of trading. If the VII instrument based on a migrated provided no data or evidence for its index becomes broad-based during the security index to satisfy listing and request that the Commissions diverge first 30 days of trading, paragraph clearing requirements applicable to from that grace period and provide for (3)(i)(B) of rule 1.3(yyy) under the CEA swaps or security-based swaps, as a longer grace period with respect to and paragraph (c)(1)(ii) of rule 3a68–3 appropriate. swaps and security-based swaps. The under the Exchange Act provide that the As was noted in the Proposing Commissions believe that the three- index must have been a non-narrow- Release,920 there will be no overlap month grace period is similarly based (i.e., a broad-based) security index between the tolerance and the grace appropriate to apply in the context of a during every trading day of the 6 full periods under the rules and no ‘‘re- Title VII instrument based on an index calendar months preceding a date no triggering’’ of the tolerance period. For that has migrated to provide sufficient earlier than 30 days prior to the example, if a security index becomes time to execute off-setting positions. commencement of trading of a security- narrow-based for more than 45 business With respect to the commenter’s other based swap on such index. If either of days over 3 consecutive calendar suggestion that entities operating both a these alternatives is met, the index will months, solely with respect to swaps SEF and a security-based SEF should be be a narrow-based security index if it that are traded on or subject to the rules able to move the index from one has been a security index that is not of DCMs, SEFs, or FBOTs, but as a result platform to another where an index CDS narrow-based for no more than 45 of the rules is not considered a narrow- migrates simply by filing a notice with business days over 3 consecutive based security index during the grace the SEC and CFTC, the Commissions do calendar months.917 These provisions period, the tolerance period provisions not believe that this proposal is within apply solely for purposes of security- will not apply, even if the security- the scope of this rulemaking. based swaps traded on security-based index migrated temporarily during the H. Method of Settlement of Index CDS SEFs or NSEs. grace period. After the grace period has In addition, the Commissions are ended, a security index will need to The method that the parties have adopting rules as proposed that, once satisfy anew the requirements under the chosen or use to settle an index CDS the tolerance period under the rules has rules regarding the tolerance period in following the occurrence of a credit ended, there will be a grace period order to trigger a new tolerance period. event under such index CDS also can during which a Title VII instrument The rules will not result in the re- affect whether such index CDS would based on a security index that has characterization of any outstanding Title be a swap, a security-based swap, or migrated from broad-based to narrow- VII instruments. In addition, the both (i.e., a mixed swap). The based, or vice versa, will be able to trade tolerance and grace periods as adopted Commissions provided an interpretation on the platform on which Title VII will apply only to Title VII instruments in the Proposing Release regarding the instruments based on such security that are traded on or subject to the rules method of settlement of index CDS and index were trading before the security of DCMs, SEFs, FBOTs, security-based are restating the interpretation without index migrated and can also, during SEFs, and NSEs. modification. The Commissions find such period, be cleared.918 The final Comments that this interpretation is an appropriate rules provide for an additional three- way to address index CDS with different month grace period applicable to a The Commissions received one settlement methods and is designed to security index that becomes narrow- comment on the proposed rules reduce the cost associated with based for more than 45 business days described in this section.921 This determining whether such an index CDS over three consecutive calendar months, commenter stated its view that is a swap or a security-based swap.925 solely with respect to swaps that are extending the ‘‘grace period’’ from three If an index CDS that is not based on traded on or subject to the rules of months to six months would ease any DCMs, SEFs, or FBOTs. During the grace a narrow-based security index under the disruption or dislocation associated Commissions’ rules includes a period, such an index will not be with the delisting process with respect considered a narrow-based security mandatory physical settlement to an index that has migrated from provision that would require the index. The rules apply the same grace broad to narrow, or narrow to broad, period to a security-based swap on a delivery of, and therefore the purchase and that has failed the tolerance and sale of, a non-exempted security 926 security index that becomes broad-based period.922 This commenter also stated for more than 45 business days over 3 its view that where an index CDS consecutive calendar months, solely 924 See July 2006 Debt Index Rules. The migrates, for entities operating both a Commissions are not aware of any disruptions with respect to security-based swaps SEF and a security-based SEF, such caused by the three-month grace period in the that are traded on a security-based SEF entities should be permitted to move the context of security futures. or NSE. During the grace period, such index from one platform to the other 925 See supra part I, under ‘‘Overall Economic an index will not be considered a broad- simply by providing a notice to the SEC Considerations’’. 926 The Commissions note that section 3(a)(68)(C) based security index.919 As a result, this 923 and CFTC. of the Exchange Act, 15 U.S.C. 78c(a)(68)(C), As discussed above, the Commissions provides that ‘‘[t]he term ‘‘security-based swap’’ 917 These provisions are consistent with the are adopting the proposed rules without does not include any agreement, contract, or parallel provisions in the CEA and the Exchange modification. The Commissions note transaction that meets the definition of a security- Act applicable to futures contracts on security based swap only because such agreement, contract, indexes traded on DCMs. See CEA section that the three-month grace period or transaction references, is based upon, or settles 1a(35)(B)(iii), 7 U.S.C. 1a(35)(B)(iii); section applicable to security futures was through the transfer, delivery, or receipt of an 3(a)(55)(C)(iii) of the Exchange Act, 15 U.S.C. mandated by Congress in that exempted security under paragraph (12) [of the 78c(a)(55)(C)(iii). Exchange Act], as in effect on the date of enactment 918 See paragraph (4) of rule 1.3(yyy) under the of the Futures Trading Act of 1982 (other than any 1a(35)(D), 7 U.S.C. 1a(35)(D); section 3(a)(55)(E) of CEA and paragraph (d) of rule 3a68–3 under the municipal security as defined in paragraph (29) [of the Exchange Act, 15 U.S.C. 78c(a)(55)(E). Exchange Act. the Exchange Act] as in effect on the date of 920 919 These provisions are consistent with the See Proposing Release at 29858. enactment of the Futures Trading Act of 1982), parallel provisions in the CEA and the Exchange 921 See MarketAxess Letter. unless such agreement, contract, or transaction is of Act applicable to futures contracts on security 922 Id. the character of, or is commonly known in the trade indexes traded on DCMs. See CEA section 923 Id. as, a put, call, or other option.’’

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or a loan in the event of a credit event, occurrence of a credit event.932 The auction is the last limit order used to such an index CDS is a mixed swap.927 Auction Supplement ‘‘hard wired’’ the match against the open interest. The Conversely, if an index CDS that is not mechanics of credit event auctions into final price in the auction is the cash based on a narrow-based security index the 2003 Definitions.933 The price used for purposes of calculating under the Commissions’ rules includes Commissions understand that the credit the settlement payments in respect of a mandatory cash settlement 928 event auction process that is part of the the orders to buy and sell the provision, such index CDS is a swap, ISDA terms works as follows. deliverable obligations and it is also and not a security-based swap or a Following the occurrence of a credit used to determine the cash settlement mixed swap, even if the cash settlement event under a CDS, a determinations payment under the CDS. were based on the value of a non- committee (‘‘DC’’) established by ISDA, following a request by any party to a Comments exempted security or a loan. credit derivatives transaction that is One commenter believed that a An index CDS that is not based on a subject to the Big Bang Protocol or mandatory physical settlement narrow-based security index under the Auction Supplement, will determine, provision in an index CDS based on a Commissions’ rules and that provides among other matters: (i) Whether and broad-based security index should not for cash settlement in accordance with when a credit event occurred; (ii) transform a swap into a mixed swap the 2009 ISDA Credit Derivatives whether or not to hold an auction to because (i) the SEC would retain Determinations Committees and enable market participants to settle jurisdiction over a transfer of securities Auction Settlement Supplement to the those of their credit derivatives as part of such settlement and (ii) 2003 Definitions (the ‘‘Auction transactions covered by the auction; (iii) application of the interpretation would Supplement’’) or with the 2009 ISDA the list of deliverable obligations of the be difficult since many instruments Credit Derivatives Determinations relevant reference entity; and (iv) the contemplate physical settlement but Committees and Auction Settlement necessary auction specific terms. The have a cash settlement option, or vice CDS Protocol (‘‘Big Bang Protocol’’) 929 credit event auction takes place in two versa.935 is a swap, and will not be considered a parts. In the first part of the auction, As discussed above, the Commissions security-based swap or a mixed swap dealers submit physical settlement are restating the interpretation regarding solely because the determination of the requests, which are requests to buy or mandatory physical settlement as cash price to be paid is established sell any of the deliverable obligations provided in the Proposing Release. The through a securities or loan auction.930 (based on the dealer’s needs and those Commissions’ interpretation assures In 2009, auction settlement, rather than of its counterparties), and an initial that the Federal securities laws apply to physical settlement, became the default market midpoint price is created based the offer and sale of the underlying method of settlement for, among other on dealers’ initial bids and offers. securities at the time the index CDS is 936 types of CDS, index CDS on corporate Following the establishment of the sold. The Commissions note the initial market midpoint, the physical issuers of securities.931 The amount of commenter’s concerns but believe that settlement requests are then calculated the cash settlement is determined as a result of the Commissions’ to determine the amount of open through an auction triggered by the understanding of the auction settlement interest. process for index CDS, which is the The aggregate amount of open interest primary method by which index CDS 927 The SEC also notes that there must either be is the basis for the second part of the an effective registration statement covering the are settled and which addresses transaction or an exemption under the Securities auction. In the second part of the circumstances in which securities may Act would need to be available for such physical auction, dealers and investors can be tendered in the auction process delivery of securities and compliance issues under determine whether to submit limit separate from the CDS settlement the Exchange Act would also need to be considered. orders and the levels of such limit payment, it is not clear that there is in 928 The Commissions are aware that the 2003 orders. The limit orders, which are Definitions include ‘‘Cash Settlement’’ as a defined fact any significant number of term and that such ‘‘Settlement Method’’ (also a irrevocable, have a firm price in circumstances in which such index CDS defined term in the 2003 Definitions) works addition to size and whether it is a buy may be optionally physically settled. differently than auction settlement pursuant to the or sell order. The auction is conducted The Commissions note that this ‘‘Big Bang Protocol’’ or ‘‘Auction Supplement’’ as a ‘‘dutch’’ auction, in which the open (each as defined below). The Commissions’ use of commenter did not elaborate on the the term ‘‘cash settlement’’ in this section includes buy interests and open sell interests are 934 ‘‘Cash Settlement,’’ as defined in the 2003 matched. The final price of the delivered to satisfy the limit order in exchange for Definitions, and auction settlement, as described in the final price. The sale of the securities in the the ‘‘Big Bang Protocol’’ or ‘‘Auction Supplement.’’ 932 The Commissions understand that other auction occurs at the time the limit order is See infra note 929 and accompanying text. conditions may need to be satisfied as well for an submitted, even though the identification of the 929 See ISDA, ‘‘2009 ISDA Credit Derivatives auction to be held. specific deliverable obligation does not occur until Determinations Committees and Auction Settlement 933 See supra note 48. the auction is completed. CDS Protocol,’’ available at http://www.isda.org/ 934 The second part of the credit event auction 935 See ISDA Letter. bigbangprot/docs/Big-Bang-Protocol.pdf. process involves offers and sales of securities that 936 With respect to the applicability of the Federal 930 The possibility that such index CDS may, in must be made in compliance with the provisions of securities laws, the Commissions are concerned fact, be physically settled if an auction is not held the Securities Act and the Exchange Act. First, the about the use of index CDS to effect distributions or if the auction fails would not affect the submission of a physical settlement request of securities without compliance with the characterization of the index CDS. constitutes an offer by the counterparty to either requirements of the Securities Act. The 931 The Commissions understand that the Big buy or sell any one of the deliverable obligations Commissions recognize that with respect to Bang Protocol is followed for index CDS involving in the auction. Second, the submission of the transactions in security-based swaps by an issuer of corporate debt obligations but is not followed for irrevocable limit orders by dealers or investors are an underlying security, an affiliate of the issuer, or index CDS based on asset-backed securities, loan- sales or purchases by such persons at the time of an underwriter the offer and sale of the underlying only CDS, and certain other types of CDS contracts. submission of the irrevocable limit order. Through security (in this case the security to be delivered) To the extent that such other index CDS contain the auction mechanism, where the open interest occur at the time that the security-based swap is auction procedures similar to the auction (which represents physical settlement requests) is offered and sold, not at the time of settlement. procedures for corporate debt to establish the cash matched with limit orders, buyers and sellers are Further, the Commissions note the restrictions on price to be paid, the Commissions also would not matched. Finally, following the auction and offers and sales of security-based swaps to non- consider such other index CDS that are not based determination of the final price, the counterparty ECPs without compliance with the registration on narrow-based security indexes under the who has submitted the physical delivery request requirements of the Securities Act. See section 5(e) Commissions’ rules to be mixed swaps. decides which of the deliverable obligations will be of the Securities Act, 15 U.S.C. 77e(d).

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circumstances in which the auction (other than an event described in swap or security-based swap. These process would not apply. subparagraph (A)(ii)(III) [of section agreements also include termination 3(a)(68) of the Exchange Act]).940 and default events relating to one or I. Security-Based Swaps as Securities A mixed swap, therefore, is both a both of the counterparties; such Under the Exchange Act and Securities security-based swap and a swap.941 As counterparties may or may not be Act stated in the Proposing Release, the entities that issue securities.944 The Pursuant to the Dodd-Frank Act, a Commissions believe that the scope of Commissions believe that the term ‘‘any security-based swap is defined as a mixed swaps is, and is intended to be, agreement * * * based on * * * the ‘‘security’’ under the Exchange Act937 narrow.942 Title VII establishes robust occurrence of an event relating to a and Securities Act.938 As a result, and largely parallel regulatory regimes single issuer of a security,’’ as provided security-based swaps are subject to the for both swaps and security-based in the definition of the term ‘‘security- Exchange Act and the Securities Act swaps and directs the Commissions to based swap,’’ was not intended to and the rules and regulations jointly prescribe such regulations include such termination and default promulgated thereunder.939 regarding mixed swaps as may be events relating to counterparties The SEC did not provide necessary to carry out the purposes of included in standard agreements that interpretations in the Proposing Release the Dodd-Frank Act.943 More generally, are incorporated by reference into a on the application of the Exchange Act the Commissions believe the category of Title VII instrument.945 Therefore, an and the Securities Act, and the rules mixed swap was designed so that there instrument would not be and regulations thereunder, to security- would be no gaps in the regulation of simultaneously a swap and a security- based swaps. However, the SEC swaps and security-based swaps. based swap (and thus not a mixed swap) solicited comment on whether Therefore, in light of the statutory simply by virtue of having incorporated additional interpretations may be scheme created by the Dodd-Frank Act by reference a standard agreement, necessary regarding the application of for swaps and security-based swaps, the including default and termination certain provisions of the Exchange Act Commissions believe the category of events relating to counterparties to the and the Securities Act, and the rules mixed swap covers only a small subset Title VII instrument. and regulations promulgated of Title VII instruments. thereunder, to security-based swaps. For example, a Title VII instrument in Comments The SEC did not receive any comments which the underlying references are the While the Commissions did not with respect to this issue in the context value of an oil corporation stock and the receive any comments on the of this rulemaking and is not providing price of oil would be a mixed swap. interpretation regarding the scope of the any interpretations in this release. Similarly, a Title VII instrument in category of mixed swaps, one IV. Mixed Swaps which the underlying reference is a commenter recommended that the portfolio of both securities (assuming Commissions require that market A. Scope of the Category of Mixed Swap the portfolio is not an index or, if it is participants disaggregate mixed swaps The category of mixed swap is an index, that the index is narrow- and enter into separate simultaneous described, in both the definition of the based) and commodities would be a transactions so that they cannot employ term ‘‘security-based swap’’ in the mixed swap. Mixed swaps also would mixed swaps to obscure the underlying Exchange Act and the definition of the include certain Title VII instruments substance of transactions.946 The term ‘‘swap’’ in the CEA, as a security- called ‘‘best of’’ or ‘‘out performance’’ Commissions are not adopting any rules based swap that is also based on the swaps that require a payment based on or interpretations to require value of 1 or more interest or other rates, the higher of the performance of a disaggregation of mixed swaps into their currencies, commodities, instruments of security and a commodity (other than a separate components, as the Dodd-Frank indebtedness, indices, quantitative security). As discussed elsewhere in this Act specifically contemplated that there measures, other financial or economic release, the Commissions also believe would be mixed swaps comprised of interest or property of any kind (other that certain Title VII instruments may be both swaps and security-based swaps. than a single security or a narrow-based mixed swaps if they meet specified B. Regulation of Mixed Swaps security index), or the occurrence, non- conditions. occurrence, or the extent of the The Commissions also believe that the 1. Introduction occurrence of an event or contingency use of certain market standard The Commissions are adopting as associated with a potential financial, agreements in the documentation of proposed paragraph (a) of rule 1.9 under economic, or commercial consequence Title VII instruments should not in and the CEA and rule 3a68–4 under the of itself transform a Title VII instrument Exchange Act to define a ‘‘mixed swap’’ 937 See section 761(a)(2) of the Dodd-Frank Act into a mixed swap. For example, many in the same manner as the term is (inserting the term ‘‘security-based swap’’ into the instruments are documented by defined in both the CEA and the definition of ‘‘security’’ in section 3a(10) of the incorporating by reference market Exchange Act, 15 U.S.C. 78c(a)(10)). Exchange Act. The Commissions also 938 See section 768(a)(1) of the Dodd-Frank Act standard agreements. Such agreements are adopting as proposed two rules to (inserting the term ‘‘security-based swap’’ into the typically set out the basis of establishing address the regulation of mixed swaps. definition of ‘‘security’’ in section 2(a)(1) of the a trading relationship with another First, paragraph (b) of rule 1.9 under the Securities Act, 15 U.S.C. 77b(a)(1)). party but are not, taken separately, a 939 Sections 761(a)(3) and (4) of the Dodd-Frank CEA and rule 3a68–4 under the Act amend sections 3(a)(13) and (14) of the Exchange Act will provide a regulatory 940 Exchange Act, 15 U.S.C. 78c(a)(13) and (14), and Section 3(a)(68)(D) of the Exchange Act, 15 framework with which parties to U.S.C. 78c(a)(68)(D); section 1a(47)(D) of the CEA, section 768(a)(3) of the Dodd-Frank Act adds bilateral uncleared mixed swaps (i.e., section 2(a)(18) to the Securities Act, 15 U.S.C. 7 U.S.C. 1a(47)(D). 77b(a)(18), to provide that the terms ‘‘purchase’’ 941 Id. The exclusion from the definition of the and ‘‘sale’’ of a security-based swap shall mean the term ‘‘swap’’ for security-based swaps does not 944 Those standard events include inter alia ‘‘the execution, termination (prior to its scheduled include security-based swaps that are mixed swaps. bankruptcy, breach of agreement, cross default to maturity date), assignment, exchange, or similar See section 1a(47)(B)(x) of the CEA, 7 U.S.C. other indebtedness, and misrepresentations. transfer or conveyance of, or extinguishing of rights 1a(47)(B)(x). 945 See section 3(a)(68)(A)(ii)(III) of the Exchange or obligations under, a security-based swap, as the 942 See Proposing Release at 29860. Act, 15 U.S.C. 78c(a)(68)(A)(ii)(III). context may require.’’ 943 See section 712(a)(8) of the Dodd-Frank Act. 946 See Better Markets Letter.

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mixed swaps that are neither executed they enter into certain mixed swaps 4s(h)(1)(A), applies to swap dealers and on or subject to the rules of a DCM, under specified circumstances. The major swap participants and prohibits NSE, SEF, security-based SEF, or FBOT Commissions received no comments on fraud, manipulation, and other abusive nor cleared through a DCO or clearing the proposed rules. practices and also imposes requirements agency), as to which at least one of the Accordingly, as adopted, paragraph regarding the confidential treatment of parties is dually registered with both (b) of rule 1.9 under the CEA and rule counterparty information, which will Commissions, will need to comply. 3a68–4 under the Exchange Act provide apply to mixed swaps.959 Second, paragraph (c) of rule 1.9 under that a bilateral uncleared mixed As discussed in the Proposing the CEA and rule 3a68–4 under the swap,950 where at least one party is Release, the Commissions believe that Exchange Act establishes a process for dually-registered with the CFTC as a paragraph (b) of rule 1.9 under the CEA persons to request that the Commissions swap dealer or major swap participant and rule 3a68–4 under the Exchange Act issue a joint order permitting such and with the SEC as a security-based will address potentially conflicting or persons (and any other person or swap dealer or major security-based duplicative regulatory requirements for persons that subsequently lists, trades, swap participant, will be subject to all dually-registered dealers and major or clears that class of mixed swap)947 to applicable provisions of the Federal participants that are subject to comply, as to parallel provisions948 securities laws (and SEC rules and regulation by both the CFTC and the only, with specified parallel provisions regulations promulgated thereunder). SEC, while requiring dual registrants to of either the CEA or the Exchange Act, The rules as adopted also provide that comply with the regulatory and related rules and regulations such mixed swaps will be subject to requirements the Commissions believe (collectively ‘‘specified parallel only the following provisions of the are necessary to provide sufficient provisions’’), instead of being required CEA (and CFTC rules and regulations regulatory oversight for mixed swap to comply with parallel provisions of promulgated thereunder): • transactions entered into by such dual both the CEA and the Exchange Act. Examinations and information registrants. The CFTC also believe that sharing: CEA sections 4s(f) and 8; 951 2. Bilateral Uncleared Mixed Swaps • paragraph (b) of rule 1.9 under the CEA Enforcement: CEA sections and rule 3a68–4 under the Exchange Act Entered Into by Dually-Registered 2(a)(1)(B), 4(b), 4b, 4c, 4s(h)(1)(A), will provide clarity to dually-registered Dealers or Major Participants 4s(h)(4)(A), 6(c), 6(d), 6c, 6d, 9, 13(a), dealers and major participants, who are Swap dealers and major swap 13(b) and 23; 952 • Reporting to an SDR: CEA section subject to regulation by both the CFTC participants will be comprehensively and the SEC, as to the requirements of regulated by the CFTC, and security- 4r; 953 each Commission that will apply to based swap dealers and major security- • Real-time reporting: CEA section their bilateral uncleared mixed swaps. based swap participants will be 2(a)(13); 954 • 955 comprehensively regulated by the Capital: CEA section 4s(e); and 3. Regulatory Treatment for Other • 956 SEC.949 The Commissions recognize that Position Limits: CEA section 4a. Mixed Swaps The Commissions are modifying there may be differences in the Because mixed swaps are both requirements applicable to swap dealers proposed rule 1.9(b)(3)(i) under the CEA and Rule 3a68–4(b)(3)(i) to include security-based swaps and swaps,960 and security-based swap dealers, or absent a joint rule or order by the major swap participants and major additional ‘‘enforcement’’ authority. Specifically, as adopted, the rules Commissions permitting an alternative security-based swap participants, such regulatory approach, persons who desire that dually-registered market provide that such swaps will be subject or intend to list, trade, or clear a mixed participants may be subject to to the anti-fraud, anti-manipulation, and swap (or class thereof) will be required potentially conflicting or duplicative other provisions of the business conduct to comply with all the statutory regulatory requirements when they standards in CEA sections 4s(h)(1)(A) provisions in the CEA and the Exchange engage in mixed swap transactions. In and 4s(h)(4)(A) and the rules Act (including all the rules and order to assist market participants in promulgated thereunder for mixed 957 regulations thereunder) that were added addressing such potentially conflicting swaps. Rule 23.410 under the 958 or amended by Title VII with respect to or duplicative requirements, the CEA, adopted under CEA section swaps or security-based swaps.961 Such Commissions are adopting, as proposed 950 with one modification explained below, Under paragraph (b) of rule 1.9 under the CEA and rule 3a68–4 under the Exchange Act, a 959 Business Conduct Standards for Swap Dealers rules that will permit dually-registered ‘‘bilateral uncleared mixed swap’’ will be a mixed and Major Swap Participants With Counterparties, swap dealers and security-based swap swap that: (i) Is neither executed on nor subject to 77 FR 9734, 9751–9755 (Feb. 17, 2012). The dealers and dually-registered major the rules of a DCM, NSE, SEF, security-based SEF, Commissions note that, while the introductory text or FBOT; and (ii) will not be submitted to a DCO swap participants and major security- of rule 1.9(b)(3)(i)(A) through (F) under the CEA or registered or exempt clearing agency to be and rule 3a68–4(b)(3)(i)(A) through (F) under the based swap participants to comply with cleared. To the extent that a mixed swap is subject Exchange Act characterizes the cited CEA sections an alternative regulatory regime when to the mandatory clearing requirement (see section (e.g., ‘‘enforcement,’’ ‘‘capital,’’ etc.), such 2(h)(1)(A) of the CEA, 7 U.S.C. 2(h)(1)(A), and characterization is meant as guidance only. For section 3C(a)(1) of the Exchange Act) (and where a 947 example, final rule 1.9(b)(3)(i)(B) uses the word All references to Title VII instruments in parts counterparty is not eligible to rely on the end-user IV and VI shall include a class of such Title VII ‘‘enforcement’’ to characterize certain of the cited exclusion from the mandatory clearing requirement CEA sections and the rules and regulations instruments as well. For example, a ‘‘class’’ of Title (see section 2(h)(7) of the CEA, 7 U.S.C. 2(h)(7), and promulgated thereunder that prohibit fraud, VII instrument would include instruments that are section 3C(g) of the Exchange Act)), this alternative manipulation, or abusive practices. Other cited of similar character and provide substantially regulatory treatment will not be available. provisions, such as the Whistleblower protections similar rights and privileges. 951 7 U.S.C. 6s(f) and 12, respectively. 948 under CEA section 23, or the related rules and As stated in paragraph (c) of proposed rule 1.9 952 7 U.S.C. 2(a)(1)(B), 6(b), 6b, 6c, 6s(h)(1)(A), regulations, such as requirements to keep under the CEA and rule 3a68–4 under the Exchange 6s(h)(4)(A), 9 and 15, 13b, 13a–1, 13a–2, 13, 13c(a), Act, ‘‘parallel provisions’’ means comparable counterparty information confidential under rule 13c(b), and 26, respectively. 23.410(c) under the CEA, 17 CFR 23.410(c), are provisions of the CEA and the Exchange Act that 953 were added or amended by Title VII with respect 7 U.S.C. 6r. similarly enforcement provisions in that they 954 to security-based swaps and swaps, and the rules 7 U.S.C. 2(a)(13). protect market participants from fraudulent or other and regulations thereunder. 955 7 U.S.C. 6s(e). abusive practices. 949 Section 712(a)(7)(A) of the Dodd-Frank Act 956 7 U.S.C. 6a. 960 See supra note 10. requires the Commissions to treat functionally or 957 7 U.S.C. 6s(h)(1)(A) and 6s(h)(4)(A). 961 Because security-based swaps are also economically similar entities in a similar manner. 958 17 CFR 23.410. securities, compliance with the Federal securities

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dual regulation may not be appropriate comparability of such parallel having done so. Paragraph (c) of rule 1.9 in every instance and may result in provisions; and (3) the extent of any under the CEA and rule 3a68–4 under potentially conflicting or duplicative conflicts or differences between such the Exchange Act makes clear that regulatory requirements. However, parallel provisions; and nothing in the rules requires either before the Commissions can determine (v) such other information as may be Commission to issue a requested joint the appropriate regulatory treatment for requested by either of the Commissions. order regarding the regulation of a mixed swaps (other than the treatment This provision is intended to provide particular mixed swap (or class thereof). discussed above), the Commissions will the Commissions with sufficient These provisions are intended to need to understand better the nature of information regarding the mixed swap provide market participants with a the mixed swaps that parties want to (or class thereof) and the proposed prompt review of requests for a joint trade. As a result, the Commissions regulatory approach to make an order regarding the regulation of a proposed paragraph (c) of rule 1.9 under informed determination regarding the particular mixed swap (or class thereof). the CEA and rule 3a68–4 under the appropriate regulatory treatment of the The rules also will provide transparency Exchange Act to establish a process mixed swap (or class thereof). and accountability by requiring that at pursuant to which any person who As adopted, paragraph (c) of rule 1.9 the end of the review period, the desires or intends to list, trade, or clear under the CEA and rule 3a68–4 under Commissions issue the requested order a mixed swap (or class thereof) that is the Exchange Act also will allow a or publicly state the reasons for not not subject to the provisions of person to withdraw a request regarding doing so. the regulation of a mixed swap at any paragraph (b) of the rules (i.e., bilateral V. Security-Based Swap Agreements uncleared mixed swaps entered into by time prior to the issuance of a joint at least one dual registrant) may request order by the Commissions. This A. Introduction the Commissions to publicly issue a provision is intended to permit persons SBSAs are swaps over which the joint order permitting such person (and to withdraw requests that they no longer CFTC has regulatory and enforcement any other person or persons that need. This, in turn, will save the authority but for which the SEC also has subsequently lists, trades, or clears that Commissions time and staff resources. antifraud and certain other authority.963 As adopted, paragraph (c) of rule 1.9 class of mixed swap) to comply, as to The term ‘‘security-based swap under the CEA and rule 3a68–4 under parallel provisions only, with the agreement’’ is defined as a ‘‘swap the Exchange Act further provide that in specified parallel provisions, instead of agreement’’ (as defined in section 206A response to a request pursuant to the being required to comply with parallel of the GLBA 964) of which ‘‘a material rules, the Commissions may jointly provisions of both the CEA and the term is based on the price, yield, value, 962 issue an order, after public notice and Exchange Act. The Commissions or volatility of any security or any group opportunity for comment, permitting received no comments on the proposed or index of securities, including any the requesting person (and any other rules and are adopting the rules as interest therein’’ but does not include a person or persons that subsequently proposed. security-based swap.965 As adopted, paragraph (c) of rule 1.9 lists, trades, or clears that class of mixed under the CEA and rule 3a68–4 under swap) to comply, as to parallel 963 See section 3(a)(78) of the Exchange Act, 15 the Exchange Act further provide that a provisions only, with the specified U.S.C. 78c(a)(78); CEA section 1a(47)(A)(v), 7 U.S.C. person submitting such a request to the parallel provisions (or another subset of 1a(47)(A)(v). The Dodd-Frank Act provides that Commissions must provide the the parallel provisions that are the certain CFTC registrants, such as DCOs and SEFs, will keep records regarding SBSAs open to Commissions with: subject of the request, as the inspection and examination by the SEC upon (i) All material information regarding Commissions determine is appropriate), request. See, e.g., sections 725(e) and 733 of the the terms of the specified, or specified instead of being required to comply Dodd-Frank Act. The Commissions are committed class of, mixed swap; with parallel provisions of both the CEA to working cooperatively together regarding their (ii) the economic characteristics and and the Exchange Act. In determining dual enforcement authority over SBSAs. 964 15 U.S.C. 78c note. The Dodd-Frank Act purpose of the specified, or specified the contents of such a joint order, the amended the definition of ‘‘swap agreement’’ in class of, mixed swap; Commissions can consider, among other section 206A of the GLBA to eliminate the (iii) the specified parallel provisions, things: requirements that a swap agreement be between and the reasons the person believes (i) The nature and purposes of the ECPs, as defined in section 1a(18)(C) of the CEA, 7 U.S.C. 1a(18)(C), and subject to individual such specified parallel provisions parallel provisions that are the subject negotiation. See section 762(b) of the Dodd-Frank would be appropriate for the mixed of the request; Act. Sections 762(c) and (d) of the Dodd-Frank Act swap (or class thereof); (ii) the comparability of such parallel also made conforming amendments to the Exchange (iv) an analysis of (1) the nature and provisions; and Act and the Securities Act to reflect the changes to purposes of the parallel provisions that (iii) the extent of any conflicts or the regulation of ‘‘swap agreements’’ that are either ‘‘security-based swaps’’ or ‘‘security-based swap are the subject of the request; (2) the differences between such parallel agreements’’ under the Dodd-Frank Act. provisions. 965 See section 3(a)(78) of the Exchange Act, 15 laws and rules and regulations thereunder (in Finally, as adopted, paragraph (c) of U.S.C. 78c(a)(78). The CFMA amended the addition to the provisions of the Dodd-Frank Act rule 1.9 under the CEA and rule 3a68– Exchange Act and the Securities Act to exclude and the rules and regulations thereunder) will also 4 under the Exchange Act require the swap agreements from the definitions of security in be required. To the extent one of the Commissions those statutes but subjected ‘‘security-based swap has exemptive authority with respect to other Commissions, if they determine to issue agreements,’’ as defined in section 206B of the provisions of the CEA or the Federal securities laws a joint order pursuant to these rules, to GLBA, 15 U.S.C. 78c note, to the antifraud, anti- and the rules and regulations thereunder, persons do so within 120 days of receipt of a manipulation, and anti-insider trading provisions of may submit separate exemptive requests or complete request (with such 120-day the Exchange Act and Securities Act. See CFMA, rulemaking petitions regarding those provisions to supra note 697, title III. the relevant Commission. period being tolled during the pendency The CEA does not contain a stand-alone 962 Other than with respect to the specified of a request for public comment on the definition of ‘‘security-based swap agreement,’’ but parallel provisions with which such persons may be proposed interpretation). If the includes the definition instead in subparagraph permitted to comply instead of complying with Commissions do not issue a joint order (A)(v) of the swap definition in CEA section 1a(47), parallel provisions of both the CEA and the within the prescribed time period, the 7 U.S.C. 1a(47). The only difference between these Exchange Act, any other provision of either the CEA definitions is that the definition of SBSA in the or the Federal securities laws that applies to swaps rules require that each Commission Exchange Act specifically excludes security-based or security-based swaps will continue to apply. publicly provide the reasons for not Continued

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B. Swaps That are Security-Based Swap C. Books and Records Requirements for requirements were not necessary for Agreements Security-Based Swap Agreements SBSAs.971 The Commissions received Although the Commissions believe it The Commissions are adopting rule no comments on the proposed rules. is not possible to provide a bright line 1.7 under the CEA and rule 3a68–3 Accordingly, rule 1.7 under the CEA test to define an SBSA, the under the Exchange Act, as proposed, to and rule 3a68–3 under the Exchange Act Commissions believe that it is possible clarify that there will not be additional provide that persons registered as SDRs to clarify that certain types of swaps books and records requirements under the CEA and the rules and clearly fall within the definition of regarding SBSAs other than those that regulations thereunder are not required SBSA. For example, as the Commissions are required for swaps. The Dodd-Frank to (i) keep and maintain additional noted in the Proposing Release, a swap Act provides that the Commissions shall books and records regarding SBSAs based on an index of securities that is adopt rules regarding the books and other than the books and records regarding swaps that SDRs would be not a narrow-based security index (i.e., records required to be kept for required to keep and maintain pursuant a broad-based security index) would fall SBSAs.969 As discussed above, SBSAs to the CEA and rules and regulations within the definition of an SBSA under are swaps over which the CFTC has thereunder; and (ii) collect and maintain the Dodd-Frank Act.966 Similarly, an regulatory authority, but for which the additional data regarding SBSAs other index CDS that is not based on a SEC has antifraud, anti-manipulation, than the data regarding swaps that SDRs narrow-based security index or on the and certain other authority. In the are required to collect and maintain ‘‘issuers of securities in a narrow-based Proposing Release, the Commissions pursuant to the CEA and rules and security index,’’ as defined in rule noted that the CFTC had proposed rules regulations thereunder. In addition, rule 1.3(zzz) under the CEA and rule 3a68– governing books and records for swaps, 1.7 under the CEA and rule 3a68–3 1a under the Exchange Act, would be an which would apply to swaps that also are SBSAs.970 The Commissions further under the Exchange Act provide that SBSA. In addition, a swap based on a persons registered as swap dealers or U.S. Treasury security or on certain stated their belief that those proposed rules would provide sufficient books major swap participants under the CEA other exempted securities other than and the rules and regulations municipal securities would fall within and records regarding SBSAs, and that additional books and records thereunder, or registered as security- the definition of an SBSA under the based swap dealers or major security- 967 Dodd-Frank Act. based swap participants under the The Commissions received no under the Dodd-Frank Act—including, for example, Exchange Act and the rules and comments on the examples provided in a CDS on a single loan. Accordingly, although such transactions were not subject to insider trading regulations thereunder, are not required the Proposing Release regarding SBSAs. restrictions under the CFMA, under the Dodd-Frank to keep and maintain additional books Accordingly, the Commissions are not Act they are subject to the Federal securities laws, and records, including daily trading further defining SBSA beyond restating including insider trading restrictions. 969 records, regarding SBSAs other than the the examples above.968 Specifically, section 712(d)(2)(B) of the Dodd- Frank Act requires the Commissions, in books and records regarding swaps that consultation with the Board, to jointly adopt rules those persons are required to keep and swaps (see section 3(a)(78)(B) of the Exchange Act, governing books and records requirements for 15 U.S.C. 78c(a)(78)(B)), while the definition of maintain pursuant to the CEA and the SBSAs by persons registered as SDRs under the 972 SBSA in the CEA does not contain a similar CEA, including uniform rules that specify the data rules and regulations thereunder. exclusion. Instead, the exclusion for security-based elements that shall be collected and maintained by swaps is placed in the general exclusions from the each SDR. Similarly, section 712(d)(2)(C) of the VI. Process for Requesting swap definition in the CEA (see CEA section Dodd-Frank Act requires the Commissions, in Interpretations of the Characterization 1a(47)(B)(x), 7 U.S.C. 1a(47)(B)(x)). consultation with the Board, to jointly adopt rules of a Title VII Instrument 966 See Proposing Release at 29863. Swaps based governing books and records for SBSAs, including on indexes that are not narrow-based security daily trading records, for swap dealers, major swap The Commissions recognize that there indexes are not included within the definition of participants, security-based swap dealers, and may be Title VII instruments (or classes the term security-based swap under the Dodd-Frank major security-based swap participants. of Title VII instruments) that may be Act. See section 3(a)(68)(A)(ii)(I) of the Exchange 970 See Swap Data Recordkeeping and Reporting difficult to categorize definitively as Act, 15 U.S.C. 78c(a)(68)(A)(ii)(I), and discussion Requirements, 75 FR 76573 (Dec. 8, 2010) supra part III.G. However, such swaps have a (proposed rules regarding swap data recordkeeping swaps or security-based swaps. Further, material term that is ‘‘based on the price, yield, and reporting requirements for SDRs, DCOs, DCMs, because mixed swaps are both swaps value, or volatility of any security or any group or SEFs, swap dealers, major swap participants, and and security-based swaps, identifying a index of securities, or any interest therein,’’ and swap counterparties who are neither swap dealers mixed swap may not always be therefore such swaps fall within the SBSA nor major swap participants); See Reporting, definition. Recordkeeping, and Daily Trading Records straightforward. 967 Swaps on U.S. Treasury securities that do not Requirements for Swap Dealers and Major Swap Section 712(d)(4) of the Dodd-Frank have any other underlying references involving Participants, 75 FR 76666 (Dec. 9, 2010) (proposed Act provides that any interpretation of, securities are expressly excluded from the rules regarding reporting and recordkeeping or guidance by, either the CFTC or SEC definition of the term ‘‘security-based swap’’ under requirements and daily trading records regarding a provision of Title VII shall the Dodd-Frank Act. See section 3(a)(68)(C) of the requirements for swap dealers and major swap Exchange Act, 15 U.S.C. 78c(a)(68)(C) (providing participants). These rules have been adopted by the be effective only if issued jointly by the that an agreement, contract, or transaction that CFTC. See Swap Data Recordkeeping and Reporting Commissions (after consultation with would be a security-based swap solely because it Requirements, 77 FR 2136 (Jan. 13, 2012) (final the Board) on issues where Title VII references, is based on, or settles through the rules regarding swap data recordkeeping and requires the CFTC and SEC to issue joint delivery of one or more U.S. Treasury securities (or reporting requirements for SDRs, DCOs, DCMs, certain other exempted securities) is excluded from SEFs, swap dealers, major swap participants, and regulations to implement the provision. the security-based swap definition). However, swap counterparties who are neither swap dealers The Commissions believe that any swaps on U.S. Treasury securities or on other or major swap participants); See Swap Dealer and interpretation or guidance regarding exempted securities covered by subparagraph (C) of Major Swap Participant Recordkeeping, Reporting, whether a Title VII instrument is a the security-based swap definition have a material and Duties Rules; Futures Commission Merchant term that is ‘‘based on the price, yield, value, or and Introducing Broker Conflicts of Interest Rules; volatility of any security or any group or index of and Chief Compliance Officer Rules for Swap 971 See Proposing Release at 29863. securities, or any interest therein,’’ and therefore Dealers, Major Swap Participants, and Futures 972 Rule 1.7 under the CEA and Rule 3a69–3 fall within the SBSA definition. Commission Merchants, 77 FR 20128 (Apr. 3, 2012) under the Exchange Act provide that the term 968 The Commissions noted that certain (final rules regarding reporting and recordkeeping ‘‘security-based swap agreement’’ has the meaning transactions that were not ‘‘security-based swap requirements and daily trading records set forth in CEA section 1a(47)(A)(v), 7 U.S.C. agreements’’ under the CFMA are nevertheless requirements for swap dealers and major swap 1a(47)(A)(v), and section 3(a)(78) of the Exchange included in the definition of security-based swap participants). Act, 15 U.S.C. 78c(a)(78), respectively.

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swap, a security-based swap, or both The final rules provide that a person no longer needs an interpretation. This, (i.e., a mixed swap), must be issued requesting an interpretation as to the in turn, should save the Commissions jointly pursuant to this requirement. characterization of a Title VII time and staff resources. If the The Commissions proposed rules in instrument as a swap, a security-based Commissions believe such an the Proposing Release to establish a swap, or both (i.e., a mixed swap), must interpretation is necessary regardless of process for interested persons to request provide the Commissions with the a particular request for interpretation, a joint interpretation by the person’s determination of the however, the Commissions may provide Commissions regarding whether a characterization of the instrument and such a joint interpretation of their own particular Title VII instrument (or class supporting analysis, along with certain accord. of Title VII instruments) is a swap, a other documentation.976 Specifically, The final rules provide that if either security-based swap, or both (i.e., a the person must provide the Commission receives a proposal to list, mixed swap).973 The Commissions are Commissions with the following trade, or clear an agreement, contract, or adopting the rules as proposed. information: transaction (or class thereof) that raises Section 718 of the Dodd-Frank Act • All material information regarding questions as to the appropriate establishes a process for determining the the terms of the Title VII instrument; characterization of such agreement, status of ‘‘novel derivative products’’ • A statement of the economic contract, or transaction (or class thereof) that may have elements of both characteristics and purpose of the Title as a swap, security-based swap, or both securities and futures contracts. Section VII instrument; (i.e., a mixed swap), the receiving 718 of the Dodd-Frank Act provides a • The requesting person’s Commission promptly shall notify the useful model for a joint Commission determination as to whether the Title other.979 This provision of the final review process to appropriately VII instrument should be characterized rules further provides that either categorize Title VII instruments. As a as a swap, a security-based swap, or Commission, or their Chairmen jointly, result, the final rules include various both (i.e., a mixed swap), including the may submit a request for a joint attributes of the process established in basis for such determination; and interpretation to the Commissions as to section 718 of the Dodd-Frank Act. In • Such other information as may be the characterization of the Title VII particular, to permit an appropriate requested by either Commission. instrument where no external request review period that provides sufficient This provision should provide the has been received. time to ensure Federal regulatory Commissions with sufficient This provision is intended to ensure interests are satisfied that also does not information regarding the Title VII that Title VII instruments do not fall unduly delay the introduction of new instrument at issue so that the into regulatory gaps and will help the financial products, the adopted process, Commissions can appropriately evaluate Commissions to fulfill their like the process established in section whether it is a swap, a security-based responsibility to oversee the regulatory 718, includes a deadline for responding swap, or both (i.e., a mixed swap).977 By regime established by Title VII of the to a request for a joint interpretation.974 requiring that requesting persons Dodd-Frank Act by making sure that The Commissions are adopting rule furnish a determination regarding Title VII instruments are appropriately 1.8 under the CEA and rule 3a68–2 whether they believe the Title VII characterized, and thus appropriately under the Exchange Act that establish a instrument is a swap, a security-based regulated. An agency, or their Chairmen process for parties to request a joint swap, or both (i.e., a mixed swap), jointly, submitting a request for an interpretation regarding the including the basis for such interpretation as to the characterization characterization of a particular Title VII determination, this provision also will of a Title VII instrument under this instrument (or class thereof). assist the Commissions in more quickly paragraph will be required to submit the Specifically, the final rules provide that identifying and addressing the relevant same information as, and could any person may submit a request to the issues involved in arriving at a joint withdraw a request in the same manner Commissions to provide a public joint interpretation of the characterization of as, a person submitting a request to the interpretation of whether a particular the instrument. Commissions. The bases for these Title VII instrument is a swap, a The final rules provide that a person provisions are set forth above with security-based swap, or both (i.e., a may withdraw a request at any time respect to paragraphs (b) and (c) of the mixed swap).975 prior to the issuance of a joint final rules. The final rules afford market interpretation or joint notice of The final rules require that the participants with the opportunity to proposed rulemaking by the Commissions, if they determine to issue obtain greater certainty from the Commissions.978 Notwithstanding any a joint interpretation as to the Commissions regarding the regulatory such withdrawal, the Commissions may characterization of a Title VII status of particular Title VII instruments provide an interpretation regarding the instrument, do so within 120 days of under the Dodd-Frank Act. This characterization of the Title VII receipt of the complete external or provision should decrease the instrument that was the subject of a agency submission (unless such 120-day possibility that market participants withdrawn request. period is tolled during the pendency of inadvertently might fail to meet the This provision will permit parties to a request for public comment on the regulatory requirements applicable to a withdraw requests for which the party proposed interpretation).980 If the particular Title VII instrument. Commissions do not issue a joint 976 See paragraph (b) of rule 1.8 under the CEA interpretation within the prescribed 973 See Proposing Release at 29864–65. and rule 3a68–2 under the Exchange Act. time period, the final rules require that 974 The Commissions note that section 718 of the 977 The Commissions also may use this each Commission publicly provide the Dodd-Frank Act is a separate process from the information to issue (within the timeframe for process the Commissions are adopting, and that any issuing a joint interpretation) a joint notice of reasons for not having done so within future interpretation involving the process under proposed rulemaking to further define one or more section 718 would not affect the process being of the terms ‘‘swap,’’ ‘‘security-based swap,’’ or 979 See paragraph (d) of rule 1.8 under the CEA adopted here, nor will any future interpretation ‘‘mixed swap.’’ See paragraph (f) of rule 1.8 under and rule 3a68–2 under the Exchange Act. involving the process adopted here affect the the CEA and rule 3a68–2 under the Exchange Act, 980 See paragraph (e) of rule 1.8 under the CEA process under section 718. which are discussed below. and rule 3a68–2 under the Exchange Act. This 120- 975 See paragraph (a) of rule 1.8 under the CEA 978 See paragraph (c) of rule 1.8 under the CEA day period is based on the timeframe set forth in and rule 3a68–2 under the Exchange Act. and rule 3a68–2 under the Exchange Act. section 718(a)(3) of the Dodd-Frank Act.

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such prescribed time period. This that the Commissions should seek retaining the flexibility in the provision of the final rules also expedited judicial review in the event interpretive process rules to decide incorporates the mandate of the Dodd- the Commissions do not agree on the whether or not to issue joint Frank Act that any joint interpretation interpretation.986 interpretations. The Commissions by the Commissions be issued only after The Commissions are adopting the believe, however, that it is appropriate consultation with the Board of final rules as proposed and are not to advise market participants of the Governors of the Federal Reserve including SBSAs in the process. The reasons why such interpretation is not System.981 Finally, the rules make clear joint interpretive process is intended to being issued and the final rules retain that nothing requires either Commission decrease the possibility that market the requirement that the Commissions to issue a requested joint interpretation participants inadvertently might fail to publicly explain the reasons for not regarding the characterization of a meet regulatory requirements that are issuing a joint interpretation. particular instrument. applicable to swaps, security-based Further, the Commissions are not These provisions are intended to swaps, or mixed swaps and, as such, revising the final rules to provide for assure market participants a prompt provides a mechanism for market expedited judicial review. The Dodd- review of submissions requesting a joint participants to request whether an Frank Act does not contain any interpretation of whether a Title VII instrument will be regulated by the provision that provides for expedited instrument is a swap, a security-based CFTC, the SEC, or both. However, the judicial review if the Commissions do swap, or both (i.e., a mixed swap). The Commissions do not believe it is not issue a joint interpretation with final rules also provide transparency appropriate to predetermine whether respect to a Title VII instrument. and accountability by requiring that at particular swaps also are SBSAs as Although the Commissions note that the end of the review period, the SBSAs are already swaps over which section 718 of the Dodd-Frank Act Commissions issue the requested the CFTC has regulatory and contains a statutorily mandated interpretation or publicly state the enforcement authority and as to which expedited judicial review of one of the reasons for not doing so. the SEC has antifraud and certain other Commission’s actions (if sought by the The final rules permit the related authorities.987 Predetermining other Commission) regarding novel Commissions, in lieu of issuing a whether particular swaps may be SBSAs derivative products that may have requested interpretation, to issue under this process is not needed to elements of both securities and futures (within the timeframe for issuing a joint provide certainty as to the applicable contracts, such statutory provision does interpretation) a joint notice of proposed regulatory treatment of these not apply to Title VII instruments.988 rulemaking to further define one or instruments. Further, Title VII provides flexibility to more of the terms ‘‘swap,’’ ‘‘security- The Commissions also are retaining in the Commissions to determine the based swap,’’ or ‘‘mixed swap.’’ 982 the final rules the framework for methods by which joint interpretations Under the final rules, the 120-day providing or not providing joint are provided. Title VII does not contain period to provide a response will be interpretations. As noted above, section any required expedited judicial review tolled during the pendency of a request 718 of the Dodd-Frank Act contains a of Commission actions, and the for public comment on any such framework for evaluating novel Commissions do not have the authority proposed interpretation. Such a derivative products that may have to require expedited judicial review rulemaking, as required by Title VII, elements of both securities and futures under Title VII, with respect to a Title would be required to be done in contracts (other than swaps, security- VII instrument. Accordingly, the consultation with the Board of based swaps or mixed swaps). The Commissions do not believe that Governors of the Federal Reserve Commissions believe that establishing a including such a provision is System. This provision is intended to joint interpretive process for swaps, appropriate in the context of providing provide the Commissions with needed security-based swaps and mixed swaps interpretations to market participants flexibility to address issues that may be that is modeled in part on this statutory regarding the definitions of swap, of broader applicability than the framework should facilitate providing security-based swap, or mixed swap. particular Title VII instrument that is interpretations to market participants in Two commenters were concerned the subject of a request for a joint a timely manner, if the Commissions about the length of the review period interpretation. determine to do so. Establishing a and believed that the Commissions Comments process by rule will provide market should shorten such time period.989 The participants with an understandable Three commenters discussed the method by which they can request an 988 The Commissions note that judicial review proposed process for requesting interpretation from the Commissions. provisions in section 718 relating to the status of interpretations of the characterization of As the Commissions have the authority, novel derivative products only provide that either a Title VII instrument,983 and while Commission (either the SEC or the CFTC) has the but not the obligation, under the Dodd- right to petition for review of a final order of the supporting such joint interpretive Frank Act to further define the terms other Commission with respect to novel derivative process, suggested certain changes, products that may have elements of both securities 984 ‘‘swap,’’ ‘‘security-based swap,’’ and including extending it to SBSAs, ‘‘mixed swap,’’ the Commissions are and futures that affects jurisdictional issues. mandating that the Commissions issue a Nothing in section 718 requires that the 985 Commissions issue exemptions or interpretations response to a request, and suggesting 986 See CME Letter. This commenter suggested pursuant to such section or provides any person that the Commissions should seek expedited other than the Commissions the right to petition for 981 See section 712(d)(4) of the Dodd-Frank Act. judicial review to determine the characterization of Court review of a Commission order issued 982 See paragraph (f) of rule 1.8 under the CEA a Title VII instrument if the Commissions cannot pursuant to section 718. and rule 3a68–2 under the Exchange Act. agree on a joint interpretation. Id. 989 See CME Letter and Markit Letter. One of 983 See Better Markets Letter; CME Letter; and 987 See section 3(a)(78) of the Exchange Act, 15 these commenters suggested that the Commissions SIFMA Letter. U.S.C. 78c(a)(78), and section 1a(47)(A)(v) of the should reduce the 120-day review period to 30 days 984 See Better Markets Letter. CEA, 7 U.S.C. 1a(47)(A)(v). The Dodd-Frank Act because the value of receiving a joint interpretation 985 See CME Letter and SIFMA Letter. These provides that certain CFTC registrants, such as would be negated if a market participant had to commenters suggested that the Commissions should DCOs and SEFs, will keep records regarding wait 120 days. This commenter also suggested that be required to issue a joint interpretation for all security-based swap agreements open to inspection foreign competitors will gain a competitive joint interpretive requests that are not withdrawn. and examination by the SEC upon request. See, e.g., advantage to U.S. market participants because they Id. sections 725(e) and 733 of the Dodd-Frank Act. will not need to wait for a joint interpretation before

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Commissions are not modifying the Finally, some commenters expressed VII. Anti-Evasion final rules from those proposed with concern about the public availability of A. CFTC Anti-Evasion Rules respect to the length of the review information regarding the joint period. The 120-day review period is interpretive process and asked that the 1. CFTC’s Anti-Evasion Authority based on a timeframe established by parties be able to seek confidential (a) Statutory Basis for the Anti-Evasion 992 Congress with respect to determining treatment of their submissions. The Rules the status of novel derivative Commissions note that under existing products.990 The Commissions believe rules of both Commissions, requesting Pursuant to the authority in sections that this length of the review period also parties may seek confidential treatment 721(c) and 725(g)(2) of the Dodd-Frank Act and CEA sections 1a(47)(E) and is appropriate for other derivative for joint interpretive requests from the 2(i),995 the CFTC is promulgating the products such as swaps, security-based SEC and the CFTC in accordance with anti-evasion rules as they were swaps, and mixed swaps. Further, the the applicable existing rules relating to 993 proposed and restating the Commissions believe the 120-day confidential treatment of information. accompanying interpretation with review period is necessary to enable the The Commissions also note that even if confidential treatment has been modifications in response to Commissions to obtain the necessary commenters. The CFTC also is information regarding a Title VII requested, all joint interpretive requests, as well all joint interpretations and any providing an additional interpretation instrument, thoroughly analyze the regarding rules 1.3(xxx)(6) and 1.6 instrument, and formulate any joint decisions not to issue a joint interpretation (along with the under the CEA. interpretation regarding the instrument. Section 721(c) of the Dodd-Frank Act In a related comment, one commenter explanation of the grounds for such decision), will be made publicly requires the CFTC to further define the suggested that the Commissions allow a terms ‘‘swap,’’ ‘‘swap dealer,’’ ‘‘major requesting party, while awaiting a joint available at the conclusion of the review period.994 swap participant,’’ and ‘‘eligible interpretation, to make a good faith contract participant,’’ in order ‘‘[t]o characterization of a particular Title VII 992 One commenter suggested that the include transactions and entities that instrument and engage in transactions Commissions should permit the parties seeking a have been structured to evade’’ subtitle based on such characterization.991 The joint interpretation to request confidential treatment A of Title VII (or an amendment made Commissions believe that it is essential from the Commissions during the course of the by subtitle A of the CEA). Moreover, as review period in order to protect proprietary that the characterization of an information and deal structures. See SIFMA Letter. the CFTC noted in the Proposing instrument be established prior to any Another commenter suggested that the Release,996 several other provisions of party engaging in the transactions so Commissions should make public all requests for Title VII reference the promulgation of that the appropriate regulatory schemes joint interpretations, any guidance actually anti-evasion rules, including: provided in response to such requests, and any • apply. The Commissions do not believe decisions not to provide guidance in response to Subparagraph (E) of the definition that allowing market participants to such requests (along with an explanation of the of ‘‘swap’’ provides that foreign make such a determination as to the grounds for any such decision). See Better Markets exchange swaps and foreign exchange status of a product is either appropriate Letter. forwards shall be considered swaps 993 See 17 CFR 200.81 and 17 CFR 140.98. The or consistent with the statutory Commissions note that the joint interpretive process unless the Secretary of the Treasury provisions providing for the is intended to provide, among other things, makes a written determination that Commissions to further define the terms notification to all market participants as to the either foreign exchange swaps or foreign regulatory classification of a particular Title VII exchange forwards, or both, among ‘‘swap,’’ ‘‘security-based swap’’ and instrument. In this regard, the Commissions do not ‘‘mixed swap.’’ Further, allowing market believe it is appropriate to provide a joint other things, ‘‘are not structured to participants to determine the status of a interpretation only to the market participants evade the [Dodd-Frank Act] in violation product could give rise to regulatory requesting the interpretation, while delaying of any rule promulgated by the [CFTC] arbitrage and inconsistent treatment of publication of the same joint interpretation to pursuant to section 721(c) of that market participants generally. Therefore, CFTC staff 997 similar products. will not exercise its discretion under 17 CFR Act;’’ 140.98(b) to delay publication of a joint • Section 722(d) of the Dodd-Frank interpretation. SEC staff does not have discretion trading similar or identical products. See CME Act provides that the provisions of the under 17 CFR 200.81(b) to delay publication of a Letter. The Commissions note that to the extent CEA relating to swaps shall not apply to joint interpretation. foreign competitors are engaging in swap and activities outside the United States 994 The CFTC’s publication of any joint security-based swap transactions subject to either interpretative request and the joint interpretation unless those activities, among other Commission’s jurisdiction, they will be subject to itself will be subject to the restrictions of section 8 the same process for requesting interpretations of things, ‘‘contravene such rules or of the CEA. See 7 U.S.C. 12. Subject to limited the characterization of Title VII instruments as U.S. regulations as the [CFTC] may prescribe exceptions, CEA section 8 generally restricts the market participants. The other commenter CFTC from publishing ‘‘data and information that or promulgate as are necessary or requested that the Commissions issue a joint would separately disclose the business transactions appropriate to prevent the evasion of interpretation for each ‘‘widely-utilized index,’’ at or market positions of any person and trade secrets the time of the index series’ launch, within a two- any provision of [the CEA] that was or names of customers…’’ Id. The CFTC and its staff 998 week period rather than the proposed 120-day enacted by the [Title VII];’’ and have a long history of providing interpretive period for novel derivative products under section • guidance with respect to the regulatory status of Section 725(g) of the Dodd-Frank 718 of the Dodd-Frank Act. This commenter did not specific proposed transactions in compliance with Act amends the Legal Certainty for Bank recognize that the joint interpretive process would CEA section 8. However, market participants Products Act of 2000 to provide that, be available in this case, and that it may be initiated making a joint interpretive request should be aware by an index provider. See paragraph (a) of rule 1.8 that the SEC is not subject to CEA section 8 and, 995 7 U.S.C. 1a(47)(E) and 2(i). under the CEA and rule 3a68–2 under the Exchange therefore, is not subject to the restrictions of CEA 996 Act (providing that ‘‘[a]ny person’’ may submit a section 8. The CFTC anticipates that most joint Proposing Release at 29866. request for a joint interpretation). See Markit Letter. interpretive requests will not contain CEA Section 997 CEA section 1a(47)(E), 7 U.S.C. 1a(47)(E). 990 See section 718(a)(3) of the Dodd-Frank Act. 8 information. However, given that the SEC is not 998 CEA section 2(i), 7 U.S.C. 2(i). New CEA 991 See SIFMA Letter. This commenter also subject to the restrictions of CEA section 8, the section 2(i), as added by section 722(d) of the Dodd- suggested that while the requesting party, and all CFTC intends to work with requesting parties to Frank Act, also provides that the provisions of Title other market participants, would be bound by the assure that joint interpretive requests do not VII relating to swaps shall not apply to activities joint interpretation when issued, they should not include CEA section 8 information. Nevertheless, outside the United States unless those activities face retroactive re-characterization of a transaction given the foregoing, market participants should not ‘‘have a direct and significant connection with executed during the review period and prior to the submit CEA section 8 information in their joint activities in, or effect on, commerce of the United issuance of the joint interpretation. Id. interpretive requests. States.’’

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although identified banking products of the CEA provides that activities this standard would blur the distinction generally are excluded from the CEA, conducted outside the United States, between whether a transaction (or that exclusion shall not apply to an including entering into agreements, entity) is lawful and whether it is identified banking product that is a contracts and transactions or structuring structured in a way to evade the Dodd- product of a bank that is not under the entities, which willfully evade or Frank Act and the CEA. The anti- regulatory jurisdiction of an appropriate attempt to evade any provision of the evasion rules provided herein are Federal banking agency,999 meets the CEA, shall be subject to the provisions concerned with the latter conduct, not definition of the terms ‘‘swap’’ or of Subtitle A of Title VII of the Dodd- the former.1011 Thus, the CFTC does not ‘‘security-based swap,’’ and ‘‘has been Frank Act; it does not limit the CFTC’s believe it is appropriate to limit the structured as an identified banking other authorities cited above. enforcement of its anti-evasion authority product for the purpose of evading the Accordingly, nothing in CEA sections to only unlawful transactions. provisions of the [CEA], the [Securities 2(h)(4)(A), 2(i) or 6(e) prevent the CFTC Act], or the [Exchange Act].’’ 1000 from prescribing rules 1.3(xxx)(6) and 2. Final Rules 1.6. (a) Rule 1.3(xxx)(6) Comments Two commenters supported the One commenter asserted the CFTC proposal’s ‘‘principles-based’’ approach The CFTC is adopting the Rule has no statutory basis to promulgate the to anti-evasion,1005 while several others 1.3(xxx)(6) as proposed. As adopted, anti-evasion rules, as proposed.1001 suggested modifications.1006 Two Rule 1.3(xxx)(6)(i) under the CEA Specifically, this commenter stated that commenters believed that the Proposing generally defines as swaps those neither CEA sections 2(h)(4)(A) nor 6(e) Release is overly broad and that, if the transactions that are willfully structured grant the CFTC authority to prescribe an CFTC does finalize anti-evasion rules, to evade the provisions of Title VII anti-evasion rule and interpretation as such rules should be narrower in governing the regulation of swaps. described in the Proposing Release.1002 scope.1007 Similarly, one other Furthermore, rules 1.3(xxx)(6)(ii) and Moreover, this commenter argued that commenter asserted that the CFTC erred (iii) effectuate CEA section 1a(47)(E)(i) CEA section 2(i) limits the CFTC to in the Proposing Release by placing too and section 725(g) of the Dodd-Frank prescribing anti-evasion rules related great an emphasis on the flexibility of Act, respectively, and will be applied in only to activities occurring outside of the rules as opposed to providing clarity a similar fashion as rule 1.3(xxx)(6)(i). the United States.1003 The CFTC finds for market participants.1008 The CFTC Rule 1.3(xxx)(6)(ii) applies to currency these comments misplaced because CEA continues to believe a ‘‘principles- and interest rate swaps that are willfully sections 2(h)(4)(A) and 6(e) provide the based’’ approach to its anti-evasion structured as foreign exchange forwards CFTC with additional authority to rules is appropriate. The CFTC is not or foreign exchange swaps to evade the prescribe anti-evasion rules for specific adopting an alternative approach, new regulatory regime for swaps purposes above and beyond the whereby it provides a bright-line test of enacted in Title VII. Rule 1.3(xxx)(6)(iii) authority provided by sections 721(c) non-evasive conduct, because such an applies to transactions of a bank that are and 725(g) of the Dodd-Frank Act and approach may provide potential not under the regulatory jurisdiction of CEA sections 1a(47)(E) and 2(i), upon wrongdoers with a roadmap for an appropriate Federal banking agency which the CFTC is relying in this structuring evasive transactions. and where the transaction is willfully rulemaking.1004 In addition, section 2(i) Notwithstanding this concern, as structured as an identified banking described below, the CFTC is providing product to evade the new regulatory 999 The term ‘‘identified banking product’’ is an additional interpretation and regime for swaps enacted in Title VII. defined in section 402 of the Legal Certainty for examples of evasion in order to provide Rule 1.3(xxx)(6)(iv) provides that in Bank Products Act of 2000, 7 U.S.C. 27. The term clarity to market participants.1009 determining whether a transaction has ‘‘appropriate Federal banking agency’’ is defined in CEA section 1a(2), 7 U.S.C. 1a(2), and section One commenter suggested an been willfully structured to evade rules 3(a)(72) of the Exchange Act, 15 U.S.C. 78c(a)(72), alternative standard for a finding of 1.3(xxx)(6)(i) through (iii), the CFTC which were added by sections 721(a) and 761(a) of evasion should be ‘‘whether the will not consider the form, label, or the Dodd-Frank Act, respectively. transaction is lawful or not’’ under the written documentation dispositive.1012 1000 Section 741(b) of the Dodd-Frank Act amends CEA, CFTC rules and regulations, section 6(e) of the CEA, 7 U.S.C. 9a, to provide that This approach is intended to prevent any DCO, swap dealer, or major swap participant orders, or other applicable federal, state evasion through clever draftsmanship of ‘‘that knowingly or recklessly evades or participates or other laws.1010 The CFTC is not a form, label, or other written in or facilitates an evasion of the requirements of adopting this suggested alternative documentation. section 2(h) [of the CEA] shall be liable for a civil standard for evasion because to adopt monetary penalty in twice the amount otherwise Rule 1.3(xxx)(6)(v) further provides available for a violation of section 2(h) [of the that transactions, other than CEA].’’ This anti-evasion provision is not in twice the amount otherwise available for a transactions structured as securities, dependent upon the promulgation of a rule under violation of section 2(h). (5) Any swap dealer or willfully structured to evade (as section 721(c) of the Dodd Frank Act, and hence the major swap participant that knowingly or recklessly proposed rule and interpretive guidance is not evades or participates in or facilitates an evasion of provided in rules 1.3(xxx)(6)(i) through meant to apply to CEA section 6(e). the requirements of section 2(h) shall be liable for (iii)) will be considered in determining 1001 See IECA Letter. a civil money penalty in twice the amount whether a person is a swap dealer or 1002 Id.; 7 U.S.C. 2(h)(4)(A) and 9a. otherwise available for a violation of section 2(h). 1005 major swap participant. 1003 See IECA Letter; 7 U.S.C. 2(i). See Barnard Letter and Better Markets Letter. 1006 Lastly, rule 1.3(xxx)(6)(vi) provides 1004 CEA section 2(h)(4)(A), 7 U.S.C. 2(h)(4)(A), See CME Letter; ISDA Letter; and SIFMA provides: The Commission shall prescribe rules Letter. that rule 1.3(xxx)(6) will not apply to under this subsection (and issue interpretations of 1007 See ISDA Letter and SIFMA Letter. any agreement, contract or transaction rules prescribed under this subsection) as 1008 See CME Letter. structured as a security (including a determined by the Commission to be necessary to 1009 Examples described in the guidance are security-based swap) under the prevent evasions of the mandatory clearing illustrative and not exhaustive of the transactions, requirements under this Act. instruments or entities that could be considered CEA section 6(e), 7 U.S.C. 9a, in relevant part, evasive. In considering whether a transaction, 1011 If a transaction is unlawful, the CFTC (or provides: (4) Any designated clearing organization instrument or entity is evasive, the CFTC will another authority) may be able to bring an action that knowingly or recklessly evades or participates consider the facts and circumstances of each alleging a violation of the applicable rule, in or facilitates an evasion of the requirements of situation. regulation, order or law. section 2(h) shall be liable for a civil money penalty 1010 See WGCEF Letter. 1012 See supra part II.D.1.

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securities laws as defined in section discovered, and (iv) documentation all CEA provisions and the regulations 3(a)(47) of the Exchange Act.1013 considerations.1015 thereunder (as applied to the party who With regard to the forward exclusion, willfully structures a transaction to (b) Rule 1.6 the CFTC is clarifying, in response to a evade). In rare situations where there is The CFTC is adopting rule 1.6 as commenter,1016 that entering into a true ‘‘innocent party,’’1021 it will likely proposed. Section 2(i) of the CEA states transactions that qualify for the forward be due to fraud or misrepresentation by that the provisions of the CEA relating exclusion from the swap definition shall the evading party and the business to swaps that were enacted by Title VII not be considered evasive. However, in consequences and remedies will be the (including any rule prescribed or circumstances where a transaction does same as for any such victim.1022 The regulation promulgated thereunder) not, in fact, qualify for the forward CFTC will impose appropriate sanctions shall not apply to activities outside the exclusion, the transaction may or may only on the willful evader for violations United States unless, among other not be evasive depending on an analysis of the relevant provisions of the CEA things, those activities ‘‘contravene such of all relevant facts and and CFTC regulations since the rules or regulations as the [CFTC] may circumstances.1017 individual agreement, contract or prescribe or promulgate as are necessary Concerning the applicability of the transaction was (and always should or appropriate to prevent the evasion of anti-evasion rules to transactions have been) subject to them.1023 Further, any provision of [the CEA] that was executed on a SEF, the CFTC is on a prospective basis for future 1018 enacted by [Title VII].’’ clarifying, in response to comments, transactions or instruments similar to that a transaction that has been self- those of the particular evasive swap, the Pursuant to this authority, rule 1.6(a), certified by a SEF (or a DCM), or that CFTC will consider these transactions or as adopted, makes it unlawful to has received prior approval from the instruments to be swaps within the conduct activities outside the United CFTC, will not be considered meaning of the Dodd-Frank Act (as States, including entering into evasive.1019 applied to both the party who willfully transactions and structuring entities, to With respect to the treatment of structures a transaction to evade and the willfully evade or attempt to evade any evasive transactions after they are ‘‘innocent party’’). provision of the CEA as enacted under discovered, the CFTC is clarifying, in Moreover, evasive transactions will Title VII or the rules and regulations response to comments,1020 that in count toward determining whether each promulgated thereunder. instances where one party willfully evading party with the requisite intent In addition, rule 1.6(b) provides that structures a transaction to evade but the is a swap dealer or major swap in determining whether a transaction or counterparty does not, the transaction, participant.1024 In response to a entity has been entered into or which meets the swap definition under commenter’s suggestion that, as structured willfully to evade, as rule 1.3(xxx)(6), or is subject to the proposed, rule 1.3(xxx)(6)(v) should provided in rule 1.6(a), the CFTC will provisions of Subtitle A of Title VII require a pattern of transactions,1025 the not consider the form, label, or written pursuant to rule 1.6, will be subject to CFTC is not requiring a pattern of documentation as dispositive. evasive transactions as a prerequisite to Rule 1.6(c) provides that an activity 1015 The CFTC also is adopting the interpretive prove evasion, although such a pattern conducted outside the United States to guidance from the Proposing Release, as proposed, may be one factor in analyzing whether but with certain clarifications. See infra part evasion has occurred under rules evade, as described in proposed rule VII.A.3. 1.6(a), shall be subject to the provisions 1016 See COPE Letter (requesting clarification that 1.3(xxx)(6) or 1.6. Further, in of Subtitle A of Title VII of the Dodd- transacting in the physical markets (e.g., entering Frank Act. As the CFTC explained in into nonfinancial commodity forward contracts), as 1021 The analysis of whether a party is ‘‘innocent’’ 1014 opposed to executing a swap, would not be is based on the facts and circumstances of a the Proposing Release, such considered evasion). particular transaction as well as a course of dealing provisions are necessary to fully prevent 1017 The CFTC is aware that there are by each of the parties. those who seek to willfully evade the circumstances where a forward contract can 1022 This is not dissimilar to an enforcement regulatory requirements established by perform the same or a substantially similar action for trading illegal off-exchange futures Congress in Title VII relating to swaps economic function as a swap through alternative contracts in violation of CEA section 4(a), 7 U.S.C. delivery procedures. Further, there are 6(a). The CFTC regularly seeks restitution for from enjoying any benefits from their circumstances where a person who deals in both victims in enforcement actions where applicable. efforts to evade. forwards and swaps may make decisions regarding Additionally, victims retain their private rights of Lastly, rule 1.6(d) provides that no financial risk assessment that will involve the action for breach of contract and any related consideration of regulatory obligations. The CFTC equitable remedies. agreement, contract or transaction will carefully scrutinize the facts and circumstances 1023 In considering which provisions of the CEA structured as a security (including a associated with forward contracts. and CFTC regulations are relevant, the CFTC will security-based swap) under the 1018 See MarketAxess Letter (commenting that the evaluate which CEA provisions and CFTC securities laws shall be deemed a swap anti-evasion rules should not apply to transactions regulations the evasive swap would have had to executed on, or subject to the rules of, a SEF, comply with had it not evaded the definition of pursuant to rule 1.6. because before a SEF may list a swap, it must self- swap (e.g., reporting, recordkeeping, clearing, etc.). (c) Interpretation of the Final Rules certify or voluntarily obtain CFTC approval to list However, where both parties have willfully the product). structured to evade or attempted to evade the The CFTC is providing an 1019 Pursuant to part 40 of the CFTC’s regulations, requirements of the Dodd-Frank Act, the CFTC may 17 CFR Part 40, registered SEFs and DCMs must subject the agreement, contract, instrument, or interpretation of the final rules in self-certify with the CFTC that any products that transaction itself to the full regulatory regime and response to commenters, addressing (i) they list ‘‘[comply] with the [CEA] and regulations the willful evaders to applicable sanctions. the applicability of the anti-evasion thereunder’’ and are liable for any false self- 1024 In other words, the evasive transaction would rules to transactions that qualify for the certifications. Therefore, market participants that count toward the relevant thresholds (e.g., de have entered into such transactions will not be minimis (with respect to determining swap dealer forward exclusion, (ii) the applicability considered to be engaging in evasion, while a SEF status, if the evasive transaction constituted dealing of the anti-evasion rules to transactions or DCM could be found to have falsely self-certified. activity) and substantial position (with respect to executed on a SEF, (iii) the treatment of 1020 See WGCEF Letter (generally expressing determining major swap participant status)). evasive transactions after they are concern that the penalty for anti-evasion is 1025 See IECA Letter. This same commenter ‘‘draconian’’) and IECA Letter (commenting that the suggested that rule 1.3(xxx)(6)(v) should be applied non-evading party should not become a party to an only to the authorities regarding evasion provided 1013 15 U.S.C. 78c(a)(47). evasive ‘‘swap’’ transaction, and thus subject to the by Congress and refer to the entity structuring the 1014 Proposing Release at 29866. regulatory requirements of the Dodd-Frank Act.) . evading transaction have been addressed above.

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determining whether such a transaction transaction, or entity (like its form or requirements of the Dodd-Frank Act. is a swap, the CFTC will consider label) is a relevant, but not dispositive, Therefore, the CFTC has provided an whether the transaction meets the factor in determining whether evasion interpretation described above about definition of the term ‘‘swap’’ as defined has occurred. how a transaction, discovered to have by statute and as it is further defined in evaded the CEA or the Dodd-Frank Act Comments this rulemaking.1026 (and therefore, a swap under rule As an illustration of some of the The CFTC received a number of 1.3(xxx)(6) or subject to the provisions foregoing concepts, if the market for comments on various aspects of of Subtitle A under rule 1.6) will be foreign exchange forwards on a proposed rules 1.3(xxx)(6) and 1.6. treated after the evasion is discovered. particular currency settles on a T+ 4 Several commenters requested clarity Furthermore, the CFTC agrees that a basis, but two counterparties agree to as to what types of transactions might be transaction that is determined to have expedite the settlement of an foreign considered evasive under proposed rule violated the CFTC’s anti-evasion rules exchange forward on such currency to 1.3(xxx)(6) and 1.6.1031 One commenter will be considered a swap only if it characterize the transaction falsely as a requested that the CFTC clarify that meets the definition of the term ‘‘swap,’’ spot transaction in order to avoid transacting in the physical markets (e.g., and has provided an interpretation to reporting the transaction, rule entering into nonfinancial commodity address this comment. In response to 1.3(xxx)(6)(i) would define the forward contracts), as opposed to both comments, the CFTC also has transaction as a swap. In this example, executing a swap, would not be provided an example to illustrate the both parties may be subject to sanctions considered evasion.1032 As discussed concepts in the interpretation. if they both have the requisite intent above, the CFTC has provided an The CFTC received one comment (i.e., willfully evaded). However, had interpretation regarding the regarding rules 1.3(xxx)(6)(iv) and the counterparty with the reporting applicability of the anti-evasion rules to 1.6(b). This commenter believed that a obligation in this example convinced transactions that qualify for the forward difference exists between the other counterparty, by using a false exclusion. Another commenter ‘‘documentation,’’ which contains rationale unrelated to avoiding requested that the CFTC clarify that the terms, conditions, etc. of an agreement, reporting, to expedite the foreign anti-evasion rules would not apply to and the ‘‘form or label.’’ 1038 Thus, exchange forward settlement in order to transactions executed on a SEF because, because a form or label may be avoid reporting, then the only party that before a SEF may list a swap, it must duplicitously assigned to a transaction, would be at risk for sanctions (i.e., the self-certify or voluntarily obtain CFTC this commenter agreed that neither the only party with the requisite intent) permission to list that product.1033 The form nor the label should be would be the counterparty with the CFTC has provided an interpretation dispositive.1039 However, because reporting obligation who deceived the discussed above to address this documentation contains the substance other counterparty. comment. of an agreement, this commenter With regard to documentation Two commenters expressed concern believed that documentation should be considerations, as discussed above, the regarding the penalty to the dispositive in determining whether a CFTC is adopting rules 1.3(xxx)(6)(iv) counterparties to a transaction that is given contract has been entered to and 1.6(b), as proposed,1027 but is deemed to violate the CFTC’s anti- 1034 willfully evade because the substance of providing the following interpretation. evasion provisions. Pursuant to the a contract is derived from its As stated in the Proposing Release,1028 final rule, when a transaction violates documentation.1040 Alternatively, this the structuring of instruments, the anti-evasion rules, the CFTC will commenter requested that if the CFTC transactions, or entities to evade the consider the transaction a swap. One of does not amend its proposal, the CFTC requirements of the Dodd-Frank Act these commenters said that the non- clarify what evidence or subject matter evading party should not unilaterally may be ‘‘limited only by the ingenuity would be dispositive of willful become a party to a swap, and thus be of man.’’1029 Therefore, the CFTC will evasion.1041 The CFTC disagrees with subject to the regulatory requirements of look beyond manner in which an these comments and has provided an the Dodd-Frank Act.1035 This instrument, transaction, or entity is interpretation discussed above that the commenter believed the rule should be documented to examine its actual documentation of an instrument, clear that only the ‘‘evading’’ party substance and purpose to prevent any transaction, or entity is a relevant, but would become a party to a swap, but the evasion through clever draftsmanship— not dispositive, factor. This view not ‘‘non-evading’’ party would not.1036 The an approach consistent with the CFTC’s only is consistent with CFTC case law, other comments believed that a case law in the context of determining and the CFTC’s interpretations herein, transaction that is determined to have whether a contract is a futures contract violated the CFTC’s anti-evasion rules but reduces the possibility of providing and the CFTC’s interpretations in this should be considered a swap only if it a potential roadmap for evasion. release regarding swaps.1030 The Two commenters raised issues meets all other aspects of the statutory documentation of an instrument, applicable to proposed rule 1.6 alone. definition of the term ‘‘swap.’’ 1037 The One commenter believed that proposed CFTC agrees that the anti-evasion rules 1026 Thus, for example, if a person, in seeking to rule 1.6 should not be adopted until the are not meant to ‘‘punish the innocent,’’ evade Title VII, structures a product that is a cross-border application of the swap but rather to appropriately address the privilege on a certificate of deposit, the CFTC’s anti- provisions of Title VII is addressed.1042 evasion rules would not be implicated because CEA evading counterparty’s or section 1a(47)(B)(iii), 7 U.S.C. 1a(47)(B)(iii), counterparties’ failure to meet the The CFTC disagrees and believes that excludes such a product from the swap definition. the rule provides sufficient clarity to 1027 Rules 1.3(xxx)(6)(iv) and 1.6(b) provide that 1031 See CME Letter; COPE Letter; IECA Letter; market participants even though the ‘‘in determining whether a transaction has been CFTC has not yet finalized guidance willfully structured to evade, neither the form, MarketAxess Letter; and WGCEF Letter. label, nor written documentation of the transaction 1032 See COPE Letter. shall be dispositive.’’ 1033 See MarketAxess Letter. 1038 See CME Letter. 1028 Proposing Release at 29866. 1034 See IECA Letter and WGCEF Letter. 1039 Id. 1029 Cargill v. Hardin, 452 F.2d 1154, 1163 (8th 1035 See IECA Letter. 1040 Id. Cir. 1971). 1036 Id. 1041 Id. 1030 See supra part II.D.1. 1037 See WGCEF Letter. 1042 See ISDA Letter.

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regarding the cross-border application of Act,1046 and the Internal Revenue or transaction may be found to the swap provisions of the Dodd-Frank Code.1047 constitute willful evasion.1049 Act. The other commenters believed The CFTC will not consider Although some commenters suggest that the proposed rule text and transactions, entities, or instruments that the determination that there is a interpretation does not fully explain structured in a manner solely motivated legitimate business purpose, and the use how the CFTC would apply proposed by a legitimate business purpose to of that concept as a relevant fact in the rule 1.6 in determining whether a swap constitute willful evasion (‘‘Business determination of the possibility of subject to foreign jurisdiction and Purpose Test’’). Additionally, relying on evasion, will not provide appropriate Internal Revenue Service (‘‘IRS’’) clarity, it is a recognized analytical regulated by a foreign regulator is concepts, when determining whether method and would be useful in the evasive.1043 As stated above, an particular conduct is an evasion of the overall analysis of potentially willful agreement, contract, instrument or Dodd-Frank Act, the CFTC will consider evasive conduct. transaction that is found to have been the extent to which the conduct The CFTC fully expects that a person willfully structured to evade will be involves deceit, deception, or other acting for legitimate business purposes subject to CEA provisions and the unlawful or illegitimate activity. within its respective industry will regulations thereunder pursuant to rule naturally weigh a multitude of costs and 1.6(c). (a) Business Purpose Test benefits associated with different types Interpretation of financial transactions, entities, or 3. Interpretation Contained in the instruments, including the applicable Proposing Release Consistent with the Proposing Release,1048 the CFTC recognizes that regulatory obligations. In that regard, The CFTC is restating the transactions may be structured, and and in response to commenters, the interpretation contained in the entities may be formed, in particular CFTC is clarifying that a person’s Proposing Release,1044 but is providing ways for legitimate business purposes, specific consideration of regulatory additional clarification regarding certain without any intention of circumventing burdens, including the avoidance thereof, is not dispositive that the types of circumstances that may (or may the requirements of the Dodd-Frank Act person is acting without a legitimate not) constitute an evasion of the with respect to swaps. Thus, in evaluating whether a person is evading business purpose in a particular case. requirements of Title VII. However, the The CFTC will view legitimate business or attempting to evade the swap CFTC notes that each activity will be purpose considerations on a case-by- requirements with respect to a evaluated on a case-by-case basis with case basis in conjunction with all other particular instrument, entity, or consideration given to all relevant facts relevant facts and circumstances. and circumstances. transaction, the CFTC will consider the Moreover, the CFTC recognizes that it extent to which the person has a is possible that a person intending to In developing its interpretation, the legitimate business purpose for CFTC considered legislative, willfully evade Dodd-Frank may structuring the instrument or entity or attempt to justify its actions by claiming administrative, and judicial precedent entering into the transaction in that with respect to the anti-evasion that they are legitimate business particular manner. Although different practices in its industry; therefore, the provisions in other Federal statutes. For means of structuring a transaction or example, the CFTC examined the anti- CFTC will retain the flexibility, via an entity may have differing regulatory analysis of all relevant facts and evasion provisions in the Truth in implications and attendant 1045 circumstances, to confirm not only the Lending Act, the Bank Secrecy requirements, absent other indicia of legitimacy of the business purpose of evasion, the CFTC will not consider those actions but whether the actions transactions, entities, or instruments could still be determined to be willfully structured in a manner solely motivated evasive. For example, a person may by a legitimate business purpose to attempt to disguise a product that may constitute evasion. However, to the be a swap by employing accounting extent a purpose in structuring an entity practices that are not appropriate for or instrument or entering into a 1043 swaps. Whether or not the method of See CME Letter. transaction is to evade the requirements 1044 See Proposing Release at 29865. of Title VII with respect to swaps, the 1049 As the CFTC observed in the Proposing 1045 15 U.S.C. 1604(a) provides, in relevant part, structuring of such instrument, entity, Release, a similar concept applies with respect to that the Federal Reserve Board: shall prescribe tax evasion. See Proposing Release at 29867 n. 324. regulations to carry out the purposes of this A transaction that is structured to avoid the 1046 31 U.S.C. 5324 (stating, in pertinent part, that subchapter * * *. [T]hese regulations may contain payment of taxes but that lacks a valid business ‘‘[n]o person shall, for the purpose of evading the such classifications, differentiations, or other purpose may be found to constitute tax evasion. reporting requirements of [the Bank Secrecy Act provisions, and may provide for such adjustments See, e.g., Gregory v. Helvering, 293 U.S. 465, 469 (BSA) or any regulation prescribed thereunder] (1935) (favorable tax treatment disallowed because and exceptions for any class of transactions, as in * * * . structure or assist in structuring, or attempt transaction lacked any business or corporate the judgment of the Board are necessary or proper to structure or assist in structuring, any transaction to effectuate the purposes of this subchapter, to purpose). Under the ‘‘sham-transaction’’ doctrine, with one or more domestic financial institutions’’). ‘‘a transaction is not entitled to tax respect if it lacks prevent circumvention or evasion thereof, or to The Federal Deposit Insurance Corporation economic effects or substance other than the facilitate compliance therewith. regulations implementing the BSA require banks to generation of tax benefits, or if the transaction In affirming the Board’s promulgation of report transactions that ‘‘the bank knows, suspects, serves no business purpose.’’ Winn-Dixie Stores, Regulation Z, the Supreme Court noted that anti- or has reason to suspect’’ are ‘‘designed to evade Inc. v. Comm’r, 254 F.3d 1313, 1316 (11th Cir. any regulations promulgated under the Bank evasion provisions such as section 1604(a) evince 2001) (citing Knetsch v. United States, 364 U.S. 361 Secrecy Act.’’ 12 CFR 353.3 (2010). Congress’s intent to ‘‘stress[] the agency’s power to (1960)). ‘‘The doctrine has few bright lines, but ‘it 1047 The Internal Revenue Code makes it unlawful counteract attempts to evade the purposes of a is clear that transactions whose sole function is to for any person willfully to attempt ‘‘in any manner statute.’’ Mourning v. Family Publ’ns Serv., Inc., 411 produce tax deductions are substantive shams.’ ’’ Id. to evade or defeat any tax * * * .’’ 26 U.S.C. 7201. (quoting United Parcel Serv. of Am., Inc. v. Comm’r, U.S. 356, 370 (1973) (citing Gemsco v. Walling, 324 While a considerable body of case law has 254 F.3d 1014, 1018 (11th Cir. 2001)). To be clear, U.S. 244 (1945) (giving great deference to a developed under the tax evasion provision, the though, while the Proposing Release references the regulation promulgated under similar prevention- statute itself does not define the term, but generally use of the business purpose test in tax law, the of-evasion rulemaking authority in the Fair Labor prohibits willful attempts to evade tax. CFTC is not using the legitimate business purpose Standards Act)). 1048 Proposing Release at 29867. consideration in the same manner as the IRS.

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accounting or employed accounting commenter believed such a statement are prerequisites to an evasion finding. practices are determined to be for does not give market participants any As stated throughout this release, the legitimate business purposes, that alone relief or guidance.1054 The CFTC has presence or absence of fraud, deceit, or will not be dispositive in determining addressed these comments received on unlawful activity is one fact (or whether it is willfully evasive according the business purpose test through the circumstance) the CFTC will consider to either rule 1.3(xxx)(6) or 1.6. clarifications to its interpretation when evaluating a person’s activity. Because transactions and instruments discussed above and reiterates that the That said, the anti-evasion rules do are regularly structured, and entities CFTC will consider all relevant facts require willfulness, i.e. ‘‘scienter.’’ In regularly formed, in a particular way for and circumstances in determining response to the commenter who various, and often times multiple, whether an action is willfully evasive. requests the CFTC define ‘‘willful reasons, it is essential that all relevant (b) Fraud, Deceit or Unlawful Activity conduct,’’ the CFTC will interpret facts and circumstances be considered. ‘‘willful’’ consistent with how the CFTC Where a transaction, instrument, or Interpretation has in the past, that a person acts entity is structured solely for legitimate When determining whether a ‘‘willfully’’ when they act either business purposes, it is not willfully particular activity constitutes willful intentionally or with reckless evasive. By contrast, where a evasion of the CEA or the Dodd-Frank disregard.1056 consideration of all relevant facts and Act, the CFTC will consider the extent circumstances reveals the presence of a to which the activity involves deceit, Comments purpose that is not a legitimate business deception, or other unlawful or purpose, evasion may exist. One commenter, although generally illegitimate activity. This concept was supportive of the use of the IRS ‘‘tax derived from the IRS’s delineation of Comments evasion’’ concept as a guidepost for this what constitutes tax evasion, as criterion, requested the CFTC provide Two commenters believed the elaborated upon by the courts. The IRS examples of legitimate versus evasive proposed business purpose test is distinguishes between tax evasion and conduct in a manner similar to what is inappropriate for determining if a legitimate means for citizens to contained in the Internal Revenue transaction is structured to evade Title minimize, reduce, avoid or alleviate the 1050 1057 VII. One of these commenters stated tax that they pay under the Internal Manual. The CFTC does not believe that the CFTC misunderstood how the Revenue Code.1055 Similarly, persons it is appropriate to provide an example ‘‘business purpose’’ test is applied by that craft derivatives transactions, because such an example may provide the IRS in the tax evasion context structure entities, or conduct themselves a guidepost for evasion. resulting in misguided proposed in a deceptive or other illegitimate Two commenters suggested that a 1051 interpretive guidance. As stated manner in order to avoid regulatory finding of fraud, deceit, or unlawful above, the CFTC believes that it is requirements should not be permitted to activity should be a prerequisite to any appropriate to consider legitimate enjoy the fruits of their deceptive or finding of evasion.1058 As noted above, business purposes in determining if a illegitimate conduct. the CFTC disagrees that such activity transaction is structured to evade Title Although it is likely that fraud, deceit, should be a prerequisite to a finding of VII. In response to this comment, or unlawful activity will be present evasion, but its presence or absence is although the interpretation references where willful evasion has occurred, the one relevant fact and circumstance the the use of legitimate business purpose CFTC does not believe that these factors CFTC will consider. Finally, one in tax law, the CFTC is not bound to use commenter requested further guidance the legitimate business purpose 1054 Id. defining willful conduct in the context consideration in the same manner as the 1055 Whereas permissible means of reducing tax of deliberate and knowing IRS and, accordingly, is not adopting (or ‘‘tax avoidance,’’ as the IRS refers to the 1059 practice) is associated with full disclosure and wrongdoing. As noted above, the the IRS’s interpretation. CFTC has considered the suggestion that Two commenters urged the CFTC to explanation of why the tax should be reduced under law, tax evasion consists of the willful the CFTC provide guidance on what clarify that considering the costs of attempt to evade tax liability, and generally defines ‘‘willful behavior,’’ with some regulation is a legitimate business involves ‘‘deceit, subterfuge, camouflage, commenters submitting that some purpose when structuring a transaction. concealment, or some attempt to color or obscure definitional guidance should be offered Accordingly, they request that the CFTC events or to make things seem other than they are.’’ The IRS explains: or that the standard should be whether clarify that entering into a transaction to Avoidance of taxes is not a criminal offense. Any or not a transaction is ‘‘lawful.’’ 1060 The avoid costly regulations, even though attempt to reduce, avoid, minimize, or alleviate CFTC agrees with the need for legal that transaction could otherwise be taxes by legitimate means is permissible. The clarity and believes that the concept of structured as a swap, will not be distinction between avoidance and evasion is fine, yet definite. One who avoids tax does not conceal willfulness is a well-recognized legal considered per se evasion/evasive.1052 or misrepresent. He/she shapes events to reduce or concept of which there is substantial Finally, one commenter took issue with eliminate tax liability and, upon the happening of case law and legal commentary familiar the statement that ‘‘absent other indicia the events, makes a complete disclosure. Evasion, to the financial industry.1061 of evasion, [the CFTC] would not on the other hand, involves deceit, subterfuge, camouflage, concealment, some attempt to color or consider transactions, entities, or obscure events or to make things seem other than 1056 See In re Squadrito, [1990–1992 Transfer instruments in a manner solely they are. For example, the creation of a bona fide Binder] Comm. Fut. L. Rep. (CCH) ¶ 25,262 (CFTC motivated by a legitimate business partnership to reduce the tax liability of a business Mar. 27, 1992) (adopting definition of ‘‘willful’’ in purpose to constitute evasion.’’ 1053 by dividing the income among several individual McLaughlin v. Richland Shoe Co., 486 U.S. 128 partners is tax avoidance. However, the facts of a (1987)). Because ‘‘transactions, entities, or particular investigation may show that an alleged 1057 See CME Letter. instruments’’ are rarely structured a partnership was not, in fact, established and that 1058 certain way solely for one purpose, this one or more of the alleged partners secretly See ISDA Letter and SIFMA Letter. returned his/her share of the profits to the real 1059 See ISDA Letter (citing U.S. v. Tarallo, 380 owner of the business, who, in turn, did not report F.3d 1174, 1187 (9th Cir. 2004), and Merck & Co. 1050 See CME Letter and WGCEF Letter. this income. This would be an instance of v. Reynolds, 130 S. Ct. 1784, 1796 (2010)). 1051 See CME Letter. attempted evasion. IRS, Internal Revenue Manual, 1060 See CME Letter; ISDA Letter; and WGCEF 1052 See ISDA Letter and WGCEF Letter. part 9.1.3.3.2.1, available at http://www.irs.gov/irm/ Letter. 1053 See SIFMA Letter. part9/irm_09-001-003.html#d0e169. 1061 See supra note 1056.

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B. SEC Position Regarding Anti-Evasion adopt a final rule that further interprets organization. ANPR commenters Rules the statutory ‘‘swap’’ definition.1066 advanced international comity, national Section 761(b)(3) of the Dodd-Frank The CFTC declines to provide the treatment, limited regulatory resources, Act grants discretionary authority to the requested clarification or adopt a rule. limits on the Commissions’ respective SEC to define the terms ‘‘security-based Prior distinctions that the CFTC relied extraterritorial jurisdiction, and swap,’’ ‘‘security-based swap dealer,’’ upon (such as the presence or absence international harmonization as ‘‘major security-based swap of clearing) to distinguish between rationales for such an approach. The participant,’’ and ‘‘eligible contract futures and swaps may no longer be Proposing Release was silent on this relevant.1067 As a result, it is difficult to participant,’’ with regard to security- issue.1071 based swaps, ‘‘for the purpose of distinguish between futures and swaps including transactions and entities that on a blanket basis as the commenter Comments suggested. However, a case-by-case have been structured to evade’’ subtitle Several commenters asserted that B of Title VII (or amendments made by approach for distinguishing these swaps transactions to which an IFI is a subtitle B). products may lead to more informed The SEC did not propose rules under decision-making by the CFTC. counterparty should be excluded from section 761(b)(3) regarding anti-evasion Moreover, the CFTC notes that a DCM the swap and security-based swap 1072 but requested comment on whether SEC may self-certify its contracts pursuant to definitions. In addition to the 1068 rules or interpretive guidance Part 40 of the CFTC’s rules, subject arguments noted above, commenters addressing anti-evasion with respect to to the CFTC’s oversight authority. If a asserted that certain IFIs have been security-based swaps, security-based DCM has a view that a particular granted certain statutory immunities by swap dealers, major security-based swap product is a futures contract, it may self- the United States, and that regulation participants, or ECPs were necessary. certify the contract consistent with that under the Dodd-Frank Act of their Two commenters responded to the view. The DCM also has a number of request for comment and recommended other options, including seeking prior institutions defined as such in 22 U.S.C. 262r(c)(2) that the SEC adopt anti-evasion rules approval from the CFTC, requesting an and the institutions defined as ‘‘multilateral and interpretive guidance.1062 One interpretation, or requesting a development banks’’ in the Proposal for the rulemaking if it is in doubt about Regulation of the European Parliament and of the commenter suggested that the SEC Council on OTC Derivative Transactions, Central model its anti-evasion rules and whether a particular agreement, contract Counterparties and Trade Repositories, Council of interpretive guidance on the CFTC’s or transaction should be classified as a the European Union Final Compromise Text, anti-evasion rules.1063 futures contract or a swap. Article 1(4a(a)) (March 19, 2012). There is overlap between the two definitions, but together they The SEC is not adopting anti-evasion B. Transactions Entered Into by Foreign include the following institutions: the International rules under section 761(b)(3) at this Central Banks, Foreign Sovereigns, Monetary Fund, International Bank for time. The SEC notes that since security- International Financial Institutions, and Reconstruction and Development, European Bank based swaps are ‘‘securities’’ for for Reconstruction and Development, International Similar Entities Development Association, International Finance purposes of the Federal securities laws, Corporation, Multilateral Investment Guarantee unless the SEC grants a specific The swap definition excludes ‘‘any agreement, contract, or transaction a Agency, African Development Bank, African exemption,1064 all of the SEC’s existing Development Fund, Asian Development Bank, regulatory authority will apply to counterparty of which is a Federal Inter-American Development Bank, Bank for Reserve bank, the Federal Government, Economic Cooperation and Development in the security-based swaps. Since existing Middle East and North Africa, Inter-American regulations, including antifraud and or a Federal agency that is expressly backed by the full faith and credit of the Investment Corporation, Council of Europe Development Bank, Nordic Investment Bank, anti-manipulation provisions, will 1069 apply to security-based swaps, the SEC United States.’’ Some commenters Caribbean Development Bank, European Investment believes that it is unnecessary to adopt to the ANPR suggested that the Bank and European Investment Fund. (The term international financial institution includes entities additional anti-evasion rules for Commissions should exercise their authority to further define the terms referred to as multilateral development banks. The security-based swaps under section International Bank for Reconstruction and 761(b)(3) at this time. ‘‘swap’’ to similarly exclude Development, the International Finance transactions in which a counterparty is Corporation and the Multilateral Investment VIII. Miscellaneous Issues a foreign central bank, a foreign Guarantee Agency are parts of the World Bank sovereign, an international financial Group.) The Bank for International Settlements, A. Distinguishing Futures and Options 1070 which also submitted a comment, is a bank in From Swaps institution (‘‘IFI’’), or similar which the Federal Reserve and foreign central banks are members. Another commenter, KfW, is a The Commissions did not propose 1066 Id. CME suggested that the CFTC modify the corporation owned by the government of the rules or interpretations in the Proposing futures contract exclusion in CEA Section Federal Republic of Germany and the German State Release regarding distinguishing futures 1a(47)(B)(i) so that the modified language would governments and backed by the ‘‘full faith and from swaps. One commenter requested read as follows: (B) EXCLUSIONS.—The term credit’’ of the Federal Republic of Germany. ‘swap’ does not include— (i) any contract for the 1071 But see Dissent of Commissioner Sommers, that the CFTC clarify that nothing in the sale of a commodity for future delivery listed for Proposing Release at 29899. release was intended to limit a DCM’s trading by a designated contract market (or option 1072 See Letter from Gu¨ nter Pleines and Diego ability to list for trading a futures on such contract) * * * CME believes that such a Devos, Bank for International Settlements, dated rule would clarify the scope of Section 4(a) of the July 20, 2011; Letter from Jacques Mirante-Pe´re´ and contract regardless of whether it could CEA, which makes it illegal to trade a futures Jan De Bel, Council of Europe Development Bank, be viewed as a swap if traded over-the- contract except on or subject to the rules of a DCM. dated July 22, 2011; Letter from Isabelle Laurant, counter or on a SEF, since futures and CME believed that such a modification would European Bank for Reconstruction and swaps are indistinguishable in material clarify the scope of Section 4(a) of the CEA, 7 U.S.C. Development, dated July 22, 2011; Letter from A. economic effects.1065 This commenter 6(a), which makes it unlawful to trade a futures Querejeta and B. de Mazie`res, European Investment contract except on or subject to the rules of a DCM. Bank, dated July 22, 2011; Letter from J. James further recommended that the CFTC 1067 See, e.g., Swap Policy Statement, supra note Spinner and S

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activities would be inconsistent with such technical rule to assure consistent Exemptive Order and as provided in the the grant of these immunities. definitions of these terms under the SB Swaps Interim Final Rules, the The CFTC declines to provide an Securities Act and the Exchange Act. exemptions granted pursuant to the exclusion from the swap definition Exchange Act Exemptive Order and the IX. Effective Date and Implementation along the lines suggested by these SB Swaps Interim Final Rules will commenters.1073 An exclusion from the Consistent with sections 754 and 774 expire upon the compliance date of the swap definition for swap transactions of the Dodd-Frank Act, the final rules final rules further defining the terms entered into by foreign sovereigns, and interpretations will be effective ‘‘security-based swap’’ and ‘‘eligible foreign central banks, IFIs and similar October 12, 2012. The compliance date contract participant.’’ The final rules entities, would mean that swaps entered for the final rules and interpretations further defining the term ‘‘eligible into by such entities would be also will be October 12, 2012; with the contract participant,’’ adopted in the completely excluded from Dodd-Frank following exceptions: Entity Definitions Release,1079 were regulation. Their counterparties, who • The compliance date for the published in the Federal Register on may be swap dealers or major swap interpretation regarding guarantees of May 23, 2012. The compliance date and participants, or security-based swap swaps will be the effective date of the the effective date for such final rules is dealers or major security-based swap rules proposed in the separate CFTC the same, July 23, 2012. The SEC participants, would have no regulatory release when such rules are adopted by believes that establishing a compliance obligations with respect to such swaps. the CFTC. date for the definition of ‘‘security-based These regulated counterparties could • Solely for the purposes of the Order swap’’ solely for purposes of the develop significant exposures to the Granting Temporary Exemptions under Exchange Act Exemptive Order and the foreign sovereigns, foreign central the Securities Exchange Act of 1934 in SB Swaps Interim Final Rules that is banks, IFIs and similar entities, without Connection with the Pending Revision February 11, 2013 (i.e. 120 days after the the knowledge of the Commissions. of the Definition of ‘‘Security’’ to effective date) is appropriate because In addition, swaps entered into by Encompass Security-Based Swaps 1077 doing so will leave in place the foreign sovereigns, foreign central and the Exemptions for Security-Based exemptions granted by the Exchange banks, IFIs and similar entities Swaps,1078 the compliance date for the Act Exemptive Order and the SB Swaps undeniably are swaps. To be sure, the final rules further defining the term Interim Final Rules for a period of time Commissions have adopted rules and ‘‘security-based swap’’ will be February that is sufficient to facilitate interpretations to further define the term 11, 2013. consideration of that order and rule. ‘‘swap’’ to exclude certain transactions, The CFTC believes that it is Specifically, the SEC will consider the which prior to the enactment of the appropriate to make the compliance appropriate treatment of security-based Dodd-Frank Act generally would not date for the interpretation regarding swaps under the provisions of the have been considered swaps. However, guarantees of swaps the same as the Exchange Act not amended by the the CFTC is not using its authority to effective date of the rules proposed in Dodd-Frank Act before expiration of the further define the term ‘‘swap’’ to the separate CFTC release when such exemptions set forth in the Exchange effectively exempt transactions that are, rules are adopted by the CFTC in order Act Exemptive Order, and will consider in fact, swaps. While, as noted above, to relieve market participants from the appropriate treatment of security- Congress included a counterparty- compliance obligations that would arise based swaps for purposes of the specific exclusion for swaps entered as a result of the interpretation. As registration provisions of the Securities into by the Federal Reserve Board, the described in the Exchange Act Act, the registration provisions of the Federal government and certain Exchange Act, and the indenture government agencies, Congress did not 1077 76 FR 39927 (Jul. 7, 2011) (‘‘Exchange Act qualification provisions of the Trust provide a similar exemption for foreign Exemptive Order’’). The Exchange Act Exemptive Indenture Act of 1939 before the Order grants temporary relief and provides central banks, foreign sovereigns, IFIs, interpretive guidance to make it clear that a expiration of the exemptions set forth in or similar organizations. substantial number of the requirements of the the SB Swaps Interim Final Rules.1080 Exchange Act do not apply to security-based swaps If any provision of these final rules or C. Definition of the Terms ‘‘Swap’’ and as a result of the revised definition of ‘‘security’’ interpretations, or the application ‘‘Security-Based Swap’’ as Used in the going into effect on July 16, 2011. The Exchange Act thereof to any person or circumstance, Securities Act Exemptive Order also provided temporary relief from provisions of the Exchange Act that allow the is held to be invalid, such invalidity The SEC is adopting a technical rule voiding of contracts made in violation of those shall not affect other provisions or that provides that the terms ‘‘swap’’ and laws. application of such provisions to other ‘‘security-based swap’’ as used in the 1078 Rule 240 under the Securities Act, 17 CFR persons or circumstances that can be Securities Act 1074 have the same 230.240, rules 12a–11 and 12h–1(i) under the Exchange Act 1934, 17 CFR 240.12a–11 and 1075 meanings as in the Exchange Act 240.12h–1(i), and Rule 4d–12 under the Trust 1079 See supra note 12. and the rules and regulations Indenture Act of 1939, 17 CFR 260.4d–12 (‘‘SB 1080 The SEC has received a request for certain thereunder.1076 The SEC is adopting Swaps Interim Final Rules’’). See also 76 FR 40605 permanent exemptions upon the expiration of the (Jul. 11, 2011). The SB Swaps Interim Final Rules exemptions contained in the Exchange Act provide exemptions under the Securities Act, the Exemptive Order. See SIFMA SBS Exemptive Relief 1073 The commenters’ suggested exclusion from Exchange Act, and the Trust Indenture Act of 1939 Request (Dec. 5, 2011), which is available at the swap definition would also exclude their for those security-based swaps that prior to July 16, http://www.sec.gov/comments/s7-27-11/s72711- transactions from the security-based swap 2011, were security-based swap agreements and are 10.pdf. The SEC also has received comments definition, which is based on the definition of defined as ‘‘securities’’ under the Securities Act and regarding the exemptions under the Securities Act, swap. the Exchange Act as of July 16, 2011, due solely to the Exchange Act, and the Trust Indenture Act of 1074 See section 2(a)(17) of the Securities Act, 15 the provisions of the Dodd-Frank Act. The SB 1939. See Letter from Kenneth E. Bentsen, Jr., U.S.C. 77b(a)(17). Swaps Interim Final Rules exempt offers and sales Executive Vice President, Public Policy and 1075 See sections 3(a)(69) of the Exchange Act, 15 of these security-based swaps from all provisions of Advocacy, SIFMA, and Robert Pickel, Chief U.S.C. 78c(a)(69), and 3(a)(68) of the Exchange Act, the Securities Act, other than the Section 17(a) anti- Executive Officer, ISDA, dated Apr. 20, 2012, which 15 U.S.C. 78c(a)(68). The definitions of the terms fraud provisions, as well as exempt these security- is available at http://www.sec.gov/comments/s7-26- ‘‘swap’’ and ‘‘security-based swap’’ in the Exchange based swaps from Exchange Act registration 11/s72611-5.pdf. The SEC is reviewing the request Act are the same as the definitions of these terms requirements and from the provisions of the Trust for exemptive relief and each related comment and in the CEA. See section 1a of the CEA, 7 U.S.C. 1a. Indenture Act of 1939, provided certain conditions will consider any appropriate actions regarding 1076 See rule 194 under the Securities Act. are met. such request.

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given effect without the invalid requirements within the meaning of the the SEC’s calculations regarding the provision or application. PRA. Rule 1.8 under the CEA will allow impact of this collection of information persons to submit a request for a joint X. Administrative Law Matters—CEA under the PRA and the request for a interpretation from the Commissions Revisions control number submitted by the SEC to regarding whether an agreement, OMB.1084 A. Paperwork Reduction Act contract or transaction (or a class thereof) is a swap, security-based swap, (b) Information Collection Comments 1. Introduction or mixed swap. Rule 1.8 provides that In the Proposing Release, the CFTC The Paperwork Reduction Act of 1995 a person requesting an interpretation as invited public comment on the (‘‘PRA’’) imposes certain requirements to the nature of an agreement, contract, on Federal agencies in connection with or transaction as a swap, security-based reporting and recordkeeping burdens their conducting or sponsoring any swap, or mixed swap must provide the discussed above with regard to rules 1.8 collection of information as defined by Commissions with the person’s and 1.9. Pursuant to 44 U.S.C. the PRA.1081 An agency may not determination of the nature of the 3506(c)(2)(B), the CFTC solicited conduct or sponsor, and a person is not instrument and supporting analysis, comments in order to: (i) Evaluate required to respond to, a collection of along with certain other documentation, whether the proposed collections of information unless it displays a including a statement of the economic information are necessary for the proper currently valid control number. Certain purpose for, and a copy of all material performance of the functions of the provisions of this rule will result in new information regarding the terms of, each CFTC, including whether the collection of information requirements relevant agreement, contract, or information will have practical utility; within the meaning of the PRA. With transaction (or class thereof). The (ii) evaluate the accuracy of the CFTC’s the exception of the new ‘‘book-out’’ Commissions also may request the estimate of the burden of the proposed confirmation requirement discussed submitting person to provide additional collections of information; (iii) below, the CFTC believes that the information. In response to the determine whether there are ways to burdens that will be imposed on market submission, the Commissions may issue enhance the quality, utility, and clarity participants under rules 1.8 and 1.9 a joint interpretation regarding the of the information to be collected; and already have been accounted for within status of that agreement, contract, or (iv) minimize the burden of the the SEC’s calculations regarding the transaction (or class of agreements, collections of information on those who impact of this collection of information contracts, or transactions) as a swap, are to respond, including through the under the PRA and the request for a security-based swap, or mixed swap. use of automated collection techniques control number submitted by the SEC to Rule 1.9 of the CEA enables persons or other forms of information OMB for rule 3a68–2 (‘‘Interpretation of to submit requests to the Commissions technology. Swaps, Security-Based Swaps, and for joint orders providing an alternative Mixed Swaps’’) and rule 3a68–4 regulatory treatment for particular No comments were received with (‘‘Regulation of Mixed Swaps: Process mixed swaps. Under rule 1.9, a person respect to the reporting and for Determining Regulatory Treatment will provide to the Commissions a recordkeeping burdens discussed in the for Mixed Swaps’’). In response to this statement of the economic purpose for, proposing release. In response to the submission, OMB issued control and a copy of all material information request for a control number by the SEC, number 3235–0685. The responses to regarding, the relevant mixed swap. In OMB issued control number 3235–0685. these collections of information will be addition, the person will provide the mandatory.1082 The CFTC will protect specific alternative provisions that the 3. Book-Out Confirmation proprietary information according to the person believes should apply to the As noted above, the CFTC believes Freedom of Information Act and 17 CFR mixed swap, the reasons the person that its interpretation which clarifies part 145, headed ‘‘Commission Records believes it would be appropriate to that oral book-out agreements must be and Information.’’ In addition, the CFTC request an alternative regulatory followed in a commercially reasonable emphasizes that section 8(a)(1) of the treatment, and an analysis of: (i) The timeframe by a confirmation in some CEA 1083 strictly prohibits the nature and purposes of the specified type of written or electronic form would Commission, unless specifically provisions; (ii) the comparability of the result in a new ‘‘collection of authorized by the CEA, from making specified provisions to other statutory information’’ requirement within the public ‘‘data and information that provisions of Title VII of the Dodd- meaning of the PRA. Therefore, the would separately disclose the business Frank Act and the rules and regulations transactions or market positions of any thereunder; and (iii) the extent of any CFTC is submitting the new ‘‘book-out’’ person and trade secrets or names of conflicting or incompatible information collection to OMB for customers.’’ The CFTC also is required requirements of the specified provisions review in accordance with 44 U.S.C. to protect certain information contained and other statutory provisions of Title 3506(c)(2)(A) and 5 CFR 1320.8(d). The in a government system of records VII and the rules and regulations CFTC will, by separate action, publish pursuant to the Privacy Act of 1974. thereunder. The Commissions also may in the Federal Register a notice on the request the submitting person to provide paperwork burden associated with the 2. Rules 1.8 and 1.9 additional information. interpretation’s requirement that oral As discussed in the proposal, Rules book-outs be followed in a 1.8 and 1.9 under the CEA will result in (a) Information Provided by Reporting commercially reasonable timeframe by new ‘‘collection of information’’ Entities confirmation in some type of written or The burdens imposed by rules 1.8 and electronic form in accordance with 5 1081 44 U.S.C. 3501 et seq. 1.9 under the CEA are the same as the CFR 1320.8 and 1320.10. If approved, 1082 As discussed below, the ‘‘collection of burdens imposed by the SEC’s rules this new collection of information will information’’ related to the new ‘‘book out’’ 3a68–2 and 3a68–4. Therefore, the be mandatory. confirmation requirement was not included in the SEC’s submission and will be the subject of a burdens that will be imposed on market request for a control number by the CFTC to OMB. participants under rules 1.8 and 1.9 1084 44 U.S.C. 3501–3521. See also 44 U.S.C. 3509 1083 7 U.S.C. 12(a)(1). already have been accounted for within and 3510.

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B. Regulatory Flexibility Act light of its past determination, and the Interpretation.1093 Thus, to the extent The Regulatory Flexibility Act increased thresholds on ECPs added by any entities, small or otherwise, relied (‘‘RFA’’) requires that agencies consider the Dodd-Frank Act making it more on the Energy Exemption, such entities whether the rules they propose will difficult for entities to qualify as an ECP, can now rely on the expanded Brent have a significant economic impact on the CFTC determined in its proposed Interpretation to qualify for the forward a substantial number of small entities rulemakings that ECPs are not small contract exclusion. Accordingly, the and, if so, provide a regulatory entities. withdrawal of the Energy Exemption Furthermore, the CFTC provided that flexibility analysis respecting the will not result in a significant economic certain entities that would be subject to impact.1085 A regulatory flexibility impact on any entities. the proposed rule—namely SDs, MSPs, analysis or certification typically is With respect to this rulemaking, SDRs, SEFs, and FBOTs—are entities for required for ‘‘any rule for which the which includes interpretations, as well which the CFTC had not previously agency publishes a general notice of as general rules of construction and made a size determination for RFA proposed rulemaking pursuant to’’ the definitions that will largely be used in purposes. The CFTC determined that other rulemakings, the CFTC received notice-and-comment provisions of the these entities should not be considered Administrative Procedure Act, 5 U.S.C. one comment respecting its RFA small entities based on their size and certification. The commenter, an 553(b). characteristics analogous to non-small With respect to the proposed release, association that represents producers, entities that pre-dated the adoption of while the CFTC provided an RFA generators, processors, refiners, Dodd-Frank,1090 and certified in merchandisers and commercial end statement that the proposed rule would rulemakings that would have an have a direct effect on numerous users of nonfinancial energy economic impact on these entities that commodities, including energy and entities, specifically DCMs, SDRs, SEFs, these entities are not small entities for SDs, MSPs, ECPs, FBOTs, DCOs, and natural gas, contended that the CFTC’s RFA purposes.1091 overall new jurisdiction under the certain ‘‘appropriate persons’’ who Finally, the CFTC recognized that, in relied on the Energy Exemption,1086 the Dodd-Frank Act over ‘‘swaps’’ and the light of the CFTC’s proposed burdens that the CFTC’s rules place on Chairman, on behalf of the CFTC, withdrawal of the Energy Exemption, certified that the rulemaking would not nonfinancial entities, including small the proposed rule could have an 1094 have a significant economic effect on a entities such as its members that economic impact on certain execute such swaps, can only be substantial number of small entities. ‘‘appropriate persons’’ who relied on the Comments on that certification were determined after the rules and Energy Exemption. The Energy interpretations in the product sought. Exemption listed certain ‘‘appropriate In the Proposing Release, the CFTC definitions rulemaking are finalized. persons’’ that could rely on the Moreover, the commenter asserted that provided that it previously had exemption and also required that, to be its small entity members seek to established that certain entities subject eligible for this exemption, an continue their use of nonfinancial to the CFTC’s jurisdiction—namely, ‘‘appropriate person must have commodity ‘‘swaps’’ only to hedge the DCMs, DCOs and ECPs—are not small demonstrable capacity or ability to make 1087 commercial risks of their not-for profit entities for purposes of the RFA. As or take delivery.’’ The Energy public service activities. The commenter the CFTC previously explained, because Exemption stated: ‘‘in light of the concluded that the CFTC should of the central role they play in the general nature of the current conduct a regulatory flexibility analysis regulatory scheme concerning futures participants in the market, the CFTC for the entire mosaic of its rulemakings trading, the importance of futures believes that smaller commercial firms, under the Dodd-Frank Act, taking into trading in the national economy, and which cannot meet [certain] financial consideration the products definition the financial requirements needed to criteria, should not be included.’’ 1092 rulemaking. comply with the regulatory Therefore, the CFTC did not believe that The commenter did not provide requirements imposed on them under the ‘‘appropriate persons’’ eligible for specific information on how the further the CEA, DCMs and DCOs have long the Energy Exemption, and who may be defining of the terms swap, security- been determined not to be small affected by its withdrawal, are ‘‘small 1088 based swap and security-based swap entities. Based on the definition of entities’’ for purposes of RFA. Moreover, agreement, providing regulations ECP in the Commodity Futures as previously discussed, the CFTC is regarding mixed swaps, and providing Modernization Act of 2000 (‘‘CFMA’’) expanding the Brent Interpretation to all regulations governing books and records and the legislative history underlying nonfinancial commodities for both requirements for security-based swap that definition, the CFTC determined swaps and future delivery definitions 1089 agreements would have a significant that ECPs were not small entities. In and is clarifying that certain alternative impact on a substantial number of small delivery procedures discussed in the 1085 entities. Nonetheless, the CFTC has 5 U.S.C. 601 et seq. Energy Exemption will not disqualify a 1086 reevaluated this rulemaking in light of See 76 FR 29868–89. transaction from the forward contract 1087 See respectively, Policy Statement and the commenter’s statements. Upon exclusion under the Brent Establishment of Definitions of ‘‘Small Entities’’ for consideration, the CFTC declines to Purposes of the Regulatory Flexibility Act, supra note 331, at 18619 (DCMs); A New Regulatory 1090 See 76 FR 29868–89. consider the economic impacts of the Framework for Clearing Organizations, 66 FR 1091 See respectively, Registration of Swap entire mosaic of rules under the Dodd- 45604, 45609 (Aug. 29, 2001) (DCOs); Opting Out Dealers and Major Swap Participants, 77 FR 2613, of Segregation, 66 FR 20740, 20743 (Apr. 25, 2001) 2620, Jan. 19, 2012 (swap dealers and major swap 1093 See supra part II.B.2.(a)(i)(C). (ECPs). participants); Requirements for Derivatives Clearing 1094 See ETA Letter. In general, ETA states that 1088 See respectively, Policy Statement and Organizations, Designated Contract Markets, and the Small Business Administration (‘‘SBA’’) has Establishment of Definitions of ‘‘Small Entities’’ for Swap Execution Facilities Regarding the Mitigation determined that many of its members are ‘‘small Purposes of the Regulatory Flexibility Act, supra of Conflicts of Interest, 75 FR 63732, 63745, Oct. 18, entities’’ for purposes of the RFA. Id. (references the note 331, at 18619 (DCMs); A New Regulatory 2010 (SEFs); Swap Data Repositories, 76 FR 54538, comment letter filed by the NRECA, APPA and Framework for Clearing Organizations, 66 FR 54575, Sept. 1, 2011; Registration of Foreign Boards LLPC as the ‘‘Not-for-Profit Electric Coalition’’ in 45604, 45609, Aug. 29, 2001 (DCOs). of Trade, 76 FR 80674, 80698, Dec. 23, 2011 response to the Commodity Option NOPR’s (76 FR 1089 See Opting Out of Segregation. 66 FR 20740, (FBOTs). 6095) assertion that there are no ECPs that are 20743, Apr. 25, 2001 (ECPs). 1092 Energy Exemption, supra note 207. ‘‘small entities’’ for RFA purposes).

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Frank Act, since an agency is only regulatory regime, for historical context management practices of certain required to consider the impact of how to help inform the reader. financial firms and the lack of it exercises its discretion to implement In the Proposing Release, the CFTC supervisory oversight for financial the statute through a particular rule. In assessed the costs and benefits of the institutions as a whole.1100 More all rulemakings, the CFTC performs an proposed rules in general, followed by specifically, the crisis demonstrated the RFA analysis for that particular rule. assessments of the costs and benefits of need for regulation of the over-the- Moreover, as the commenter each of the rules, taking into account the counter derivatives markets.1101 mentioned, most of the transactions into considerations described above. The On July 21, 2010, President Obama which its members enter are based on CFTC also requested comment on these signed the Dodd-Frank Act into law. nonfinancial commodities. The CFTC assessments, and a number of comments Title VII of the Dodd-Frank Act has provided interpretations in this were received. In this Adopting Release, established a comprehensive new release clarifying the forward exclusion the CFTC will again assess the costs and regulatory framework for swaps and in nonfinancial commodities from the benefits of the rules in general followed security-based swaps. As discussed swap definition (and the forward by the individual rules in this above, the legislation was enacted, exclusion from the definition of ‘‘future rulemaking, for each case taking into among other reasons, to reduce risk, delivery’’), including forwards with account the above considerations and increase transparency, and promote embedded volumetric options, and the comments received. These costs and market integrity within the financial separately, has provided for a trade benefits, to the extent identified and, system, including by: (i) Providing for option exemption.1095 The CFTC also where possible, quantified have helped the registration and comprehensive has provided an interpretation that to inform the decisions of and the regulation of swap dealers, security- certain customary commercial actions taken by the CFTC that are based swap dealers, major swap transactions are excluded from the swap described throughout this release. participants, and major security-based 1096 swap participants; (ii) imposing clearing definition. 1. Introduction Accordingly, for the reasons stated in and trade execution requirements on the proposal and the foregoing Prior to the adoption of Title VII, swaps and security-based swaps, subject discussion in response to the comment swaps and security-based swaps were to certain exceptions; (iii) creating received, the CFTC continues to believe by and large unregulated. The rigorous recordkeeping and real-time that the rulemaking will not have a Commodity Futures Modernization Act reporting regimes; and (iv) enhancing significant impact on a substantial of 2000 (‘‘CFMA’’) excluded financial the rulemaking and enforcement number of small entities. Therefore, the over-the-counter swaps from regulation authorities of the Commissions with Chairman, on behalf of the CFTC, under the CEA, provided that trading respect to, among others, all registered hereby certifies pursuant to 5 U.S.C. occurred only among ‘‘eligible contract entities and intermediaries subject to 1098 1102 605(b) that the rules will not have a participants.’’ Swaps based on the Commissions’ oversight. significant impact on a substantial exempt commodities—including energy 1100 number of small entities. and metals—could be traded among See Financial Crisis Inquiry Commission, ECPs without CFTC regulation, but ‘‘The Financial Crisis Inquiry Report: Final Report C. Costs and Benefits Considerations of the National Commission on the Causes of the certain CEA provisions against fraud Financial and Economic Crisis in the United Section 15(a) of the CEA requires the and manipulation continued to apply to States,’’ Jan. 2011, at xxvii, available at http:// CFTC to consider the costs and benefits these markets. No statutory exclusions www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO- were provided for swaps on agricultural FCIC.pdf. of its actions before promulgating a 1101 Id. at 25 (concluding that ‘‘enactment of regulation or issuing certain orders commodities by the CFMA, although * * * [the Commodity Futures Modernization Act under the CEA.1097 Section 15(a) further they could be traded under certain of 2000 (‘‘CFMA’’)] to ban the regulation by both specifies that the costs and benefits regulatory exemptions provided by the the Federal and State governments of over-the- CFTC prior to its enactment. Swaps counter (OTC) derivatives was a key turning point shall be evaluated in light of the in the march toward the financial crisis.’’). See also following five broad areas of market and based on securities were subject to id. at 343 (‘‘Lehman, like other large OTC public concern: (1) Protection of market certain SEC enforcement authorities, but derivatives dealers, experienced runs on its participants and the public; (2) the SEC was prohibited from derivatives operations that played a role in its prophylactic regulation of such swaps. failure. Its massive derivatives positions greatly efficiency, competitiveness, and complicated its bankruptcy, and the impact of its financial integrity of markets; (3) price In the fall of 2008, an economic crisis bankruptcy through interconnections with discovery; (4) sound risk management threatened to freeze U.S. and global derivatives counterparties and other financial credit markets. The Federal government institutions contributed significantly to the severity practices; and (5) other public interest and depth of the financial crisis.’’) and id. at 353 considerations. The CFTC considers the intervened to buttress the stability of the 1099 (‘‘AIG’s failure was possible because of the costs and benefits resulting from its U.S. financial system. The crisis sweeping deregulation of [OTC] derivatives, [* * *] discretionary determinations with revealed the vulnerability of the U.S. including capital and margin requirements that respect to the Section 15(a) factors. The financial system and economy to wide- would have lessened the likelihood of AIG’s failure. spread systemic risk resulting from, The OTC derivatives market’s lack of transparency CFTC also considers, qualitatively, costs and of effective price discovery exacerbated the and benefits relative to the status quo, among other things, poor risk collateral disputes of AIG and Goldman Sachs and that is, the pre-Dodd Frank Act similar disputes between other derivatives 1098 See 7 U.S.C. 1a(12) (2006). counterparties.’’). 1099 On October 3, 2008, President Bush signed 1102 The CFTC has provided a table in the 1095 See Commodity Options, 77 FR 25320, Apr. the Emergency Economic Stabilization Act of 2008, Appendix that cross-references the costs and 27, 2012. which was principally designed to allow the U.S. benefits considerations of the final rules effectuated 1096 To the extent the transactions entered into by Treasury and other government agencies to take by the Product Definitions in order to provide more ETA members are traded or executed on Regional action to help to restore liquidity and stability to transparency with respect to this qualitative Transmission Organizations and Independent the U.S. financial system (e.g., the Trouble Asset assessment of the programmatic costs. See System Operators, or entered into between entities Relief Program—also known as TARP—under Appendix, ‘‘Rules Effectuated by Product described in section 201(f) of the Federal Power which the U.S. Treasury was authorized to Definitions.’’ The CFTC is not providing a Act, they may be addressed through the public purchase up to $700 billion of troubled assets that quantitative estimate of total programmatic costs, interest waiver process described in CEA section weighed down the balance sheets of U.S. financial because it cannot be reliably estimated at this time. 4(c)(6). institutions). See Public Law 110–343, 122 Stat. Many rules have not been finalized, including 1097 7 U.S.C. 19(a). 3765 (2008). Continued

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Section 721 of the Dodd-Frank Act comments, the rules and interpretations within the definitions of foreign amends the Commodity Exchange Act clarify that certain traditional insurance exchange swap and forward, such (‘‘CEA’’) by adding definitions of the products, consumer and commercial products are not subject to the Treasury terms ‘‘swap,’’ ‘‘security-based swap,’’ agreements, and loan participations are Secretary’s determination to exempt. and ‘‘security-based swap agreement.’’ not swaps or security-based swaps, Outside of the foreign exchange suite of Section 712(d)(1) provides that the which will increase legal certainty and products, the rules and interpretations CFTC and the SEC, in consultation with lower the costs of assessing whether a clarify that certain transactions are the Federal Reserve Board, shall jointly product is a swap or security-based swaps or security-based swaps. These further define those terms. Section swap for market participants. In this products include forward rate 712(a)(8) provides further that the regard, the rules and interpretations are agreements, certain contracts for Commissions shall jointly prescribe intended to reduce unnecessary burdens differences, swaptions and forward such regulations regarding ‘‘mixed on persons using such agreements, swaps. The rules and the interpretations swaps’’ as may be necessary to carry out contracts, or transactions, the regulation are intended to increase clarity and legal the purposes of Title VII of the Dodd- of which under Title VII may not be certainty for market participants with Frank Act (‘‘Title VII’’). Section necessary or appropriate to further the respect to these products. 712(d)(2) requires the Commissions, in purposes of Title VII. Next this release addresses the consultation with the Federal Reserve In addition, the CFTC is clarifying the relationship between swaps and Board, to jointly adopt rules governing scope of the forward contract security-based swaps and how to books and records requirements for exclusion 1103 for nonfinancial distinguish them. The Commissions are security-based swap agreements. commodities from the statutory swap clarifying whether particular Under the comprehensive framework definition to provide legal certainty for agreements, contracts or transactions for regulating swaps and security-based market participants as to which that are subject to Title VII of the Dodd- swaps established in Title VII, the CFTC transactions will qualify for the Frank Act (which are referred to as is given regulatory authority over swaps, exclusion. In this regard, the CFTC is ‘‘Title VII Instruments’’ in this release) the SEC is given regulatory authority clarifying the circumstances under are swaps, security-based swaps or both over security-based swaps, and the which market participants may rely on (i.e., mixed swaps). In addition, the Commissions jointly are to prescribe past CFTC guidance regarding the Commissions are clarifying the use of such regulations regarding mixed swaps forward exclusion from the definition of the term ‘‘narrow-based security index’’ as may be necessary to carry out the ‘‘future delivery,’’ and in particular the in the security-based swap definition. In purposes of Title VII. In addition, the Brent Interpretation for booked-out general, the CFTC has jurisdiction over 1104 SEC is given antifraud authority over, transactions, with respect to the Title VII instruments on broad-based and access to information from, certain forward exclusion from the swap security indexes, while the SEC has CFTC-regulated entities regarding definition. The CFTC is extending the jurisdiction over Title VII instruments security-based swap agreements, which Brent Interpretation to all nonfinancial on narrow-based security indexes. This are a type of swap related to securities commodities, and is withdrawing the release clarifies that the existing criteria 1105 over which the CFTC is given regulatory Energy Exemption as proposed, for determining whether a security and enforcement authority. with certain clarifications. The final index is narrow-based, and the past The statutory definitions of ‘‘swap’’ interpretation with clarifications in guidance of the Commissions regarding and ‘‘security-based swap’’ in Title VII response to comments should enhance those criteria in the context of security are detailed and comprehensive. The legal certainty regarding the forward futures, apply to Title VII instruments. Dodd-Frank Act directs the exclusions. Credit default swaps (‘‘CDS’’) also are Commissions, among other things, to While the statutory definitions of subject to this same jurisdictional ‘‘further define’’ these terms; it does not swap and security-based swap are division—CDS on broad-based security direct the Commissions to provide detailed and comprehensive, the rules indexes are regulated by the CFTC, definitions for them, which are already further clarify whether particular types while CDS on narrow-based security provided for in the statute. Thus, even of transactions are swaps or security- indexes (as well as CDS on single name in the absence of these rules, the Dodd- based swaps. For example, foreign securities or loans) generally are Frank Act would require regulating exchange forwards and swaps are regulated by the SEC. This release products that meet the statutory defined as swaps, subject to the provides new criteria tailored to CDS for determining whether a CDS is based on definitions of these terms as swaps and Treasury Secretary’s determination to an index that is a narrow-based security security-based swaps. Consequently, a exempt them from the swap definition. index. Also, it explains the term large part of the costs and benefits The statute provides that certain ‘‘index’’ and adopts a final rule resulting from the regulation of swaps provisions of the CEA apply to foreign governing tolerance and grace periods and security-based swaps derives from exchange forwards and swaps, even if for Title VII instruments on security the Dodd-Frank Act itself and not from the Treasury Secretary determines to indexes traded on trading platforms. these rules that further define swaps. exempt them, and the rules reflect this. These rules and interpretations Several commenters to the ANPR Specifically, these transactions still generally are designed to provide clarity issued by the Commissions regarding would be subject to certain and enhanced legal certainty regarding the definitions expressed a concern that requirements for reporting swaps, and the appropriate classification of Title VII the product definitions could be read swap dealers and major swap instruments as swaps, security-based broadly to include certain types of participants engaging in such swaps or mixed swaps, so that market transactions that previously had never transactions still would be subject to participants may ascertain the been considered swaps or security- certain business conduct standards. The applicable regulatory requirements more based swaps. In response to those rules also clarify that, because certain foreign exchange products do not fall easily. This release anticipates that mixed capital and margin which may have significant costs. Any estimate made of the programmatic costs 1103 See supra part II.B.2.a). swaps, which are both swaps and of the Product Definitions would be unreliable and 1104 See supra part II.B.2.a)i)(B). security-based swaps, will be a narrow therefore may be misleading. 1105 See supra part II.B.2.a)i)(C). category, but lists a few examples of

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mixed swaps and interprets how to provision or regulation that depends, in endeavored to narrow the scope of the distinguish one type of TRS that is a whole or in part, on the effectiveness of terms ‘‘swap’’ and ‘‘security-based mixed swap from another that is not. this final rulemaking. By fulfilling the swap’’ without excluding agreements, This release addresses the regulatory statutory mandate, many of the contracts and transactions that the CFTC treatment of bilateral, uncleared mixed programmatic benefits of Title VII and has determined should be regulated as swaps where one counterparty is a dual the CFTC’s implementing regulations swaps and security-based swaps. registrant with the CFTC and SEC. It are triggered, including risk reduction, Narrowing the scope of the statutory also establishes a process for requesting increasing transparency, and promoting definitions should reduce the overall a joint order from the Commissions to market integrity and, by extension, the programmatic costs of Title VII because determine the appropriate regulatory increased possibility of preventing or fewer agreements, contracts, and treatment of mixed swaps that do not reducing the severity of another global transactions will be subject to the full fall into the category of mixed swaps financial crisis such as occurred in panoply of Title VII regulation. where one counterparty is a dual 2008. Delimiting the scope of the terms Narrowing the scope of the statutory registrant. Concerning ‘‘security-based ‘‘swap,’’ ‘‘security-based swap,’’ definitions should also increase the net swap agreements’’ (or SBSAs), this ‘‘security-based swap agreement,’’ and programmatic benefits of the CFTC’s release explains what types of ‘‘mixed swaps’’ also helps to determine Title VII regulations because the CFTC transactions are SBSAs and includes the scope of activities and entities that is targeting in the Product Definitions rules that provide that there will not be will be subject to the various Title VII rulemaking agreements, contracts and additional books and records regulatory requirements. Requirements transactions that the CFTC has requirements regarding SBSAs other for clearing and trade execution, capital determined, after considering comments than those that have been proposed by and margin, business conduct, and received and undertaking a qualitative the CFTC for swaps in order to avoid reporting and recordkeeping, all of analysis, are swaps or security-based duplicative regulation and costs. which have been or will be swaps. The CFTC anticipates that This release also includes rules implemented in other CFTC rules, will applying the full panoply of Title VII establishing a process for members of lead to programmatic costs that have regulation to only those agreements, the public to request a joint been or will be addressed in the CFTC’s contracts or transactions that the CFTC interpretation from the Commissions rules to implement those requirements. has determined are swaps or security- regarding whether a Title VII instrument When considering the programmatic based swaps will be most effective in is a swap, security-based swap or a costs and benefits of the Product achieving the net benefits of Title VII mixed swap. The process includes a Definitions, the CFTC recognizes the regulation under the Dodd-Frank Act. deadline for a decision, as well as a scope of activities and entities affected (a) Costs requirement that if the Commissions do by the further Product Definitions by not issue a joint interpretation within reference to the other final rulemakings The scope of the terms ‘‘swap,’’ the prescribed time period, each under Title VII accomplished to date. ‘‘security-based swap,’’ ‘‘security-based Commission must publicly provide the The costs that parties will incur to swap agreement,’’ and ‘‘mixed swap’’ is reasons for not having done so. assess whether certain agreements, an important factor in determining the Finally, this release includes anti- contracts, or transactions are ‘‘swaps,’’ range of activities and entities that will evasion rules and related interpretations ‘‘security-based swaps,’’ ‘‘security-based be subject to various requirements set adopted by the CFTC, which in general swap agreements,’’ or ‘‘mixed swaps’’ forth in the Dodd-Frank Act, such as would apply to agreements, contracts, that are subject to the Title VII trade execution, clearing, reporting, transactions and entities that are regulatory regime, and, if so, costs to registration, business conduct, and willfully structured to evade Dodd- assess whether such Title VII capital requirements. Complying with Frank requirements. instrument is subject to the regulatory these requirements, which will be implemented in other rules by the 2. Costs and Benefits of the regime of the SEC or the CFTC are CFTC, are programmatic costs, which Definitions—In General referred to herein as assessment costs. also have been or will be addressed in In general, many commenters have The rules and interpretations in this the CFTC’s rules to implement those suggested that the statutory definitions Adopting Release: further define the requirements.1107 of swap and security-based swap are terms ‘‘swap,’’ ‘‘security-based swap,’’ The CFTC believes that the overbroad in that they could be viewed and ‘‘security-based swap agreement;’’ rulemaking to further define the terms to include agreements, contracts, and provide for the regulation of ‘‘mixed ‘‘swap,’’ ‘‘security-based swap,’’ transactions that the market had not swaps;’’ and address books and records ‘‘security-based swap agreement,’’ and considered to be swaps or security- requirements for security-based swap ‘‘mixed swap’’ is consistent with how based swaps prior to the enactment of agreements. In the discussion that market participants understand these the Dodd-Frank Act, are (or could be) follows, the CFTC considers the costs products. The further definitions swaps or security-based swaps. Thus, in and benefits resulting from its own increase legal certainty and thereby response to these comments, the CFTC discretionary determinations with reduce assessment costs by clarifying has engaged in a qualitative analysis of respect to the section 15(a) factors. that certain products that meet the various agreements, contracts, and There are ‘‘programmatic’’ costs and requirements of the applicable rules and transactions of which the CFTC is aware benefits as well as ‘‘assessment’’ costs of interpretations, such as traditional and that commenters have brought to its the Product Definitions. Programmatic insurance products, are not swaps. costs result from subjecting certain attention. Based on this analysis, the agreements, contracts, or transactions to CFTC has established rules and (b) Benefits the regulatory regime of Title VII.1106 interpretations to identify agreements, Many of the benefits of Title VII and Effectiveness of the Products Definitions contracts, and transactions that are the CFTC’s implementing regulations, will trigger effectiveness of any statutory swaps or security-based swaps where including risk reduction, increasing the statutory definition may be 1106 See Appendix, ‘‘Rules Effectuated by Product inadequate or ambiguous. In developing 1107 See Appendix, ‘‘Rules Effectuated by Product Definitions.’’ the further definitions, the CFTC has Definitions.’’

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transparency, and promoting market through its determinations as discussed requested that multilateral development integrity are programmatic benefits of below. banks’ transactions be exempted from the Products Definitions since they are Another commenter 1109 contended the definition of a swap. As explained effectuated by Product Definitions. that the costs and benefits above, these transactions are swaps. In These programmatic benefits are considerations in the Proposing Release addition, the proposed exclusion is difficult to quantify and measure. were not based on any empirical data overbroad because it would mean that Moreover, these benefits can be and are not consistent with the expected swaps and security-based swaps entered expected to manifest themselves over costs of compliance anticipated by into by foreign central banks, foreign the long run and be distributed over the market participants. However, the CFTC sovereigns, international financial market as a whole. cannot do a comprehensive empirical institutions, and similar organizations The CFTC believes that the final rules analysis regarding costs and benefits of would be completely excluded from and interpretations can be consistently the Products Definitions before actual Dodd-Frank regulation. Their applied by substantially all market data is available when the swap counterparties, who may be swap participants to determine which regulatory regime has been dealers and other regulated entities, agreements, contracts, or transactions implemented in full. Moreover, the would have no regulatory obligations are, and which are not, swaps, security- CFTC did use some empirical estimates with respect to such swaps, and could based swaps, security-based swap in its costs and benefits considerations develop significant exposures without agreements, or mixed swaps. The in the Proposing Release, namely in the knowledge of the CFTC, other benefits of the individual rules and assessment costs for the process to seek regulators and market participants. If interpretations are discussed in their an interpretation of whether a product these transactions were not swaps, then respective sections below. is a swap, security-based swap, or no market participant would be mixed swap, as well as in the process obligated to report them to a U.S.- (c) Comments and Consideration of to determine regulatory treatment for registered swap data repository or real- Alternatives mixed swaps.1110 Commenters did not time report them. This lack of The CFTC requested comment on the submit data or other information to transparency might distort swap pricing costs and benefits of the proposed rules support an argument that the CFTC’s and impede proper risk management in and interpretations regarding the estimates were inaccurate. as much as the market may not be aware 1111 definitions in general for market Commenters expressed concern of the risk entailed in these opaque participants, markets and the public. about costs from regulatory uncertainty transactions and might thwart price Further, the CFTC requested comment imposed on swaps market participants discovery. as to whether there are any aspects of resulting from other Title VII The Commissions did not propose the proposed rules and interpretive rulemakings not yet being final. The rules or interpretations on how to guidance regarding the definitions that consideration of thousands of letters distinguish futures from swaps. A are both burdensome to apply and not and the process of due deliberation and commenter requested that the CFTC helpful to achieving clarity as to the reasoned decision-making by the CFTC clarify that nothing in the release was scope of the defined terms, and whether has caused delays. Nevertheless, the intended to limit a DCM’s ability to list there are less burdensome means of CFTC is working with deliberate speed for trading a futures contract regardless providing clarity as to the scope of the to complete the rulemakings, and of whether it could be viewed as a swap defined terms. eventually this particular type of legal if traded over-the-counter or on a SEF, uncertainty will be eliminated. A commenter 1108 argued that a proper since futures and swaps are A commenter 1112 requested that inter- cost-benefit analysis can only be ‘‘indistinguishable in material economic affiliate swaps be exempt from the swap 1115 performed once an integrated and effects.’’ The commenter further definition, arguing that regulating such complete mosaic of rules is available for recommended that the CFTC adopt a swaps may increase costs to consumers analysis and doubted that the final rule that amends the statutory and undermine efficiencies from the use definitions impose no independent definition of the term ‘‘swap’’ by adding of centralized hedging affiliates. The costs. The CFTC has considered, to the futures contract exclusion in CEA CFTC anticipates that it will address qualitatively, the costs and benefits of Section 1a(47)(B)(i) the following inter-affiliate swaps in a subsequent the entire mosaic of CFTC rules under language after the word ‘‘delivery’’: rulemaking. the Dodd-Frank Act in this rulemaking. ‘‘Listed for trading by a designated Several commenters 1113 argued that Due to data limitations and other contract market.’’ The same commenter foreign central banks, foreign uncertainty, the CFTC cannot perform a believed that such a rule would clarify sovereigns, international financial 1116 meaningful quantitative analysis, yet. the scope of Section 4(a) of the CEA, institutions, such as multilateral The CFTC considers in this rulemaking which makes it illegal to trade a futures development banks, and similar the costs and benefits of how the contract except on or subject to the rules organizations should be exempt from 1117 Commissions are exercising their of a DCM. swap regulations, since regulations discretion in further defining the Although it is potentially more costly would impose costs on these entities. Product Definitions because Congress to a DCM in terms of providing Specifically, a commenter 1114 asserted included in the Dodd-Frank Act additional analysis to support listing a that multilateral development banks statutory definitions of these terms, over futures contract on its exchange, the should not have to register or be subject which the CFTC has no discretion. CFTC is not adopting the distinction the to clearing and margin requirements and Moreover, the CFTC has considered the commenter advocates. Prior distinctions that the CFTC relied upon (such as the independent costs (i.e. costs imposed 1109 See WGCEF Letter. presence or absence of clearing) to through exercising its discretion) that 1110 See Proposing Release at 29874. the Products Definitions may impose 1111 See FIA Letter; IIB Letter; and ISDA Letter. distinguish between futures and swaps 1112 See Shell Trading Letter. 1108 See ETA Letter. See also IECA Letter II 1113 See CEB Letter; EIB Letter; and World Bank 1115 See CME Letter. (requesting a comprehensive costs benefits analysis Letter. 1116 7 U.S.C. 6(a). on all of Title VII). 1114 See World Bank Letter. 1117 See CME Letter.

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may no longer be relevant.1118 As a the insurance commissioner (or similar pools); and reinsurance (including result, it is difficult to distinguish official or agency) of any State or by the retrocession) of any of the foregoing. between futures and swaps on a blanket United States or an agency or Based on comments received, the basis as the commenter suggested. instrumentality thereof, and such Commissions are adding three products However, a case-by-case approach for agreement, contract, or transaction is to the list of products as proposed, distinguishing these products may lead regulated as insurance applicable State adding reinsurance (including to more informed decision-making by law or the laws of the United States (the retrocession) of any of the traditional the CFTC. ‘‘first prong’’); (ii) directly or indirectly insurance products included in the list, The CFTC notes that a DCM may self- by the United States, any State, or any and deleting a requirement applicable to certify its contracts pursuant to Part 40 of their respective agencies or annuities that they must be subject to of the CFTC’s rules,1119 subject to the instrumentalities, or pursuant to a tax treatment under section 72 of the CFTC’s oversight authority. If a DCM statutorily authorized program thereof Internal Revenue Code. has a view that a particular product is (the ‘‘second prong’’); (iii) in the case of The Commissions are also clarifying a futures contract, it may self-certify the reinsurance only, by a person to another that the Product Test, the Provider Test contract consistent with that view. The person that satisfies the Provider Test, and the Enumerated Products in the DCM also has a number of other provided that: such person is not rules are a non-exclusive safe harbor options, including seeking prior prohibited by applicable State law or (the ‘‘Insurance Safe Harbor’’), such that approval from the CFTC, requesting an the laws of the United States from if a product fails the Insurance Safe interpretation, or requesting a offering such agreement, contract, or Harbor, that does not necessarily mean rulemaking if it is in doubt about transaction to such person that satisfies that the product is a swap or security- whether a particular agreement, contract the Provider Test; the agreement, based swap—further analysis may be or transaction should be classified as a contract, or transaction to be reinsured required in order to make that futures contract or a swap. satisfies the Product Test or is one of the determination. Enumerated Products; and except as Rule 1.3(xxx)(4)(ii) provides a 3. Costs and Benefits of Rules and ‘‘grandfather’’ for insurance transactions Interpretations Regarding Insurance otherwise permitted under applicable State law, the total amount reimbursable (as opposed to insurance products), Rule 1.3(xxx)(4)(i) under the CEA by all reinsurers for such agreement, pursuant to which transactions that are clarifies that agreements, contracts or contract, or transaction may not exceed entered into on or before the effective transactions that satisfy its provisions the claims or losses paid by the cedant; date of the Product Definitions will not will not be swaps or security-based or (iv) in the case of non-admitted fall within the definition of swap or swaps. Specifically, the term ‘‘swap’’ insurance by a person who: is located security-based swap, provided that, at such time that it was entered into, the and ‘‘security-based swap’’ does not outside of the United States and listed transaction was provided in accordance include an agreement, contract, or on the Quarterly Listing of Alien with the Provider Test. transaction under rule 1.3(xxx)(4)(i)(A) Insurers as maintained by the that, by its terms or by law, as a The CFTC is interpreting the term International Insurers Department of the ‘‘swap’’ (that is not a security-based condition of performance on the National Association of Insurance agreement, contract, or transaction: (i) swap or mixed swap) to include a Commissioners; or meets the eligibility guarantee of such swap, to the extent Requires the beneficiary of the criteria for non-admitted insurers under agreement, contract, or transaction to that a counterparty to a swap position applicable State law (the ‘‘Provider would have recourse to the guarantor in have an insurable interest that is the Test’’). subject of the agreement, contract, or connection with the position. The CFTC transaction and thereby carry the risk of In response to commenters’ requests is persuaded that when a swap has the loss with respect to that interest that the Commissions codify the benefit of a guarantee, the guarantee is continuously throughout the duration of proposed interpretation regarding an integral part of that swap. The CFTC the agreement, contract, or transaction; certain enumerated types of insurance finds that a guarantee of a swap (that is (ii) requires that loss to occur and be products in the final rules, the not a security-based swap or mixed proved, and that any payment or interpretation is being codified in swap) is a term of that swap that affects indemnification therefor be limited to paragraph (i)(C) of rule 1.3(xxx)(4) the price or pricing attributes of that the value of the insurable interest; (iii) under the CEA. In addition, in response swap. When a swap counterparty is not traded, separately from the to comments, the Commissions are typically provides a guarantee as credit insured interest, on an organized market expanding and revising the list of support for its swap obligations, the or over-the-counter; and (iv) with traditional insurance products. As market will not trade with that respect to financial guaranty insurance adopted, the rule provides that the counterparty at the same price, on the only, in the event of payment default or terms ‘‘swap’’ and ‘‘security-based same terms, or at all without the insolvency of the obligor, any swap’’ will not include an agreement, guarantee. The guarantor’s resources are acceleration of payments under the contract, or transaction that is provided added to the analysis of the swap; if the policy is at the sole discretion of the in accordance with the conditions set guarantor is financially more capable insurer (the ‘‘Product Test’’). forth in the Provider Test and is one of than the swap counterparty, the analysis Rule 1.3(xxx)(4)(i)(B) under the CEA the following types of products of the swap becomes more dependent provides that for an agreement, contract, (collectively, ‘‘Enumerated Products’’): on the creditworthiness of the or transaction that meets the Product surety bonds; fidelity bonds; life guarantor. The CFTC anticipates that a Test to be excluded from the swap and insurance; health insurance; long-term ‘‘full recourse’’ guarantee would have a security-based swap definitions as care insurance; title insurance; property greater effect on the price of a swap than insurance, it must be provided: (i) By a and casualty insurance; annuities; a ‘‘limited’’ or ‘‘partial recourse’’ person that is subject to supervision by disability insurance; insurance against guarantee; nevertheless, the CFTC is default on individual residential determining that the presence of any 1118 See, e.g., Swap Policy Statement, supra mortgages (commonly known as private guarantee with recourse, no matter how note 214. mortgage insurance, as distinguished robust, is price forming and an integral 1119 17 CFR Part 40. from financial guaranty of mortgage part of a guaranteed swap. The CFTC’s

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interpretation of the term ‘‘swap’’ to Nevertheless, it is anticipated that such CFTC does, however, anticipate that include guarantees of swap does not cases will be infrequent. Moreover, it there will be some programmatic costs limit or otherwise affect in any way the may be difficult to assess whether associated with the requirements that it relief provided by the Insurance products that do not fall within the will propose for guarantees of swaps in Grandfather. In a separate release, the Insurance Safe Harbor are swaps or the separate CFTC release.1124 The CFTC will address the practical security-based swaps rather than CFTC will carefully consider those costs implications of interpreting the term insurance. Market participants may in that rulemaking. ‘‘swap’’ to include guarantees of swaps need to request an interpretation from (b) Benefits (the ‘‘separate CFTC release’’). the Commissions regarding such products, or obtain an opinion of Subjecting traditional insurance (a) Costs counsel, which will involve certain products to Title VII could, absent A market participant will need to costs.1122 However, the CFTC expects exception, prevent individuals who are ascertain whether an agreement, such cases will arise less frequently in not ECPs from obtaining insurance to contract, or transaction satisfies the light of the increased clarity provided protect their properties or families criteria set forth in rule 1.3(xxx)(4). This by the rule. An alternative to a safe against accidental hazards or risks,1125 analysis will have to be performed prior harbor approach under the rule—that or require insurance sold to individuals to entering into the agreement, contract, failure to meet the rule and who are not ECPs to be traded on or transaction to ensure that the relief interpretation would automatically exchanges and be cleared. The provided by the Insurance Safe Harbor mean that the product is a swap and not Commissions have found no evidence is available. The CFTC expects that insurance—would likely impose greater that Congress intended them to be potential costs associated with any costs on market participants and result regulated as swaps or security-based possible uncertainty cited by in more frequent misclassification of swaps. In light of the above commenters as to whether an products. considerations, the Commissions have agreement, contract, or transaction that The CFTC is interpreting the term determined to provide the Insurance the participants consider to be ‘‘swap’’ (that is not a security-based Safe Harbor and Insurance Grandfather insurance could instead be regulated as swap or mixed swap) to include a in the final rules in order to assure a swap would be greater without the guarantee of such swap, to the extent market participants that those Insurance Safe Harbor than the cost of that a counterparty to a swap position agreements, contracts, or transactions the analysis under the final rule herein. would have recourse to the guarantor in that meet their conditions will not fall Although the Insurance Safe Harbor is connection with the position. The CFTC within the swap or security-based swap designed to mitigate costs associated anticipates minimal or no assessment definitions. Limiting the number of with legal uncertainty and costs from the interpretation with unexpected product classification misclassification of products, to the respect to guarantees of swaps.1123 The outcomes for market participants extent that it inadvertently fails to provides the benefit of predictability exclude certain types of insurance 1122 The CFTC believes that $27,000 represents a when entering into their transactions products from the definitions, these reasonable estimate of the upper end of the range The business of insurance is already failures could lead to costs for market of the costs to undertake the legal analysis of the subject to established pre-Dodd-Frank status of an agreement, contract, or transaction as participants entering into agreements, a swap or security-based swap. The average cost Act regulatory regimes. Requirements contracts, or transactions. Some incurred by market participants in connection with that may work well for swaps and insurance products might inadvertently assessing whether an agreement, contract, or security-based swaps may not be be subjection to regulation as swaps. To transaction is a swap or security-based swap is appropriate for traditional insurance based upon the estimated amount of time that staff the extent that the Insurance Safe believes will be required for both in-house counsel products. To the extent that the final Harbor leads to the inadvertent and outside counsel to apply the definition. Staff rules distinguish insurance from swaps misclassification of some swaps as estimates that some agreements, contracts, or and security-based swaps, the CFTC insurance, costs for market participants transactions will clearly satisfy the Insurance Safe should be able to tailor rules for specific Harbor, Insurance Grandfather and an in-house entering into agreements, contracts, or attorney, without the assistance of outside counsel, transactions that are inadvertently will be able to make a determination in less than commerce since long before the existence of swaps regulated as insurance products, and not one hour. Based upon data from SIFMA’s markets, the CFTC anticipates that whether a as swaps, may increase.1120 Similarly, Management & Professional Earnings in the guarantee is present or not will be obvious. 1124 insurance products inadvertently Securities Industry 2011 (modified by SEC staff to As a result of interpreting the term ‘‘swap’’ account for an 1800-hour-work-year and multiplied (that is not a security-based swap or mixed swap) mischaracterized as swaps could impose by 5.35 to account for bonuses, firm size, employee to include a guarantee of such swap, to the extent additional costs on market participants, benefits and overhead), staff estimates that the that a counterparty to a swap position would have who could be required to meet certain average national hourly rate for an in-house counsel recourse to the guarantor in connection with the regulatory requirements applicable to is $378. If an agreement, contract, or transaction is position, and based on the reasoning set forth in the more complex, the CFTC estimates the analysis will Entity Definitions Release in connection with major swaps. require approximately 30 hours of in-house counsel swap participants, the CFTC will not deem holding Assessment costs should be minimal time and 40 hours of outside counsel time. The companies to be swap dealers as a result of or non-existent for traditional insurance CFTC estimates the costs for outside legal services guarantees to certain U.S. entities that are already products,1121 but for a new and novel to be $400 per hour. This is based on an estimated subject to capital regulation. This interpretation $400 per hour cost for outside legal services. This mitigates the programmatic costs imposed on insurance product that is more complex, is the same estimate used by the SEC for these potential swap dealers by not attributing to a the costs of analysis may be greater. services in the release involving Exemptions for guarantor swap positions of a guaranteed entity that Security-Based Swaps Issued By Certain Clearing is already subject to capital regulation. 1120 Improperly characterizing swaps as insurance Agencies, Release No. 33–9308 (Mar. 30, 2012), 77 1125 An individual is considered an ECP if the may theoretically cause market participants that are FR 20536 (Apr. 5, 2012). Accordingly, on the high individual ‘‘has amounts invested on a not licensed insurance companies to become end of the range the CFTC estimates the cost to be discretionary basis, the aggregate of which is in licensed insurance companies, if applicable, thus $27,340 ($11,340 (based on 30 hours of in-house excess of—(i) $10,000,000; or (ii) $5,000,000 and imposing costs of complying with state insurance counsel time ✖ $378) + $16,000 (based on 40 hours who enters into the agreement, contract, or regulation. of outside counsel ✖ $400). The estimate is rounded transaction in order to manage the risk associated 1121 The CFTC anticipates that traditional to two significant digits to avoid the impression of with an asset owned or liability incurred, or insurance products will either be easy to identify false precision of the estimate. reasonable likely to be owned or incurred, by the from the list of Enumerated Products or will 1123 Because a guarantee is a common and well- individual.’’ Section 1a(18)(A)(xi) of the CEA, 7 unambiguously satisfy the Products Test. understood product, that has been used in U.S.C. 1a(18)(A)(xi).

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products that are swaps or security- uncertainty may result in conflicting commenter’s test is potentially easier based swaps to achieve Title VII interpretations, which can be a and thus may be less costly to apply regulatory objectives. In adopting the significant burden for financial guaranty than the Commissions’ test, it would be Insurance Safe Harbor, the CFTC has transactions that typically require the inadequate because, as explained in sought to achieve those net benefits that delivery of a legal opinion. section II.B.1.(d) above, it would may be obtained from not supplanting The Commissions have expanded the essentially delete the product prong of existing insurance regulation that are list of insurance products excluded from the insurance safe harbor, and thus consistent with the regulatory objectives the swap definition to cover certain begging the question of how to of Title VII. traditional insurance products that distinguish insurance from swaps and Without the Insurance Safe Harbor, commenters have brought to their security-based swaps and allowing state market participants might be more attention and that the Commissions insurance regulators to supplant the uncertain about whether an agreement, have determined are not swaps. The Commissions’ role in further defining, contract, or transaction is an insurance Commissions are also clarifying that the or determining what is, a swap. Further, product rather than a swap. Rule Insurance Safe Harbor does not imply or market participants might misconstrue 1.3(xxx)(4) is intended to reduce the presume that an agreement, contract or the commenter’s test in close cases to potential uncertainty of what constitutes transaction that does not meet its mean that any activity permitted by the a swap by setting forth clear and requirements is a swap or security-based insurance commissioner of the relevant objective criteria for distinguishing an swap, but will require further analysis state(s) may not be regulated as swaps agreement, contract, or transaction that of the applicable facts and or security-based swaps. However, is insurance from a swap. Providing circumstances, including the form and insurance companies are in many such an objective rule and explanation substance of the agreement, contract, or circumstances permitted by state mitigates the potential additional costs transaction, to determine whether it is insurance regulators to enter into swaps of petitioning the Commissions, or insurance, and thus not a swap or or security-based swaps, illustrating that obtaining an opinion of counsel, about security-based swap. With regard to the fact that while an insurance whether an agreement, contract, or financial guaranty in particular, the company may enter into an agreement, transaction is insurance or a swap. acceleration of payment criterion is contract or transaction, it does not The objective criteria provided by the designed to reflect market practice and necessarily mean that such agreement, rule also will aid sound risk aid appropriate product classification. contract or transaction is insurance. management practices because it will be The Commissions are stating that they Further, the domain of insurance easier for market participants to decide intend to interpret concepts upon which regulation may change and then this whether a particular agreement, the Product Test relies that are derived commenter’s test would induce an contract, or transaction is insurance or from state law consistently with the evolving boundary between state and a swap. existing and developing laws of the CFTC regulation. Further, the CFTC anticipates that the relevant state(s) governing the Several commenters suggested an interpretation of the term ‘‘swap’’ to agreement, contract, or transaction in approach in which insurance products include guarantees of swaps and the question. However, the Commissions that qualify for the exclusion contained separate CFTC release will provide note their authority to diverge from state in section 3(a)(8) of the Securities Act of programmatic benefits by enabling the law if the Commissions become aware 1933 would be excluded from the swap CFTC and market participants to receive of evasive conduct. While the CFTC definition.1131 One commenter argued more price-forming data about swaps, cannot anticipate under what that ‘‘Section 3(a)(8) has long been which may help improve price circumstances or how often the recognized as the definitive provision as discovery for swaps. The CFTC will Commissions might diverge from state to where Congress intends to separate carefully consider these and other law, the CFTC believes that there will be securities products that are subject to benefits in the separate CFTC release. more consistent than inconsistent SEC regulation from ‘insurance’ and interpretations. Accordingly, the rules ‘annuity’ products that are to be left to (c) Comments and Consideration of state insurance regulation’’ and that the Alternatives do not present the increased burden or legal uncertainty that these commenters section 3(a)(8) criteria are well The CFTC requested comment on the suggested. understood and have a long history of costs and benefits of proposed rule Several commenters also requested interpretation by the SEC and the 1.3(xxx)(4) and interpretive guidance to that the Commissions codify the courts.1132 Other commenters suggest distinguish between insurance products proposed interpretive guidance that because section 3(a)(8) includes and swaps for market participants, regarding enumerated insurance both a product and a provider markets, and the public. Several products in rule text on the basis that requirement, if the Commissions commenters 1126 argued that any codification would enhance legal include it in their final rules, it should additional requirement beyond the certainty, and thereby reduce costs.1129 be a requirement separate from the requirement of the rules that a product The Commissions have decided to Product Test and the Provider Test, and is a regulated insurance product creates include a list of products in rule text in should extend to insurance products legal uncertainty and imposes costs. response to these commenters concerns. that are securities.1133 Specifically, a commenter 1127 asserted A commenter proposed that the sole While the Commissions agree that the that it is a burden to introduce test for determining whether an section 3(a)(8) criteria have a long conditions that are neither universal nor agreement, contract or transaction is history of interpretations by the SEC fundamental, such as showing a insurance should be whether it is and the courts, the Commissions find continuing risk of loss for some subject to regulation as insurance by the that it is inappropriate to apply the insurance contracts. Another insurance commissioner of the section 3(a)(8) criteria in this context. commenter 1128 argued that legal applicable state(s).1130 While the Although section 3(a)(8) contains some

1126 See AFGI Letter; AIA Letter; and ISDA Letter. 1129 See ACLI Letter; NAIC Letter; and RAA 1131 See supra note 162 1127 See ISDA Letter. Letter. 1132 See supra note 163. 1128 See AFGI Letter. 1130 See MetLife Letter. 1133 See supra note 164.

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conditions applicable to insurance (2) The insurance contract must be the contracts, and transactions entered into providers that are similar to the prongs type of contract issued by insurance on or before the effective date of the of the Provider Test, it does not contain companies; and Products Definitions. Moreover, the any conditions that are similar to the (3) The insurance contract must not commenter’s test would eliminate the prongs of the Product Test. Moreover, be of a type that the CFTC and SEC provider test for new products, which section 3(a)(8) provides an exclusion determine to regulate.1136 the Commissions believe is important to from the Securities Act and the CFTC The commenter stated that its help prevent products that are swaps or has no jurisdiction under the Federal approach does not contain a definition security-based swaps from being securities laws. Congress directed both of insurance, and for that reason characterized as insurance. agencies to further define the terms believes that is preferable to the In sum, the CFTC finds that, while ‘‘swap’’ and ‘‘security-based swap.’’ As Commissions’ approach, which it some of the alternatives proposed by such, the Commissions find that it is believes creates legal uncertainty commenters may appear less costly to more appropriate to have a standalone because any attempted definition of apply than the Commissions’ test, in all rule that incorporates features that insurance has the potential to be over- cases they would sweep out of the distinguish insurance products from or under-inclusive.1137 Dodd-Frank Act regulatory regime for swaps and security-based swaps and While the commenter’s test may swaps agreements, contracts, and over which both Commissions will have appear simpler on its face, the CFTC transactions that have not historically joint interpretative authority. does not believe that it represents a less been considered insurance, and that Another commenter proposed the costly alternative. The first two should, in appropriate circumstances, following test for an agreement, requirements of the commenter’s test do be regulated as swaps or security-based contract, or transaction to be insurance: not help to distinguish swaps from swaps. Accordingly, the CFTC does not [It] [e]xists for a specified period of time; insurance; the third provides no greater find these alternative tests proposed by Where the one party to the contract certainty than the Commissions’ facts commenters to be better tools than the promises to make one or more payments such and circumstances approach. Moreover, Insurance Safe Harbor for limiting the as money, goods or services; as discussed in section II.B.1(d) above, scope of the statutory definitions of In exchange for another party’s promise to the Commissions’ rules and related swap and security-based swap. provide a benefit of pecuniary value for the interpretations are not intended to Excluding agreements, contracts, and loss, damage, injury, or impairment of an define insurance. Rather, they provide a transactions that are, in fact, swaps from identified interest of the insured as a result safe harbor for certain types of of the occurrence of a specified event or the further definition of the term contingency outside of the parties’ control; traditional insurance products by ‘‘swap’’ is inconsistent with the CFTC’s and reference to factors that may be used to regulatory objectives and could increase Where such payment is related to a loss distinguish insurance from swaps and risk to the U.S. financial system. occurring as a result of a contingency or security-based swaps. Agreements, Three commenters provided specified event.1134 contracts, and transactions that do not comments regarding the treatment of This test may not represent a less qualify for the Insurance Safe Harbor guarantees of swaps. Two costly alternative to the Commissions’ may or may not be swaps, depending commenters 1139 opposed treating test in light of its complexity, and in any upon the facts and circumstances. Thus, insurance or guarantees of swaps as event would not distinguish swaps and the Commissions’ test neither creates swaps. Suggesting that the products are security-based swaps from insurance legal uncertainty as suggested by the not economically similar, one more effectively than the Commissions’ commenter, nor the costs associated commenter argued that insurance wraps test for two reasons. The requirements with such uncertainty. of swaps do not ‘‘necessarily replicate of a specified term and the payment of Another commenter proposed the economics of the underlying swap, premiums are present in both insurance different approaches for existing and only following default could the products and in agreements, contracts, products and new products. According wrap provider end up with the same or transactions that are swaps or to the commenter, if an existing type of payment obligations as a wrapped security-based swaps, and therefore agreement, contract or transaction is defaulting swap counterparty.’’ 1140 This such requirements do not help to currently reportable as insurance in the commenter also stated that the non- distinguish between them. A test based provider’s regulatory and financial insurance guarantees are not swaps solely on these requirements, then, reports under a state or foreign because the result of most guarantees is would be over-inclusive and exclude jurisdiction’s insurance laws, then that that the guarantor is responsible for from the Dodd-Frank regulatory regime agreement, contract or transaction monetary claims against the defaulting agreements, contacts, and transactions would be insurance rather than a swap party, which in this commenter’s view that have not traditionally been or security-based swap. On the other is a different obligation than the considered insurance. Also, the third hand, for new products, if this approach arrangement provided by the underlying and fourth requirements of the is inconclusive, the commenter swap itself.1141 commenter’s test collapse into the recommended that the Commissions use One commenter supported treating Product Prong’s requirement that the the product prong of the Commissions’ financial guaranty insurance of a swap loss must occur and be proved, and any test only.1138 or security-based swap as itself a swap payment or indemnification therefor The commenter’s proposal may or a security-based swap. This must be limited to the value of the represent a less costly alternative than commenter argued that financial insurable interest. the Commissions’ test. However, rather guaranty insurance of a swap or Another commenter offered a 3-part than treating existing products and new security-based swap transfers the risk of test1135 in lieu of the Commissions’ test: products differently, the Commissions counterparty non-performance to the (1) The insurance contract must be as discussed above are providing guarantor, making it an embedded and issued by an insurance company and ‘‘grandfather’’ protection for agreements, essential feature of the insured swap or subject to state insurance regulation; 1136 See ACLI ANPR Letter. 1139 See AFGI Letter, ISDA Letter. 1134 See NAIC Letter. 1137 See ACLI Letter. 1140 ISDA Letter. 1135 See also CAI Letter and Nationwide Letter. 1138 See AIA Letter. 1141 Id.

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security-based swap. This commenter guarantees of swaps as part of the with the intent of the book out provision further argued that the value of such underlying swaps ensures that the CFTC in the Brent Interpretation—provided swap or security-based swap is largely will be able to take appropriate action that the parties had a bona fide intent, determined by the likelihood that the if, after evaluating information collected when entering into the transactions, to proceeds from the financial guaranty with respect to the guarantees and the make or take (as applicable) delivery of insurance policy will be available if the underlying swaps, such guarantees of the commodity covered by those counterparty does not meet its swaps are revealed to pose particular transactions. The CFTC also is obligations.1142 This commenter problems in connection with the swaps providing an interpretation regarding maintained that financial guaranty markets. The separate CFTC release documentation of orally booked-out insurance of swaps and security-based clarifies the limited practical effects of transactions. swaps serves a similar function to credit the CFTC’s interpretation, which should In addition, the CFTC is clarifying default swaps in hedging counterparty address industry concerns regarding that its prior guidance regarding default risk.1143 duplicative regulation. commodity options embedded in While the CFTC is not further One commenter also argued that forward contracts should be applied as defining guarantees of swaps to be regulating financial guaranty of swaps well to the treatment of forward swaps, the CFTC is persuaded that as swaps would cause monoline contracts in nonfinancial commodities when a swap (that is not a security- insurers to withdraw from the market, that contain embedded options under based swap or mixed swap) has the which could adversely affect the U.S. the Dodd-Frank Act. The final benefit of a guarantee, the guarantee and and international public finance, interpretation also explains the CFTC’s related guaranteed swap should be infrastructure and structured finance position with regard to forwards with analyzed together. The events markets, given that insuring a related embedded volumetric optionality, surrounding the failure of AIG Financial swap often is integral to the insurance including an explanation of how it Products (‘‘AIGFP’’) highlight how of municipal bonds and other would treat some of the specific guarantees can cause major risks to flow securities.1147 The CFTC finds this contracts described by commenters, 1144 to the guarantor. The CFTC finds argument unpersuasive. The CFTC such as full requirements contracts. It that the regulation of swaps and the risk understands that the 2008 global also explains the CFTC’s view with exposures associated with them, which financial crisis severely affected most respect to certain contractual is an essential concern of the Dodd- monolines and only one remains active provisions, such as liquidated damages Frank Act, would be less effective if the in U.S. municipal markets. Thus, it and renewable/evergreen provisions CFTC did not interpret the term ‘‘swap’’ appears that the monolines have, for the that do not disqualify the transactions in to include a guarantee of a swap. most part, already exited these markets. which they are contained from the Two commenters cautioned against In addition, as stated above, the separate forward exclusions. The CFTC has also unnecessary and duplicative regulation. CFTC release clarifies the limited provided an interpretation regarding One commented that, because the practical effects of the CFTC’s nonfinancial commodities, including underlying swap, and the parties to it, interpretation, which should address environmental commodities, and will be regulated and reported to the industry concerns. interpretations concerning physical extent required by Title VII, there is no exchange transactions, fuel delivery need for regulation of non-insurance 4. Costs and Benefits of the 1145 agreements, certain physical guarantees. The other commented Withdrawing the Energy Exemption and commercial agreements, and energy that an insurance policy on a swap Interpretation Regarding the Forward management agreements. would be subject to state regulation; Contract Exclusion From the Swap without addressing non-insurance Definition (a) Costs guarantees, this commenter stated that The CFTC is clarifying that the The CFTC’s statement that it will additional Federal regulation would be forward contract exclusion from the construe the forward contract exclusion duplicative.1146 The CFTC disagrees swap definition for nonfinancial consistently with respect to the with these arguments. As stated above, commodities should be read definitions of the terms ‘‘swap’’ and the CFTC is treating financial guaranty consistently with the forward contract ‘‘future delivery,’’ as discussed herein, insurance of swaps and all other exclusion from the CEA definition of the will not impose any new material costs guarantees of swaps in a similar manner term ‘‘future delivery.’’ In that regard, on market participants. It also will because they are functionally or the CFTC is retaining the Brent establish a uniform interpretation of the economically similar products. If a Interpretation and extending it to apply forward contract exclusion from the guarantee of a swap is not treated as an to all nonfinancial commodities, and definitions of both statutory terms, integral part of the underlying swap, which will avoid the significant costs price forming terms of swaps and the withdrawing the Energy Exemption, which had extended the Brent that some commenters state would risk exposures associated with the result if the forward contract exclusion guarantees may remain hidden from Interpretation regarding the forward contract exclusion from the term ‘‘future were construed differently in these two regulators and may not be regulated contexts.1148 In addition, the CFTC’s appropriately. Moreover, treating delivery’’ to energy commodities other than oil, as it is no longer necessary. Although the CFTC is withdrawing the 1148 See EEI Letter (‘‘Without legal certainty as to 1142 See Better Markets Letter. the regulatory treatment of their forward contracts, 1143 See Better Markets Letter. Energy Exemption, the CFTC is EEI’s members and other end users who rely on the 1144 ‘‘AIGFP’s obligations were guaranteed by its providing that certain alternative forward contract exclusion likely will face higher highly rated parent company * * * an arrangement delivery procedures, such as physical transaction costs due to greater uncertainty. These that facilitated easy money via much lower interest netting agreements, that are mentioned increased transaction costs may include: (i) More rates from the public markets, but ultimately made volatile or higher commodity prices; and (ii) it difficult to isolate AIGFP from its parent, with in the Energy Exemption, are consistent increased credit costs, in each case caused by disastrous consequences.’’ Congressional Oversight changes in market liquidity as end users change the Panel, The AIG Rescue, Its Impact on Markets, and 1147 See AFGI Letter. Of the members of AFGI, way they transact in the commodity markets. A the Government’s Exit Strategy 20 (2010). only Assured Guaranty (or its affiliates) is currently single regulatory approach that uses the same 1145 See ISDA Letter. writing financial guaranty insurance policies on criteria to confirm that a forward contract is 1146 See AFGI Letter. U.S. municipal obligations. Continued

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clarification regarding the continued practices and is necessary to prevent market participants’ efficient use of the viability of the alternative delivery abuse of the Brent safe harbor. swaps markets and, as described above, procedures in the Energy Exemption Market participants will need to reduce costs on industry. Documenting should reduce costs to the industry by assess whether products are forward oral book-outs should promote good conferring legal certainty that their contracts that qualify for the forward business practices and aid the CFTC in transactions may continue to have these exclusions from the swap and future preventing evasion through abuse of the procedures without losing their delivery definitions, and may need to forward exclusion. Finally, the CFTC’s eligibility for the forward exclusions. request an interpretation regarding such interpretation regarding commercial products, or obtain an opinion of As noted in section II.B.2.(a)(ii) above, market participants should ensure that counsel, which will involve certain the CFTC has explained its position the forward exclusions may only be costs. 1149 regarding nonfinancial commodities. used for commercial merchandising This should help the industry to (b) Benefits activity and not for speculative purposes. 1150 determine whether their transactions are The CFTC’s interpretations regarding eligible for the forward exclusions, and the forward exclusions should provide The CFTC’s position regarding consequently reduce costs to the market participants with greater legal nonfinancial commodities should help industry for transactions involving non- certainty regarding whether their the industry to determine whether their financial commodities such as transactions qualify for the forward transactions are eligible for the forward renewable energy credits that may be exclusion from the swap definition, exclusions, which should facilitate eligible for the forward exclusions. The which should facilitate commercial commercial merchandising activity for final interpretation regarding forwards merchandising activity. For example, transactions involving non-financial with embedded volumetric optionality the interpretation regarding forwards commodities such as renewable energy should reduce costs to the industry, with embedded volumetric options credits that may be eligible for the because these transactions may qualify should facilitate commercial forward exclusions. for the forward exclusions from the merchandising activity of the electricity, (c) Comments and Consideration of swap and ‘‘future delivery’’ definitions. natural gas, and other industries that Alternatives The explanation of how the CFTC will employ these contracts where delivery view specific contracts mentioned by quantities are flexible, while the The CFTC requested comment in the commenters under this interpretation conditions in the interpretations should Proposing Release on the costs and should enhance legal certainty and help to assure that these contracts are benefits of the proposed interpretive thereby reduce costs. bona fide forwards. guidance regarding the forward contract The clarification that certain In addition, the interpretation should exclusion and the withdrawal of the contractual provisions do not disqualify result in the appropriate classification of Energy Exemption for market transactions from the forward exclusion transactions as commercial participants, markets and the public. also should reduce costs to the industry merchandising transactions (and thus Several commenters requested that by providing increased legal certainty forward contracts) that are not subject to the CFTC codify its proposed guidance that these provisions will not render Title VII regulation. This will enhance regarding the forward contract exclusion their transactions subject to Dodd-Frank in rule text to provide greater legal Act regulation. Similar cost reductions 1149 The CFTC believes that $20,000 represents a certainty, which they argued may should be achieved through enhanced reasonable estimate of the upper end of the range 1151 of the costs to undertake the legal analysis of the mitigate costs. However, upon legal certainty provided by the CFTC’s status of an agreement, contract, or transaction as consideration, the CFTC is not codifying interpretations of physical exchange a forward contract that qualifies for the forward its interpretation in rule text. As transactions, fuel delivery agreements, exclusions. The average cost incurred by market discussed in section II.B.2.(a)(i), above, and certain physical commercial participants in connection with assessing whether an agreement, contract, or transaction is a forward the CFTC has never codified its prior agreements, all of which may qualify for contract is based upon the estimated amount of interpretations of the forward contract the forward exclusions under these time that staff believes will be required for both in- exclusion with respect to the future interpretations. The interpretation house counsel and outside counsel to apply the delivery definition as a rule or regarding energy management definition. The staff estimates that costs associated with determining whether an agreement, contract, regulation. Publishing an interpretation agreements, which provides that the fact or transaction is a forward contract will range up in this release is consistent with the that a particular transaction is done to $20,000 after rounding to two significant digits. manner in which the CFTC has under the auspices of such agreements Staff estimates that some agreements, contracts, or interpreted the forward exclusion in the does not alter the nature of that transactions will clearly fall within the Brent safe harbor, and an internal attorney, without the past. The additional research costs transaction, should likewise enhance assistance of outside counsel, will be able to make associated with an interpretation as legal certainty and reduce costs. While a determination in less than one hour. Based upon opposed to codification in the Code of the CFTC’s interpretation regarding data from SIFMA’s Management & Professional Federal Regulations will be small, documentation of oral book-outs—that Earnings in the Securities Industry 2011 (modified by CFTC staff to account for an 1800-hour-work- because the CFTC has placed this an oral book-out be followed by a year and multiplied by 5.35 to account for bonuses, interpretation, and all other product confirmation in a commercially firm size, employee benefits and overhead), staff interpretations, in this adopting release reasonable time in written or electronic estimates that the average national hourly rate for for the convenience of practitioners. form—may impose costs for industries an internal attorney is $378. If an agreement, contract, or transaction is more complex, the CFTC Moreover, courts may rely upon agency that do not document their orally estimates the analysis will require approximately 20 interpretations; thus, the CFTC believes booked out transactions, the CFTC hours of in-house counsel time and 30 hours of that codification would not mitigate believes that this requirement is outside counsel time. The CFTC estimates the costs costs much. consistent with prudent business for outside legal services to be $400 per hour. Accordingly, on the high end of the range the CFTC estimates the cost to be $19,560 ($7,560 (based on 1150 If contracts are being used for speculative excluded from the Commission’s jurisdiction over 20 hours of in-house counsel time × $378) + $12,000 purposes they are probably swaps and should be swaps and futures will reduce this uncertainty and (based on 30 hours of outside counsel × $400) subject regulation under Title VII. the associated costs to end users.’’ (footnote which is then rounded to two significant digits to 1151 See BGA Letter; COPE Letter; ETA Letter; omitted)). $20,000. FERC Staff Letter; and Just Energy Letter.

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Some commenters1152 argued that example, price, quantity, delivery point, exclusion from the swap definition. physical options should be considered delivery date, contract term) that does Such an approach would be overbroad forward contracts excluded from the not permit a unilateral election of because it would exclude contracts that definition of a swap, because increased financial settlement based upon the are not appropriately classified as regulation would cause harm to value change in an underlying cash forwards. The commenter also requested physical commodity markets without market should not render the contract a that trade option exemptions be granted providing significant benefits. The swap.1156 While the commenter’s for physical commodities. The costs and statutory definition of ‘‘swap’’ provides approach with respect to ‘‘any’’ benefits of the trade option exemption that options—including physical embedded option may result in lower are addressed in that rulemaking. options—are swaps. Accordingly, the costs for market participants because Another commenter urged the CFTC CFTC may not exclude such options more contracts likely would be to broadly exempt commercial forward from the swap definition. Further, excluded as forwards from the swap contracting from swap regulation by treating physical options as forward definition and thus not be subject to generally excluding from the swap contracts would be inconsistent with regulation under the Dodd-Frank Act, definition any forward contract with longstanding CFTC precedent. such an expansive approach may embedded optionality between end Nonetheless, the CFTC has provided inappropriately classify contracts as users ‘‘whose primary purpose is relief using its plenary authority under forwards. The CFTC is providing an consistent with that of an ‘end user’, CEA Section 4c(b)1153 over commodity interpretation with respect to forwards and in which any embedded option is options through the trade option with embedded volumetric options to directly related to ‘end use.’ ’’1159 exemption. While certain capacity address commenters’ concerns. The While this alternative may appear to contracts on RTOs and ISOs and certain CFTC is also explaining its position be less costly than the CFTC’s contracts entered into by section 201(f) above regarding price optionality, interpretation, its vagueness may create entities may be considered options and optionality with respect to delivery significant legal uncertainty about the therefore would be swaps, regulation of points and delivery dates specifically in scope of the forward exclusion, which these contracts may be addressed response to the commenter’s letter, and may increase costs on market through the public interest waiver optionality as to certain contract terms participants. Even if this approach does process in CEA section 4(c)(6). (such as evergreen and renewal represent a lower cost alternative, Several commenters1154 argued that provisions) to address particular however, it is overbroad and likely renewable energy credits should not be concerns raised by commenters. would result in the inappropriate swaps; rather, renewable energy credits Another commenter suggested that an classification of transactions as forward should be considered nonfinancial option to purchase or sell a physical contracts, and thus would not achieve commodities eligible for the forward commodity, whether embedded in a the CFTC’s objective of appropriately exclusion from the swap definition. forward contract or stand alone, should classifying transactions that should They asserted that swap regulations either (i) fall within the statutory qualify for the forward exclusions. would raise transaction costs making it forward exclusion from the swap Another commenter believed that the more difficult and expensive to support definition, or (ii) alternatively, if CFTC’s ‘‘facts and circumstances’’ renewable energy. The CFTC is deemed by the CFTC to be a swap, approach to forwards with embedded clarifying that renewable energy credits should be exempt from the swap options does not provide the legal are nonfinancial commodities and that definition pursuant to a modified trade certainty required by nonfinancial transactions therein are eligible for the option exemption pursuant to CEA entities engaging in commercial forward exclusion if they satisfy the Section 4c(b).1157 Although this contracts in the normal course of terms thereof. So if these transactions proposal may on its face appear to be business.1160 The commenter further meet the forward exclusion, they will simpler than the CFTC’s, it is argued that many option-like contract bear no increased costs. substantively similar to the one the terms could be determined to ‘‘target the A commenter1155 requested that CFTC is adopting. The CFTC has delivery term’’ under a facts and tolling contracts be considered forwards modified the proposed interpretive circumstances analysis. Accordingly, and not swaps, seeking to avoid guidance regarding forwards with the commenter believed that the CFTC unnecessary cost of regulatory embedded options as discussed in should provide in its rules that an uncertainty and unintended conflict section II.B.2.(b)(ii) above; contracts embedded option or embedded between the CFTC and other regulators. with embedded options that are swaps optionality will not result in a The CFTC has not provided blanket under the final interpretation may nonfinancial forward being a swap interpretations regarding particular nevertheless qualify for the modified products in the rulemaking, but has trade option exemption recently 1159 See NMPF Letter. provided an interpretation regarding the adopted by the CFTC.1158 The CFTC is 1160 See ETA Letter at 19 n. 47. Similarly, COPE comments that a nonfinancial commodity forward forward contract exclusions provided not adopting an approach that forwards contract that, ‘‘by its terms,’’ is intended to settle above in section II.B.2. To the extent a with any type of embedded option physically should be permitted to contain commenter still is uncertain about the should fall within the statutory forward optionality without being transformed into a swap treatment of a specific type of unless such optionality negates the physical settlement element of the contract. That is, if one 1156 transaction, the commenter may request See COPE Letter, Appendix. party can exercise an option to settle the contract an interpretation from the CFTC. 1157 See WGCEF Letter; 7 U.S.C. 6c(b). financially based upon the value change in an Another commenter argued more 1158 See Commodity Options, 77 FR 25320, April underlying cash market, then the intent for physical generally that any embedded option (for 27, 2012. 17 CFR 32.3. Encana Marketing (USA) Inc. settlement is not contained in ‘‘the four corners of (‘‘Encana’’) believes that the guidance on forwards the contract’’ and may render the contract a swap. with embedded options should include embedded COPE Letter. While COPE’s approach may impose 1152 See Just Energy Letter; NEMA Letter; NGSA/ physical delivery options because it asserts that less costs on market participants (as more NCGA Letter; ONEOK Letter; and WGCEF Letter. many of the contracts currently used by participants transactions likely would qualify for the forward 1153 7 U.S.C. 6c(b). in the wholesale natural gas market contain an exclusion, as discussed in section II.B.2.(b)(ii), 1154 See 3Degrees Letter; AWEA Letter; CERP option for the physical delivery of natural gas. See above, the CFTC has eschewed approaches to the Letter; EMA Letter; GreenX Letter; PMAA/NEFI Encana Letter. To the extent that Encana’s comment forward exclusion that rely on the ‘‘four corners of Letter; REMA Letter; and WGCEF Letter. goes beyond volumetric optionality, commodity the contract,’’ which can provide a roadmap to 1155 See California Utilities Letter. options are discussed above in section II.B.2.(b)(i). evasion of statutory requirements.

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unless: (1) Delivery is optional; (2) future direct or indirect ownership respect to commercial transactions, the financial settlement is allowed; and (3) interest in the related loan; and (ii) the Commissions are adopting as proposed transfer and trading of the option loan participations are ‘‘true the interpretation that certain separately from the forward is participations’’ (the participant acquires commercial transactions involving permitted.1161 a beneficial ownership interest in the customary business arrangements The CFTC has long applied a facts underlying loans). One commenter (whether or not involving a for-profit and circumstances approach to the expressed concern with the second entity) would not be considered swaps forward exclusion, including with prong of the proposed guidance. or security-based swaps. The respect to forwards with embedded Specifically, the commenter said that Commissions also are clarifying that options, an approach with which market the ‘‘true participation’’ requirement commercial loans by the Federal Home participants are familiar. That approach may result in the improper classification Loan Banks and Farm Credit Institutions balances the need for legal certainty of loan participations as swaps, because are not swaps. Finally, the Commissions against protecting market participants, LMA-style loan participations may not are explaining the factors characteristic market integrity and the risk of qualify. Moreover, because of legal of consumer and commercial providing opportunities for evasion.1162 uncertainty associated with the ‘‘true transactions that the Commissions will By contrast, the commenter’s bright-line participation’’ terminology derived from consider in determining whether other approach may be simpler to apply, but U.S. bankruptcy law, LSTA-style loan consumer and commercial transactions could undermine market integrity and participations may be subject to that are not specifically listed in the creates greater evasion opportunities. improper classification as well. The interpretation should be considered Moreover, the CFTC’s additional commenter proposed an alternative test swaps or security-based swaps. interpretation noted above, including described in section II.B.3., above. (a) Costs clarification about the meaning of the The Commissions largely are adopting phrase ‘‘target the delivery term,’’ and the recommendation from the The CFTC believes that the forgoing forwards with embedded volumetric commenter regarding the Commissions’ interpretation should mitigate costs optionality, provides enhanced legal proposed guidance concerning loan because it increases legal certainty that certainty in response to the commenter’s participations as not swaps or security- specific customary consumer and concerns, which should mitigate the based swaps, with certain commercial transactions are not swaps costs of the CFTC’s approach to market modifications. This reduces costs for or security-based swaps subject to participants.1163 market participants because the Dodd-Frank regulation. As a result of Another commenter 1164 stated its Commissions’ test for loan this interpretation, consumers and view that the full costs of applying the participations from the proposal industry participants will not have to Dodd-Frank regulatory apparatus to included a ‘‘true participation’’ seek legal advice regarding whether physical energy transactions, or of requirement that commenters suggested these transactions are swaps or security- energy companies being forced to is subject to legal uncertainty. Benefits based swaps. The interpretation abandon full-requirements bilateral of the rule include enhanced legal regarding commercial loans made by the contracting will significantly increase certainty that loan participations that Federal Home Loan Banks and Farm the costs to be paid by U.S. consumers. meet the requirements of the Credit Institutions also reduces costs by The CFTC is sensitive to these concerns. interpretation are not swaps, which not subjecting these transactions to The CFTC is providing relief for full- should facilitate loan participation additional Dodd-Frank Act regulation. requirements contracts so long as they market activity. To the extent a customary consumer or satisfy the conditions set forth in the commercial transaction is not included 6. Interpretation Regarding Commercial/ in the interpretation, consumers and interpretation. Consumer Transactions The CFTC is also providing relief for market participants may incur costs in other types of physical energy contracts The Commissions are stating that seeking an interpretation from the that may qualify for the forward certain customary consumer and Commissions regarding the status of exclusions. Separately, the CFTC has commercial transactions that have not their transactions or an opinion of provided relief for trade options in previously been considered swaps or counsel. However, the CFTC has another rulemaking.1165 security-based swaps do not fall within emphasized that the lists are not the statutory definitions of those terms. exclusive, and has provided the factors 5. Loan Participations Specifically with regard to consumer it will consider for determining whether In the Proposing Release, the transactions, the Commissions are other consumer and commercial Commissions proposed guidance that adopting as proposed the interpretation transactions that are not specifically they do not interpret the swap and that certain transactions entered into by listed in the interpretation should be security-based swap definitions to consumers (natural persons) as considered swaps or security-based include loan participations in which: (i) principals or their agents primarily for swaps, which should assist consumers The purchaser is acquiring a current or personal, family or household purposes and market participants in deciding would not be considered swaps or whether to seek an interpretation and 1161 See ETA Letter. security-based swaps. The Commissions thus mitigate these costs. 1162 See also NCFC Letter (supporting the CFTC’s have added to the list of consumer guidance because it provides legal certainty). transactions certain residential fuel (b) Benefits 1163 See also Commodity Options, 77 FR 25320, storage contracts; service contracts; The foregoing interpretation provides 25324 n. 25, April 27, 2012 (discussing the CFTC’s conclusion that an ‘‘option[] to redeem’’ under the consumer options to buy, sell or lease increased legal certainty benefits for USDA Commodity Credit Corporation’s marketing real or personal property; and certain market participants and should ensure loan program constitutes a cotton producer’s consumer guarantees of loans (credit that customary consumer and contractual right to repay its marketing loan and cards, automobile, and mortgage). The commercial transactions, which have ‘‘redeem’’ the collateral (cotton) to sell in the open market). Commissions have also clarified that never been considered swaps or 1164 See IECA II Letter. consumer transactions used to purchase security-based swaps, will not be 1165 See Commodity Options, 77 FR 25320, April nonfinancial energy commodities are subject to Dodd-Frank Act regulation, 27, 2012. not swaps or security-based swaps. With and may facilitate consumer and

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commercial activity. As discussed A commenter 1168 asserted that The Commissions do not consider the above, the interpretation regarding the Federal courts will have to hear more REP transactions described by the factors that the Commissions will disputes, because proposed CFTC commenter to be swaps or security- consider in determining whether jurisdiction would pre-empt significant based swaps. Consequently, this transactions that are not listed in the aspects of state and Federal law rulemaking clarifies that Dodd-Frank interpretation are swaps or security- concerning the purchase and sale of regulatory costs will not be imposed on based swaps should assist market goods and services. This rulemaking REPs and allows the subsidy to continue participants in determining whether to includes safe-harbors from the to be provided to residential and small seek an interpretation regarding such definition of a swap for customary farm utilities. transactions. Therefore, this consumer and commercial transactions. 8. Costs and Benefits of Rule Regarding interpretation helps to mitigate costs of The Commissions have expanded the Foreign Exchange Products and Forward legal uncertainty. list of consumer transactions that are Rate Agreements excluded from the swap definition. (c) Comments and Consideration of While it may be possible that Federal CFTC rule 1.3(xxx)(2) under the CEA Alternatives courts will nevertheless hear more explicitly defines the term ‘‘swap’’ to Several commenters believed that the disputes, that would be a result of the include an agreement, contract, or proposed interpretive guidance statutory swap definition and not from transaction that is a cross-currency regarding consumer/commercial the interpretation being adopted by the swap, currency option, foreign currency transactions does not provide sufficient Commissions (which should reduce the option, foreign exchange option, foreign legal certainty and request that the number of such disputes). exchange rate option, foreign exchange Commissions codify such guidance in Another commenter 1169 agreed with forward, foreign exchange swap, regulations in order to provide greater the general factors proposed for forward rate agreement, and non- legal certainty, which may mitigate identifying agreements, contracts, or deliverable forward involving foreign costs.1166 The Commissions decline to transactions that are not swaps, but exchange, unless such agreement, codify the interpretation into rule text. requested additional clarity with respect contract, or transaction is otherwise The interpretation is intended to to particular transactions. Specifically, excluded by section 1a(47)(B) of the provide guidance to assist consumers the commenter requested that CEA. Rule 1.3(xxx)(3) provides that: (i) and commercial and non-profit entities commercial loans and financing A foreign exchange forward or a foreign in evaluating whether certain facilities with embedded interest rate exchange swap shall not be considered arrangements that they enter into will be options should not be considered a swap if the Secretary of the Treasury regulated as swaps or security-based swaps. To clarify, interest rate options makes the determination described in swaps. The interpretation is intended to are swaps. As discussed in section CEA section 1a(47)(E)(i); and (ii) allow the flexibility necessary, II.B.3. above, plain vanilla interest rate notwithstanding any such including the consideration of the options embedded in a loan, such as determination, certain provisions of the applicable facts and circumstances by rate locks, rate caps and rate collars, are CEA will apply to such a foreign the Commissions, in evaluating not swaps. If a product is more complex, exchange forward or foreign exchange consumer and commercial arrangements it may be appropriate for the CFTC to swap (specifically, the reporting to ascertain whether they may be swaps consider it in response to a specific requirements in section 4r of the or security-based swaps. The request for interpretation. CEA 1174 and regulations thereunder representative characteristics and and, in the case of a swap dealer or factors taken together are indicators that 7. Residential Exchange Program major swap participant that is a party to a consumer or commercial arrangement (‘‘REP’’) a foreign exchange swap or foreign is not a swap or security-based swap, The REP 1170 was established by exchange forward, the business conduct and the Commissions have provided Congress ‘‘[t]o extend the benefits of low standards in section 4s of the CEA 1175 specific examples demonstrating how cost Federal System hydro power to and regulations thereunder). Rule these characteristics and factors apply to residential and small farm electric 1.3(xxx)(3) further clarifies that a some common types of consumer and power consumers throughout the Pacific currency swap, cross-currency swap, commercial arrangements. However, as Northwest Region.’’ 1171 A commenter currency option, foreign currency the interpretation is not intended to be requests that the CFTC further define option, foreign exchange option, foreign a bright-line test for determining the term ‘‘swap’’ to exclude consumer exchange rate option, or non-deliverable whether a particular consumer or benefits under the Pacific Northwest forward involving foreign exchange is commercial arrangement is a swap or Electric Power Planning and not a foreign exchange forward or security-based swap, if the particular Conservation Act of 1980 (‘‘Northwest foreign exchange swap subject to a arrangement does not meet all of the Power Act’’) 1172 and transactions under determination by the Secretary of the identified characteristics and factors, the REP 1173 to allow a subsidy to Treasury as described in the preamble. the arrangement will be evaluated based continue to be received by residential The Commissions are also clarifying on its particular facts and and small farm utilities. that a bona fide foreign exchange spot circumstances. Also, the courts may rely transaction, i.e., a foreign exchange on the interpretation and as such, the Code of Federal Regulations will be small, because transaction that is settled on the CFTC does not believe that the adoption the CFTC has placed this interpretation, and all customary timeline 1176 of the relevant other products interpretations, in this adopting of rule text as opposed to an release for the convenience of practitioners. 1174 7 U.S.C. 6r. interpretation will mitigate costs 1168 See IECA Letter. 1175 7 U.S.C. 6s. associated with perceived legal 1169 See FCC Letter. 1176 As discussed in section II.C.2.(c) above, in 1167 1170 uncertainty. The BPA refers to the implementation of general, a foreign exchange transaction will be Section 5(c) of the Northwest Power Act, 16 U.S.C. considered a bona fide spot transaction if it settles 1166 See ETA Letter; ICEA Letter; and Just Energy 839c(c), as the ‘‘Residential Exchange Program.’’ via an actual delivery of the relevant currencies Letter. 1171 Id. at 3. within two business days. However a foreign 1167 The additional research costs associated with 1172 16 U.S.C. Chapter 12H. exchange transaction with a longer settlement an interpretation as opposed to codification in the 1173 See Bonneville Letter. Continued

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spot market, is not within the definition the Secretary of the Treasury makes In addition, including certain FX of the term ‘‘swap.’’ In addition, the such a determination, certain transactions, forward rate agreements interpretation clarifies that retail foreign agreements, contracts, or transactions and certain other transactions in the currency options described in CEA would be swaps. Rule 1.3(xxx)(3) swap definition protects the public by Section 2(c)(2)(B) are not swaps. This increases legal certainty that a currency explicitly subjecting these transactions clarification allows market participants swap, cross-currency swap, currency to Dodd-Frank regulation. to engage in these transactions with option, foreign currency option, foreign (c) Comments and Consideration of non-ECP customers who would exchange option, foreign exchange rate Alternatives otherwise have to engage in on- option, or non-deliverable forward exchange transactions. involving foreign exchange, is a swap The CFTC requested comment as to the costs and benefits of proposed rules (a) Costs (unless it is otherwise excluded by the statutory definition of the term ‘‘swap’’). 1.3(xxx)(2) and (3). As discussed in the In complying with rule 1.3(xxx)(2), a The rule also increases legal certainty preamble, some commenters 1178 argued market participant will need to ascertain that reporting requirements, and that non-deliverable foreign exchange whether an agreement, contract, or business conduct requirements for swap forward transactions should be transaction is a swap under the dealers and major swap participants, are regulated as foreign exchange forwards, definition. This analysis will have to be applicable to foreign exchange forwards because regulating them as swaps would performed upon entering into the and foreign exchange swaps even if the increase the cost of hedging foreign agreement, contract, or transaction. Secretary of the Treasury determines currency exposures in emerging However, any costs associated with this that they should not be considered markets. analysis are expected to be less than the swaps, and is consistent with the Non-deliverable forward transactions costs of doing the same analysis absent statute. The CFTC also is concerned that do not satisfy the statutory definition of the rule, particularly given potential confusion could be generated by the foreign exchange forwards, as explained confusion in the event of a ‘‘forward’’ label of non-deliverable in section II.C.2.(b)(ii), supra. They do determination by the Secretary of the forwards involving foreign exchange, satisfy the swap definition, however. Treasury that foreign exchange forwards and forward rate agreements. Rule Accordingly, the CFTC lacks discretion and/or foreign exchange swaps not be 1.3(xxx)(2) increases legal certainty that not to define them as swaps. considered swaps. To the extent that these types of agreements, contracts, 9. Costs and Benefits of Rule Regarding rule 1.3(xxx)(2) improperly includes and transactions are swaps. certain types of agreements, contracts, Title VII Instruments on Futures on Providing such a rule to market and transactions in the swap definition, Foreign Sovereign Debt Under Exchange participants to determine whether and therefore the imposition of Act Rule 3a12–8 certain types of agreements, contracts, additional requirements and obligations, or transactions are swaps alleviates Rule 1.3(bbbb) provides that a Title these requirements and obligations additional costs to persons of inquiring VII instrument that is based on or could lead to costs for market with the Commissions, or obtaining an references a qualifying foreign futures participants entering into such opinion of counsel, about whether such contract on the debt securities of one or agreements, contracts, or transactions. agreements, contracts, or transactions more of the 21 enumerated foreign However, the CFTC has carefully are swaps. In addition, such a rule governments is a swap and not a considered each of the agreements, regarding the requirements that apply to security-based swap if the Title VII contracts and transactions described foreign exchange forwards and foreign instrument satisfies the following above that it is further defining as swaps exchange swaps that are subject to a conditions: under rule 1.3(xxx)(2) and believe that • The futures contract on which the determination by the Secretary of the they are appropriately classified as Title VII instrument is based or that is Treasury similarly alleviates additional such, subject to the statutory exclusions. referenced must be a qualifying foreign costs to persons of inquiring with the futures contract (as defined in rule (b) Benefits Commissions, or obtaining an opinion 3a12–8) on the debt securities of any of counsel, to determine the Because the statutory definition of the one or more of the 21 enumerated requirements that are applicable to such term ‘‘swap’’ includes a process by foreign governments that satisfies the foreign exchange forwards and foreign which the Secretary of the Treasury may conditions of rule 3a12–8; exchange swaps. As with the other rules determine that certain agreements, • The Title VII instrument is traded comprising the Product Definitions, contracts, and transactions that meet the on or through a board of trade (as enhanced legal certainty will help statutory definition of a ‘‘foreign defined in section 1a(6) of the CEA); exchange forward’’ or ‘‘foreign exchange market participants to engage in sound • The debt securities on which the swap,’’ respectively,1177 shall not be risk management practices, which will qualifying foreign futures contract is considered swaps, the CFTC is benefit both market participants and the based or referenced and any security concerned that application of the public. used to determine the cash settlement definition, without further clarification, The interpretation concerning bona amount pursuant to the fourth condition may cause uncertainty about whether, if fide foreign exchange spot transactions below are not registered under the should result in the appropriate Securities Act or the subject of any period concluding with the actual delivery of the classification of such transactions as not American depositary receipt registered relevant currencies may be considered a bona fide subject to Dodd-Frank Act regulation. under the Securities Act; spot transaction depending on the customary The interpretation regarding retail • timeline of the relevant market. In particular, a The Title VII instrument may only foreign exchange transaction that is entered into foreign currency options subject to CEA be cash settled; and solely to effect the purchase or sale of a foreign Section 2(c)(2)(B) as not swaps provides • The Title VII instrument is not security is a bona fide spot transaction where clarity and reduces costs for market entered into by the issuer of the certain conditions are met. participants, who could not offer the 1177 CEA section 1a(24), 7 U.S.C. 1a(24)(definition securities upon which the qualifying of a ‘‘foreign exchange forward’’); CEA section product to non-ECP customers off- 1a(25), 7 U.S.C. 1a(25)(definition of a ‘‘foreign exchange in accordance with the 1178 See CEIBA Letter; Covington Letter; ISDA exchange swap’’). provisions of CEA Section 2(c)(2)(B). Letter; and MFA Letter.

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foreign futures contract is based or cross-margining would enhance sound securities in a narrow-based security referenced (including any security used risk management practices. index. to determine the cash payment due on The CFTC believes that the Rule 1.3(yyy)(1) under the CEA settlement of such Title VII instrument), assessment cost associated with provides that, for purposes of the an affiliate (as defined in the Securities determining whether a swap on certain security-based swap definition, the term Act and the rules and regulations futures contracts on foreign government ‘‘narrow-based security index’’ would thereunder) 1179 of the issuer, or an securities constitute a swap or security- have the same meaning as the statutory underwriter with respect to such based swap under rule 1.3(bbbb) should definition set forth in CEA section securities. be minimal. Currently, qualifying 1a(35), and the rules, regulations, and Only those Title VII instruments that foreign futures contracts on debt orders issued by the Commissions are based on qualifying foreign futures securities of the 21 enumerated foreign relating to such definition. As a result, contracts on the debt securities of the 21 governments are traded on exchanges or except where the new rules the enumerated foreign governments and boards of trade. Market participants may Commissions are adopting provide for that satisfy these five conditions will be look at the exchange or board of trade other treatment, market participants swaps. The final rules are intended to listing to determine what they are. generally will be able to use the provide consistent treatment (other than Therefore, the assessment, in Commissions’ past guidance in with respect to method of settlement) of accordance with the rule, would determining whether certain Title VII qualifying foreign futures contracts and primarily focus on whether such swap instruments based on a security index are swaps or security-based swaps. Title VII instruments based on itself is traded on or through a board of The Commissions are promulgating qualifying foreign futures contracts on trade; whether the swap is cash-settled; whether the futures is traded on a board additional rules and providing the debt securities of the 21 enumerated interpretations regarding Title VII 1180 of trade; whether any security used to foreign governments. The instruments based on a security index. determine the cash settlement amount Commissions understand that many of The interpretations and additional rules are not registered under the Securities the qualifying foreign futures contracts set forth new narrow-based security Act or the subject of any American on the debt securities of the 21 index criteria with respect to indexes depositary receipt registered under the enumerated foreign governments trade composed of securities, loans, or issuers Securities Act; and whether the swap is with substantial volume through foreign of securities referenced by an index entered into by the foreign government trading venues under the conditions set CDS. The interpretations and rules also 1181 issuing the debt securities upon which forth in rule 3a12–8 and permitting address the definition of an ‘‘index’’ and the qualifying futures contract is based swaps on such futures contracts subject the treatment of broad-based security or referenced, an affiliate of such foreign to similar conditions would not raise indexes that become narrow-based and concerns that such swaps could be used government or an underwriter of such narrow-based indexes that become to circumvent the conditions of rule foreign government securities. All of broad-based, including rule provisions 3a12–8 and the Federal securities laws these determinations may be readily and regarding tolerance and grace periods concerns that such conditions are quickly ascertained by the parties for swaps on security indexes that are 1182 intended to protect. Further, entering into the agreement, contract, or traded on CFTC-regulated and SEC- providing consistent treatment for transaction. Therefore, the assessment regulated trading platforms. qualifying foreign futures contracts on costs associated with rule 1.3(bbbb) the debt securities of the 21 enumerated should be nominal because parties (a) Costs foreign governments and Title VII should be able to make assessments in In complying with the rules and instruments based on futures contracts less than an hour. interpretations, a market participant on the debt securities of the 21 10. Costs and Benefits of Rules and will need to ascertain whether a Title enumerated foreign governments will Interpretations Regarding Title VII VII instrument is a swap or a security- allow trading of these instruments Instruments Where the Underlying based swap according to the criteria set through DCMs on which such futures Reference Is a Security Index forth in the definitions of the terms are listed. There may also be cross- ‘‘issuers of securities in a narrow-based margining benefits when different Historically, the market for index CDS security index’’ and ‘‘narrow-based contracts are margined at the same did not divide along jurisdictional security index’’ as used in the security- derivatives clearing organization, such divisions between the CFTC and based swap definition. This analysis as may be the case if a swap on a futures SEC; 1183 however, the Dodd-Frank Act will have to be performed prior to the contract and a corresponding futures created a jurisdictional divide between execution of, but no later than an offer contract trade on the same DCM. This swaps and security-based swaps. Under to enter into, a Title VII instrument, and the jurisdictional division, the CFTC has when the material terms of a Title VII 1179 See, e.g., rule 405 under the Securities Act, jurisdiction over Title VII instruments instrument are amended or modified, to 17 CFR 230.405. based on non-narrow-based security ensure compliance with rules 1.3(yyy), 1180 The Commissions note that the final rules indexes while the SEC has jurisdiction 1.3(zzz) or 1.3(aaaa). provide consistent treatment of qualifying foreign over Title VII instruments based on futures contracts on the debt securities of the 21 However, any such costs are expected enumerated foreign governments and Title VII narrow-based security indexes. The SEC to be less than the costs of doing the instruments based on qualifying foreign futures also has jurisdiction over Title VII same analysis absent the rules, which contracts on the debt securities of the 21 instruments based on a single security the CFTC believes would be more enumerated foreign governments unless the Title or loan, and certain events related to an VII instrument is entered into by the issuer of the difficult and lead to greater uncertainty. securities upon which the qualifying foreign futures issuer of securities or issuers of In particular, rule 1.3(yyy) allows contract is based or referenced (including any market participants to reduce the costs security used to determine the cash payment due 1183 For example, index CDS and single name of determining whether a Title VII on settlement of such Title VII instrument), an CDS have typically been traded on the same trading instrument based on a security index, affiliate of the issuer, or an underwriter with respect desk, and customers have typically held their to such securities. positions in a single account. The CFTC notes that other than an index CDS, is a swap or 1181 See supra note 716 and accompanying text. the jurisdictional divide will impact among other security-based swap by clarifying that 1182 See supra note 712 and accompanying text. things portfolio margining. they will be able to use the

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Commissions’ past guidance regarding costs of obtaining the services of outside rules benefit the public by requiring that narrow-based security index in making professional in undertaking the the providers of index CDS make that determination. In the context of analysis.1185 The CFTC believes that publicly available sufficient information index CDS, the Commissions’ past some index CDS based on an regarding the reference entities in an guidance regarding narrow-based established index would not need the index underlying the index CDS. By security indexes does not establish assistance of outside counsel, and a requiring that such information be made criteria on whether index CDS is a swap determination can be made in less than publicly available, rules 1.3(zzz) and or a security-based swap. Accordingly, one hour. If an agreement, contract, or 1.3(aaaa) seek to assure the transparency without further explanation, it would transaction is more complex, the CFTC of the index components that will be not be clear on which side of the CFTC/ estimates the analysis will require up to beneficial to market participants who SEC jurisdictional divide index CDS approximately 20 hours of in-house trade such instruments and to the would fall. CFTC rules 1.3(zzz) and counsel time and 30 hours of outside public. 1.3(aaaa) allow market participants to counsel time. Separately, rule 1.3(yyy) addresses exchange-traded swaps based on reduce the costs of determining whether (b) Benefits an index CDS is a swap or a security- security indexes where the underlying based swap by providing a test with Rules 1.3(zzz) and 1.3(aaaa) clarify the index migrates from broad-based to objective criteria that is similar to a test treatment of an index CDS as either a narrow-based. The rule includes with which they already are familiar in swap or a security-based swap by setting provisions that many market the security futures context, yet tailored forth objective criteria for meeting the participants are familiar with from to index CDS in particular. definition of the terms ‘‘issuers of security futures trading. The CFTC Additionally, absent rule 1.3(yyy), securities in a narrow-based security believes that by using a familiar which applies the tolerance period index’’ and ‘‘narrow-based security regulatory scheme, market participants rules, if a security index underlying a index,’’ respectively. These objective will be able to more readily understand Title VII instrument traded on a trading rules alleviate additional costs to the rule as compared to a wholly new platform migrated from being broad- persons trading index CDS of inquiring regulatory scheme. Also, the use of a based to being narrow-based, market with the Commissions, or obtaining an ‘‘tolerance period’’ for swaps on security participants may suffer disruption of opinion of counsel, to make complex indexes that migrate from broad-based their ability to offset or enter into new determinations regarding whether an to narrow-based also creates greater Title VII instruments, and incur index is broad- or narrow-based, and clarity by establishing a 45-day additional costs as a result. whether an index CDS based on such an timeframe (and subsequent grace DCMs and SEFs will incur costs in underlying index is a swap or security- period) on which market participants assessing whether an index underlying based swap. may rely. This tolerance period results a Title VII instrument is broad-based, in Also, rules 1.3(zzz) and 1.3(aaaa) in cost savings when compared to the monitoring the index for migration from should reduce the potential for market alternative scenario where no tolerance broad to narrow-based. There will also participants to use an index CDS to period is provided and a migration of an be other costs resulting from the evade regulations, because they set index from broad-based to narrow-based migration such as delisting costs. Such objective requirements relating to the would result in potential impediments migration costs are mitigated by the concentration of the notional amount to the ability of market participants to tolerance period of 45 business days allocated to each reference entity or offset their swap positions. over three calendar months which security included in the index, as well Finally, the Commissions are stating should reduce the incidence of as the eligibility conditions for reference that the determination of whether a migration. Similarly, the three-month entities and securities. Finally, these Title VII instrument is a swap, a security-based swap, or both (i.e., a grace period following an indexes 1185 The average cost incurred by market mixed swap), is made prior to the failure of the tolerance period should participants in connection with assessing whether execution of, but no later than an offer mitigate delisting and other costs. There an agreement, contract, or transaction is a swap or to enter into, the Title VII instrument. If will be a range of assessment costs security-based swap is based upon the estimated the security index underlying a Title VII depending on how customized the amount of time that staff believes will be required for both in-house counsel and outside counsel to instrument migrates from being broad- index underlying an index CDS is.1184 apply the definition. The staff estimates that costs based to being narrow-based, or vice In determining whether a Title VII associated with determining whether an agreement, versa, during the life of a Title VII instrument is a swap or a security-based contract, or transaction is a swap or security-based instrument, the characterization of that swap, market participants will need to swap will range up to $20,000 after rounding to two significant digits. Staff estimates that some index Title VII instrument would not change apply the criteria found in CFTC rules CDS will be standard and an internal attorney, from its initial characterization 1.3(yyy), 1.3(zzz) and 1.3(aaaa). Market without the assistance of outside counsel will be regardless of whether the Title VII participants may conduct such analysis able to make a determination in less than one hour. instrument was entered into bilaterally in-house or employ outside third-party Based upon data from SIFMA’s Management & or was executed through a trade on or service providers to conduct such Professional Earnings in the Securities Industry 2011 (modified by CFTC staff to account for an subject to the rules of a DCM, SEF, analysis. The costs associated with 1800-hour-work-year and multiplied by 5.35 to FBOT, security-based SEF, or NSE. obtaining such outside professional account for bonuses, firm size, employee benefits and overhead), staff estimates that the average Absent this interpretation, market services would vary depending on the participants potentially would need to relevant facts and circumstances, national hourly rate for an internal attorney is $378. If an agreement, contract, or transaction is more expend additional resources to particularly the composition of the complex, the CFTC estimates the analysis will continually monitor their swaps to see index. The CFTC believes, however, that require approximately 20 hours of in-house counsel if the indexes on which they are based $20,000 represents a reasonable estimate time and 30 hours of outside counsel time. The CFTC estimates the costs for outside legal services have migrated from broad-based to of the upper end of the range of the to be $400 per hour. Accordingly, on the high end narrow-based. Since the rule provides of the range the CFTC estimates the cost to be that the initial determination prevails 1184 Additionally, the number of components in $19,560 ($7,560 (based on 20 hours of in-house an index may impact the assessment costs based on counsel time × $378) + $12,000 (based on 30 hours regardless of whether the underlying having to determine whether the indexes of outside counsel x $400) which is then rounded index migrates from broad-based to components satisfy the various tests within the rule. to two significant digits to $20,000. narrow-based, market participants do

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not need to expend these monitoring commenter 1189 believed that the public believe that the three-month grace costs. information availability test will cause period is similarly appropriate to apply indices to switch between narrow-based in the context of an index that has (c) Comments and Consideration of and broad-based classification, which migrated to provide sufficient time to Alternatives could result in unnecessary cost, execute off-setting positions. With A commenter asserted that the confusion, and market disruption. respect to the commenter’s other regulatory complexity for index CDS is The statutory framework requires suggestion that entities operating both a not worth the high compliance delisting and relisting. These costs are SEF and a security-based SEF should be costs.1186 The statute provides that the mitigated by the tolerance period for able to move the index from one CFTC has jurisdiction over swaps on migration, which may help to prevent platform to another where an index CDS broad-based security indices, and the frequent migration of indices from migrates simply by filing a notice with SEC has jurisdiction over swaps on broad-based to narrow-based or vice the SEC and CFTC, the Commissions do narrow-based security indices, single versa. Moreover, it is the case for both not believe that this proposal is within securities or loans, and certain events on and off-exchange Title VII the scope of this rulemaking. related to the issuers of securities. The instruments that the Commissions are Many commenters offered alternatives Commissions need to establish criteria stating that the determination of to the various tests in proposed rules for index CDS, because their past whether a Title VII instrument on a 1.3(zzz) and 1.3(aaaa).1192 As discussed guidance regarding narrow-based security index is a swap or security- more fully above in Section III.G.3.(b), security indices does not address them. based swap is made prior to execution, the Commissions have incorporated Without further explanation, it would but no later than the offer to enter into many of the suggested alternatives into not be clear on which side of the CFTC/ the instrument, and remains the same the final rules and interpretations and SEC jurisdictional division certain throughout the life of the instrument. rejected, after careful consideration, products would fall. The number and Accordingly, even if the public other suggested alternatives. For concentration limits are derived from information availability test would example, three commenters requested criteria that Congress has imposed in cause indexes underlying index CDS to that the Commissions revise the the security futures context. The public migrate as suggested by a commenter, affiliation definition that applies when information availability test does not that will not affect the classification of calculating the number and require that index constituents satisfy outstanding index CDS entered into concentration criteria to require a all of its requirements; rather, the prior to such migration. However, if an majority control affiliation threshold, constituents may satisfy any one of amendment or change is made to such rather than the 20 percent threshold in them for the index to be broad-based, outstanding index CDS that would the proposed rules.1193 As discussed in and there is a de minimis level for cause it to be a new purchase or sale of section III.G.3.(b) above, the noncompliance. such index CDS, that could affect the Commissions are modifying the Another commenter 1187 stated that classification of such outstanding index affiliation definition that applies when the proposed interpretation needs to be CDS. calculating the number and clearer on loan-based swap transactions A commenter asserted that extending concentration criteria in response to and that it is costly to determine the ‘‘grace period’’ from three months to commenters to use an affiliation test whether a particular set of loans or six months would ease any disruption based on majority ownership. Based on borrowers meets the Commissions’ or dislocation associated with the commenters’ letters, the Commissions public information availability delisting process with respect to an understand that the current standard requirement. The Commissions are index that has migrated from broad to CDS documentation and the current clarifying that a TRS on two or more narrow, or narrow to broad, and that has approach used by certain index loans is not subject to the broad-based/ failed the tolerance period.1190 The providers for index CDS with respect to narrow-based jurisdictional divide, but commenter further suggested that where the inclusion of affiliated entities in the is a swap under the CFTC’s jurisdiction. an index CDS migrates, for entities same index use majority ownership With respect to loan index CDS, the operating both a SEF and a security- rather than 20 percent ownership to Commissions believe that the index CDS based SEF, such entities should be determine affiliation. The Commissions rules, including the public information permitted to move the index from one are persuaded by commenters that in availability requirement, should apply platform to the other simply by the case of index CDS only it is more to indexes of loans underlying index providing a notice to the SEC and CFTC. appropriate to use majority ownership CDS. However, the Commissions are The Commissions are adopting the because majority-owned entities are amending the proposed rules to include proposed rules without modification. As more likely to have their economic loans within the categories of discussed in Section III.G.5(b) above, interests aligned and be viewed by the instruments to be aggregated for the the Commissions note that the three- market as part of a group. The total principal amount of debt month grace period applicable to Commissions believe that revising the outstanding threshold of the public security futures was mandated by affiliation definition in this manner for 1191 information availability requirement, Congress in that context, and the purposes of calculating the number and and will aggregate outstanding debt of commenter has provided no data or concentration criteria responds to affiliates for purposes of the test, which evidence for its request that the commenters’ concerns that the the CFTC believes should address the Commissions diverge from that grace percentage control threshold may commenter’s concerns. period and provide for a longer grace inadvertently include entities that are A commenter 1188 pointed out that period with respect to swaps and not viewed as part of a group. Thus, as there may be costs to relist index-based security-based swaps. The Commissions revised, the affiliation definition will CDS when the index stops being, or include only those reference entities or 1189 becomes, broad-based. Another See Markit Letter. issuers included in an index that satisfy 1190 See MarketAxess Letter. 1191 See July 2006 Debt Index Rules. The 1186 See ISDA Letter. Commissions are not aware of any disruptions 1192 See section III.G.3.(b). 1187 See LSTA Letter. caused by the three-month grace period in the 1193 See ISDA Letter; Markit Letter; and SIFMA 1188 See MarketAxess Letter. context of security futures. Letter.

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the more than 50 percent (i.e., majority toward the $1 billion debt threshold to Once such a joint interpretation is ownership) control threshold. include any indebtedness, including made, however, other market Due to the high compliance costs loans, so long as such indebtedness in participants that seek to transact in the resulting from the public information not a revolving credit facility. same agreement, contract, or transaction availability test in particular, a In response to a request for comment (or class thereof) would have regulatory commenter 1194 argued that the by the Commissions, two commenters clarity about whether it is a swap, Commissions should abandon that test. believed that the presence of a third- security-based swap, or mixed swap, so The final rules retain the public party index provider would assure that the CFTC expects the aggregate costs of information availability test, which does sufficient information is available submitting joint interpretations to not present significant compliance costs regarding the index CDS itself, but decrease over time as joint because it does not require that neither commenter provided an analysis interpretations are issued and the constituents satisfy all of the to explain how or whether a third-party number of new requests decrease as a requirements and permits a de minimis index provider would be able to provide result. level of noncompliance. information about the underlying Separately, CFTC rule 1.9 under the One commenter offered an alternative securities or issuers of securities in the CEA allows persons to submit a request to the public information availability index.1198 Accordingly, the for a joint order from the Commissions test based on the volume of trading.1195 Commissions are not adopting this regarding an alternative regulatory After careful consideration and as alternative. treatment for particular mixed swaps. described more fully above in section A commenter 1199 argued that legal This process applies except with respect II.G.3.(b), above, the Commissions are uncertainty would present a burden to to bilateral, uncleared mixed swaps not adopting a volume based test either market participants absent the where one of the parties to the mixed as a replacement or alternative for the Commissions clarifying the status of swap is dually registered with the CFTC public information availability test. A swaps on shares of exchange traded as a swap dealer or major swap volume based test would not be readily funds that reference broad-based participant and with the SEC as a ascertainable with respect to certain security indices. However, market security-based swap dealer or major underlying components which are not participants can request a clarification security-based swap participant. With exchange traded or do not satisfy listing through the interpretation process respect to bilateral uncleared mixed standards. The public information established herein by the Commissions. swaps where one of the parties is a dual availability test allows for more registrant, the rule provides that such flexibility with respect to the II. Costs and Benefits of Processes To mixed swaps would be subject to the components included in indexes Determine Whether a Title VII regulatory scheme set forth in rule 1.9 underlying index CDS than a volume- Instrument is a Swap, Security-Based in order to provide clarity as to the based test. Individual components in an Swap, or Mixed Swap, and To regulatory treatment of such mixed index CDS may not satisfy a volume- Determine Regulatory Treatment for swaps. based test but could otherwise satisfy Mixed Swaps The CFTC estimates that the cost of one of the criteria of the public (a) Costs submitting a request for a joint order information availability test. The public seeking an alternative regulatory Rule 1.8 under the CEA allows information availability test is similar to treatment for a particular mixed swap persons to submit a request for a joint the test in the rules for debt security would be approximately $31,000.1201 interpretation from the Commissions indexes, which, as noted above, apply Absent such a process, though, market regarding whether an agreement, in the context of Title VII Instruments. participants that desire or intend to contract or transaction (or a class of The public information availability test, enter into such a mixed swap (or class agreements, contracts, or transactions) is accordingly, provides a consistent set of thereof) would be required pursuant to a swap, security-based swap, or mixed rules under which index compilers and swap. The CFTC estimates the cost of market participants can analyze the services to be $400 per hour. Accordingly, the CFTC submitting a request for a joint characterization of index CDS. estimates the cost to be $20,000 ($7,560 (based on interpretation pursuant to rule 1.8 20 hours of in-house counsel time × $378) + $12,000 In the public information availability × would be a cost of about $7,700 for (based on 30 hours of outside counsel $400) test, one commenter proposed moving rounded to two significant digits to $20,000 to the outstanding debt threshold from $1 internal company or individual time submit a joint request for interpretation. and associated costs of $12,000 for the 1201 billion to $100 million.1196 As stated This estimate is based on information services of outside professionals.1200 indicating that the average costs associated with above, the CFTC believes that the $1 preparing and submitting a no-action request to the billion debt threshold, which is the SEC staff in connection with the identification of 1198 See ISDA Letter and SIFMA Letter. whether certain products are securities, which the same amount as the outstanding debt 1199 See Anon. Letter. CFTC believes is a process similar to the process threshold in the rules for debt security 1200 This estimate is based on information under rule 3a68–4(c). The staff estimates that costs indexes, is set at the appropriate level indicating that the average costs associated with associated with such a request will cost to achieve the objective that such preparing and submitting a no-action request to the approximately $31,000. The CFTC estimates the entities are likely to have public SEC staff in connection with the identification of analysis will require approximately 30 hours of in- whether certain products are securities, which the 1197 house counsel time and 50 hours of outside counsel information available about them. CFTC believes is a process similar to the process time. Based upon data from SIFMA’s Management However, the adopted rules expand on under rule 1.8. The staff estimates that costs & Professional Earnings in the Securities Industry the types of debt that are counted associated with such a request will cost 2011 (modified by CFTC staff to account for an approximately $20,000. The CFTC estimates the 1800-hour-work-year and multiplied by 5.35 to analysis will require approximately 20 hours of in- account for bonuses, firm size, employee benefits 1194 See SIFMA Letter. house counsel time and 30 hours of outside counsel and overhead), staff estimates that the average 1195 See Markit Letter. time. Based upon data from SIFMA’s Management national hourly rate for an internal attorney is $378. 1196 Id. & Professional Earnings in the Securities Industry The CFTC estimates the costs for outside legal 1197 See supra part III.G.3(b)(iii); See Securities 2011 (modified by CFTC staff to account for an services to be $400 per hour. Accordingly, the CFTC Offering Reform, Release No. 33–8591 (Jul. 19, 1800-hour-work-year and multiplied by 5.35 to estimates the cost to be $31,000 ($11,340 (based on 2005), 70 FR 44722 (Aug. 3, 2005) (discussing account for bonuses, firm size, employee benefits 30 hours of in-house counsel time × $378) + $20,000 economic analysis involved in determining the $1 and overhead), staff estimates that the average (based on 50 hours of outside counsel × $400) billion threshold for non-convertible securities in national hourly rate for an internal attorney is $378. rounded to two significant digits to submit a joint the context of well-known seasoned issuers). The CFTC estimates the costs for outside legal request for interpretation.

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Title VII of the Dodd-Frank Act to disaggregation of mixed swaps into their CFTC rule 1.3(xxx)(6) under the CEA comply with all regulatory requirements separate components, as the Dodd-Frank defines as a swap any agreement, applicable to both swaps and security- Act specifically contemplated that there contract, or transaction that is willfully based swaps. The CFTC believes that would be mixed swaps comprised of structured to evade the provisions of the cost of such dual regulation would both swaps and security-based swaps. Title VII governing the regulation of likely be at least as great, if not greater, Moreover, the CFTC believes that swaps. Further, CFTC rule 1.6 under the than the costs of the process set forth in requiring market participants to CEA would prohibit activities rule 1.9 to request an alternative disaggregate their agreements, contracts, conducted outside the United States, regulatory treatment for such the mixed or transactions into swaps and security- including entering into agreements, swap. The rule regarding bilateral based swaps may limit the freedom of contracts, and transactions and uncleared mixed swaps where at least contract or discourage innovation of structuring entities, to willfully evade or one party is a dual registrant does not financial products and potentially attempt to evade any provision of the entail any additional costs, and may increase transaction costs for swap CEA as enacted by Title VII or the rules reduce costs for dual registrants that market participants. and regulations promulgated enter into such mixed swaps by thereunder. 12. Costs and Benefits of SBSA Books eliminating potentially duplicative or As opposed to providing a bright-line and Records, and Data, Requirements inconsistent regulation. test, rule 1.3(xxx)(6) would apply to CFTC rule 1.7 under the CEA would agreements, contracts, and transactions (b) Benefits clarify that there would not be books that are willfully structured to evade The CFTC believes that the rules that and records or data requirements and rule 1.6 would apply to entering enable market participants to submit regarding SBSAs other than those that into agreements, contracts, or requests for joint interpretations would exist for swaps. The rule transactions to evade (or as an attempt regarding the nature of various alleviates any additional books and to evade) and structuring entities to agreements, contracts, or transactions, records or information costs to persons evade (or as an attempt to evade) and requests for joint orders regarding who are required to keep and maintain subtitle A of Title VII governing the the regulatory treatment of mixed swaps books and records regarding, or collect regulation of swaps. Although this test will help to create a more level playing and maintain data regarding, SBSAs does not provide a bright line, it helps field (since the joint interpretations and because the rule does not require such ensure that would-be evaders cannot joint orders will be available to all persons to keep or maintain any books willfully structure their transactions or market participants) regarding which and records, or collect and maintain any entities for the purpose of evading the agreements, contracts, or transactions data, regarding SBSAs that differs from requirements of subtitle A of Title VII. constitute swaps, security-based swaps, the books, records, and data required The CFTC also is explaining some or mixed swaps, and the regulatory regarding swaps. circumstances that may constitute an treatment applicable to particular mixed Specifically, rule 1.7 would require evasion of the requirements of subtitle swaps. The joint interpretations and persons registered as SDRs to: i) keep A of Title VII, while at the same time joint orders will be available to all and maintain books and records preserving the CFTC’s ability to market participants. The availability of regarding SBSAs only to the extent that determine, on a case-by-case basis, with such joint interpretations and joint SDRs are required to keep and maintain consideration given to all the facts and orders regarding the scope of the books and records regarding swaps; and circumstances, that other types of definitions and the regulatory treatment ii) collect and maintain data regarding transactions or actions constitute an of mixed swaps will reduce transaction SBSAs only to the extent that SDRs are evasion of the requirements of the costs and thereby promote the use of required to collect and maintain data statute or the regulations promulgated Title VII instruments for risk regarding swaps. In addition, rule 1.7 thereunder. would require persons registered as management and other purposes. (a) Costs The product interpretation process swap dealers or major swap participants established by the Commissions has a to keep and maintain books and records, Market participants may incur costs 120-day deadline. This deadline will including daily trading records, when deciding whether a particular facilitate new products coming to regarding SBSAs only to the extent that transaction or entity could be construed market relatively quickly. Further, the those persons would be required to keep as being willfully structured to evade process holds the Commissions and maintain books and records subtitle A of Title VII of the Dodd-Frank accountable because they will have to regarding swaps. Act; however, the rules and related state why they are not providing an Because rule 1.7 imposes no interpretations explain what constitutes interpretation when they decline to do requirements with respect to SBSAs evasive conduct, which should serve to so. other than those that exist for swaps, mitigate such costs. rule 1.7 would impose no costs other (b) Benefits (c) Comments and Consideration of than those that are required with respect Alternatives to swaps in the absence of rule 1.7. Rule Absent the proposed anti-evasion A commenter 1202 recommended that 1.7 provides clarity by establishing rules and related interpretations, price the Commissions require that market uniform requirements regarding books discovery might be impaired because participants disaggregate mixed swaps and records, and data collection, markets would not be informed about and enter into separate simultaneous requirements for swaps and for SBSAs. those transactions, since through transactions so that they cannot employ No comments were received with evasion such transactions would not mixed swaps to obscure the underlying respect to Rule 1.7. comply with Dodd-Frank Act regulatory substance of transactions.1203 The requirements. Additionally, certain risks 13. Costs and Benefits of the Anti- Commissions are not adopting any rules could increase in a manner that the Evasion Rules and Interpretation or interpretations to require CFTC would not be able to measure The CFTC is exercising the anti- accurately. The anti-evasion rules and 1202 See Better Markets Letter. evasion rulemaking authority granted to related interpretations will bring the 1203 Id. it by the Dodd-Frank Act. Generally, appropriate scope of transactions and

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entities within the regulatory framework CFTC regulations and not on non- (i.e., a mixed swap), is made prior to the established by the Dodd-Frank Act, evading parties. execution of, but no later than an offer which will better allow the CFTC to A commenter suggests that an to enter into, the Title VII instrument, assure transparency and protect the U.S. alternative standard for a finding of and remains the same throughout the financial system from certain risks that evasion should be ‘‘whether the instrument’s life (absent amendment of could go undetected through evasive transaction is lawful or not’’ under the the instrument), improves resource conduct. CEA, CFTC rules and regulations, allocation efficiency because, without orders, or other applicable federal, state this interpretation, market participants (c) Comments and Consideration of or other laws.1209 While the potentially would need to expend Alternatives commenter’s alternative standard for additional resources to continually A commenter 1204 asserted that a evasion may impose lower costs on monitor their swaps to see if the indexes market participant should be able to market participants because it is a on which they are based have migrated enter into a transaction or structure an bright-line test, the CFTC is not from broad-based to narrow-based. The instrument or entity to avoid higher adopting it. The commenter’s alternative tolerance and grace periods for index regulatory burdens and attendant costs standard would blur the distinction CDS traded on CFTC and SEC-regulated as long as the transaction or entity has between whether a transaction (or trading platforms should lower the an overriding business purpose. entity) is lawful and whether it is frequency of index migration and Another commenter 1205 noted that the structured in a way to evade Dodd- attendant costs, also improving resource CFTC recognized in the Proposing Frank and the CEA. The anti-evasion allocation efficiency. Release that choosing to do a security- rules provided herein are concerned (3) Price Discovery based swap over a swap to lessen a with the latter conduct, not the regulatory burden does not constitute former.1210 Thus, the CFTC does not Not exempting swaps from foreign evasion in itself, but expressed the view believe it is appropriate to limit the central banks, foreign sovereigns, that this should not be limited to a enforcement of its anti-evasion authority international financial institutions, such choice between structuring a transaction to only unlawful transactions. as multilateral development banks, and as a swap and security. In this similar organizations helps improve commenter’s view, parties must be able CEA Section 15(a) Summary: transparency and price discovery to legitimately consider all relevant (1) Protection of Market Participants and through disclosure that might otherwise factors, including the cost and burden of the Public not occur. Market participants will be regulation, in making their structuring informed about the prices of these Including certain foreign exchange choices. Another commenter 1206 transactions. Furthermore, they will be transactions, forward rate agreements requested that the CFTC make clear that better informed about the risks that and certain other transactions in the movements away from swaps towards these transactions entail. swap definition protects the public by physical trades that reduce regulatory The CFTC’s interpretation of the term subjecting these transactions to Dodd- burdens will not be considered evasion ‘‘swap’’ to include guarantees of swaps Frank regulation. Similarly, the anti- under the final rule. A different that are not security-based swaps or evasion rules protect market commenter 1207 argued that the anti- mixed swaps and the separate CFTC participants against evasive conduct evasion proposal is overly broad and release will enable the CFTC and market that would take away the protection unnecessarily limits the ability of participants to receive more price- afforded to them under Dodd-Frank market participants to choose between forming data about such swaps, which regulation. legitimate structuring alternatives. help improve price discovery for swaps. Finally, another commenter 1208 believes (2) Efficiency, Competitiveness, and the Without anti-evasion rules, price that the proposed rules will create an Financial Integrity of Markets discovery might be impaired, since market participants would otherwise ‘‘impossible burden’’ on the innocent The CFTC believes that the final rules (non-evading) party. not be informed about relevant but and interpretations can be consistently evasive swap transactions. Activity conducted solely for a applied by substantially all market legitimate business purpose, absent participants to determine which (4) Sound Risk Management Practices other indicia of evasion, does not agreements, contracts, or transactions Properly classifying transactions as constitute evasion as described in the are, and which are not, swaps, security- CFTC’s interpretation. The CFTC has swaps or not swaps may lead to sound based swaps, security-based swap risk management practices, because the clarified that consideration of regulatory agreements, or mixed swaps. This may burdens, including evidence of added clarity provided by the rules and improve resource allocation efficiency interpretations herein will enable regulatory avoidance, is not dispositive as market participant may not have to of whether there has been evasion or market participants to consider whether incur the cost of petitioning the a particular agreement, contract, or not, but should be considered along Commissions or obtaining an opinion of with all other relevant facts and transaction is a swap, prior to entering counsel to determine the status of into such agreement, contract or circumstances. For example, activities agreements, contracts or transactions as structured as securities instead of swaps transaction. frequently as would be necessary The business of insurance is already and transactions that meet the forward without the rules or interpretations. subject to established pre-Dodd-Frank exclusion are not evasion per se. The Moreover, the Commissions’ Act regulatory regimes. Requirements CFTC has clarified that it will impose statement that the determination of that may work well for swaps and appropriate sanctions on the willful whether a Title VII instrument is a security-based swaps may not be evader for violation of the CEA and swap, a security-based swap, or both appropriate for traditional insurance

1204 products. To the extent that the final See CME Letter. 1209 See WGCEF Letter. 1205 rules distinguish insurance from swaps See ISDA Letter. 1210 If a transaction is unlawful, the CFTC (or 1206 See COPE Letter. another authority) may be able to bring an action and security-based swaps, the CFTC 1207 See SIFMA Letter. alleging a violation of the applicable rule, believes that the Commissions should 1208 See IECA Letter II. regulation, order or law. be able to tailor rules for specific

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products that are swaps or security- a security-based swap if the Title VII 120-day deadline. This deadline will based swaps to achieve Title VII instrument satisfies certain conditions. facilitate new products coming to regulatory objectives. In adopting the The classification may provide cross- market relatively quickly. Further, the Insurance Safe Harbor, the CFTC margining benefits when swap contracts process holds the Commissions believes that the Commissions seek to and the futures contract are margined at accountable, because they will have to achieve those net benefits that may be the same derivatives clearing state why they are not providing an obtained from not supplanting existing organization, and thus, may enhance interpretation when they decline to do insurance regulation. sound risk management practices. so. Documenting oral book-outs should promote good business practices and aid Other Public Interest Considerations The rule for books and records the CFTC in preventing evasion through Documenting oral book-outs should requirements for SBSAs does not abuse of the forward exclusion. promote good business practices and aid impose new recordkeeping Title VII instruments on qualifying the CFTC in preventing evasion through requirements on SBSAs, but relies on foreign futures contracts on debt abuse of the forward exclusion. existing recordkeeping requirements for securities of one of the 21 enumerated The product interpretation process swaps, which avoids unnecessary foreign governments is a swap and not established by the Commissions has a regulation.

APPENDIX—RULES EFFECTUATED BY THE PRODUCT DEFINITIONS

Agricultural Swaps ...... Makes no distinction between agricultural swaps and other 76 FR 49291, 49297, Aug. 10, swaps. 2011 Commodity Options ...... Exempts subject to conditions certain options on physical com- 77 FR 25320, 25331, Apr. 27, modities where parties are commercials or ECPs. The option 2012 results in physical delivery of the underlying. CPO/CTA compliance obligations ...... Rescinds the exemption from CPO registration; rescinds relief 77 FR 11252, 11275, Feb. 24, from the certification requirement for annual reports provided 2012 to operators of certain pools offered only to qualified eligible persons (QEPs; modifies the criteria for claiming relief); and require the annual filing of notices claiming exemptive relief under several sections of the Commission’s regulations. Fi- nally, the adopted amendments include new risk disclosure requirements for CPOs and CTAs. Business Conduct Standards for SDs and Applies to SDs and (except where indicated) MSPs and pro- 77 FR 9734, 9805, Feb. 17, 2012 MSPs With Counterparties. hibits certain abusive practices, requires disclosures of mate- rial information to counterparties and requires SDs/MSPs to undertake certain due diligence relating to their dealings with counterparties. Certain rules do not apply to transactions ini- tiated on a swap execution facility (SEF) or designated con- tract market (DCM) when the SD/MSP does not know the identity of the counterparty prior to execution. SD and MSP Recordkeeping, Reporting, Establishes reporting, recordkeeping, and daily trading records 77 FR 20128, 20166, Apr. 3, and Duties Rules; FCMs and IBs Con- requirements for SDs and MSPs; establishes and governs 2012 flicts of Interest Rules; and Chief Com- the duties of SDs and MSPs; establishes conflicts of interest pliance Officer Rules for SDs, MSPs, requirements for SDs, MSPs, FCMs, and IBs; establishes the and FCMs. designation, qualifications, and duties of the chief compliance officers (CCOs) of FCMs, SDs, and MSPs and describes the required contents of the annual report detailing a registrant’s compliance policies and activities, to be prepared by the chief compliance officer and furnished to the CFTC. Position Limits for Futures and Swaps ...... Establishes limits on speculative positions in 28 selected phys- 76 FR 71626, 71662, Nov. 18, ical commodity futures and swaps. 2011 Real-Time Public Reporting of Swap Establishes regulations concerning the real-time public report- 77 FR 1182, 1232, Jan. 9, 2012 Transaction Data. ing of swap transactions and pricing data. Swap Data Recordkeeping and Reporting Establishes swap data recordkeeping and reporting require- 77 FR 2136, 2176, Jan. 13, 2012 Requirements. ments for registered entities and counterparties. Swap Data Repositories: Registration Establishes regulations concerning the registration and regula- 76 FR 54538, 54572, Sept. 1, Standards, Duties and Core Principles. tion of swap data repositories. 2011 Registration of SDs and MSPs ...... Establishes the process for the registration of SDs and MSPs .. 77 FR 2613, 2623, Jan. 19, 2012

XI. Administrative Law Matters— the Title VII regulatory regime efficiency, and capital formation.1211 Exchange Act Revisions established by Congress. In addition, Moreover, section 23(a)(2) of the section 3(f) of the Exchange Act requires Exchange Act requires the SEC, when A. Economic Analysis the SEC, whenever it engages in adopting rules under the Exchange Act, 1. Overview rulemaking and is required to consider to consider the impact such rules would or determine whether an action is have on competition. Section 23(a)(2) The SEC is sensitive to the costs and necessary or appropriate in the public also prohibits the SEC from adopting benefits of its rules. In adopting the final interest, to consider, in addition to the any rule that would impose a burden on rules in this release, the SEC has been protection of investors, whether the competition not necessary or mindful of the costs and benefits action will promote competition, appropriate in furtherance of the associated with these rules which provide fundamental building blocks for 1211 15 U.S.C. 78c(f).

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purposes of the Exchange Act.1212 The based security index’’ or events relating SEC with limited enforcement authority SEC requested comment on all aspects to securities in a ‘‘narrow-based security over such instruments with respect to of the costs and benefits of the proposed index’’.1218 The final rules further fraud, manipulation, and insider rules in the Proposing Release,1213 and define the terms ‘‘issuers of securities in trading.1226 Title VII created an entirely any effect these rules may have on a narrow-based security index’’ and new regulatory regime to regulate competition, efficiency, and capital ‘‘narrow-based security index’’ for swaps, security-based swap agreements formation. purposes of this analysis.1219 Further, and security-based swaps. These final rules implement the the Commissions are adopting rules that 2. Economic Analysis Considerations mandate of Title VII that the CFTC and provide tolerance and grace periods for the SEC, in consultation with the Title VII instruments based on a security The rules adopted in this release Federal Reserve Board, jointly further index that are traded on certain trading implicate different types of potential define the terms ‘‘swap,’’ ‘‘security- platforms where the security index may costs and benefits. First, there are costs, based swap,’’ and ‘‘security-based swap temporarily move from being within the agreement.’’ 1214 The rules adopted in ‘‘narrow-based security index’’ agreement’’ to mean a swap agreement (as defined in section 206A of the GLBA) on which a material this release may be divided into three definition to being outside (e.g.,. moving term is based on the price, yield, value, or volatility categories: from narrow-based to broad-based, or of any security or any group or index of securities, First, the Commissions are adopting vice versa.) 1220 Additionally, the or any interest therein. Furthermore, the CFMA rules that will assist market participants Commissions are providing clarification added section 206C to the GLBA, 15 U.S.C. 78c in determining whether particular note, which defined a ‘‘non-security-based swap that a Title VII instrument based on a agreement’’ to mean any swap agreement (as agreements, contracts, and transactions qualifying foreign futures contract on defined in section 206A of the GLBA) that is not fall within or outside the swap and the debt securities of one or more of the a security-based swap agreement (as defined in security-based swap definitions (i.e., 21 enumerated foreign governments is a section 206B of the GLBA). Title VII amended the identifying products subject to Title definition of the term ‘‘swap agreement’’ (discussed swap and not a security-based swap, if in footnote 1284) and repealed the definition of the VII). The final rules provide: (1) An certain conditions are met.1221 terms ‘‘security-based swap agreement’’ and ‘‘non- Insurance Safe Harbor for those Third, the Commissions are adopting security-based agreement.’’ See sections 762(a) and agreements, contracts, and transactions rules that provide: (1) A regulatory (b) of the Dodd-Frank Act. However, Title VII also that the Commissions believe Congress framework for certain mixed swaps and added a new definition of the term ‘‘security-based swap agreement’’ in section 3(a)(78) of the does not intend to be Title VII a process for market participants to Exchange Act, 15 U.S.C. 78c(a)(78), that is generally instruments; 1215 (2) a ‘‘grandfather’’ for request that the Commissions issue a consistent with the repealed definition, except that those insurance agreements, contracts, joint order determining the appropriate the new definition excludes security-based swaps. or transactions (as opposed to insurance regulatory treatment of certain other Accordingly, Title VII provides jurisdiction to the CFTC for security-based swap agreements, such as 1222 product categories) entered into on or mixed swaps and (2) a process for Title VII Instruments based on broad-based before the effective date of the Product market participants to request a joint securities indexes, and also retains the SEC’s Definitions provided that, when the interpretation from the Commissions jurisdiction over such instruments in instances of parties entered into such agreement, regarding whether a particular Title VII fraud, manipulation, or insider trading. 1226 The CFMA excluded from the definition of contract, or transaction, it was provided instrument is a swap, security-based the term ‘‘security’’ the term ‘‘security-based swap in accordance with the Provider swap, or mixed swap.1223 The final agreement’’ as well as the term ‘‘non-security based Test; 1216 and (3) further definition of rules also provide that market swap agreement’’ (as those terms are defined in the term ‘‘swap’’ to specifically list participants have no additional books section 206B and 206C (respectively) of the GLBA, 15 U.S.C. 78c note). See sections 2A(a) and (b)(1) certain enumerated products and not and records requirements for SBSAs of the Securities Act, 15 U.S.C. 77b–1(a) and (b)(1), include certain foreign exchange other than those for swaps.1224 and sections 3A(a) and (b)(1) of the Exchange Act, forwards and foreign exchange In considering the economic 15 U.S.C. 78c–1(a) and (b)(1). Furthermore, the swaps.1217 consequences of the final rules, the SEC CFMA explicitly prohibited the SEC from Second, the Commissions are registering, or requiring, recommending, or acknowledges the regulatory regime that suggesting the registration under the Securities Act adopting rules that will assist market was in place prior to the enactment of and the Exchange Act of any security-based swap participants in determining whether a Title VII. Prior to the enactment of Title agreement (as defined in section 206B of the GLBA). particular Title VII instrument is a swap VII, swaps and security-based swaps See section 2A(b)(2) of the Securities Act, 15 U.S.C. subject to CFTC regulation, a security- 77b–1(b)(2), and section 3A(b)(2) of the Exchange were by-and-large unregulated. The Act, 15 U.S.C. 78c–1(b)(2). The CFMA also made based swap subject to SEC regulation, or Commodity Futures Modernization Act explicit that the SEC is prohibited from either (1) a mixed swap subject to regulation by of 2000 (‘‘CFMA’’) created a regulatory promulgating, interpreting, or enforcing rules or (2) the CFTC and the SEC (i.e., mapping the regime that prohibited the SEC from issuing orders of general applicability under the jurisdictional divide between the CFTC Securities Act or Exchange Act in a manner that regulating security-based swap imposes or specifies reporting or recordkeeping 1225 and the SEC). Specifically, Title VII agreements, though it provided the requirements, procedures, or standards as instruments that are CDS referencing a prophylactic measures against fraud, manipulation, security index or a group or index of 1218 See section 3(a)(68)(A)(ii)(III) of the Exchange or insider trading with respect to any security-based issuers of securities or obligations of Act, 15 U.S.C. 78c(a)(68)(A)(ii)(III). swap agreement (as defined in section 206B of the 1219 GLBA). However, the CFMA did provide the SEC issuers of securities may be swaps See supra part III.G. 1220 See supra part III.G.5. with limited enforcement authority under section subject to CFTC regulation or security- 10(b) of the Exchange Act, 15 U.S.C. 78j(b), and the 1221 See supra part III.E. rules promulgated thereunder that prohibit fraud, based swaps subject to SEC regulation, 1222 See supra part IV. manipulation, or insider trading (but not rules depending on whether such Title VII 1223 See supra part VI. imposing or specifying reporting or record-keeping instruments are based on events relating 1224 See supra part V. requirements, procedures, or standards as to ‘‘issuers of securities in a narrow- 1225 The CFMA added section 206A to the GLBA, prophylactic measures against fraud, manipulation, 15 U.S.C. 78c note, to define the term ‘‘swap or insider trading). Furthermore, the CFMA applies 1212 15 U.S.C. 78w(a)(2). agreement’’ to mean any agreement, contract, or judicial precedents under sections 9, 10(b), 15, 16, transaction between ECPs, the material terms of 20, and 21A of the Exchange Act, 15 U.S.C. 78i, 1213 See Proposing Release at 29885. which (other than price and quantity) are subject to 78j(b), 78o, 78p, 78t, and 78u–1, as well as section 1214 See section 712(d)(1) of the Dodd-Frank Act. individual negotiation, that fall within certain 17(a) of the Securities Act, 15 U.S.C. 77q(a), to 1215 See supra part II.B.1. categories of transactions. Additionally, the CFMA security-based swap agreements (as defined in 1216 See supra part II.B.1.c). added section 206B to the GLBA, 15 U.S.C. 78c section 206B of the GLBA) to the same extent as 1217 See supra part II.C.2. note, which defined a ‘‘security-based swap they apply to securities.

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as well as benefits, arising from security-based swap, the security-based costs. These costs and benefits have subjecting certain agreements, contracts, swap will be a security subject to the informed the decisions and the actions or transactions to the regulatory regime full panoply of the Federal securities taken that are described throughout the of Title VII. The SEC refers to these laws. Such treatment will give rise to release. Accordingly, the analysis below costs and benefits as ‘‘programmatic’’ costs and benefits, including those that includes references to the discussions of costs and benefits. Additionally, there apply to securities generally. Security- the decisions and actions taken by the are costs that parties will incur to assess based swaps may be subject to Commissions set forth above in other whether certain agreements, contracts, additional costs to the extent that there parts of this release. Finally the SEC or transactions are indeed subject to the are overlapping regulatory requirements discusses the effects of these rules on Title VII regulatory regime, and, if so, arising from the Title VII regulatory competition, efficiency, and capital costs to assess whether such Title VII requirements and those Federal formation. instrument is subject to the regulatory securities laws requirements that apply 3. Programmatic Benefits and Costs regime of the SEC or the CFTC. The SEC to securities generally. The SEC has refers to these costs as ‘‘assessment’’ already taken action to address some of By enacting Title VII, Congress costs.1227 such overlapping or inconsistent created a regulatory regime for swaps The programmatic costs and benefits requirements 1228 and will continue to and security-based swaps that and the assessment costs raise distinct evaluate other needed actions, if any, to previously did not exist.1229 Title VII analytic issues. First, the SEC recognizes minimize any such overlapping amendments to the Exchange Act that the Product Definitions, while regulatory implications. impose, among other requirements, the integral to the regulatory requirements Second, in determining the following: (1) Registration and that will be imposed on the swap and appropriate scope of these rules, the comprehensive oversight of SBS dealers security-based swap markets pursuant SEC considers the types of agreements, and MSBSPs; 1230 (2) reporting of to Title VII, do not themselves establish contracts, or transactions that should be security-based swaps to a registered the scope or nature of those substantive regulated as swaps, security-based security-based swap data repository requirements or their related costs and swaps, or mixed swaps under Title VII (‘‘SB SDR’’), or to the SEC (if the benefits. The SEC anticipates that the in light of the purposes of the Dodd- security-based swap is uncleared and no rules implementing the substantive Frank Act, the overall regulatory SB SDR will accept the security-based requirements under Title VII will be framework, the historical treatment of swap for reporting), and dissemination subject to their own economic analysis, the instruments and other regulatory of the security-based swap market data 1231 but final rules have not yet been frameworks, and the data currently to the public; (3) clearing of adopted that would subject agreements, available to the SEC. The SEC has security-based swaps at a registered contracts, or transactions, or entities sought to further define the terms clearing agency (or a clearing agency that act as intermediaries (such as ‘‘swap,’’ ‘‘security-based swap,’’ and that is exempt from registration) if the security-based swap dealers (‘‘SBS ‘‘mixed swap’’ to address the status of SEC makes a determination that such dealers’’) or major security-based swap agreements, contracts, and transactions security-based swaps are required to be participants (‘‘MSBSPs’’)) or provide that are appropriate to regulate as cleared, unless an exception from the market infrastructures (such as clearing swaps, security-based swaps and mixed mandatory clearing requirement 1232 agencies, trade repositories and trade swaps within the purposes of Title VII applies; and (4) if a security-based execution facilities), to such substantive and not to include those agreements, 1229 requirements. The costs and benefits contracts, and transactions that See supra part XI.A.1. 1230 See section 15F of the Exchange Act, 15 described below are therefore those that historically have not been considered to be swaps or security-based swaps U.S.C. 78o–10. may arise in connection with: (1) 1231 See section 3(a)(75) of the Exchange Act, 15 Determining whether certain thereby not imposing unnecessary or U.S.C. 78c(a)(75) (defining the term ‘‘security-based agreements, contracts, or transactions inappropriate Title VII costs and swap data repository’’); section 13(m) of the Exchange Act, 15 U.S.C. 78m(m) (regarding public are Title VII instruments (i.e., the burdens on parties engaging in agreements, contracts, and transactions. availability of security-based swap data); section assessment costs) and (2) subjecting 13(n) of the Exchange Act, 15 U.S.C. 78m(n) those agreements, contracts, or In addition, the SEC recognizes that (regarding requirements related to SB SDRs); and transactions that are Title VII these rules may have effects on section 13A of the Exchange Act, 15 U.S.C. 78m– 1 (regarding reporting and recordkeeping instruments, determined based on the competition, efficiency, and capital formation as a result of certain requirements for certain security-based swaps). See statutory definitional lines that the also Security-Based Swap Data Repository Commissions are further defining, to a agreements, contracts, and transactions Registration, Duties, and Core Principles, Release being determined to fall under or No. 34–63347 (Nov. 19, 2010), 75 FR 77306 (Dec. complete and fully effective 10, 2010); corrected at 75 FR 79320 (Dec. 20, 2010) complement of Title VII statutory and outside the Title VII regulatory regime, or as a result of the jurisdictional divide and 76 FR 2287 (Jan. 13, 2011) (‘‘SDR Proposing regulatory requirements. In addition, the Release’’); and Regulation SBSR—Reporting and between the SEC and CFTC as mandated discussion below addresses the costs Dissemination of Security-Based Swap Information, by the statute. Release No. 34–63346 (Nov. 19, 2010), 75 FR 75208 and benefits arising from security-based In the sections below, the SEC begins (Dec. 2, 2010) (‘‘Regulation SBSR Proposing swaps being within the definition of by recognizing that the Title VII Release’’). In each proposing release the SEC invited comment with respects to the costs and benefits of security under the Securities Act and regulatory regime has programmatic the Exchange Act. Once a Title VII each of the proposed rules. The costs associated benefits and costs, as well as assessment with these and other substantive rules, along with Instrument is determined to be a any comments received by the SEC addressing the 1228 See Order Pursuant to Sections 15F(b)(6) and costs of the proposed rules, are being addressed in 1227 The SEC expects that the benefits resulting 36 of the Securities Exchange Act of 1934 Granting more detail in connection with the applicable from further defining the terms ‘‘swap,’’ ‘‘security- Temporary Exemptions and Other Temporary rulemakings. based swap,’’ and ‘‘mixed swap’’ will likely accrue Relief, Together With Information on Compliance 1232 See section 3C(a)(1) of the Exchange Act, 15 primarily at the programmatic level. To the extent Dates for New Provisions of the Securities Exchange U.S.C. 78c–3(a)(1). See also Process for Submissions appropriate, given the purposes of Title VII, the Act of 1934 Applicable to Security-Based Swaps, for Review of Security-Based Swaps for Mandatory Commissions have sought to mitigate the costs and Request for Comment, Release No. 34–64678 Clearing and Notice Filing Requirements for persons will incur in connection with determining (June 15, 2011), 76 FR 36287 (June 22, 2011); Clearing Agencies; Technical Amendments to Rule whether the instrument is a swap, security-based Exchange Act Exemptive Order; and SB Swaps 19b–4 and Form 19b–4 Applicable to All Self- swap, or mixed swap. Interim Final Rules. Continued

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swap is subject to the clearing security-based swap transaction with or dealers and MSBSPs,1240 SB SEFs,1241 requirement, execution of the security- for a person that is not an ECP must be SB SDRs,1242 and clearing agencies based swap transaction on an exchange, effected on a national securities registered to clear security-based on a security-based swap execution exchange.1238 swaps.1243 The SEC expects that facility (‘‘SB SEF’’) registered under the registrants will incur costs in gathering The creation of regulatory regimes for Exchange Act,1233 or on an SB SEF that information, accurately completing agreements, contracts, or transactions has been exempted from registration by forms and filing these forms with the the SEC under the Exchange Act,1234 that are defined as a swap or security- SEC.1244 Registration will provide the unless no SB SEF or exchange makes based swap will result in an array of SEC with information regarding such security-based swap available for programmatic benefits. However, if an registrants which will enable the SEC to trading.1235 In addition, Title VII agreement, contract or transaction falls oversee the SEC’s security-based swap amends the Securities Act and the within the swap or security-based swap registrants. Exchange Act to include security-based definition, the parties to the agreement, (b) Business Conduct Standards, swaps in the definition of ‘‘security’’ for contract, or transaction also may incur Compliance, Operation, and Governance the purposes of those statutes.1236 As a a number of upfront and ongoing costs result, security-based swaps are subject associated with the regulation of Title Title VII imposes requirements on to the full panoply of the Federal VII instruments and transactions. These registrants that did not exist prior to the securities laws. Title VII also added programmatic benefits and costs, adoption of Title VII, including core specific provisions to the Securities Act discussed in more detail below, relate to principles, duties and/or standards that and Exchange Act affecting how Title VII registration; business conduct are related to the type of registrant and 1245 security-based swaps may be sold. For standards, compliance, operation and its function. For example, Title VII includes core principles for SB SEFs, example, Title VII amended section 5 of governance; clearing, trade execution, many of which require SB SEFs to the Securities Act to require that a and reporting and processing; investor registration statement meeting the establish and enforce rules specific to protection provisions of Title VII and the trading of security-based swaps.1246 requirements of the Securities Act be in the application of the Federal securities effect before there can be an offer to sell, Similarly, Title VII assigns duties (in laws.1239 offer to buy, purchase or sale of a addition to core principles) that are security-based swap from or to any (a) Title VII Registration of Entities specific to the nature of SB SDRs, e.g. person who is not an ECP.1237 In Involved in Security-Based Swaps the acceptance and maintenance of data addition, Title VII added section 6(l) to related to security-based swaps.1247 The the Exchange Act to require that any As a result of Title VII imposing a new regulatory regime on security-based 1240 See section 15F(b)(5) of the Exchange Act, 15 Regulatory Organizations, 75 FR 82490 (Dec. 30, swaps, in addition to making such U.S.C. 78o–10(b)(5). 1241 See section 3D(a) of the Exchange Act, 15 2010) (‘‘Clearing Procedures Proposing Release’’). In security-based swaps securities under the Clearing Procedures Proposing Release the SEC U.S.C. 78c–4. invited comment with respects to the costs and the Securities Act and the Exchange 1242 See section 13(n)(1) of the Exchange Act, 15 benefits of each of the proposed rules. The costs Act, Title VII will require the U.S.C. 78m(n)(1). associated with these and other substantive rules, registration of entirely new types of 1243 See section 17A(g) of the Exchange Act, 15 along with any comments received by the SEC registrants with the SEC, including SBS U.S.C. 78q–1(g). addressing the costs of the proposed rules, are being 1244 The SEC has proposed rules related to the addressed in more detail in connection with the registration requirements for each of these new applicable rulemakings. 1238 See section 6(l) of the Exchange Act, 15 registrants. See SB Swap Participant Registration 1233 See section 3D of the Exchange Act, 15 U.S.C. U.S.C. 78f(l). Proposing Release; SB SEF Proposing Release; SDR 78c–4. 1239 For example, dealers and major participants Proposing Release; and Clearing Agency Standards 1234 See section 3D(e) of the Exchange Act, 15 will be subject to business conduct requirements of for Operation and Governance, Release No. 34– U.S.C. 78c–4(e). section 15F of the Exchange Act, and thus will be 64017 (Mar. 3, 2011), 76 FR 14472 (Mar. 16, 2011) 1235 See sections 3C(g) and (h) of the Exchange required, among other things, to determine that (‘‘Clearing Agency Standards Proposing Release’’). Act, 15 U.S.C. 78c–3(g) and (h). See also section their counterparty meets certain eligibility In each proposing release the SEC invited comment 3(a)(77) of the Exchange Act, 15 U.S.C. 78c(77) standards before entering into security-based swaps with respects to the costs and benefits of each of (defining the term ‘‘security-based swap execution with them and to disclose information about the proposed rules. The costs associated with these facility’’). See also Registration and Regulation of material risks and characteristics, material and other substantive rules, along with any Security-Based Swap Execution Facilities, Release incentives, conflicts of interest, the daily mark, and comments received by the SEC addressing the costs No. 34–63825 (Feb. 2, 2011), 76 FR 10948 (Feb. 28, clearing rights. See Business Conduct Standards for of the proposed rules, are being addressed in more 2011) (‘‘SB SEF Proposing Release’’). In the SB SEF Security-Based Swaps Dealer and Major Security- detail in connection with the applicable Proposing Release each proposing release the SEC Based Swap Participants, Release No. 34–64766 rulemakings. invited comment with respects to the costs and (June 29, 2011), 76 FR 42396, 42406, 42410 (July 1245 See sections 3D(d), 13(n)(5) and (7), and benefits of each of the proposed rules. The costs 18, 2011) (‘‘Business Conduct Standards Proposing 15F(h) and (j) of the Exchange Act, 15 U.S.C. 78c– associated with these and other substantive rules, Release’’). Also, for example, in connection with 4(d), 78m(n)(5) and (7), and 78o–10(h) and (j). along with any comments received by the SEC registration requirements the SEC expects security- 1246 See sections 3D(d)(2), (3), (4), (6), and (8) of addressing the costs of the proposed rules, are being based swap dealers and major security-based swap the Exchange Act, 15 U.S.C. 78c–4(d)(2), (3), (4), (6), addressed in more detail in connection with the participants to incur costs in connection with and (8). See also SB SEF Proposing Release. In the applicable rulemakings. completing and filing forms, providing related SB SEF Proposing Release the SEC invited comment 1236 See sections 761(a)(2) and 768(a)(1) of the certifications, addressing additional requirements with respects to the costs and benefits of each of Dodd-Frank Act (amending sections 3(a)(10) of the in connection with associated persons, as well as the proposed rules. The costs associated with these Exchange Act, 15 U.S.C. 78c(a)(10), and 2(a)(1) of certain additional costs. See Registration of and other substantive rules, along with any the Securities Act, 15 U.S.C. 77b(a)(1), Security-Based Swap Dealers and Major Security- comments received by the SEC addressing the costs respectively). The Dodd-Frank Act also amended Based Swap Participants, Release No. 34–65543 of the proposed rules, are being addressed in more the Securities Act to provide that any offer or sale (Oct. 12, 2011), 76 FR 65784, 65813–18 (Oct. 24, detail in connection with the applicable of a security-based swap by or on behalf of the 2011) (‘‘SB Swap Participant Registration Proposing rulemakings. issuer of the securities upon which such security- Release’’). In each proposing release the SEC invited 1247 See section 13(n)(5) of the Exchange Act, 15 based swap is based or is referenced, an affiliate of comment with respects to the costs and benefits of U.S.C. 78m(n)(5). See also SDR Proposing Release. the issuer, or an underwriter, shall constitute a each of the proposed rules. The costs associated In the SDR Proposing Release the SEC invited contract for sale of, sale of, offer for sale, or offer with these and other substantive rules, along with comment with respects to the costs and benefits of to sell such securities. See section 768(a) of the any comments received by the SEC addressing the each of the proposed rules. The costs associated Dodd-Frank Act (amending section 2(a)(3) of the costs of the proposed rules, are being addressed in with these and other substantive rules, along with Securities Act, 15 U.S.C. 77b(a)(3)). more detail in connection with the applicable any comments received by the SEC addressing the 1237 15 U.S.C. 77e. rulemakings. costs of the proposed rules, are being addressed in

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provisions of Title VII related to SB management policies and procedures of Title VII, swaps which traded on a SEFs and SB SDRs are designed to that are designed to prevent them from bilateral basis were subject to provide transparency in the security- taking on excessive risk and to enable counterparty credit risk, which may not based swap market. them to better deal with market have been fully mitigated by the posting Title VII also imposes a number of fluctuations that might otherwise of collateral.1262 Section 3C of the requirements on registered SBS dealers endanger their financial health.1255 Exchange Act requires that security- and MSBSPs, such as external business Section 15F(e) of the Exchange Act as based swaps, with some exceptions, be conduct requirements.1248 Specifically, added by section 764(a) of the Dodd cleared through a central counterparty section 15F(h)(3)(B) of the Exchange Act Frank Act, imposes capital and margin (‘‘CCP’’) registered with the SEC.1263 establishes certain disclosure requirements on dealers and major Clearing a security-based swap places a 1256 requirements for SBS dealers and participants, which are designed to CCP between the parties to a trade and MSBSPs,1249 and section 15F(h)(3)(C) of reduce the financial risks of these reduces the counterparty risk. the Act requires that communications institutions and contribute to the Title VII also requires the execution of by these entities meet certain standards stability of the security-based swap of fairness and balance.1250 The level of market in particular and the U.S. clearable security-based swaps on protection becomes higher for special financial system more generally.1257 exchanges or SB SEFs if such security- entities 1251 to whom dealers offer With respect to a security-based swap based swaps are available to trade and security-based swaps.1252 For example, submitted for clearing, counterparties the reporting of trades to an SB SDR and an SBS dealer that acts as an advisor to will be required to post initial margin dissemination of trading data to the 1264 a special entity has a duty to act in the and maintenance margin to secure its public. Title VII also imposes best interest of the special entity and is obligations under the trade. requirements relating to the operations 1265 required to make reasonable efforts to Section 3E of the Exchange Act, of the SB SEFs and SDRs. Section obtain such information as is necessary among other things, requires registered 15F(i) of the Exchange Act establishes for the SBS dealer to make a reasonable brokers, dealers and SBS dealers that regulatory standards for certain determination that any security-based collect initial and variation margin from [registered security-based swap entities] swap recommended by the SBS dealer counterparties to cleared security-based related to the confirmation, processing, swap transactions to maintain that netting, documentation, and valuation is in the best interests of the special 1258 entity.1253 In addition, section 15F(j)(5) collateral in segregated accounts. of security-based swaps, which should of the Exchange Act imposes With respect to uncleared swaps, enhance the efficiency of the trade requirements intended to address section 3E gives a counterparty to a SBS execution and processing of security- potential conflicts of interest that may dealer or MSBSP that collects collateral based swaps.1266 arise in transactions between a SBS the right to request segregation of initial margins and maintenance of such initial Furthermore, sections 15F(f), (g), and dealer or MSBSP and its margins in accordance with rules (j)(3) of the Exchange Act impose certain counterparty.1254 Title VII also imposes promulgated by the SEC.1259 These reporting, recordkeeping, and regulatory upon SBS dealers and MSBSPs protections provide market participants disclosure requirements on SBS dealers requirements to implement risk who enter into transactions with these entities confidence that their collateral the proposed rules. The SEC has received more detail in connection with the applicable comments on the cost and benefits of these rulemakings. accounts will remain separate from the proposed rules. The costs associated with these and 1248 The SEC has proposed rules regarding SBS dealer or MSBSP’s assets in the other substantive rules are being addressed in more business conduct standards for security-based swap event of bankruptcy.1260 detail in connection with the applicable dealers and major security-based swap participants. rulemakings. See Business Conduct Standards Proposing Release. (c) Clearing, Trade Execution, Reporting 1262 See U.S. Gov’t Accountability Office, In the Business Conduct Standards Proposing and Processing Systemic Risk: Regulatory Oversight and Recent Release the SEC invited comment regarding the Initiatives to Address Risk Posed by Credit Default costs and benefits associated with the proposed Section 763 of the Dodd-Frank Act Swaps, GAO–09–397T, at 13 (Mar. 5, 2009). rules. The costs associated with these and other adds section 3C to the Exchange Act, 1263 15 U.S.C. 78c–3. Such clearing agencies also substantive rules, along with any comments which deals with clearing for security- are required to register. See section 17A(g) of the received by the SEC addressing the costs of the 1261 Exchange Act, 15 U.S.C. 78q–1(g). proposed rules, are being addressed in more detail based swaps. Prior to the enactment 1264 See sections 3C(h) and 13(m) of the Exchange in connection with the applicable rulemakings. Act, 15 U.S.C. and 13m(m). See also Regulation 1249 1255 See section 15F(j)(2) of the Exchange Act, 15 See section 15F(h)(3)(B) of the Exchange Act, SBSR Proposing Release; and SDR Proposing U.S.C. 78o–10(j)(2). 15 U.S.C. 78o–10(h)(3)(B). Release. 1250 1256 See section 15F(e) of the Exchange Act, 15 See section 15F(h)(3)(C) of the Exchange Act, 1265 See SDR Proposing Release; and SB SEF U.S.C. 78o–10(e). 15 U.S.C. 78o–10(h)(3)(C). Proposing Release. In each proposing release the 1257 1251 Title VII amends the Exchange Act to define See Entity Definitions Release at 30723, supra SEC invited comment with respects to the costs and a special entity as: (1) A Federal agency; (2) a State, note 12. benefits of each of the proposed rules. The costs State agency, city, county, municipality, or other 1258 See 15 U.S.C. 78c–5. associated with these and other substantive rules, political subdivision of a State; (3) any employee 1259 Id. along with any comments received by the SEC benefit planned, as defined in section 3 of the 1260 Id. addressing the costs of the proposed rules, are being Employee Retirement Income Security Act of 1974; 1261 See 15 U.S.C. 78c–3. See also Clearing addressed in more detail in connection with the or (4) any governmental plan, as denied in section Procedures Proposing Release; Clearing Agency applicable rulemakings. 3 of the Employee Retirement Income Security Act Standards Proposing Release; End-User Exception 1266 See section 15F(i) of the Exchange Act, 15 of 1974; or any endowment, including an of Mandatory Clearing of Security-Based Swaps, U.S.C. 78o–10(i). See also Trade Acknowledgment endowment that is an organization in section Release No. 34–63556 (Dec. 15, 2010), 75 FR 79992 and Verification on Security-Based Swap 501(c)(3) of the Internal Revenue Code of 1986. See (Dec. 21, 2010) (‘‘End-User Exception Proposing Transactions, Release No. 34–63727 (Jan. 14, 2011), section 15F(h)(2)(C) of the Exchange Act, 15 U.S.C. Release’’); and Ownership Limitations and 76 FR 3859 (Jan. 21, 2011) (‘‘Trade Documentation 78o–10(h)(2)(C). Governance Requirements for Security-Based Swap Proposing Release’’). In the Trade Documentation 1252 See sections 15F(h)(2), (h)(4), and (h)(5) of the Clearing Agencies, Security-Based Swap Execution Proposing Release the SEC invited comment with Exchange Act, 15 U.S.C. 78o–10(h)(2), (h)(4), and Facilities, and National Securities Exchanges with respects to the costs and benefits of each of the (h)(5). Respect to Security-Based Swaps under Regulation proposed rules. The costs associated with these and 1253 See section 15F(h)(4)(B) and (C) of the MC, Release No. 34–63107, (Oct. 14, 2010), 75 FR other substantive rules, along with any comments Exchange Act, 15 U.S.C. 78o–10(h)(4)(B) and (C). 65882 (Oct. 26, 2010) (‘‘Proposed Regulation MC’’). received by the SEC addressing the costs of the 1254 See section 15F(j)(5) of the Exchange Act, 15 In each proposing release the SEC invited comment proposed rules, are being addressed in more detail U.S.C. 78o–10(j)(5). with respects to the costs and benefits of each of in connection with the applicable rulemakings.

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and MSBSPs.1267 Specifically, Title VII By including security-based swaps in if an exemption from such registration imposes on parties to a security-based the definition of security under the provisions is not available.1277 swap the responsibility to ‘‘report Securities Act and the Exchange Act The above programmatic benefits and security-based swap transaction and repealing the restrictions on costs that will flow from regulation of information to the appropriate regulating security-based swap the security-based swap market registered entity in a timely manner as agreements as securities, Title VII mandated by Title VII will be may be prescribed by the [SEC].’’ 1268 extended the investor protections under Title VII’s reporting, recordkeeping, and significant, although very difficult to the Federal securities laws to security- 1278 disclosure requirements should enhance quantify and measure. Moreover, the based swaps. In particular, Title VII benefits can be expected to manifest the volume and quality of information amends the Exchange Act and the themselves over the long run and be available in the market and facilitate Securities Act to include security-based distributed over the market as a whole. effective oversight by the SEC. swaps within the definition of the term The programmatic costs and benefits ‘‘security.’’ 1272 Accordingly, security- (d) Investor Protection Provisions of associated with substantive rules based swaps are securities and benefit Title VII and the Application of the applicable to security-based swaps Federal Securities Laws from the investor protections provided under Title VII are being addressed in by the Federal securities laws.1273 In Prior to the enactment of Title VII, the more detail in connection with the SEC had the ability to bring actions addition to the antifraud and anti- manipulation provisions, these applicable rulemakings implementing based on fraud, manipulation or insider Title VII. There are programmatic costs trading relating to security-based swap protections include the registration, disclosure and civil liability provisions that may arise from the application of agreements (as defined in section 206B other provisions of the Federal of the GLBA 1269) but did not have any of the Securities Act and the disclosure provisions of the Exchange Act. Title VII securities laws to security-based swaps, other regulatory authority over swaps, security-based swap transactions and security-based swaps or market specifically provides protections to non- market participants involved in such participants involved in security-based ECPs by adding section 5(e) to the security-based swap transactions, swap transactions.1270 Title VII provides Securities Act, which requires that a including costs arising from potential the SEC with antifraud enforcement registration statement must be in effect authority over SBSAs under Title VII before a person can offer to sell, offer to overlapping regulatory requirements. and gives the SEC the authority to purchase from, or otherwise enter into The SEC already has taken interim regulate security-based swap security-based swaps with non- actions to mitigate such overlapping and transactions and the security-based ECPs.1274 Any security-based swap with potentially conflicting regulatory swaps market, including the authority to or for a person that is not an ECP must requirements and will be carefully prevent or deter fraud, manipulation or be effected on a national securities evaluating any future actions that may deceptive conduct and take other exchange.1275 Furthermore, Title VII be necessary and appropriate to address actions.1271 ensures that a security-based swap such overlapping or conflicting cannot be used to avoid registration or requirements. 1267 See section 15F(f) of the Exchange Act, 15 investor protection under the Securities U.S.C. 78o–10(f) (reporting and recordkeeping Act by providing that if a security-based requirements); section 15F(g) of the Exchange Act, 15 U.S.C. 78o–10(g) (daily trading records swap is entered into by an issuer’s requirements); section 15F(j)(3) of the Exchange affiliate or underwriter, the offer and Act, 15 U.S.C. 78o–10(j)(3) (requirements related to sale of the underlying security must 1277 For offers and sales to non-ECPs, the statute the disclosure of information to regulators). See also comply with the Securities Act.1276 requires registration of the security-based swap Regulation SBSR Proposing Release. In the transaction. Regulation SBSR Proposing Release the SEC invited The programmatic benefits related to 1278 comment with respects to the costs and benefits of investor protection under the Federal One commenter suggested that the best measure of the benefits of the Dodd-Frank Act is the each of the rules proposed in the release. The costs securities laws have corresponding costs associated with these and other substantive rules, cost of the 2008 financial crisis. This commenter along with any comments received by the SEC including costs associated with provided, as an example, an estimate from the Bank addressing the costs of the proposed rules, are being compliance with the registration and of England that the cost of the 2008 financial crisis addressed in more detail in connection with the disclosure regime of the Securities Act in terms of lost output was between $60 trillion and applicable rulemakings. $200 trillion. See Letter from Dennis Kelleher, 1268 See section 13(m)(1)(F) of the Exchange Act, Better Markets to the CFTC, June 3, 2011, regarding more detail in connection with the applicable 15 U.S.C. 13m(m)(1)(F). See also Regulation SBSR the reopening and extension of comment periods Proposing Release. In the Regulation SBSR rulemakings. for rulemaking implementing the Dodd-Frank Wall Proposing Release the SEC invited comment with 1272 See section 2(a)(1) of the Securities Act and respects to the costs and benefits of each of the section 3(a)(10) of the Exchange Act, 15 U.S.C. Street Reform and Consumer Protection Act. The proposed rules. The costs associated with these and 77b(a)(1) and 15 U.S.C. 78c(a)(10). SEC recognizes that this estimate addresses the other substantive rules, along with any comments 1273 See, e.g., Order Granting Temporary aggregate cost of the financial crisis. It is also received by the SEC addressing the costs of the Exemptions under the Securities Exchange Act of recognized that others have expressed concern proposed rules, are being addressed in more detail 1934 in Connection with the Pending Revision of regarding the potential cost of the requirements of in connection with the applicable rulemakings. the Definition of ‘‘Security’’ to Encompass Security- Dodd-Frank. See, e.g., letters from SIFMA, the 1269 15 U.S.C. 78c note. Based Swaps, and Request for Comment, 76 FR American Bankers Association, the Financial 1270 See supra part XI.A.1, notes 1225 and 1226. 39927 (July 7, 2011) (discussing the effect of the Services Roundtable and the Clearing House 1271 See supra part XI.A.1, notes 1225 and 1226 amendment to the definition of the term ‘‘security’’ Association, dated February 13, 2012 (commenting to include security-based swaps under the and part I. See also Prohibition Against Fraud, on Prohibitions and Restrictions on Proprietary Manipulation, and Deception in Connection with Exchange Act and granting certain temporary relief and providing interpretive guidance). Trading and Certain Interests in, and Relationships Security-Based Swaps, Release No. 34–63236 (Nov. With, Hedge Funds and Private Equity Funds, 76 FR 1274 See section 768(b) of the Dodd Frank Act 3, 2010), 75 FR 68560 (Nov. 8, 2010) (‘‘SB Swap 68846 (Nov. 7, 2011)) and The Financial Services Antifraud Proposing Release’’). In the SB Swap (adding section 5(e) of the Securities Act, 15 U.S.C. Roundtable, dated October 17, 2011 (commenting Antifraud Proposing Release the SEC invited 77e(d)). comment with respects to the costs and benefits of 1275 See section 6(l) of the Exchange Act, 15 on Further Definition of ‘‘Swap Dealer,’’ ‘‘Security- each of the proposed rules. The costs associated U.S.C. 78f(l). Based Swap Dealer,’’ ‘‘Major Swap Participant,’’ with these and other substantive rules, along with 1276 See section 768(a) of the Dodd-Frank Act ‘‘Major Security-Based Swap Participant’’ and any comments received by the SEC addressing the (amending section 2(a)(3) of the Securities Act, 15 ‘‘Eligible Contract Participant,’’ 75 FR 80174 (Dec. costs of the proposed rules, are being addressed in U.S.C. 77b(a)(3)). 21, 2010)).

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4. Costs and Benefits Associated With include products that meet the security-based swap dealers would be Specific Rules Insurance Safe Harbor or Insurance required to register as swap dealers or 1288 (a) Insurance Safe Harbor and Grandfather in the swap or security- SBS dealers and be subject to the Grandfather for Insurance Products based swap definition would subject substantive requirements that result (Rules 3a69–1 Under the Exchange Act) traditional insurance products to the from such registration. Title VII regime which the SEC does not The rules adopted in this release (i) Programmatic Benefits and Costs believe is intended by Congress. provide continuity in the regulatory The Commissions are adopting rules Imposing programmatic costs on the treatment of agreements, contracts, and that establish an Insurance Safe Harbor insurance industry, such as those transactions that are insurance and fall and an Insurance Grandfather for certain associated with compliance with the outside the swap and security-based agreements, contracts, and transactions registration, compliance, and operation swap definitions. Market participants that meet the conditions and tests set and governance requirements as will be able to continue to rely on their forth in rule 3a69–1 under the Exchange described above, in addition to the existing understanding of insurance Act.1279 The agreements, contracts, and Securities Act and Exchange Act laws and regulations to engage in transactions that satisfy the Insurance requirements applicable to security- business activities relating to the Safe Harbor or Insurance Grandfather based swap transactions involving non- insurance agreements, contracts, and under the Exchange Act will fall outside ECPs, would increase the business costs transactions that satisfy the Insurance the statutory swap and security-based of insurance providers, which costs Safe Harbor or Insurance Grandfather. 1280 swap definitions. The SEC believes could be passed on to the consumers (ii) Assessment Costs that the conditions and tests set forth in who need such insurance. In addition, the Insurance Safe Harbor represent the because of the above costs as well as the Market participants will need to characteristics of many types of Securities Act and Exchange Act assess whether a particular agreement, traditional insurance products.1281 As restrictions applicable to offers and contract, or transaction satisfies the stated above, the Commissions are not sales of security-based swaps to non- Insurance Safe Harbor or Insurance aware of anything in the legislative ECPs, including products that meet the Grandfather, prior to execution, but no history or Title VII itself to suggest that Insurance Safe Harbor in the swap or later than when the parties offer to enter Congress intended for traditional security-based swap definition could into the agreement, contract, or insurance products to be regulated as potentially affect the ability of insurance transaction. If such agreement, contract, swaps or security-based swaps.1282 providers to continue to offer insurance or transaction satisfies rules 3a69–1 Typically, insurance has not been products and disrupt contracts that under the Exchange Act, it would fall regulated under the Federal securities satisfy the Insurance Grandfather that outside the swap and security-based laws; although variable life insurance are used every day in the American swap definitions. If such agreement, and annuities are securities and are economy. For example, if Title VII contract, or transaction does not satisfy regulated under the Federal securities applied to traditional insurance the Insurance Safe Harbor or Insurance laws.1283 Although a broad reading of products, people who purchased Grandfather, it would need to be the swap definition could encompass insurance to protect their property or analyzed based upon its own facts and traditional insurance, the SEC does not families against accidental hazards or circumstances in order to determine believe that such a reading is consistent risks would need to be qualified as whether it falls within or outside the with Congressional intent.1284 To ECPs 1285 or the offer and sale of the swap or security-based swap definition. insurance products that were security- For agreements, contracts, or 1279 See supra part II.B.1. based swaps would need to be transactions entered into subsequent to 1280 Id. registered with the SEC 1286 and traded the effective date of such rule, this 1281 Id. on an exchange; 1287 and for swaps that analysis will have to be performed prior 1282 Id. are under the CFTC jurisdiction would to execution but no later than when the 1283 See generally section 3(a)(8) of the Securities only be able to be sold on or subject to parties offer to enter into the agreement, Act, 15 U.S.C. 77c(a)(8), and section 12(g) of the contract, or transaction to customers to Exchange Act, 15 U.S.C. 78l(g). The SEC has the rules of a board of trade. In addition, previously stated its view that Congress intended insurance providers that offer insurance ensure compliance with Title VII. any insurance contract falling within section 3(a)(8) products exceeding the de minimis Incurring these assessment costs with to be excluded from all provisions of the Securities threshold (as adopted in the Entities respect to these agreements, contracts, Act notwithstanding the language of the Securities or transactions would not have been Act indicating that section 3(a)(8) is an exemption Release) applicable to swap dealers and from the registration but not the antifraud required in most cases prior to Title VII provisions. See Definition of ‘‘Annuity Contract or swap transactions with non-ECPs are subject to for two primary reasons. First, as Optional Annuity Contract’’, 49 FR 46750, 46753 additional restrictions under the Federal securities security-based swaps were not regulated (Nov. 28, 1984). See also Tcherepnin v. Knight, 389 laws and the Commodity Exchange Act. See CEA prior to Title VII, there was no need to U.S. 332, 342 n.30 (1967) (Congress specifically section 1a(47), 7 U.S.C. 1a(47). Insurance policies stated that ‘‘insurance policies are not to be are typically not subject to individual negotiation. determine whether an agreement, regarded as securities subject to the provisions of Additionally, the average insurance purchaser may contract or transaction fell within or the [Securities] act,’’ (quoting H.R. Rep. 85, 73rd not qualify as an ECP. See CEA section outside the definition of security-based Cong., 1st Sess. 15 (1933)). See also supra note 42. 1a(18)(A)(xi), 7 U.S.C. 1a(18)(A)(xi). swap agreement in the CFMA. Second, 1284 Section 206A of the GLBA, 15 U.S.C. 78c note 1285 An individual is considered an ECP if the defined the term ‘‘swap agreement’’ and the CFMA individual ‘‘has amounts invested on a the need for parties to assess individual had two requirements in addition to the definition discretionary basis, the aggregate of which is in types of insurance for purposes of of ‘‘swap’’ itself: (1) The transaction is between excess of—(i) $10,000,000; or (ii) $5,000,000 and determining whether the Federal ECPs (as defined prior to enactment of the Dodd- who enters into the agreement, contract, or securities laws apply would be limited Frank Act); and (2) the material terms of the swap transaction in order to manage the risk associated agreement (other than price and quantity) are with an asset owned or liability incurred, or because, as previously stated, typically, subject to individual negotiation. Section 762 of the reasonable likely to be owned or incurred, by the Dodd-Frank Act removed these requirements from individual.’’ CEA section 1a(18)(A)(xi), 7 U.S.C. 1288 See Registration of Swap Dealers and Major the definition of swap agreement. See supra part 1a(18)(A)(xi). Swap Participants, 77 FR 2613, corrected at 77 FR XI.A.1, notes 1225 and 1226. The definition of swap 1286 See section 5(e) of the Securities Act, 15 3590 (regarding swap dealers and major swap in Title VII of the Dodd-Frank Act is not U.S.C. 77e(d). participants); SB Swap Participant Proposing conditioned on the existence of either of the two 1287 See CEA section 2(e), 7 U.S.C. 2(e), and Release, supra note 1239, (regarding SBS dealers requirements, although swap or security-based section 6(l) of the Exchange Act, 15 U.S.C. 78f(l). and MSBSPs).

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insurance has not been regulated under determine whether the Insurance Safe swap or security-based swap the Federal securities laws, although Harbor or Insurance Grandfather applies definition.1293 variable life insurance and annuities are to an agreement, contract, or transaction The Commissions received several securities and are regulated under the will range from $378 to $27,000, with comments in support of alternatives to Federal securities laws.1289 $27,000 representing a reasonable rule 3a69–1 under the Exchange Act as The SEC believes that rule 3a69–1 estimate of the upper end of the range proposed.1294 The alternatives suggested under the Exchange Act reduces the of the costs.1292 by commenters include: assessment costs that would otherwise • A test based on whether the exist without these rules. Without rule (iii) Alternatives agreement, contract, or transaction is 3a69–1 under the Exchange Act, market The SEC could have determined to subject to regulation as insurance by the participants would still need to assess not further define the terms ‘‘swap’’ and insurance commissioner of the whether or not the agreement, contract, ‘‘security-based swap’’ to address the applicable state(s).1295 or transaction they are offering falls status of traditional insurance products. • A test based on the application of within the swap or security-based swap If the Commissions did not further section 3(a)(8) of the Securities Act 1296 definition. More time and effort would define the terms ‘‘swap’’ and ‘‘security- to the agreement, contract, or likely be spent on the assessment based swap’’ to address the status of transaction.1297 because of lack of any safe harbor or traditional insurance products by • Various alternative tests that add (or grandfather to rely on. Without rule adopting the Insurance Safe Harbor or exclude) requirements to the Product 3a69–1 under the Exchange Act, market the Insurance Grandfather certain Test and the Provider Test.1298 participants may feel the need to request insurance providers would have treated The Commissions have considered joint interpretations from the their insurance products as swaps or each of these alternatives proposed by Commissions before they invest security-based swap, thereby incurring commenters and are adopting the final resources in insurance business, even programmatic costs that would rule as discussed above.1299 The with respect to agreements, contracts, or otherwise be avoidable. Other insurance Commissions are not adopting the transactions that would otherwise meet providers could misinterpret the specific alternative tests as proposed by the Insurance Safe Harbor or Insurance application of the definition of swap to commenters. In considering each of Grandfather. certain agreements, contracts, or these alternatives, the SEC has taken The SEC recognizes that the transactions to determine that they fall into account the costs and benefits assessment costs associated with rule outside such definition of swap or associated with each alternative. 3a69–1 under the Exchange Act may security-based swap, in which case the In the SEC’s view, as discussed 1300 include costs related to obtaining legal amount of Title VII programmatic above, because these alternative advice on whether an agreement, benefits and costs with respect to such tests do not adequately distinguish contract, or transaction meets the products may potentially decrease. As traditional insurance products from requirements of the Insurance Safe stated above, without rule 3a69–1 under Title VII instruments, they could result Harbor or Insurance Grandfather. The the Exchange Act, there also would be in an over-inclusive Insurance Safe SEC has sought to minimize the costs of higher assessment costs to determine Harbor or Insurance Grandfather and this analysis by adopting an approach whether an agreement, contract, or fail to include in the Title VII regulatory that incorporates the characteristics of transaction falls within or outside the regime agreements, contracts, and traditional insurance into the transactions that Congress intended to straightforward Product Test and 1292 The average cost incurred by market be regulated as swaps or security-based 1301 Provider Test, as described in the participants in connection with assessing whether swaps. Therefore, the programmatic an agreement, contract, or transaction is a swap or benefits of the Title VII regime would discussions of relevant rules above. security-based swap is based on the estimated The SEC believes there will be amount of time that staff believes will be required not be fully realized if any of the minimal assessment costs for parties to for both in-house counsel and outside counsel to alternatives were adopted. determine whether an agreement, apply rule 3a69–1. Staff estimates that some agreements, contracts, or transactions will clearly (b) Narrow-Based Security Index Rules contract, or transaction is among those satisfy the Insurance Safe Harbor, Insurance (Rules 3a68–1a, 3a68–1b, and 3a68–3(a) specifically enumerated in rule 3a69–1 Grandfather and an in-house attorney, without the Under the Exchange Act) under the Exchange Act 1290 or that falls assistance of outside counsel, will be able to make within the Insurance Grandfather.1291 a determination in one hour. Based upon data from (i) Programmatic Costs and Benefits SIFMA’s Management & Professional Earnings in With respect to rule 3a69–1 under the the Securities Industry 2011 (modified by SEC staff As previously stated, Title VII created Exchange Act, the SEC believes that at to account for an 1800-hour-work-year and a jurisdictional division between the least some market participants are likely multiplied by 5.35 to account for bonuses, firm size, CFTC and the SEC. The CFTC has to seek legal counsel for interpretation employee benefits and overhead), staff estimates jurisdiction over swaps, whereas the that the average national hourly rate for an in-house of various aspects of the rule, counsel is $378. If an agreement, contract, or SEC has jurisdiction over security-based particularly when structuring new or transaction is more complex, the SEC estimates the novel insurance products. The costs analysis will require approximately 30 hours of in- 1293 See supra part XI.A.4(a)(ii). associated with obtaining such legal house counsel time and 40 hours of outside counsel 1294 See supra part II.B.1.d), for a discussion of counsel would vary depending on the time. The SEC estimates the costs for outside legal each of the proposed alternatives. services to be $400 per hour. This is based on an 1295 See ACLI Letter; AFGI Letter; AIA Letter; relevant facts and circumstances, estimated $400 per hour cost for outside legal MetLife Letter and Travelers Letter. including the complexity of the services. This is the same estimate used by the SEC 1296 15 U.S.C. 77c(a)(8). for these services in the release involving agreement, contract, or transaction and 1297 See ACLI Letter at 7; AFGI Letter at 3; CAI Exemptions for Security-Based Swaps Issued By Letter at 21–25 and Nationwide Letter at 4. whether an interpretation from the Certain Clearing Agencies, Release No. 33–9308 1298 Commissions is requested. The SEC (Mar. 30, 2012), 77 FR 20536 (Apr. 5, 2012). See ACLI Letter; AIA Letter; Nationwide believes that the range of costs to Accordingly, on the high end of the range the SEC Letter and NAIC Letter. 1299 undertake the legal analysis required to estimates the cost to be $27,340 ($11,340 (based on See supra part II.B.1. 30 hours of in-house counsel time x $378) + 1300 See supra part II.B.1.d). $16,000 (based on 40 hours of outside counsel x 1301 For a more detailed discussion of the 1289 See supra note 1283. $400). This estimate is rounded by two significant comments, including those that suggested 1290 See supra part II.B.1. digits to avoid the impression of false precision of alternatives, and the Commissions’ response, see 1291 See supra part II.B.1.c). the estimate. supra part II.B.1.d).

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swaps. In most instances it is clear swaps to be different from its requirements, and incur the costs based on a plain reading of the statute application to the swaps that will be associated with such Exchange Act whether a Title VII instrument is a swap regulated by the CFTC, as the relevant periodic reporting. or security-based swap (e.g., a CDS products, entities and market (ii) Assessment Costs referencing a single security or issuer is themselves are different, or because the a security-based swap).1302 In other relevant statutory provisions are Market participants will need to instances, such as index CDS, whether different. The SEC believes, however, ascertain whether an agreement, a Title VII instrument is a swap or that the programmatic costs and benefits contract or transaction based on an security-based swap depends on (which will be discussed in subsequent index is a swap or a security-based whether such instrument is based on a releases adopting substantive rules) that swap, prior to execution, but no later ‘‘narrow-based security index’’ or events will flow from the application of rules than when the parties offer to enter into relating to ‘‘issuers of securities in a under either jurisdiction as a result of it, according to the criteria set forth in narrow-based security index’’.1303 The applying rules 3a68–1a, 3a68–1b, and the definitions of the terms ‘‘narrow- Commissions are adopting rules 3a68– 3a68–3(a) under the Exchange Act are based security index’’ and ‘‘issuers of 1a and 3a68–1b under the Exchange Act expected to be broadly similar and securities in a narrow-based security to further define the terms ‘‘issuers of complementary. index.’’ The SEC expects that this assessment will be made each time an securities in a narrow-based security In addition, since Title VII index’’ and ‘‘narrow-based security index is considered to be used or specifically provides that security-based created for purposes of transactions index’’ for purposes of analyzing swaps are securities and grants the SEC 1304 based on such index, and each time the CDS. Additionally, the Commissions the exclusive authority to regulate are adopting rule 3a68–3(a) under the material terms of the index on which security-based swaps (other than as to the agreement, contract, or transaction is Exchange Act to define narrow-based mixed swaps for which the SEC shares security index, except as otherwise based are amended or modified.1308 jurisdiction with the CFTC), in adopting These assessment costs with respect to provided in rules 3a68–1a and 3a68–1b, rules 3a68–1a, 3a68–1b, and 3a68–3(a) consistent with the statutory definition agreements, contracts, or transactions under the Exchange Act to further based on indexes did not arise prior to set forth in section 3(a)(55) of the define the terms ‘‘narrow-based security Exchange Act and the rules, regulations the enactment of Title VII. The SEC index,’’ and ‘‘issuers of securities in a and orders of the SEC thereunder. believes that such assessment costs may narrow-based security index’’, the SEC As discussed above, there are vary depending on the composition of programmatic costs and benefits that is mindful of the programmatic costs the index that may underlie agreement, flow from being a Title VII and benefits specifically associated with contract, or transaction. For example, instrument.1305 The overall security-based swaps falling under the the number of components in an index programmatic costs and benefits flowing Federal securities laws regime and being may impact the assessment costs from an agreement, contract, or regulated by the SEC. These because of the need to determine transaction being a swap or a security- programmatic benefits include, for whether the index’s components satisfy based swap may be impacted by the example, the applicability of the the various tests within the rule. similarities and differences in the Securities Act registration, disclosure, However, once such assessment is Commissions’ regulatory programs for and civil liability scheme, as well as the performed and the narrow-based or swaps and security-based swaps. SEC’s authority to take action to protect broad-based characteristics have been Generally, the Title VII regulatory investors and prevent fraud and market established with respect to an index, regimes of the CFTC and SEC are manipulation. These benefits could in unless the characteristic of such index expected to be broadly similar and some cases have corresponding costs changes, any market participants complementary. Title VII requires the associated with the application of the engaging in agreements, contracts, or SEC and the CFTC to consult and Securities Act related to registration, transactions referencing such index coordinate for the purposes of assuring disclosure and civil liability scheme and would not need to incur any material regulatory consistency and the registration, disclosure and liability assessment costs, other than to confirm comparability with respect to rules provisions of the Exchange Act. For that the index has not changed in a way adopted and orders issued pursuant to example, if an issuer of an underlying that would change its classification from Title VII to the extent possible.1306 Title security enters into a security-based narrow-based to broad-based or vice VII provides that the Commissions swap it will have to comply with the versa. should treat functionally or Securities Act registration requirements Although the assessment cost economically similar products or both for the security-based swap and the associated with rules 3a68–1a, 3a68–1b, entities in a similar manner in such underlying security unless an and 3a68–3(a) under the Exchange Act rules or orders, but does not require exemption from registration is available. may vary, the SEC estimates that costs identical rules.1307 The Commissions As another example, if market associated with undertaking the may, therefore, diverge substantively on participants wish to sell security-based determination of whether an agreement, certain rulemakings. In certain areas, the swaps to non-ECPs they will have to contract or transaction based on an SEC believes it may be appropriate for comply with the registration index is a swap or security-based swap 1309 Title VII’s application to security-based requirements of the Securities Act. Any will range from $378 to $20,000. The person that would be required to 1308 See generally supra part III.G. 1302 See section 3(a)(68)(A)(II) of the Exchange comply with the registration 1309 Act, 15 U.S.C. 78c(a)(68)(A)(II). requirements of the Securities Act with The average cost incurred by market participants in connection with assessing whether 1303 See section 3(a)(68)(A)(I) and (III) of the respect to security-based swaps will an agreement, contract, or transaction is a swap or Exchange Act, 15 U.S.C. 78c(a)(68)(A)(I) and (III). incur the costs of such registration, security-based swap is based on the estimated 1304 See supra part III.G.3.b). including legal and accounting costs. amount of time that staff believes will be required 1305 See supra part XI.A.3. Additionally, such person will become for both in-house counsel and outside counsel to 1306 See section 712(a)(1) and (a)(2) of the Dodd- apply the definition. Staff estimates that the average Frank Act. subject to the periodic reporting national hourly rate for an in-house counsel is $378 1307 See section 712(a)(7)(A) and (B) of the Dodd- requirements of the Exchange Act, based on data from SIFMA’s Management & Frank Act. unless already subject to such Continued

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SEC believes that some agreements, index.’’ The SEC believes the to the specific provisions of the contracts, or transactions based on an assessment cost associated with statutory ADTV test, the Commissions established index would not need the determining whether an index CDS is a have determined that the ADTV test is assistance of outside counsel, and a swap or security-based swap would be not a useful test for purposes of determination can be made in one hour. greater in the absence of rules 3a68–1a determining whether an index of If an agreement, contract, or transaction and 3a68–1b. Without these rules, reference entities or debt securities is a is more complex, the SEC estimates the market participants would still need to ‘‘narrow-based security index’’ because analysis will require approximately 20 analyze index components and it would the components of the index are either hours of in-house counsel time and 30 be difficult to apply the statutory reference entities, which do not ‘‘trade,’’ hours of outside counsel time. language of ‘‘issuer of securities in a or debt instruments, which commonly Accordingly, if an agreement, contract narrow-based security index’’ in section are not listed, and, therefore, do not or transaction is based on a newly 3(a)(68)(A)(ii)(III) of the Exchange Act to have a significant trading volume.1317 structured customized index or basket index CDS, given that the existing Applying the ADTV test in the existing to suit a particular investment or statutory definition of ‘‘narrow-based statutory narrow-based security index hedging need, the SEC estimates that the security index’’ and the past guidance definition would not serve any are focused on equity security indexes, assessment may be at or close to the purposes. However, the basis for such upper end of the estimated range, as volatility indexes and debt security provision, that there is sufficient trading part of the structuring of such indexes, none of which are specifically in the securities, public information customized index or basket.1310 tailored for index CDS.1312 Absent rules about, and therefore market following 3a68–1a and 3a68–1b, it is very likely (iii) Alternatives that market participants would need to of, the issuer of the securities, applies to The Commissions received many request interpretations from the index CDS. As a substitute for such comments on proposed rules 3a68–1a Commissions. Rules 3a68–1a and 3a68– ADTV test, the SEC believes that there and 3a68–1b and have incorporated 1b provide tailored and objective should be public information available many of the suggested alternatives into criteria, similar to the criteria used in about a predominant percentage of the the final rules and rejected, after careful the context of futures contracts on reference entities included in the index, consideration, other suggested volatility indexes and debt security or, in the case of an index CDS on an alternatives, as fully discussed in indexes, to assist market participants in index of securities, about the issuers of section III.G.3.b. The policy choices determining whether an index CDS is the securities or the securities made with respect to accepting or based on issuers of securities in a underlying the index. The SEC believes rejecting the alternatives suggested by narrow-based security index.1313 These that this should reduce the likelihood the commenters have been informed by rules will allow market participants to that non-narrow-based indexes the cost and benefit considerations. In make determinations without requesting referenced in index CDS, or the particular, as stated above, the SEC is interpretations from the Commissions component securities, or the named mindful of the programmatic costs and and, therefore, should reduce the issuers of securities in that index would benefits specifically associated with assessment costs. be used as a surrogate for the reference security-based swaps falling under the Commenters expressed concern entities securities without complying Federal securities laws regime.1311 associated with the public information with the Federal securities laws. In One alternative to rules 3a68–1a and availability test and suggested that the particular, the SEC believes that the 3a68–1b is for the Commissions to not public information availability test not public information availability test further define the terms ‘‘issuers of be incorporated into the final rule for should reduce the likelihood that the securities in a narrow-based security various reasons.1314 As discussed index CDS could be used to circumvent 1315 index’’ or ‘‘narrow-based security above , the Commissions are the registration provisions of the adopting the public information Securities Act and provisions of the Professional Earnings in the Securities Industry availability test with some 2011 (modified by SEC staff to account for an 1800- Exchange Act through the use of CDS modifications. based on such indexes, manipulate the hour-work-year and multiplied by 5.35 to account The SEC believes there are many for bonuses, firm size, employee benefits and reference entities securities or the programmatic benefits associated with overhead). The SEC estimates the costs for outside securities in the index and reduce the legal services to be $400 per hour. This is the same the public information availability test. potential for misuse of material non- estimate used by the SEC for these services in the As noted above, the public information release involving Exemptions for Security-Based public information through the use of Swaps Issued By Certain Clearing Agencies, Release availability test is intended as the 1318 substitute test for the ADTV provision CDS based on such indexes. If a CDS No. 33–9308 (Mar. 30, 2012), 77 FR 20536 (Apr. 5, is based on an index that does not 2012). Accordingly, on the high end of the range the in the statutory narrow-based security SEC estimates the cost to be $19,560 ($7,560 (based index definition.1316 The ADTV test is satisfy the public information 1319 on 20 hours of in-house counsel time x $378) + designed to take into account the availability test, such index CDS $12,000 (based on 30 hours of outside counsel x will be a security-based swap and thus $400). This estimate is rounded by two significant trading of equity securities and, because digits to avoid the impression of false precision of the listing standards for equity the estimate. securities require that the security be 1317 Id. 1310 For example, the legal costs associated with registered under the Exchange Act, the 1318 Id. the analysis of whether an index or basket CDS is 1319 So long as the effective notional amounts a swap or security-based swap will include, among issuer of the equity security will be allocated to reference entities or securities included other things, analysis of the weighting of each index subject to the periodic reporting in the index that satisfy the public information or basket component, the aggregate weighting of any requirements of the Exchange Act. Due availability test comprise at least 80 percent of the five non-affiliated reference entities included in the index’s weighting, failure by a reference entity or index or basket, whether a predominant percentage security included in the index to satisfy the public 1312 See supra part III.G.3. (by weighting) of the issuers included in the index information availability test would be disregarded 1313 or basket satisfy the public information availability Id. if the effective notional amounts allocated to that test and whether any issuer included in the index 1314 See LSTA Letter (with respect to loans), reference entity or security comprise less than 5 or basket with 5% or more weighting satisfies the Markit Letter, ISDA Letter and SIFMA Letter. percent of the index’s weighting. See paragraph (b) public information availability test. 1315 See supra part III.G.3.b(iii). of rules 1.3(zzz) and 1.3(aaaa) under the CEA and 1311 See supra part XI.4.(b)(i). 1316 Id. rule 3a68–1a and 3a68–1b under the Exchange Act.

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subject to the Federal securities laws believes that these modifications will described above with respect to the and the SEC’s oversight.1320 mitigate the assessment costs that the public information availability test. Some commenters indicated that the commenter is concerned about.1323 Similarly, the Commissions also determinations of public availability of The SEC believes that the overall rejected commenters’ suggestion that the information would be costly but did not assessment costs of including a public presence of a third-party index provider quantify such costs or explain the information availability test are justified would assure that sufficient information difficulty in making an assessment of in light of its benefits of preventing the is available regarding the index CDS whether information was publicly index CDS from being used as a itself without the need for a public 1327 available.1321 The SEC recognizes that surrogate for the underlying securities information availability test. As there will be assessment costs or securities of the referenced issuer of stated above, the public information associated with application of the securities. This should, in turn, prevent availability test is intended to assure the public information availability test. The circumvention of the application of the availability of information about the SEC notes that the public information Securities Act to index CDS components of the index, the availability test applies only for underlying securities and issuers of the transactions, and prevent fraud, 1328 purposes of determining whether an manipulation and misuse of material securities. The existence of a third- index is a ‘‘narrow-based security non-public information. party index provider does not imply any index.’’ The SEC would expect that greater likelihood that such public One commenter suggested replacing market participants would look to the information is available.1329 Although the public information availability test index provider to make the assessment the existence of a third-party index with a volume trading test.1324 The or, if the index or basket is customized provider as a substitute for the public Commissions are not adopting a by the market participant that the information availability test would volume-trading test based on the CDS creator of the index would take into reduce assessment costs of the market components of the index or on the index account the public information participants using such an index (other itself, either as a replacement for the availability of the index components in than the index provider who must public information availability test or as creating the custom index or basket. As evaluate compliance with index an alternative means of satisfying it. A a result, while the SEC recognizes that criteria), the SEC does not believe that volume trading test based on CDS is not there will be costs in evaluating whether the existence of the third party index practicable to use to determine the the index components satisfy the tests, provider is a substitute for the public character of such index CDS because the including the public information information availability test. The SEC character of the index CDS would have availability test, the SEC believes that believes that the information a third- to be determined prior to any the index provider (or the creator of the party index provider makes available transaction in the Title VII Instrument. custom index or basket) would already about the construction of an index, Given that there would be no trading be evaluating the index components to index rules, components, and volume at the time such determination determine whether the provider’s index predetermined adjustments provides is made, the index CDS would fail a criteria were satisfied and, as part of information only about the index and is volume-trading test in all cases 1325 and such evaluation, would be able to not a substitute for the public the assessment costs incurred in ascertain whether the public availability of information about the connection with such test would not information availability test is satisfied. issuers of the securities or the securities 1330 One commenter raised a specific serve any purpose. There also would be in the index. In addition, the SEC concern about the assessment cost assessment costs in determining how does not believe that the existence of a relating to applying the public many transactions in the CDS index or third-party index provider indicates any information availability test to indexes each CDS component of the index likelihood that such public information of loans or borrowers and stated that existed, and it is not apparent that any is available about the components of the unlike index of securities, which are such trade information is either publicly index, which the SEC believes is generally subject to national or available or verifiable at this time. In important to reduce the potential for exchange-based reporting and addition, the SEC also believes that a manipulation of the component disclosure regimes, a higher proportion volume test based either on the CDS securities of an index, or the named of the components of an index of loans components of the index or the CDS issuers of securities in an index, the or borrowers may not be registered index itself would not be an appropriate misuse of non-public information about securities or reporting companies under substitute for or an alternative to a such an index, the component securities the Exchange Act and therefore, this public information availability test with or the reference entities and commenter stated that it would be more respect to the referenced entity, issuer of circumvention of other provisions of the securities, or underlying security Federal securities laws through the use difficult or costly to determine whether 1331 an index of loans or borrowers meets the because such a volume-based test would of CDS based on such an index. not provide transparency on such public information availability test.1322 Further, the SEC notes that a third-party underlying entities, issuers of securities The SEC has modified the public index provider may create customized or securities.1326 information availability test to expand The volume of indexes at the behest of market the categories of instrument to be transactions in a particular CDS or the participants, including as part of its aggregated for purposes of the CDS index does not relate to whether regular business and be paid by such outstanding indebtedness criterion and there is public information about the market participants for its index to change the method of calculating reference entity or reference security 1327 affiliation for purposes of the public underlying the CDS or CDS index. See ISDA Letter; and SIFMA Letter. Neither Therefore, a volume-trading test would commenter provided any analysis to explain how information availability test. The SEC or whether a third-party index provider would be not achieve the programmatic benefits able to provide information about the underlying 1320 See id. securities or issuers of securities in the index. 1321 See LSTA Letter (with respect to loans); and 1323 See supra part III.G.3.b)iii). 1328 See supra part III.G.3.b)iii). SIFMA Letter 1324 See Markit Letter. 1329 Id. 1322 See July LSTA Letter. See also supra part 1325 See supra part III.G.3.b)iii). 1330 Id. III.G.3(b)(iii). 1326 Id. 1331 Id.

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customization and creation services.1332 security-based swaps, their affiliates, or entered into by the foreign government Accordingly, the SEC does not believe underwriters of their securities).1337 issuing the debt securities upon which that a third party index test is an There are certain programmatic costs the qualifying futures contract is based appropriate alternative for the public associated with the rule that market or referenced, an affiliate of such foreign information availability test and the participants will need to be cognizant government or an underwriter of such costs to market participants is justified of. For example, although rule 3a12–8 foreign government securities. All of by the programmatic benefits such test allows qualifying foreign futures to be these determinations may be readily provides.1333 physically settled outside the United ascertained by the parties entering into As more fully discussed above in States, the conditions of rule 3a68–5 the agreement, contract, or transaction. section III.G.3.b.iii, in considering other require that the swap be cash settled in Therefore, the assessment costs alternatives, including whether to revise order to be a swap and not a security- associated with rule 3a68–5 under the or maintain the public information based swap. This has the potential cost Exchange Act should be nominal availability test, the SEC has of not permitting settlement on the same because parties should be able to make consistently considered the terms as the qualifying foreign future. assessments under rule 3a68–5 in less programmatic benefits described above However, the SEC believes that, as with than an hour. and the importance of assuring that other Title VII Instruments, if the Title there is information available with VII Instrument can be physically settled (d) Tolerance and Grace Period for respect to the issuers of securities with securities, it will be a security- Swaps and Security-Based Swaps constituting a predominant percentage based swap. The other condition in rule Traded on Regulated Trading Platforms of an index on which a CDS is based if 3a68–5 that may impact the (Rule 3a68–3 Under the Exchange Act) such index is not going to be considered characterization of the Title VII (i) Programmatic Benefits and Costs a ‘‘narrow-based security index.’’ Instrument is that the Title VII In addition to defining narrow-based Instrument cannot be entered into by (c) Swaps on Certain Futures Contracts security index consistent with the the foreign government, its affiliates, or on Foreign Sovereign Debt (Rule 3a68– statutory definition set forth in section an underwriter of its securities. This 5 Under the Exchange Act) 3(a)(55) of the Exchange Act and the condition is intended to preserve the (i) Programmatic Benefits and Costs programmatic benefit of the application rules, regulations and orders of the SEC thereunder, Rule 3a68–3 under the Rule 3a68–5 provides that a Title VII of the Securities Act to transactions in Title VII Instruments entered into by Exchange Act establishes a tolerance instrument that is based on qualifying and grace period for swaps and security- foreign futures contracts on debt issuers of securities, their affiliates and underwriters. Moreover, the final rule based swaps to address the treatment of securities of one of the 21 enumerated indexes that migrate from broad-based foreign governments is a swap and not provides consistent treatment of to narrow-based or narrow-based to a security-based swap if the Title VII qualifying foreign futures contracts on broad-based, so that market participants instrument satisfies certain the debt securities of the 21 enumerated will know which regulatory jurisdiction conditions.1334 This rule is intended to foreign governments and Title VII will apply to such Title VII prevent such Title VII instruments from instruments based on such futures instruments.1338 being used to circumvent both the contracts on the debt securities of the 21 There are programmatic costs and conditions of rule 3a12–8 and the enumerated foreign governments, which benefits associated with tolerance and Federal securities laws protections will allow instruments to trade through grace periods. Because swaps may only underlying such conditions.1335 The designated contract markets. trade on designated contract markets conditions provided in rule 3a68–5 are (ii) Assessment Costs intended to address these concerns. As (‘‘DCM’’), swap execution facilities discussed above, certain of the The SEC believes that the assessment (‘‘SEF’’), and foreign boards of trade qualifying foreign futures contracts on cost associated with determining (‘‘FBOT’’), and security-based swaps the debt securities of one of the 21 whether a swap on certain futures may trade only on registered national enumerated foreign governments that contracts on foreign government securities exchanges (‘‘NSE’’) and SB satisfy the conditions of rule 3a12–8 securities constitute a swap or security- SEFs, a tolerance and grace period trade with significant volume through based swap under rule 3a68–5 should creates the benefit of permitting the foreign trading venues.1336 Treating be minimal. Currently, qualifying index provider to substitute certain Title VII Instruments on such qualifying foreign futures contracts on debt index components in order to maintain foreign futures contracts, subject to the securities of the 21 enumerated foreign the characteristic of such index being conditions provided in rule 3a68–5, as governments are traded on exchanges or narrow-based or broad-based and allow swaps and not security-based swaps boards of trade. Market participants may market participants to continue to enter would not raise the concerns that such look at the exchange or board of trade into the Title VII instrument on which 1339 swaps could be used to circumvent rule listing to determine what they are. such index is based. The associated 3a12–8, the Federal securities laws Therefore, the assessment, in programmatic costs are primarily related concerns that such conditions are accordance with the rule, would to the monitoring of index migrations intended to protect, or allow primarily focus on whether such swap performed by various trading platforms. circumvention of the provisions of the itself is traded on or through a board of Such monitoring costs would be part of Securities Act applicable to security- trade; whether the swap is cash-settled; the operation costs that a trading based swaps (including those applicable whether the futures is traded on a board platform would incur in connection to security-based swaps entered into by of trade; whether any security used to with implementing Title VII regardless issuer of securities underlie such determine the cash settlement amount of whether rule 3a68–3 under the are not registered under the Securities Exchange Act is adopted. Absent rule 1332 Id. See also Proposing Release at 29852. Act or the subject of any American 3a68–3 under the Exchange Act, trading 1333 Id. depositary receipt registered under the platforms still need to have the 1334 See supra part III.E. Securities Act; and whether the swap is 1335 See supra note 717 and accompanying text. 1338 See supra part III.G.5. 1336 Id. 1337 Id. 1339 Id.

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technology necessary to monitor and Commissions regarding whether an inside counsel in lieu of outside counsel conduct surveillance for index agreement, contract or transaction (or a would reduce this estimate. Once such migration, as well as create internal class of agreements, contracts, or a joint interpretation is made, however, policies and procedures relating to such transactions) is a swap, security-based other market participants that seek to migration. On the other hand, without a swap, or mixed swap. As stated transact in the same agreement, tolerance and grace period, if a market above,1342 if an agreement, contract, or contract, or transaction (or class thereof) participant wishes to offset a security- transaction is a swap or a security-based would be able to rely on such based swap to hedge its index CDS swap the overall programmatic costs interpretation in determining whether position on an SEC-regulated trading and benefits that may arise from the their agreement, contract, or transaction platform where the underlying security Commissions’ regulatory programs are is a swap, security-based swap, or index has migrated from narrow-based expected to be broadly similar and mixed swap. Accordingly, assessment to broad-based, the participant would be complementary.1343 However, in costs may be affected by the number of prohibited from doing so because a Title implementing Title VII the parties seeing an interpretation or VII instrument based on the index Commissions may diverge on rules and whether prior interpretations with would be a swap, and is ineligible for requirements stemming from the Title respect to the same or similar trading on an NSE or SB SEF. VII regulatory regime. Accordingly, a agreements, contracts, or transactions party to an agreement, contract, or have been sought. (ii) Assessment Costs transaction will need to know the Rule 3a68–3 under the Exchange Act appropriate classification, e.g. whether (f) Definition of Swap (Rule 3a69–2 provides a tolerance and grace period it is a swap or security-based swap, in Under the Exchange Act) and does not require any determination order to know which regulatory regime (i) Programmatic Benefits and Costs to be made beyond the programmatic and corresponding requirements is Rule 3a69–2(a) under the Exchange cost to monitor for migration as applicable. The Dodd-Frank Act Act states that the term swap has the described above. The SEC believes that requires that, with respect to the meaning set forth in section 3(a)(69) of the assessment costs associated with definitions of swaps, security-based the Exchange Act.1345 Rule 3a69–2(b) rule 3a68–3 under the Exchange Act swaps, and mixed swaps, the under the Exchange Act explicitly should be nominal on the parties Commissions must jointly interpret defines the term ‘‘swap’’ to include an entering into an agreement, contract, or such definitions. This rule, by providing agreement, contract, or transaction that transaction. a mechanism for the Commissions to is a cross-currency swap, currency provide such joint interpretations, (iii) Alternatives option, foreign currency option, foreign allows parties to understand the timing exchange option, foreign exchange rate One commenter stated its view that and process for seeing such joint option, foreign exchange forward, extending the ‘‘grace period’’ from three interpretation. Regardless of this rule, foreign exchange swap, forward rate months to six months would ease any the programmatic costs and benefits that agreement, or non-deliverable forward disruption or dislocation associated flow from being a swap or security- involving foreign exchange, unless such with the delisting process with respect based swap remain the same for parties agreement, contract, or transaction is to an index that has migrated from requesting a joint interpretation. But, otherwise excluded by section 1a(47)(B) broad-based to narrow-based, or narrow- the rule allows for parties to the of the CEA.1346 Rule 3a69–2(c) under based to broad-based, and such agreement, contract, or transaction to the Exchange Act provides that: (1) A migration is not reversed during the request through a joint interpretation foreign exchange forward or a foreign tolerance period.1340 The commenter from the Commissions, what regulatory exchange swap shall not be considered did not provide any data, evidence, or regime would apply or whether the a swap if the Secretary of the Treasury other justification for its request. The agreement, contract, or transaction is makes the determination described in Commissions are adopting the three- within the definition of swap or section 1a(47)(E)(i) of the CEA; 1347 and month grace period as proposed, which security-based swap. (2) notwithstanding any such was the time frame used by Congress in determination, certain provisions of the the context of migration of indexes (ii) Assessment Costs CEA will apply to such a foreign underlying security futures to address The SEC estimates the costs of exchange forward or foreign exchange the same issue caused by index submitting a request for a joint swap (specifically, the reporting migration.1341 The SEC believes that the interpretation pursuant to rule 3a68–2 requirements in section 4r of the three-month grace period gives parties under the Exchange Act would be CEA 1348 and regulations thereunder to a swap or security-based swap on an approximately $20,000.1344 The use of index that has migrated sufficient time to execute offsetting positions and 1342 See supra part X.4(b)(i). average national hourly rate for an in-house 1343 Id. attorney is $378. The SEC estimates the costs for believes that it is appropriate to outside legal services to be $400 per hour. This is 1344 As stated in the Proposing Release at 29878, the same estimate used by the SEC for these maintain the three-month period that is n. 354, this estimate is based on information services in the release involving Exemptions for the applicable grace period for security indicating that the average costs associated with Security-Based Swaps Issued By Certain Clearing preparing and submitting a no action request to the futures. Agencies, Release No. 33–9308 (Mar. 30, 2012), 77 SEC staff, which the SEC believes is a process (e) Request for Interpretation Process FR 20536 (Apr. 5, 2012). Accordingly, the SEC similar to the process under rule 3a68–2 under the estimates the cost to be $19,560 ($7,560 (based on (Rule 3a68–2 Under the Exchange Act) Exchange Act. The staff estimates that costs 20 hours of in-house counsel time × $378) + $12,000 (i) Programmatic Benefits and Costs associated with a request pursuant to rule 3a68–2 (based on 30 hours of outside counsel × $400)) to will cost approximately $19,560. The SEC estimates Rule 3a68–2 under the Exchange Act submit a joint request for interpretation. This the analysis will require approximately 20 hours of allows persons to submit a request for estimate is rounded by two significant digits to in-house counsel time and 30 hours of outside avoid the impression of false precision of the a joint interpretation from the counsel time. Based upon data from SIFMA’s estimate. Management & Professional Earnings in the 1345 1340 See MarketAxess Letter. See also supra part Securities Industry 2011 (modified by SEC staff to 15 U.S.C. 78c(a)(69). III.G.5.b). account for an 1800-hour-work-year and multiplied 1346 7 U.S.C. 1a(47)(B). 1341 See section 3(a)(55)(C)(iii)(II) of the Exchange by 5.35 to account for bonuses, firm size, employee 1347 7 U.S.C. 1a(47)(E)(i). Act, 15 U.S.C. 77c(a)(55)(C)(iii)(II). benefits, and overhead), staff estimates that the 1348 7 U.S.C. 6r.

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and, in the case of a swap dealer or Exchange Act establishes the regulatory framework is established under rule major swap participant that is a party to framework for mixed swaps with which 3a68–4(c). The SEC has recognized the a foreign exchange swap or foreign parties to bilateral uncleared mixed programmatic benefits associated with exchange forward, the business conduct swaps (i.e., mixed swaps that are neither rule 3a68–4(c) and believes that in the standards in section 4s of the CEA 1349 executed on or subject to the rules of a mixed swap area, the process and regulations thereunder). Rule 3a69– DCM, NSE, SEF, SB SEF, or FBOT nor established by rule 3a68–4(c) would 2(c) under the Exchange Act further cleared through a DCO or clearing eliminate potentially duplicative clarifies that a currency swap, cross- agency), as to which at least one of the regulatory requirements and reduce the currency swap, currency option, foreign parties is dually registered with both the compliance costs associated with mixed currency option, foreign exchange CFTC and the SEC, will need to comply. swaps. option, foreign exchange rate option, or The SEC believes that paragraph (b) of non-deliverable forward involving rule 3a68–4 under the Exchange Act (ii) Assessment Costs foreign exchange is not a foreign will augment the programmatic benefits With respect to rule 3a68–4(b) under exchange forward or foreign exchange of the Title VII regulatory regime. The the Exchange Act, one cost is that swap subject to a determination by the rule addresses potentially duplicative parties to a mixed swap would need to Secretary of the Treasury as described in regulatory requirements for dually- determine whether they satisfy the the preamble. registered dealers and major conditions set forth in such rule in order Rule 3a69–2 is parallel to rule participants that are subject to to ascertain the regulatory treatment of 1.3(xxx)(2) under the CEA. In order to regulation by both the CFTC and the the mixed swap. Such assessment determine whether an agreement, SEC, while requiring dual registrants to includes determining whether the contract, or transaction is a ‘‘swap’’ or comply with the regulatory mixed swap is neither executed on nor ‘‘security-based swap’’, it is necessary requirements the Commissions believe subject to the rules of a DCM, NSE, SEF, for the Commissions to adopt parallel are necessary to provide sufficient SB SEF, or FBOT, whether the mixed rules that will apply to a Title VII regulatory oversight for mixed swaps swap will not be submitted for clearing, instrument. Therefore, rule 3a69–2 is transactions entered into by such dual and whether one party to the mixed included under the Exchange Act. The registrants. It eliminates potentially swap is a dually registered dealer or definition of swap is the starting point duplicative regulation and reduces the major participant. The SEC believes that for determining the status of a Title VII programmatic costs associated with the above determinations would be Instrument as a swap, security-based regulatory implementation and based on readily ascertainable facts and swap, or mixed swap. To the extent that compliance in the context of mixed the assessment costs associated with the specific agreements, contracts, and swaps by providing that a bilateral such determinations should be minimal. transactions listed in section 1a(47)(B) uncleared mixed swap would be subject With respect to rule 3a68–4(c) under of the CEA are swaps, the programmatic to all applicable provisions of the the Exchange Act, parties to mixed costs and benefits that flow from such Federal securities laws (and the SEC swaps have the option to decide agreements, contracts or transactions rules and regulations promulgated whether to submit a request for issuing being a Title VII instrument under rule thereunder) but would be subject only a joint order, weighing the benefits 3a69–2 will be determined by the to certain CEA provisions (and the realized from the joint order against the substantive rules adopted by the CFTC CFTC rules and regulations promulgated cost of submitting such request. If mandated by Title VII. If any such thereunder). parties to mixed swaps decide to submit agreements, contracts, or transactions Rule 3a68–4(c) under the Exchange a request, the SEC estimates the total are security-based swaps, the Act establishes a process for persons to costs of preparing and submitting a programmatic costs and benefits will be request that the Commissions issue a party’s request to the Commissions the same as with other security-based joint order, with respect to parallel 1351 pursuant to rule 3a68–4(c) under the swaps. provisions applicable to mixed Exchange Act will be $31,000 per swaps, to permit such persons (and any (ii) Assessment Costs request for mixed swaps for which a other person or persons that request for a joint interpretation Since this rule lists some of the types subsequently lists, trades, or clears that of agreements, contracts or transactions pursuant to rule 3a68–4(c) was not class of mixed swap) to comply with the previously made.1352 The use of inside already listed in section 1a(47)(B) of the parallel provisions of either the CEA or CEA 1350 and the determination made by the Exchange Act and related rules and 1352 As discussed in the Proposing Release at the Secretary of the Treasury, the SEC regulations (collectively ‘‘specified 29878, note 356, this estimate is based on does not believe there would be parallel provisions’’), instead of being information indicating that the average costs assessment costs in addition to those required to comply with parallel associated with preparing and submitting a no- incurred by market participants in action request to the SEC staff, which the SEC provisions in both the CEA and the believes is a process similar to the process under determining whether an agreement, Exchange Act. This process applies rule 3a68–4(c). The staff estimates that costs contract or transaction falls within the except with respect to bilateral, associated with such a request will cost definition of swap. uncleared mixed swaps where one of approximately $31,340. The SEC estimates the the parties to the mixed swap is dually analysis will require approximately 30 hours of in- (g) Mixed Swaps (Rule 3a68–4 Under house counsel time and 50 hours of outside counsel the Exchange Act) registered with the CFTC as a swap time. Based upon data from SIFMA’s Management dealer or major swap participant and & Professional Earnings in the Securities Industry (i) Programmatic Benefits and Costs with the SEC as a security-based swap 2011 (modified by SEC staff to account for an 1800- Rule 3a68–4(a) under the Exchange dealer or major security-based swap hour-work-year and multiplied by 5.35 to account for bonuses, firm size, employee benefits, and Act defines a ‘‘mixed swap’’ in the same participant, for which the regulatory overhead), staff estimates that the average national manner as the term is defined in both hourly rate for an in-house attorney is $378. The the CEA and Exchange Act. 1351 For purposes of paragraph (c) of rule 3a68– SEC estimates the costs for outside legal services to Furthermore, rule 3a68–4(b) under the 4 under the Exchange Act, ‘‘parallel provisions’’ be $400 per hour. This is the same estimate used means comparable provisions of the CEA and the by the SEC for these services in the release Exchange Act that were added or amended by Title involving Exemptions for Security-Based Swaps 1349 7 U.S.C. 6s. VII with respect to security-based swaps and swaps, Issued By Certain Clearing Agencies, Release No. 1350 7 U.S.C. 1a(47)(B). and the rules and regulations thereunder. 33–9308 (Mar. 30, 2012), 77 FR 20536 (Apr. 5,

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counsel in lieu of outside counsel regarding SBSAs beyond those required action would promote efficiency, would reduce this estimate. Absent such for swaps. The SEC recognized the competition, and capital formation.1358 a process, though, market participants following programmatic benefits and In addition, section 23(a)(2) of the that desire or intend to offer or enter costs in adopting this rule. Exchange Act 1359 requires the SEC, into such a mixed swap (or class As discussed above, SBSAs are swaps when adopting rules under the thereof) would not have the option to over which the CFTC has primary Exchange Act, to consider the impact request for the Commissions’ joint regulatory authority, but for which the such rules would have on competition. interpretation and absent a joint SEC has antifraud, anti-manipulation, Section 23(a)(2) of the Exchange Act interpretation, they would be required and certain other authority.1355 There also prohibits the SEC from adopting pursuant to Title VII to comply with all will be programmatic benefits and costs any rule that would impose a burden on regulatory requirements applicable to as a result of the SDRs, swap dealers, competition not necessary or both swaps and security-based swaps. and major swap participants appropriate in furtherance of the implementing and complying with the purposes of the Exchange Act. (iii) Alternatives books and records requirements The Commissions are further defining One commenter recommended that provided in sections 21 and 4s of the ‘‘swap’’ and ‘‘security-based swap’’ the Commissions require that market CEA.1356 The programmatic benefits and pursuant to section 712(d)(1) of the participants disaggregate mixed swaps costs will flow from the substantive Dodd-Frank Act.1360 In the Proposing and enter into separate simultaneous rules adopted by the CFTC regarding Release, the SEC stated that the SEC transactions so that they cannot employ record keeping requirements for swaps. preliminarily believed that the proposed mixed swaps to obscure the underlying SBSAs are swaps and will be subject to Exchange Act rules would not impose substance of transactions.1353 This these books and records requirements. significant burden on competition, that commenter stated that ‘‘the regulatory The SEC believes that the rules they would create efficient processes, complexity of dealing with a mixed proposed by the CFTC would provide and that they would not have adverse swap far outweighs the legitimate sufficient books and records regarding effects on capital formation.1361 In the benefits to counterparties from SBSAs,1357 and that additional books Proposing Release, the SEC requested documenting the transactions as mixed and records requirements for SBSAs comment on each of these issues,1362 swaps.’’ 1354 This commenter asserted may be duplicative and would not and no commenters responded to that some benefits of requiring produce corresponding benefits specifically address these issues. disaggregation include more useful warranting such additional costs. Rule The SEC recognizes that the most price reporting; increased transparency; 3a69–3 under the Exchange Act avoids significant impact of the swap and regulatory reporting and monitoring that any additional programmatic costs, security-based swap definitions will will align with the transaction database especially the additional compliance derive from these definitions serving as of the counterparties; and the thwarting and operation costs that would be the foundation for implementing the of illegitimate motivations, such as incurred by SDRs, swap dealers, and Title VII regulatory regime, particularly obfuscation of prices and fees. major swap participants in the area of given the significant impacts that Title Regardless of the benefits of data maintenance and recordkeeping, VII will have on the security-based swap disaggregation raised by the commenter, beyond those which have already been market. In adopting these definitional Title VII specifically contemplates that prescribed by the CFTC’s rules. rules, the SEC has sought to fairly reflect there would be mixed swaps comprised the statutory definitions and their of both swaps and security-based swaps. (ii) Assessment Costs underlying intent to implement the The SEC believes that requiring parties The SEC does not believe that any regulatory framework Congress intended to disaggregate mixed swaps into assessment costs associated with rule to impose on the derivatives markets by separate components is not consistent 3a69–3 under the Exchange Act would enacting Title VII. with congressional intent and may be material. The scope of the definitions will result in certain programmatic costs, affect the ultimate regulatory effects on 5. Effects on Competition, Efficiency, such as limiting the types of derivatives competition, efficiency, and capital and Capital Formation products and transactions market formation that will accompany the full participants may offer and enter into Section 3(f) of the Exchange Act implementation of Title VII. The SEC and increasing transaction costs (such as requires the SEC, whenever it engages in anticipates analyzing these effects in the documentation costs) by disaggregating rulemaking and is required to consider adopting releases for the particular a mixed swap into multiple separate or determine whether an action is regulations. Below is a general transactions. necessary or appropriate in the public discussion of the impacts on interest, to consider, in addition to the competition, efficiency, and capital (h) Books and Records Requirement for protection of investors, whether the formation as a result of the rules being SBSAs (Rule 3a69–3 Under the adopted in this release. Exchange Act) 1355 See supra part V. The final rules being adopted relate (i) Programmatic Benefits and Costs 1356 7 U.S.C. 24a and 6s. Pursuant to sections primarily to further defining the terms 21(b)(2) and 4s(f)(1)(B)(ii) of the CEA, the CFTC has ‘‘swap,’’ ‘‘security-based swap,’’ and Rule 3a69–3 under the Exchange Act adopted rules with respect to data collection and ‘‘mixed swap’’ to determine (i) the provides that there are no additional maintenance by SDR and books and records instruments that will be subject to the books and records, or data, requirements requirements for swap dealers and major swap participants. See Swap Dealer and Major Swap Title VII regulatory regime and (ii) the Participant Recordkeeping, Reporting, and Duties jurisdictional line between Title VII 2012). Accordingly, the SEC estimates the cost to Rules; Futures Commission Merchant and be $31,340 ($11,340 (based on 30 hours of in-house Introducing Broker Conflicts of Interest Rules; and 1358 counsel time × $378) + $20,000 (based on 50 hours Chief Compliance Officer Rules for Swap Dealers, 15 U.S.C. 78c(f). of outside counsel × $400)) to submit a joint request Major Swap Participants, and Futures Commission 1359 15 U.S.C. 78w(a)(2). for interpretation. This estimate is rounded by two Merchants, 77 FR 20128 (April 3, 2012); and Swap 1360 The SEC is also acting pursuant to its significant digits to avoid the impression of false Data Recordkeeping and Reporting Requirements, rulemaking authority provided by sections 3 and precision of the estimate. 77 FR 2136 (January 13, 2012). 23(a) of the Exchange Act. 1353 See Better Markets Letter. 1357 See Proposing Release at 29863. See also 1361 See Proposing Release at 29885–87. 1354 Id. supra part V. 1362 Id. at 29887.

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instruments regulated by the SEC and be related to their businesses or exposure gives rise to the systemic those regulated by the CFTC. There also financing needs. chain effect of one firm’s financial are procedural rules regarding As the SEC has noted before, persons distress or losses leading to financial interpretive requests and joint orders who fall within the definitions of distress or losses of the entire financial from the Commissions, and ‘‘security-based swap dealer’’ and sector as a whole.1370 With respect to recordkeeping relating to SBSAs. The ‘‘major security-based swap participant’’ transactions involving security-based SEC believes that these procedural rules will incur a range of programmatic costs swaps, security-based swap dealers and are related to the status of a product and by virtue of their status as a registered major security-based swap participants the regulatory treatment of a mixed dealer or major participant and certain will be regulated and, as noted in the swaps, and therefore, the effects of these assessment costs regarding their Entity Definitions Release, such rules on competition, efficiency, and security-based swap activities. To the regulation and requirements are capital formation are subsumed in the extent the costs associated with these expected to increase market overall impact of the rules defining the statutorily mandated requirements are participants’ confidence in the dealers’ perimeter of the Title VII regulatory relatively fixed or large enough, they and major participants’ ability to regime, and those of the rules relating to may negatively affect competition perform their obligations.1371 the jurisdictional line between the SEC within the security-based swap The effect of the definitions on and CFTC. market.1367 This may, for example, lead efficiency and capital formation is smaller dealers or entities for whom linked to their effect on competition. (a) The Status of Products dealing is not a core business to keep Markets that are competitive, with fair The status of products as inside the their security-based swap dealing and transparent pricing and equal Title VII regulatory perimeter (i.e., activity below the volume threshold access to security-based swaps, may be swaps and security-based swaps) or required to be registered with the SEC expected to promote the efficient outside the regulatory perimeter will or exit the market if the profit from the allocation of capital. Similarly, have impacts on market participants. security-based swap dealing activity definitions that promote, or do not These rules will impact the status of cannot justify the cost incurred to unduly restrict, competition can be certain market participants currently comply with the Title VII requirements; accompanied by regulatory benefits that acting as intermediaries in the security- both scenarios could cause customers to minimize the risk of market failure and have less access to the market or to thus promote efficiency and capital based swap market, subjecting them to 1372 regulatory oversight and registration. As incur higher costs in accessing the formation within the market. As discussed above, certain Title VII the SEC has noted, the market among market. Such costs might also deter the requirements and rules relating to intermediaries for security-based swaps entry of new firms into the market. If intermediaries, such as internal and is highly concentrated. The sufficiently high, these costs of external business conduct standards, if concentration in large part appears to compliance may increase concentration 1368 adopted as proposed, are expected to reflect the fact that larger entities among dealers. Certain aspects of the regulation of reduce information asymmetries and possess competitive advantages in products defined as security-based promote price efficiency. These engaging in over-the-counter security- swaps may enhance competition in the business conduct standards, if adopted based swap dealing activities, market for security-based swaps. For as proposed, would also help regulators particularly with respect to having example, the proposed business conduct perform their functions in an effective sufficient financial resources to provide standards, if adopted as proposed, manner. The resulting increase in potential counterparties with adequate including those for disclosure of market integrity could affect capital assurances of financial performance.1363 material risks and for fair and balanced formation in U.S. capital markets At the same time, as noted by communications, may reduce positively.1373 commenters to the Entities Definition information asymmetries between Other entities also will be affected by Release, some entities engage in smaller security-based swap dealers, major the scope of the security-based swap volumes of security-based swap dealing security based swap participants, and definition, including clearing agencies activity.1364 Some small and mid-size their counterparties. The reduction of that currently, and in the future will, banks, for example, routinely provide information asymmetries should clear security-based swaps, the security- such services involving relatively small promote price efficiency, promote more based swap data repositories that collect notional amounts to their customers.1365 informed decision-making, and reduce security-based swap data, and the SB Although these relatively small dealers the incidence of fraudulent or SEFs and exchanges that are transaction in general may not compete directly misleading representations.1369 venues for security-based swaps, with the largest dealers (because they In addition, as the SEC noted in the subjecting these entities to regulation service a different segment of the Entity Definitions Release, the current and oversight by the SEC.1374 For market), they may be expected to play security-based swap market is subject to example, The SEC has noted that the a role in helping certain types of the potential for risk spillovers and intent of the proposed rules concerning customers (such as customers with a systemic risk, which can occur when standards for clearing agency operations relatively small need for security-based the financial sector as a whole (or and governance standards of clearing swaps) enter into security-based swaps, certain key segments) is exposed to a agencies is to promote the prompt and thus promoting the availability of these significant amount of concentrated accurate clearance and settlement of products.1366 This availability may financial risk, either through direct securities transactions, including assist market participants (as end users), counterparty relationships or the security-based swap transactions, by as discussed below, in engaging deterioration of asset values, and such security-based swap activities that may 1370 See Entity Definitions Release, at 30740. 1367 Id. 1371 Id. at 30723–30724. 1363 See Entity Definitions Release, at 30740. 1368 Id. 1372 See Entity Definitions Release, at 30742. 1364 Id. 1369 See Business Conduct Standards Proposing 1373 See Business Conduct Standards Proposing 1365 Id. Release, 76 FR 42396–42459, at 42452. See also Release, at 42452; SDR Proposing Release, at 77365. 1366 Id. supra part XI.A.3. 1374 See supra part XI.A.3.

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requiring certain minimum standards at Furthermore, in the proposing release by end-users may create effects on clearing agencies.1375 The SEC stated regarding SDRs, 1384 the SEC noted that, competition. that it preliminarily believes that these by allowing multiple SDRs to provide While other securities-related requirements would ensure resilient and data collection, maintenance, and derivatives have the same limitations on cost-effective clearing agency operations recordkeeping services, the rules are issuers, affiliates, and underwriters as well as promote transparent and intended to promote competition among using the derivative to avoid the effective clearing agency governance SDRs. The SEC also stated that the Securities Act application to the that would consequently support proposed rules promote data collection, underlying securities at the time the confidence among market participants maintenance, and recordkeeping transaction is entered into, these other in clearing agencies’ ability to serve as according to existing best practices that derivatives, such as security options and efficient mechanisms for clearance and are used in similar capital market security futures, do not contain the settlement and to facilitate capital institutions and are likely to positively same limitation on transactions with formation.1376 affect transparency in credit markets non-ECPs. Although security options and would help capital formation in the and security futures must be traded on Similarly, the SEC has previously a national securities exchange as one stated that the core principles, duties, broader capital markets whose participants rely on security-based swap condition to avail themselves of an and requirements imposed by Title VII markets to meet their hedging exemption from registration under the and the proposed rules on SB SEFs will 1388 objectives.1385 Securities Act, other exemptions foster innovation in the security-based from registration under the Securities swap market by allowing entities that Other parties to security-based swap Act may be available for transactions in seek to become SB SEFs to structure transactions may be affected by the security options sold to non-ECPs that diverse platforms for the trading of definitions as well. Title VII amends the are not available to security-based swap security-based swaps,1377 increase pre- Exchange Act and the Securities Act to transactions with non-ECPs. trade price transparency, and establish include security-based swap within the There also may be effects on 1386 fair, objective, and not unreasonably definition of the term ‘‘security.’’ efficiency and capital formation by discriminatory standards for granting End-users will have the benefit and facilitating end-users’ use of security- impartial access to trading on the SB protection of the existing Federal based swaps for investment or hedging SEFs,1378 thereby furthering higher securities laws, including the Exchange of risks relating to investments or efficiency, promoting competition, and Act and Securities Act provisions added business operations, thereby affecting encouraging capital formation.1379 The by Title VII. As a result of the liquidity and costs in connection with SEC also noted that any resulting amendment to the Securities Act the issuance of equity and debt increase in market integrity proceeding regarding security-based swap securities. The further definitions may from the rules intended to support the transactions entered into by issuers of promote capital formation by facilitating statutorily-mandated regulatory the securities underlying the security- these hedging and investment activities. obligations of SB SEFs would likely based swap, and their affiliates and For example, in the context of CDS, as increase market participants’ confidence underwriters,1387 such issuers, affiliates, credit risk is correlated, lenders who in the soundness and fairness of the and underwriters cannot use security- made loans and investors in debt security-based swap market.1380 Such based swaps without also complying securities may find it desirable to hedge increased confidence likely would with the Securities Act provisions with credit risks on their loan or securities stimulate financial investment in SB respect to the underlying securities. portfolios by purchasing protection swaps by corporate entities and others Furthermore, Title VII provides through single-name or index CDS.1389 that may find that more transparent protections to non-ECPs by adding Although basis risk may exist in this venues for the trading of SB swaps provisions to both the Securities Act type of trade, it should be effective at would allow them to purchase SB swaps and the Exchange Act that require reducing counterparty exposure.1390 security-based swap transactions with to offset business risks and to meet (b) Jurisdictional Divide Impacts hedging objectives.1381 Further, to the such non-ECPs to be covered by an extent that market participants utilize effective registration statement under There may be competitive impacts SB swaps to better manage portfolio the Securities Act and traded on a that arise due to the jurisdictional risks with respect to positions in national securities exchange, and for divide between the CFTC and the SEC underlying securities, the extent that brokers and dealers engaging in that Congress imposed in Title VII. they are willing to participate in the SB transactions with non-ECPs to be While the competitive impacts of the swap market may impact their registered as such under section 15 of substantive rules will be addressed as willingness to participate in the the Exchange Act. To the extent part of each substantive rulemaking, the underlying asset’s market.1382 counterparties, including issuers of the SEC acknowledges that such Therefore, the Commission stated its underlying securities, or their affiliates competitive effects may exist as a preliminary belief that the proposed or underwriters, determine to engage in consequence of the statutory rules would help encourage capital such transactions, other counterparties jurisdictional divide. These competitive impacts may arise due to capital and formation.1383 may have a greater willingness to engage in such transactions because of the margin treatment, for example, which may affect demand for security-based 1375 See Clearing Agency Standards Proposing protections afforded by the Securities Release, at 14535. Act registration, disclosure, and civil swaps as compared to other types of 1376 Id. liability scheme. An increased interest security instruments. In addition, to the 1377 See SB SEF Proposing Release, at 11049. extent there are differences in regulatory 1378 Id. 1384 See SDR Proposing Release, at 77365. treatment between security-based swaps 1379 Id. at 11049–50. 1385 Id. 1380 Id. at 11049. 1386 See section 2(a)(1) of the Securities Act and 1388 See section 3(a)(14) of the Securities Act and 1381 Id. section 3(a)(10) of the Exchange Act, 15 U.S.C. Rule 238 under the Securities Act. 1382 Id. at 11050. 77b(a)(1) and 15 U.S.C. 78c(a)(10). 1389 See Entity Definitions Release, at 30742. 1383 Id. 1387 See supra part XI.A.3. 1390 Id.

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and other securities-based or securities- purposes of calculating margin business, across two separate regulatory related instruments, there will be requirements. Absent the adoption of a regimes and if they determine that the competition across the markets affecting margin and segregation approach that incremental costs of operating the all market participants. would permit a customer to hold both derivatives business under two separate As one example of the possible swaps and security-based swaps in a regulatory regimes would outweigh competitive effects of the jurisdictional single customer account, a customer potential revenues, they may exit divide, section 3E(a) of the Exchange who clears swaps and security-based certain products to limit the application Act provides that only a registered swaps through a clearing member who of regulatory requirements to solely broker, dealer, or security-based swap is dually-registered as a futures those of the CFTC or the SEC. This dealer may accept margin from commission merchant with the CFTC could result in a redistribution of the customers to secure cleared security- and a broker-dealer with the SEC may swaps or security-based swaps dealing based swap transactions,1391 and that have to deliver collateral to the clearing activity in the derivatives market and the broker, dealer, or security-based member with respect to the customer’s lead to further concentration of security- swap dealer shall treat and deal with all cleared swap portfolio and also deliver based swap dealing activity. margin received from a customer as collateral as margin to the clearing The SEC understands that Congress belonging to the customer.1392 member with respect to its security- intended to create two parallel Similarly, section 4d(f) of the based swap portfolio even if the regulatory regimes for the derivatives Commodity Exchange Act requires that positions in the swap portfolio offset the market that complement each other. only a registered futures commission risk arising from the positions in the Each regulatory regime will have the merchant may accept margin from security-based swap portfolio. This will benefit of the regulatory expertise of the customers to secure cleared swap impact customers’ liquidity, as opposed respective agency. The rules further transactions 1393 and that the futures to holding swap and security-based defining swap, security-based swap, and commissions merchant shall treat and swap positions in one single mixed swap do not by themselves create deal with margin received from a account,1396 and increase customers’ negative competitive impacts other than customer as belonging to the transaction costs. Such an increase will those which potentially could be customer.1394 The SEC understands that affect customers’ ability to use security- imposed if the Commissions’ many members of clearing agencies are based swaps and may drive them to seek substantive requirements differ dually-registered broker-dealers and less expensive alternatives. Decrease in substantially. futures commission merchants and that demand for security-based swaps may Finally, the rules being adopted may much of the clearing of security-based increase dealer competition in the have effects on efficiency and capital swaps may occur through such dually- security-based swap market for the formation. For example, the rules registered entities.1395 Because remaining business, or result in dealers defining the terms ‘‘issuers of securities collateral for swaps and security-based exiting the market. in a narrow-based security index’’ and swaps are required under applicable In addition, there may be competitive ‘‘narrow-based security index’’ for statutory requirements to be maintained impacts on security-based swap dealers, purposes of the jurisdictional divide are in two separate accounts under the CEA major security-based swap participants, intended to, among other things, and Exchange Act, respectively, the clearing agencies, security-based swap minimize the likelihood that an index derivatives portfolio of a customer will data repositories and security-based on which a CDS is based that is outside be separated into a swap portfolio and swap execution facilities (or national of the SEC’s jurisdiction can be used as a security-based swap portfolio, with securities exchanges) if they provide a surrogate or substitute for the two separate margin accounts and services for both security-based swaps underlying security, or with respect to without the benefits of netting swaps and swaps, as their businesses will be securities of the referenced issuer, or to against security-based swaps for divided based on the jurisdictional line manipulate the market for such between swaps and security-based securities. Such provisions will provide 1391 See section 3E(a) of the Exchange Act, 15 swaps. For registered entities whose greater protection to the reference U.S.C. 78c–5(a). derivatives activities involve products issuers or the issuers of the securities in 1392 See section 3E(b)(1) of the Exchange Act, 15 that reference indexes or baskets, they the index that the index CDS cannot be U.S.C. 78c–5(b)(1). used in a manner that will adversely 1393 will incur assessment costs 1397 and, to See section 4d(f)(1) of the CEA, 7 U.S.C. affect such issuers and their ability to 6d(f)(1). the extent that SEC and CFTC 1394 See section 4d(f)(2)(A) of the CEA, 7 U.S.C. raise capital. regulations diverge, they will incur In conclusion, the SEC believes the 6d(f)(2)(A). additional regulatory compliance 1395 rules and interpretations adopted here See, e.g., letter to the SEC from ICE Clear costs 1398 to implement two sets of Credit LLC, dated November 7, 2011 (‘‘ICE Clear would not have overall adverse effects Credit Letter’’), available at http://www.sec.gov/ regulations that would not otherwise be on efficiency, competition, or capital rules/petitions/2011/petn4-641.pdf (requesting incurred if the jurisdictional divide did formation. exemptive relief from the application of section not exist. The SEC recognizes that these 15(c)(3) of the Exchange Act and Rule 15c3–3 B. Paperwork Reduction Act thereunder to allow ICE Clear Credit, and its costs may affect existing market members that are dually-registered broker-dealers participants’ considerations whether to 1. Background and futures commission merchants, to, among other continue to operate their business, and things: (1) Hold customer assets used to margin, new entrants’ desire to enter into new Rules 3a68–2 and 3a68–4(c) under the secure, or guarantee customer positions consisting Exchange Act contain new ‘‘collection of cleared credit default swaps that include swaps 1396 of information’’ requirements within the and security-based swaps in a commingled See ICE Clear Credit Letter at 6, 13–14. See customer omnibus account subject to section 4d(f) also Statement of General Policy on the Sequencing meaning of the Paperwork Reduction of the CEA; and (2) calculate margin for this of the Compliance Dates for Final Rules Applicable Act of 1995.1399 The SEC has submitted commingled customer account on a portfolio to Security-Based Swaps Adopted Pursuant to the them to the Office of Management and margin basis); see also section 4d(F)(1) of the CEA Securities Exchange Act of 1934 and the Dodd- Frank Wall Street Reform and Consumer Protection Budget (‘‘OMB’’) for review in (making it unlawful for any person to, among other 1400 things, accept money and securities from a swaps Act, 77 FR 35625 n.138 (June 14, 2012). accordance with the PRA. The titles customer for a cleared swap unless such person has 1397 See the discussion of assessment costs of registered with the CFTC as a futures commission various rules and interpretations, supra part XI.A.4. 1399 44 U.S.C. 3501 et seq. merchant). 1398 See supra parts XI.A.3and XI.A.4. 1400 44 U.S.C. 3507(d) and 5 CFR 1320.11.

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for the collections of information are: (1) confidentiality. These comments are requests to the Commissions for joint Interpretation of Swaps, Security-Based discussed below.1404 orders regarding the regulation of a particular mixed swap (or class thereof). Swaps, and Mixed Swaps and (2) 2. Summary of Collection of Information Under rule 3a68–4(c) under the Regulation of Mixed Swaps: Process for Under Rules 3a68–2 and 3a68–4(c) Exchange Act, a person will provide to determining regulatory treatment for Under the Exchange Act mixed swaps (OMB Control No. 3235– the Commissions all material 0685). An agency may not conduct or First, the SEC is adopting new rule information regarding the terms of, and sponsor, and a person is not required to 3a68–2 under the Exchange Act, which the economic characteristics and respond to, a collection of information will allow persons to submit a request purpose of, the specified (or specified unless it displays a currently valid OMB for a joint interpretation from the class of) mixed swap. In addition, a Commissions regarding whether an control number. person will provide the specified agreement, contract, or transaction (or a parallel provisions, the reasons the The rules containing these two class thereof) is a swap, security-based person believes such specified parallel collections of information are being swap, or both (i.e., a mixed swap). provisions are appropriate for the mixed adopted pursuant to the Exchange Act. Under rule 3a68–2 under the Exchange swap (or class thereof), and an analysis The rules establish a process through Act, a person will provide to the of: (1) The nature and purposes of the which a person can submit a request to Commissions all material information parallel provisions that are the subject the Commissions that the Commissions regarding the terms of, and a statement of the request; (2) the comparability of provide a joint interpretation of whether of the economic characteristics and such parallel provisions; and (3) the an agreement, contract, or transaction purpose of, each relevant agreement, extent of any conflicts or differences (or class thereof) is a swap, security- contract, or transaction (or class between such parallel provisions. The based swap, or both (i.e., a mixed swap). thereof), along with that person’s Commissions also may request the The rules also establish a process with determination as to whether each such submitting person to provide additional respect to mixed swaps through which agreement, contract, or transaction (or information. a person can submit a request to the class thereof) should be characterized as The Commissions may issue in Commissions that the Commissions a swap, security-based swap, or both response a joint order, after public issue a joint order permitting the (i.e., a mixed swap), including the basis notice and opportunity for comment, requesting person (and any other person for such a determination. The permitting the requesting person (and or persons that subsequently lists, Commissions also may request the any other person or persons that trades, or clears that class of mixed submitting person to provide additional subsequently lists, trades, or clears that swap) to comply, as to parallel information. class of mixed swap) to comply, as to provisions only, with specified parallel The Commissions may issue in parallel provisions only, with the provisions, instead of being required to response a joint interpretation or joint specified parallel provisions (or another notice of proposed rulemaking regarding comply with parallel provisions of both subset of the parallel provisions that are the status of that agreement, contract, or the CEA and the Exchange Act. The the subject of the request, as the transaction (or class thereof) as a swap, hours and costs associated with Commissions determine is appropriate), security-based swap, or both (i.e., a preparing and sending these requests instead of being required to comply mixed swap). Any joint interpretation, will constitute reporting and cost with parallel provisions of both the CEA like any joint notice of proposed burdens imposed by each collection of and the Exchange Act. Any joint order rulemaking, will be public and may information. will be public and may discuss the discuss the material information material information regarding the terms In the Proposing Release, the SEC regarding the terms of the relevant of the relevant agreement, contract, or requested comment on the collection of agreement, contract, or transaction (or transaction (or class thereof), as well as information requirements.1401 As class thereof), as well as any other any other information the Commissions discussed in connection with rules information the Commissions deem deem material to the interpretation. 3a68–2 and 3a68–4(c) under the material to the interpretation. Requesting persons also will be Exchange Act, under the Exchange Act Requesting persons also will be permitted to withdraw a request made the final rules require the same permitted to withdraw a request made pursuant to rule 3a68–4(c) under the information to be collected as pursuant to rule 3a68–2 under the Exchange Act at any time before the proposed.1402 As noted above, the Exchange Act at any time before the Commissions have issued a joint order Commissions received approximately 86 Commissions have issued a joint in response to the request. comment letters on the Proposing interpretation or joint notice of Persons will submit requests pursuant Release.1403 The SEC did not receive proposed rulemaking in response to the to rule 3a68–4(c) under the Exchange any comments that directly address its request. Act on a voluntary basis. However, if a Paperwork Reduction Act analysis or its Persons will submit requests pursuant person submits a request, all of the burden estimates. However, the SEC did to rule 3a68–2 under the Exchange Act information required under the rule, receive comments regarding on a voluntary basis. However, if a including any additional information confidentiality of information submitted person submits a request, all of the requested by the Commissions, must be as a result of the collection of information required under the rule, submitted to the Commissions, except to information requirements. These including any additional information the extent a person withdraws the comments do not directly address the requested by the Commissions, must be request pursuant to the rule. submitted to the Commissions, except to SEC’s Paperwork Reduction Act 3. Reasons for and Use of Information analysis, but they do implicate those the extent a person withdraws the aspects of the analysis regarding request pursuant to the rule. The SEC will use the information Second, the SEC is adopting rule collected pursuant to rule 3a68–2 under 1401 See Proposing Release at 29877, 29879. 3a68–4(c) under the Exchange Act, the Exchange Act to evaluate 1402 See discussion of rules 3a68–2 and 3a68–4(c) which will allow persons to submit agreements, contracts, or transactions supra parts VI and IV.B.3. (or classes thereof) in order to provide 1403 See supra part I. 1404 See infra part XI.B.3. joint interpretations or joint notices of

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proposed rulemaking with the CFTC the SEC believes that the relevant believes that the rules and interpretive regarding whether these agreements, categories of persons that will submit a guidance regarding swaps, security- contracts, or transactions (or classes request under rule 3a68–4(c) under the based swaps, and mixed swaps the thereof) are swaps, security-based Exchange Act will be SEFs, security- Commissions are adopting, as well as swaps, or both (i.e., mixed swaps) as based SEFs, and DCMs trading swaps the additional guidance issued pursuant defined in the Dodd-Frank Act. The SEC and estimates that the total number of to joint interpretations and orders under will use the information collected such persons will be 72.1410 rules 3a68–2 and 3a68–4(c) under the pursuant to rule 3a68–4(c) under the However, based on the SEC’s Exchange Act, will result in a narrow Exchange Act to evaluate a specified, or experience and information received pool of potential respondents, a specified class of, mixed swap in order from commenters to the ANPR 1411 and approximately 50,1414 to the collection to provide joint orders or joint notices during meetings with the public to of information requirements of proposed of proposed rulemaking with the CFTC discuss the Product Definitions rule 3a68–2 under the Exchange Act. regarding the regulation of that generally, and taking into consideration Although the SEC does not have precise particular mixed swap or class of mixed the certainty provided by the rules and figures for the number of requests that swap. The information provided to the interpretive guidance in this release, the persons will submit after the first year, SEC pursuant to rules 3a68–2 and 3a68– SEC believes that the number of the SEC believes it is reasonable to 4(c) under the Exchange Act also will requests for a joint interpretation to the estimate that there likely will be fewer allow the SEC to monitor the Commissions pursuant to rule 3a68–2 than 10 requests on average in each development of new OTC derivatives under the Exchange Act will be ensuing year. products in the marketplace and small.1412 With respect to proposed rule Similarly, because the SEC believes determine whether additional 3a68–4(c) under the Exchange Act, the that both the category of mixed swap rulemaking or interpretive guidance is SEC also estimates the number of transactions and the number of market necessary or appropriate. requests for joint orders will be participants that engage in mixed swap As discussed above, some small.1413 Pursuant to the Commissions’ transactions are small, the SEC believes commenters expressed concern about rules and interpretive guidance, a that the pool of potential persons the public availability of information number of persons that engage in requesting a joint order regarding the regarding the joint interpretive process agreements, contracts, or transactions regulation of a specified, or specified and asked that the parties be able to that are swaps, security-based swaps, or class of, mixed swap pursuant to seek confidential treatment of their both (i.e., a mixed swap) will be certain proposed rule 3a68–4(c) under the submissions.1405 As stated above, under that their agreements, contracts, or Exchange Act will be small. In addition, existing rules of both Commissions, transactions are, indeed, swaps, depending on the characteristics of a requesting parties may seek confidential security-based swaps, or both, (i.e., mixed swap (or class thereof), a person treatment for joint interpretive requests mixed swaps) and will not request an may choose not to submit a request from the SEC and the CFTC in interpretation pursuant to rule 3a68–2 pursuant to rule 3a68–4(c) under the accordance with the applicable existing under the Exchange Act. Also, as the Exchange Act. The SEC also notes that rules relating to confidential treatment Commissions provide joint any joint order issued by the of information.1406 Also as stated above, interpretations regarding whether Commissions will apply to any person even if confidential treatment has been agreements, contracts, or transactions that subsequently lists, trades, or clears requested, all joint interpretive requests, (or classes thereof) are or are not swaps, that specified, or specified class of, as well all joint interpretations and any security-based swaps, or both (i.e., mixed swap, so that requests for joint decisions not to issue a joint mixed swaps), the SEC expects that the orders could diminish over time. Also, interpretation (along with the number of requests for interpretation persons may submit requests for an explanation of the grounds for such will decrease over time. The SEC interpretation under rule 3a68–4(c) decision), will be made publicly under the Exchange Act that do not available at the conclusion of the review security-based swap dealers, 10 major security- result in an interpretation that the period.1407 based swap participants, 35 SEFs, 20 security-based agreement, contract, or transaction (or SEFs, 12 DCOs, 17 DCMs, 15 SDRs, 10 SBSDRs, and class thereof) is a mixed swap.1415 Also, 4. Respondents 6 clearing agencies, as set forth by the CFTC and SEC, respectively, in their other Dodd-Frank Act those requests submitted pursuant to As discussed in the Proposing rulemaking proposals. See Entity Definitions rule 3a68–2 under the Exchange Act Release, the SEC believes that the Release, supra note 12 (regarding security-based that result in an interpretation that the relevant categories of persons that will swap dealers and major security-based swap agreement, contract, or transaction (or submit requests under rule 3a68–2 participants); Registration of Swap Dealers and Major Swap Participants, supra note 1288 class thereof) is not a mixed swap will under the Exchange Act will be swap (regarding swap dealers and major security-based reduce the pool of possible persons dealers, security-based swap dealers, swap participants); SDR Proposing Release, supra submitting a request regarding the major swap participants, and major note 1231 (regarding SBSDRs); Swap Data regulation of particular mixed swaps (or security-based swap participants; SEFs, Repositories, supra note 6 (regarding SDRs); Core class thereof) pursuant to rule 3a68–4(c) Principles and Other Requirements for Swap security-based SEFs and DCMs trading Execution Facilities, 76 FR 1214, Jan. 7, 2011 under the Exchange Act. swaps; and SDRs, SBSDRs, DCOs (regarding SEFs); Registration and Regulation of Furthermore, although certain clearing swaps, and clearing agencies Security-Based Swap Execution Facilities, 76 FR requests made pursuant to rule 3a68– clearing security-based swaps.1408 The 10948, Feb. 28, 2011 (regarding security-based SEFs); Derivatives Clearing Organization General SEC estimates that the total number of 1414 The SEC believes that there will be Provisions and Core Principles, 76 FR 69334 (Nov. 1409 approximately 50 requests in the first year. See such persons will be 475. Similarly, 8, 2011); Core Principles and Other Requirements discussion infra part XI.B.5. The SEC recognizes for Designated Contract Markets, 75 FR 80572, Dec. that one person might submit more than one request 1405 22, 2010 (regarding DCMs); Clearing Agency See supra part VI. but for purposes of the PRA is considering the 1406 See 17 CFR 200.81 and 17 CFR 140.98. See Standards for Operation and Governance, 76 FR submitter of each such request as a separate person. also supra part VI. 14472, Mar. 16, 2011 (regarding clearing agencies). 1415 1410 The SEC believes it is reasonable to estimate 1407 See supra part VI. Id. that it will receive 20 requests in the first year and, 1408 See Proposing Release at 29876. 1411 See supra note 12 and accompanying text. as with rule 3a68–2 under the Exchange Act, it will 1409 This total number includes an estimated 250 1412 See infra note 1414 and accompanying text. count the submitter of each request as a separate swap dealers, 50 major swap participants, 50 1413 See infra note 1415 and accompanying text. person. See id.

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4(c) under the Exchange Act may be As discussed above, the SEC believes professionals (e.g., attorneys) (10 made without a previous request for a it is reasonable to estimate that 50 requests × 30 hours/request × $400).1420 joint interpretation pursuant to rule requests will be received in the first (b) Rule 3a68–4(c) Under the Exchange 3a68–2 under the Exchange Act, the year. For purposes of the PRA, the SEC Act SEC believes that most requests under estimates the total paperwork burden rule 3a68–2 under the Exchange Act associated with preparing and Rule 3a68–4(c) under the Exchange that result in the interpretation that an submitting a person’s request to the Act will require any party requesting a agreement, contract, or transaction (or Commissions pursuant to rule 3a68–2 joint order regarding the regulation of a class thereof) is a mixed swap will under the Exchange Act will be 20 specified, or specified class of, mixed result in a subsequent request for hours per request and associated costs swap under the rule to include certain alternative regulatory treatment of $12,000 for outside professionals, information about the agreement, pursuant to rule 3a68–4(c) under the which the SEC believes will consist of contract, or transaction (or class thereof) Exchange Act. The SEC believes that 90 services provided by attorneys.1417 that is a mixed swap, including the percent, or 18 of the estimated 20 These total costs include all collection specified parallel provisions that the requests pursuant to rule 3a68–4(c) burdens associated with the rule, person believes should apply to the under the Exchange Act in the first year including burdens related to the initial mixed swap (or class thereof), the would be such ‘‘follow-on’’ requests. determination requirements. reasons the person believes the In addition, not only the requesting Assuming 50 requests in the first year, specified parallel provisions will be party, but also any other person that the SEC estimates that this will result in appropriate for the mixed swap.1421 subsequently lists, trades, or clears that an aggregate burden for the first year of As discussed above, the SEC believes 1000 hours of company time (50 the number of requests that persons will mixed swap, will be subject to, and × must comply with, the joint order requests 20 hours/request) and submit pursuant to rule 3a68–4(c) under regarding the regulation of the specified, $600,000 for the services of outside the Exchange Act is quite small given professionals (e.g., attorneys) (50 the limited types of agreements, or specified class of, mixed swap, as × × issued by the Commissions. Therefore, requests 30 hours/request $400). The contracts, and transactions (or classes the SEC believes that the number of estimated internal or company time thereof) the Commissions believe will requests for a joint order regarding the burden for rule 3a68–2 under the constitute mixed swaps and that it will Exchange Act has not changed from that receive 20 requests in the first year.1422 regulation of mixed swaps, particularly 1418 involving specified classes of mixed included in the Proposing Release. For purposes of the PRA, the SEC However, the estimated burden of the swaps, will decrease over time. As estimates the total paperwork burden cost for outside professionals for rule discussed above, the SEC believes that associated with preparing and 3a68–2 under the Exchange Act has as the Commissions provide joint orders submitting a party’s request to the been revised from that included in the regarding alternative regulatory Commissions pursuant to rule 3a68–4(c) Proposing Release to reflect updated treatment, the number of requests under the Exchange Act will be 30 data regarding the hourly cost for an received will decrease over time. The hours and associated costs of $20,000 attorney.1419 SEC believes it is reasonable to estimate for the services of outside professionals, As discussed above, the SEC believes which the SEC believes will consist of that there likely will be five requests on that there will be 10 requests on average average in each ensuing year. services provided by attorneys,1423 per in each ensuing year, which results in request for mixed swaps for which a 5. Paperwork Reduction Act Burden an aggregate burden in each ensuing request for a joint interpretation Estimates year of 200 hours of company time (10 × pursuant to rule 3a68–4(c) under the requests 20 hours/request) and Exchange Act was not previously Rules 3a68–2 and 3a68–4(c) under the $120,000 for the services of outside Exchange Act require submission of made.1424 These total costs include all collection burdens associated with the certain information to the Commissions 1417 See discussion supra part XI.A.4.e(ii). This to the extent persons elect to request an estimate is based on information indicating that the rule, including burdens related to the interpretation and/or alternative average burden associated with preparing and initial determination requirements. regulatory treatment. Rules 3a68–2 and submitting a no-action request to the SEC staff in connection with the identification of whether 1420 See discussion supra part XI.B.4. 3a68–4(c) under the Exchange Act each certain products are securities, which the SEC 1421 See discussion supra part IV.B.3. require certain information that a believes is a process similar to the process under 1422 See supra note 1415 and accompanying text. requesting party must include in its rule 3a68–2 under the Exchange Act, is approximately 20 hours and associated costs of 1423 See supra note 1352. request to the Commissions in order to $12,000. Assuming these costs correspond to legal 1424 This estimate is based on information receive a joint interpretation or order, as fees, which the SEC estimates at an hourly cost of indicating that the average burden associated with applicable. $400, the SEC estimates that this cost is equivalent preparing and submitting a no-action request to the to approximately 30 hours ($12,000/$400). The SEC staff in connection with the regulatory (a) Rule 3a68–2 Under the Exchange Act estimated internal or company time burden for rule treatment of certain securities products, which the 3a68–2 under the Exchange Act has not changed SEC believes is a process similar to the process Rule 3a68–2 will apply only to from that included in the Proposing Release, but the under rule 3a68–4(c) under the Exchange Act, is requests made by persons that desire an estimated burden of the cost for outside approximately 30 hours and associated costs of interpretation from the Commissions. professionals for rule 3a68–2 under the Exchange $20,000. Assuming these costs correspond to legal Act has been revised from that included in the fees, which the SEC estimates at an hourly cost of For each agreement, contract, or Proposing Release to reflect updated data regarding $400 as discussed above, the SEC estimates that this transaction (or class thereof) for which hourly costs for the services of outside cost is equivalent to approximately 50 hours a person requests the Commissions’ professionals. The estimate of the dollar burden for ($20,000/$400). As with rule 3a68–2 under the joint interpretation under rule 3a68–2 rule 3a68–2 under the Exchange Act in the Exchange Act, the estimated internal or company Proposing Release was based on data from SIFMA’s time burdens for rule 3a68–4(c) under the Exchange under the Exchange Act, the requesting ‘‘Management & Professional Earnings in the Act have not changed from those included in the person will be required to provide Securities Industry 2009.’’ See Proposing Release at Proposing Release, but the estimated burdens of the certain information, as discussed 29876, note 345. The hourly rate used to estimate cost for outside professionals for rule 3a68–4(c) above.1416 the PRA burdens is discussed above. See supra note under the Exchange Act have been revised from 1344. those included in the Proposing Release to reflect 1418 See Proposing Release at 29876, 29877–78. updated data regarding hourly costs for the services 1416 See discussion supra part VI. 1419 See id. of outside professionals.

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Assuming 20 requests in the first year, 18 requests × 20 hours/request) and rulemaking on ‘‘small entities.’’ 1432 the SEC estimates that this will result in $292,000 for the services of outside Section 605(b) of the RFA provides that an aggregate burden for the first year of professionals (2 requests × 50 hours/ this requirement shall not apply to any 600 hours of company time (20 requests request × $400 and 18 requests × 35 proposed rule or proposed rule × 30 hours/request) and $400,000 for the hours/request × $400). amendment, which if adopted, would services of outside professionals (20 The estimated internal or company not have a significant economic impact × × 1425 requests 50 hours/request $400). time burden for rule 3a68–4(c) under on a substantial number of small As discussed above, the SEC believes the Exchange Act has not changed from entities.1433 that most requests under rule 3a68–2 that included in the Proposing under the Exchange Act that result in Release.1427 However, the estimated For purposes of SEC rulemaking in the interpretation that an agreement, burden of the cost for outside connection with the RFA, a small entity contract, or transaction (or class thereof) professionals for rule 3a68–4(c) has includes: (1) When used with reference is a mixed swap will result in a been revised from that included in the to an ‘‘issuer’’ or a ‘‘person,’’ other than subsequent request for alternative Proposing Release to reflect updated an investment company, an ‘‘issuer’’ or regulatory treatment pursuant to rule data regarding the hourly cost for an ‘‘person’’ that, on the last day of its most 3a68–4(c) under the Exchange Act. attorney.1428 recent fiscal year, had total assets of $5 Also as discussed above, the SEC As discussed above, the SEC believes million or less 1434 and (2) a broker- believes that 90 percent, or 18 of the that there will be five requests on dealer with total capital (net worth plus estimated 20 requests pursuant to rule average in each ensuing year. Assuming subordinated liabilities) of less than 3a68–4(c) under the Exchange Act in the five requests in each ensuing year, the $500,000 on the date in the prior fiscal first year, as discussed above will be SEC estimates that this will result in an year as of which its audited financial ‘‘follow-on’’ requests. For mixed swaps aggregate burden in each ensuing year of statements were prepared pursuant to for which a request for a joint 150 hours of company time (5 requests rule 17a–5(d) under the Exchange interpretation pursuant to rule 3a68–2 × 30 hours/request) and $100,000 for the Act,1435 or, if not required to file such under the Exchange Act was previously services of outside professionals (5 statements, a broker-dealer with total made, the SEC estimates the total requests × 50 hours/request × $400). As capital (net worth plus subordinated paperwork burden under the PRA discussed above, however, assuming liabilities) of less than $500,000 on the associated with preparing and that approximately 90 percent, or 4 of last day of the preceding fiscal year (or submitting a party’s request to the the estimated 5 requests pursuant to in the time that it has been in business, Commissions pursuant to rule 3a68–4(c) rule 3a68–4(c) under the Exchange Act if shorter); and is not affiliated with any under the Exchange Act will be 10 in each ensuing year are ‘‘follow-on’’ hours fewer and $6,000 less per request person (other than a natural person) that requests to requests for joint 1436 than for mixed swaps for which a is not a small entity. Under the interpretation from the Commissions standards adopted by the Small request for a joint interpretation under rule 3a68–4(c) under the pursuant to rule 3a68–2 under the Business Administration, small entities Exchange Act, the SEC estimates that in the finance and insurance industry Exchange Act was not previously made this will result in an aggregate burden include the following: (1) For entities because certain, although not all, of the for such ‘‘follow-on’’ requests in each engaged in credit intermediation and information required to be submitted ensuing year of 80 hours of company and necessary to prepare pursuant to × related activities, entities with $175 time (4 requests 20 hours/request) and 1437 rule 3a68–4(c) under the Exchange Act $56,000 for the services of outside million or less in assets; (2) for will have been required to be submitted professionals (4 requests × 35 hours/ entities engaged in non-depository and necessary to prepare pursuant to request × $400) and an aggregate burden credit intermediation and certain other rule 3a68–2 under the Exchange Act.1426 for all requests in each ensuing year of activities, entities with $7 million or 1438 The SEC estimates that this will result 110 hours of company time (1 request × less in annual receipts; (3) for in an aggregate burden for such ‘‘follow- 30 hours/request and 4 requests × 20 entities engaged in financial on’’ requests in the first year of 360 hours/request) and $76,000 for the investments and related activities, × hours of company time (18 requests 20 services of outside professionals (1 entities with $7 million or less in hours/request) and $252,000 for the request × 50 hours/request × $40] and 4 annual receipts; 1439 (4) for insurance services of outside professionals (18 requests × 35 hours/request × $400). carriers and entities engaged in related requests × 35 hours/request × $400) and activities, entities with $7 million or an aggregate burden for all requests in C. Regulatory Flexibility Act less in annual receipts; 1440 and (5) for the first year of 420 hours of company Certification funds, trusts, and other financial time (2 requests × 30 hours/request and The Regulatory Flexibility Act (‘‘RFA’’) 1429 requires Federal agencies, 1432 Although section 601(b) of the RFA defines 1425 See supra note 1415 and accompanying text. in promulgating rules, to consider the the term ‘‘small entity,’’ the statute permits the 1426 This estimate takes into account that certain impact of those rules on small entities. Commissions to formulate their own definitions. information regarding the mixed swap (or class 1430 The SEC has adopted definitions for the term small thereof), namely the material terms and the Section 603(a) of the Administrative entity for the purposes of SEC rulemaking in economic purpose, will have already been gathered Procedure Act,1431 as amended by the accordance with the RFA. Those definitions, as and prepared as part of the request submitted RFA, generally requires the SEC to relevant to this proposed rulemaking, are set forth pursuant to proposed rule 3a68–2 under the undertake a regulatory flexibility in Rule 0–10, 17 CFR 240.0–10. See Statement of Exchange Act. The SEC estimates that these items Management on Internal Accounting Control, 47 FR constitute approximately 10 hours fewer and a analysis of all proposed rules, or 5215, Feb. 4, 1982. reduction in associated costs of $6,000. Assuming proposed rule amendments, to 1433 See 5 U.S.C. 605(b). these costs correspond to legal fees, which the SEC determine the impact of such 1434 See 17 CFR 240.0–10(a). estimates at an hourly cost of $400, the SEC 1435 See 17 CFR 240.17a–5(d). estimates that this cost is equivalent to 1427 See Proposing Release at 29876, 29878–79. 1436 See 17 CFR 240.0–10(c). approximately 15 hours ($6,000/$400). As noted 1428 1437 above, these amounts are revised from those See id. See 13 CFR 121.201 (Subsector 522). included in the Proposing Release to reflect 1429 5 U.S.C. 601 et seq. 1438 See id. at Subsector 522. updated data regarding the hourly costs for the 1430 5 U.S.C. 603(a). 1439 See id. at Subsector 523. services of outside professionals. 1431 5 U.S.C. 551 et seq. 1440 See id. at Subsector 524.

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vehicles, entities with $7 million or less In response to the Proposing Release, PART 1—GENERAL REGULATIONS in annual receipts.1441 one commenter, representing a number UNDER THE COMMODITY EXCHANGE The Proposing Release stated that, of market participants, submitted a ACT based on the SEC’s existing information comment to the CFTC related to the about the swap markets, the SEC RFA.1447 The commenter did not ■ 1. The authority citation for part 1 is believed that the swap markets, while address the letter to the SEC or provide revised to read as follows: broad in scope, are largely dominated by comments regarding the SEC’s RFA Authority: 7 U.S.C. 1a, 2, 5, 6, 6a, 6b, 6c, entities such as those that would qualify analysis.1448 6e, 6f, 6g, 6h, 6i, 6j, 6k, 6l, 6m, 6n, 6o, 6p, as swap dealers, security-based swap The SEC continues to believe that the 6r, 7, 7a, 7b, 8, 9, 10, 12, 12a, 12c, 13a, 13a– dealers, major swap participants, and types of entities that would participate 1, 16, 16a, 21, 23, and 24. major security-based swap participants in the swap markets—which generally ■ (collectively, ‘‘swap market dealers and 2. Amend § 1.3 by: would be swap market dealers and ■ a. Adding and reserving paragraphs major participants’’) and that the SEC major participants—would not be (nnn) through (www); and believed that such entities exceed the ‘‘small entities’’ for purposes of the ■ b. Adding paragraphs (xxx), (yyy), thresholds defining ‘‘small entities’’ set RFA. The final rules and interpretive (zzz), (aaaa) and (bbbb). out above.1442 guidance do not themselves impose any The additions read as follows: The Proposing Release also stated compliance obligations. Instead they that, although it is possible that other describe the categories of agreements, § 1.3 Definitions. persons may engage in swap and contracts, and transactions that are * * * * * security-based swap transactions, the outside the scope of the Product (nnn)–(www) [Reserved] SEC did not believe that any of these Definitions and delineate the (xxx) Swap. (1) In general. The term entities would be ‘‘small entities’’ as jurisdictional divide between the SEC’s swap has the meaning set forth in defined in rule 0–10 under the and the CFTC’s regulatory regime. section 1a(47) of the Commodity 1443 Exchange Act and that feedback Accordingly, the SEC certifies that the Exchange Act. from industry participants about the final rules and interpretive guidance (2) Inclusion of particular products. swap markets indicates that only would not have a significant economic (i) The term swap includes, without persons or entities with assets impact on a substantial number of small limiting the meaning set forth in section significantly in excess of $5 million (or entities for purposes of the RFA. 1a(47) of the Commodity Exchange Act, with annual receipts significantly in the following agreements, contracts, and XII. Statutory Basis and Rule Text excess of $7 million) participate in the transactions: 1444 swap markets. List of Subjects (A) A cross-currency swap; The Proposing Release further stated (B) A currency option, foreign 17 CFR Part 1 that, to the extent that a small number currency option, foreign exchange of transactions did have a counterparty Definitions, General swap provisions. option and foreign exchange rate option; that was defined as a ‘‘small entity’’ (C) A foreign exchange forward; under SEC rule 0–10, the SEC believed 17 CFR Parts 230 and 240 (D) A foreign exchange swap; it is unlikely that the proposed rules (E) A forward rate agreement; and and interpretive guidance would have a Reporting and recordkeeping requirements, Securities. (F) A non-deliverable forward significant economic impact on that involving foreign exchange. entity because the proposed rules and 17 CFR Part 241 (ii) The term swap does not include interpretive guidance simply would an agreement, contract, or transaction Securities. address whether certain products fall described in paragraph (xxx)(2)(i) of this within the swap definition, address Commodity Futures Trading section that is otherwise excluded by whether certain products are swaps, Commission section 1a(47)(B) of the Commodity security-based swaps, SBSAs, or mixed Exchange Act. swaps, provide a process for requesting Pursuant to the Commodity Exchange (3) Foreign exchange forwards and interpretations of whether agreements, Act, 7 U.S.C. 1 et seq., as amended by foreign exchange swaps. contracts, and transactions are swaps, Title VII of the Dodd-Frank Wall Street Notwithstanding paragraph (xxx)(2) of security-based swaps, and mixed swaps, Reform and Consumer Protection Act, this section: provide a process for requesting Public Law 111–203, 124 Stat. 1376 (i) A foreign exchange forward or a alternative regulatory treatment for (2010) (‘‘Dodd-Frank Act’’), and sections foreign exchange swap shall not be mixed swaps, and specify that the books 712(a)(8), 712(d), 721(a), 721(b), 721(c), considered a swap if the Secretary of the and records for SBSAs are those that are 722(d), and 725(g) of the Dodd-Frank Treasury makes a determination 1445 applicable to all entities. Act, the CFTC is adopting rules 1.3(xxx) described in section 1a(47)(E)(i) of the As a result, the SEC certified that the through 1.3(bbbb) and 1.6 through 1.9 Commodity Exchange Act. proposed rules and interpretive under the Commodity Exchange Act. (ii) Notwithstanding paragraph guidance would not have a significant Text of Final Rules (xxx)(3)(i) of this section: economic impact on a substantial (A) The reporting requirements set number of small entities for purposes of For the reasons stated in the forth in section 4r of the Commodity the RFA, and requested written preamble, the CFTC is amending Title Exchange Act and regulations comments regarding this 17, Chapter I, of the Code of Federal 1446 promulgated thereunder shall apply to a certification. Regulations, as follows: foreign exchange forward or foreign exchange swap; and 1441 See id. at Subsector 525. 1447 See Letter from the National Rural Electric 1442 See Proposing Release at 29887. (B) The business conduct standards Cooperative Association, the American Public set forth in section 4s(h) of the 1443 See 17 CFR 240.0–10(a). Power Association, the Large Public Power Council, 1444 See Proposing Release at 29887. the Edison Electric Institute, and the Electric Power Commodity Exchange Act and 1445 See Proposing Release at 29887–88. Supply Association (July 22, 2011). regulations promulgated thereunder 1446 See Proposing Release at 29888. 1448 See id. shall apply to a swap dealer or major

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swap participant that is a party to a (ii) Such agreement, contract, or Exchange Act do not include an foreign exchange forward or foreign transaction is regulated as insurance agreement, contract, or transaction that exchange swap. under applicable State law or the laws was entered into on or before the (iii) For purposes of section 1a(47)(E) of the United States; effective date of paragraph (xxx)(4) of of the Commodity Exchange Act and (2)(i) Directly or indirectly by the this section, and that, at such time that this paragraph (xxx), the term foreign United States, any State or any of their it was entered into, was provided in exchange forward has the meaning set respective agencies or instrumentalities; accordance with the conditions set forth forth in section 1a(24) of the Commodity or in paragraph (xxx)(4)(i)(B) of this Exchange Act. (ii) Pursuant to a statutorily section. (iv) For purposes of section 1a(47)(E) authorized program thereof; or (5) State. For purposes of paragraph of the Commodity Exchange Act and (3) In the case of reinsurance only, by (xxx)(4) of this section, the term State this paragraph (xxx), the term foreign a person to another person that satisfies means any state of the United States, the exchange swap has the meaning set the conditions set forth in paragraph District of Columbia, Puerto Rico, the forth in section 1a(25) of the Commodity (xxx)(4)(i)(B) of this section, provided U.S. Virgin Islands, or any other Exchange Act. that: possession of the United States. (v) For purposes of sections 1a(24) (i) Such person is not prohibited by (6) Anti-Evasion: and 1a(25) of the Commodity Exchange applicable State law or the laws of the (i) An agreement, contract, or Act and this paragraph (xxx), the United States from offering such transaction that is willfully structured to evade any provision of Subtitle A of the following transactions are not foreign agreement, contract, or transaction to Wall Street Transparency and exchange forwards or foreign exchange such person that satisfies the conditions Accountability Act of 2010, including swaps: set forth in paragraph (xxx)(4)(i)(B) of any amendments made to the (A) A currency swap or a cross- this section; Commodity Exchange Act thereby currency swap; (ii) The agreement, contract, or transaction to be reinsured satisfies the (Subtitle A), shall be deemed a swap for (B) A currency option, foreign purposes of Subtitle A and the rules, currency option, foreign exchange conditions set forth in paragraph (xxx)(4)(i)(A) or paragraph (xxx)(4)(i)(C) regulations, and orders of the option, or foreign exchange rate option; Commission promulgated thereunder. and of this section; and (iii) Except as otherwise permitted (ii) An interest rate swap or currency (C) A non-deliverable forward swap, including but not limited to a involving foreign exchange. under applicable State law, the total amount reimbursable by all reinsurers transaction identified in paragraph (4) Insurance. (i) This paragraph is a (xxx)(3)(v) of this section, that is non-exclusive safe harbor. The terms for such agreement, contract, or transaction may not exceed the claims willfully structured as a foreign swap as used in section 1a(47) of the exchange forward or foreign exchange Commodity Exchange Act and security- or losses paid by the person writing the risk being ceded or transferred by such swap to evade any provision of Subtitle based swap as used in section 1a(42) of A shall be deemed a swap for purposes the Commodity Exchange Act do not person; or (4) In the case of non-admitted of Subtitle A and the rules, regulations, include an agreement, contract, or and orders of the Commission transaction that: insurance, by a person who: (i) Is located outside of the United promulgated thereunder. (A) By its terms or by law, as a States and listed on the Quarterly (iii) An agreement, contract, or condition of performance on the Listing of Alien Insurers as maintained transaction of a bank that is not under agreement, contract, or transaction: by the International Insurers the regulatory jurisdiction of an (1) Requires the beneficiary of the Department of the National Association appropriate Federal banking agency (as agreement, contract, or transaction to of Insurance Commissioners; or defined in section 1a(2) of the have an insurable interest that is the (ii) Meets the eligibility criteria for Commodity Exchange Act), where the subject of the agreement, contract, or non-admitted insurers under applicable agreement, contract, or transaction is transaction and thereby carry the risk of State law; or willfully structured as an identified loss with respect to that interest (C) Is provided in accordance with the banking product (as defined in section continuously throughout the duration of conditions set forth in paragraph 402 of the Legal Certainty for Bank the agreement, contract, or transaction; (xxx)(4)(i)(B) of this section and is one Products Act of 2000) to evade the (2) Requires that loss to occur and to of the following types of products: provisions of the Commodity Exchange be proved, and that any payment or (1) Surety bond; Act, shall be deemed a swap for indemnification therefor be limited to (2) Fidelity bond; purposes of the Commodity Exchange the value of the insurable interest; (3) Life insurance; Act and the rules, regulations, and (3) Is not traded, separately from the (4) Health insurance; orders of the Commission promulgated insured interest, on an organized market (5) Long term care insurance; thereunder. or over-the-counter; and (6) Title insurance; (iv) The form, label, and written (4) With respect to financial guaranty (7) Property and casualty insurance; documentation of an agreement, insurance only, in the event of payment (8) Annuity; contract, or transaction shall not be default or insolvency of the obligor, any (9) Disability insurance; dispositive in determining whether the acceleration of payments under the (10) Insurance against default on agreement, contract, or transaction has policy is at the sole discretion of the individual residential mortgages; and been willfully structured to evade as insurer; and (11) Reinsurance of any of the provided in paragraphs (xxx)(6)(i) (B) Is provided: foregoing products identified in through (xxx)(6)(iii) of this section. (1)(i) By a person that is subject to paragraphs (xxx)(4)(i)(C)(1) through (10) (v) An agreement, contract, or supervision by the insurance of this section; or transaction that has been willfully commissioner (or similar official or (ii) The terms swap as used in section structured to evade as provided in agency) of any State or by the United 1a(47) of the Commodity Exchange Act paragraphs (xxx)(6)(i) through States or an agency or instrumentality and security-based swap as used in (xxx)(6)(iii) of this section shall be thereof; and section 1a(42) of the Commodity considered in determining whether a

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person that so willfully structured to (i)(A) A security-based swap on the provided that an issuer of securities evade is a swap dealer or major swap index is traded on a national securities shall not be deemed a reference entity participant. exchange or security-based swap included in the index for purposes of (vi) Notwithstanding the foregoing, no execution facility for at least 30 days as this section unless: agreement, contract, or transaction a security-based swap on a narrow- (1) A credit event with respect to such structured as a security (including a based security index; or reference entity would result in a security-based swap) under the (B) Such index was a narrow-based payment by the credit protection seller securities laws (as defined in section security index during every trading day to the credit protection buyer under the 3(a)(47) of the Securities Exchange Act of the six full calendar months credit default swap based on the related of 1934 (15 U.S.C. 78c(a)(47))) shall be preceding a date no earlier than 30 days notional amount allocated to such deemed a swap pursuant to this prior to the commencement of trading of reference entity; or paragraph (xxx)(6) or shall be a security-based swap on such index on (2) The fact of such credit event or the considered for purposes of paragraph a market described in paragraph calculation in accordance with (xxx)(6)(v) of this section. (yyy)(3)(i)(A) of this section; and paragraph (zzz)(1)(i)(A)(1) of this section (yyy) Narrow-based security index as (ii) The index has been a security of the amount owed with respect to used in the definition of ‘‘security-based index that is not a narrow-based such credit event is taken into account swap.’’ security index for no more than 45 in determining whether to make any (1) In general. Except as otherwise business days over three consecutive future payments under the credit default provided in paragraphs (zzz) and (aaaa) calendar months. swap with respect to any future credit (4) Grace period. events; of this section, for purposes of section (i) Solely with respect to a swap that (B) The effective notional amount 1a(42) of the Commodity Exchange Act, is traded on or subject to the rules of a allocated to any reference entity the term narrow-based security index designated contract market, swap included in the index comprises more has the meaning set forth in section execution facility, or foreign board of than 30 percent of the index’s 1a(35) of the Commodity Exchange Act, trade, an index that becomes a narrow- weighting; and the rules, regulations and orders of based security index under paragraph the Commission thereunder. (yyy)(2) of this section solely because it (C) The effective notional amount (2) Tolerance period for swaps traded was a narrow-based security index for allocated to any five non-affiliated on designated contract markets, swap more than 45 business days over three reference entities included in the index execution facilities, and foreign boards consecutive calendar months shall not comprises more than 60 percent of the of trade. Notwithstanding paragraph be a narrow-based security index for the index’s weighting; or (yyy)(1) of this section, solely for following three calendar months. (D) Except as provided in paragraph purposes of swaps traded on or subject (ii) Solely with respect to a security- (zzz)(2) of this section, for each to the rules of a designated contract based swap that is traded on a national reference entity included in the index, market, swap execution facility, or securities exchange or security-based none of the criteria in paragraphs foreign board of trade, a security index swap execution facility, an index that (zzz)(1)(i)(D)(1) through (8) of this underlying such swaps shall not be becomes a security index that is not a section is satisfied: considered a narrow-based security narrow-based security index under (1) The reference entity included in index if: paragraph (yyy)(3) of this section solely the index is required to file reports (i)(A) A swap on the index is traded because it was not a narrow-based pursuant to section 13 or section 15(d) on or subject to the rules of a designated security index for more than 45 business of the Securities Exchange Act of 1934 contract market, swap execution facility, days over three consecutive calendar (15 U.S.C. 78m or 78o(d)); or foreign board of trade for at least 30 months shall be a narrow-based security (2) The reference entity included in days as a swap on an index that was not index for the following three calendar the index is eligible to rely on the a narrow-based security index; or months. exemption provided in rule 12g3–2(b) (B) Such index was not a narrow- (zzz) Meaning of ‘‘issuers of securities under the Securities Exchange Act of based security index during every in a narrow-based security index’’ as 1934 (17 CFR 240.12g3–2(b)); trading day of the six full calendar used in the definition of ‘‘security-based (3) The reference entity included in months preceding a date no earlier than swap’’ as applied to index credit default the index has a worldwide market value 30 days prior to the commencement of swaps. of its outstanding common equity held trading of a swap on such index on a (1) Notwithstanding paragraph by non-affiliates of $700 million or market described in paragraph (yyy)(1) of this section, and solely for more; (yyy)(2)(i)(A) of this section; and purposes of determining whether a (4) The reference entity included in (ii) The index has been a narrow- credit default swap is a security-based the index (other than a reference entity based security index for no more than swap under the definition of ‘‘security- included in the index that is an issuing 45 business days over three consecutive based swap’’ in section entity of an asset-backed security as calendar months. 3(a)(68)(A)(ii)(III) of the Securities defined in section 3(a)(77) of the (3) Tolerance period for security- Exchange Act of 1934 (15 U.S.C. Securities Exchange Act of 1934 (15 based swaps traded on national 78c(a)(68)(A)(ii)(III), as incorporated in U.S.C. 78c(a)(77)) has outstanding notes, securities exchanges or security-based section 1a(42) of the Commodity bonds, debentures, loans, or evidences swap execution facilities. Exchange Act, the term issuers of of indebtedness (other than revolving Notwithstanding paragraph (yyy)(1) of securities in a narrow-based security credit facilities) having a total remaining this section, solely for purposes of index means issuers of securities principal amount of at least $1 billion; security-based swaps traded on a included in an index (including an (5) The reference entity included in national securities exchange or security- index referencing loan borrowers or the index is the issuer of an exempted based swap execution facility, a security loans of such borrowers) in which: security as defined in section 3(a)(12) of index underlying such security-based (i)(A) There are nine or fewer non- the Securities Exchange Act of 1934 (15 swaps shall be considered a narrow- affiliated issuers of securities that are U.S.C. 78c(a)(12)) (other than any based security index if: reference entities included in the index, municipal security as defined in section

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3(a)(29) of the Securities Exchange Act reference entities that are issuers of (B) An issuer of securities that is an of 1934 (15 U.S.C. 78c(a)(29))); exempted securities as defined in issuing entity of an asset-backed (6) The reference entity included in section 3(a)(12) of the Securities security as defined in section 3(a)(77) of the index is a government of a foreign Exchange Act of 1934 (15 U.S.C. the Securities Exchange Act of 1934 (15 country or a political subdivision of a 78c(a)(12)), as in effect on the date of U.S.C. 78c(a)(77)); and foreign country; enactment of the Futures Trading Act of (C) An issuer of securities that is a (7) If the reference entity included in 1982 (other than any municipal security borrower with respect to any loan the index is an issuing entity of an asset- as defined in section 3(a)(29) of the identified in an index of borrowers or backed security as defined in section Securities Exchange Act of 1934 (15 loans. 3(a)(77) of the Securities Exchange Act U.S.C. 78c(a)(29))), the remaining (iv) For purposes of calculating the of 1934 (15 U.S.C. 78c(a)(77)), such portion of the index would be within thresholds in paragraphs (zzz)(1)(i)(A) asset-backed security was issued in a the term ‘‘issuer of securities in a through (1)(i)(C) of this section, the term transaction registered under the narrow-based security index’’ under reference entity included in the index Securities Act of 1933 (15 U.S.C. 77a et paragraph (zzz)(1)(i) of this section. includes a single reference entity seq.) and has publicly available (2) Paragraph (zzz)(1)(i)(D) of this included in the index or a group of distribution reports; and section will not apply with respect to a affiliated reference entities included in (8) For a credit default swap entered reference entity included in the index if: the index as determined in accordance into solely between eligible contract (i) The effective notional amounts with paragraph (zzz)(3)(i) of this section participants as defined in section 1a(18) allocated to such reference entity (with each reference entity included in of the Commodity Exchange Act: comprise less than five percent of the the index that is an issuing entity of an (i) The reference entity included in index’s weighting; and asset-backed security as defined in the index (other than a reference entity (ii) The effective notional amounts section 3(a)(77) of the Act (15 U.S.C. included in the index that is an issuing 78c(a)(77)) being considered a separate allocated to reference entities included entity of an asset-backed security as reference entity included in the index). in the index that satisfy paragraph defined in section 3(a)(77) of the (v) For purposes of determining Securities Exchange Act of 1934 (15 (zzz)(1)(i)(D) of this section comprise at whether one of the criterion in either U.S.C. 78c(a)(77))) makes available to least 80 percent of the index’s paragraphs (zzz)(1)(i)(D)(1) through the public or otherwise makes available weighting. (zzz)(1)(i)(D)(4) of this section or to such eligible contract participant (3) For purposes of this paragraph paragraphs (zzz)(1)(iv)(D)(8)(i) and information about the reference entity (zzz): (a)(1)(iv)(D)(8)(ii) of this section is met, included in the index pursuant to rule (i) A reference entity included in the the term reference entity included in the 144A(d)(4) under the Securities Act of index is affiliated with another index includes a single reference entity 1933 (17 CFR 230.144A(d)(4)); reference entity included in the index included in the index or a group of (ii) Financial information about the (for purposes of paragraph (zzz)(3)(iv) of affiliated entities as determined in reference entity included in the index this section) or another entity (for accordance with paragraph (zzz)(3)(i) of (other than a reference entity included purposes of paragraph (zzz)(3)(v) of this this section (with each issuing entity of in the index that is an issuing entity of section) if it controls, is controlled by, an asset-backed security as defined in an asset-backed security as defined in or is under common control with, that section 3(a)(77) of the Act (15 U.S.C. section 3(a)(77) of the Securities other reference entity included in the 78c(a)(77)) being considered a separate Exchange Act of 1934 (15 U.S.C. index or other entity, as applicable; entity). 78c(a)(77))) is otherwise publicly provided that each reference entity (aaaa) Meaning of ‘‘narrow-based available; or included in the index that is an issuing security index’’ as used in the definition (iii) In the case of a reference entity entity of an asset-backed security as of ‘‘security-based swap’’ as applied to included in the index that is an issuing defined in section 3(a)(77) of the index credit default swaps. entity of an asset-backed security as Securities Exchange Act of 1934 (15 (1) Notwithstanding paragraph defined in section 3(a)(77) of the U.S.C. 78c(a)(77)) will not be considered (yyy)(1) of this section, and solely for Securities Exchange Act of 1934 (15 affiliated with any other reference entity purposes of determining whether a U.S.C. 78c(a)(77)), information of the included in the index or any other credit default swap is a security-based type and level included in publicly entity that is an issuing entity of an swap under the definition of ‘‘security- available distribution reports for similar asset-backed security. based swap’’ in section 3(a)(68)(A)(ii)(I) asset-backed securities is publicly (ii) Control for purposes of this of the Securities Exchange Act of 1934 available about both the reference entity section means ownership of more than (15 U.S.C. 78c(a)(68)(A)(ii)(I), as included in the index and such asset- 50 percent of the equity of a reference incorporated in section 1a(42) of the backed security; and entity included in the index (for Commodity Exchange Act, the term (ii)(A) The index is not composed purposes of paragraph (zzz)(3)(iv) of this narrow-based security index means an solely of reference entities that are section) or another entity (for purposes index in which: issuers of exempted securities as of paragraph (zzz)(3)(v) of this section), (i)(A) The index is composed of nine defined in section 3(a)(12) of the or the ability to direct the voting of more or fewer securities or securities that are Securities Exchange Act of 1934 (15 than 50 percent of the voting equity of issued by nine or fewer non-affiliated U.S.C. 78c(a)(12)), as in effect on the a reference entity included in the index issuers, provided that a security shall date of enactment of the Futures (for purposes of paragraph (zzz)(3)(iv) of not be deemed a component of the Trading Act of 1982 (other than any this section) or another entity (for index for purposes of this section municipal security as defined in section purposes of paragraph (zzz)(3)(v) of this unless: 3(a)(29) of the Securities Exchange Act section). (1) A credit event with respect to the of 1934 (15 U.S.C. 78c(a)(29))), as in (iii) In identifying a reference entity issuer of such security or a credit event effect on the date of enactment of the included in the index for purposes of with respect to such security would Futures Trading Act of 1982; and this section, the term reference entity result in a payment by the credit (B) Without taking into account any includes: protection seller to the credit protection portion of the index composed of (A) An issuer of securities; buyer under the credit default swap

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based on the related notional amount issued in a transaction registered under (i) The effective notional amounts allocated to such security; or the Securities Act of 1933 (15 U.S.C. 77a allocated to all securities of such issuer (2) The fact of such credit event or the et seq.) and has publicly available included in the index comprise less calculation in accordance with distribution reports; and than five percent of the index’s paragraph (aaaa)(1)(i)(A)(1) of this (8) For a credit default swap entered weighting; and section of the amount owed with respect into solely between eligible contract (ii) The securities that satisfy to such credit event is taken into participants as defined in section 1a(18) paragraph (aaaa)(1)(i)(D) of this section account in determining whether to make of the Commodity Exchange Act: comprise at least 80 percent of the any future payments under the credit (i) The issuer of the security included index’s weighting. default swap with respect to any future in the index (other than an issuer of the (3) For purposes of this paragraph credit events; security that is an issuing entity of an (aaaa): (B) The effective notional amount asset-backed security as defined in (i) An issuer of securities included in allocated to the securities of any issuer section 3(a)(77) of the Securities the index is affiliated with another included in the index comprises more Exchange Act of 1934 (15 U.S.C. issuer of securities included in the than 30 percent of the index’s 78c(a)(77))) makes available to the index (for purposes of paragraph weighting; public or otherwise makes available to (aaaa)(3)(iv) of this section) or another (C) The effective notional amount such eligible contract participant entity (for purposes of paragraph allocated to the securities of any five information about such issuer pursuant (aaaa)(3)(v) of this section) if it controls, non-affiliated issuers included in the to rule 144A(d)(4) of the Securities Act is controlled by, or is under common index comprises more than 60 percent of 1933 (17 CFR 230.144A(d)(4)); control with, that other issuer or other of the index’s weighting; or (ii) Financial information about the entity, as applicable; provided that each (D) Except as provided in paragraph issuer of the security included in the issuer of securities included in the (aaaa)(2) of this section, for each index (other than an issuer of the index that is an issuing entity of an security included in the index, none of security that is an issuing entity of an asset-backed security as defined in the criteria in paragraphs asset-backed security as defined in section 3(a)(77) of the Securities (aaaa)(1)(i)(D)(1) through (8) is satisfied: section 3(a)(77) of the Securities Exchange Act of 1934 (15 U.S.C. (1) The issuer of the security included Exchange Act of 1934 (15 U.S.C. 78c(a)(77)) will not be considered in the index is required to file reports 78c(a)(77))) is otherwise publicly affiliated with any other issuer of pursuant to section 13 or section 15(d) available; or securities included in the index or any of the Securities Exchange Act of 1934 (iii) In the case of an asset-backed other entity that is an issuing entity of (15 U.S.C. 78m or 78o(d)); security as defined in section 3(a)(77) of an asset-backed security. (2) The issuer of the security included the Securities Exchange Act of 1934 (15 (ii) Control for purposes of this in the index is eligible to rely on the U.S.C. 78c(a)(77)), information of the section means ownership of more than exemption provided in rule 12g3–2(b) type and level included in public 50 percent of the equity of an issuer of under the Securities Exchange Act of distribution reports for similar asset- securities included in the index (for 1934 (17 CFR 240.12g3–2(b)); backed securities is publicly available purposes of paragraph (aaaa)(3)(iv) of (3) The issuer of the security included about both the issuing entity and such this section) or another entity (for in the index has a worldwide market asset-backed security; and purposes of paragraph (aaaa)(3)(v) of value of its outstanding common equity (ii)(A) The index is not composed this section), or the ability to direct the held by non-affiliates of $700 million or solely of exempted securities as defined voting of more than 50 percent of the more; in section 3(a)(12) of the Securities voting equity an issuer of securities (4) The issuer of the security included Exchange Act of 1934 (15 U.S.C. included in the index (for purposes of in the index (other than an issuer of the 78c(a)(12)), as in effect on the date of paragraph (aaaa)(3)(iv) of this section) or security that is an issuing entity of an enactment of the Futures Trading Act of another entity (for purposes of asset-backed security as defined in 1982 (other than any municipal security paragraph (aaaa)(3)(v) of this section). section 3(a)(77) of the Securities as defined in section 3(a)(29) of the (iii) In identifying an issuer of Exchange Act of 1934 (15 U.S.C. Securities Exchange Act of 1934 (15 securities included in the index for 78c(a)(77))) has outstanding notes, U.S.C. 78c(a)(29))), as in effect on the purposes of this section, the term issuer bonds, debentures, loans or evidences of date of enactment of the Futures includes: indebtedness (other than revolving Trading Act of 1982; and (A) An issuer of securities; and credit facilities) having a total remaining (B) Without taking into account any (B) An issuer of securities that is an principal amount of at least $1 billion; portion of the index composed of issuing entity of an asset-backed (5) The security included in the index exempted securities as defined in security as defined in section 3(a)(77) of is an exempted security as defined in section 3(a)(12) of the Securities the Securities Exchange Act of 1934 (15 section 3(a)(12) of the Securities Exchange Act of 1934 (15 U.S.C. U.S.C. 78c(a)(77)). Exchange Act of 1934 (15 U.S.C. 78c(a)(12)), as in effect on the date of (iv) For purposes of calculating the 78c(a)(12)) (other than any municipal enactment of the Futures Trading Act of thresholds in paragraphs (zzz)(1)(i)(A) security as defined in section 3(a)(29) of 1982 (other than any municipal security through (1)(i)(C) of this section, the term the Securities Exchange Act of 1934 (15 as defined in section 3(a)(29) of the issuer of the security included in the U.S.C. 78c(a)(29))); Securities Exchange Act of 1934 (15 index includes a single issuer of (6) The issuer of the security included U.S.C. 78c(a)(29))), the remaining securities included in the index or a in the index is a government of a foreign portion of the index would be within group of affiliated issuers of securities country or a political subdivision of a the term ‘‘narrow-based security index’’ included in the index as determined in foreign country; under paragraph (aaaa)(1)(i) of this accordance with paragraph (aaaa)(3)(i) (7) If the security included in the section. of this section (with each issuer of index is an asset-backed security as (2) Paragraph (aaaa)(1)(i)(D) of this securities included in the index that is defined in section 3(a)(77) of the section will not apply with respect to an issuing entity of an asset-backed Securities Exchange Act of 1934 (15 securities of an issuer included in the security as defined in section 3(a)(77) of U.S.C. 78c(a)(77)), the security was index if: the Securities Exchange Act of 1934 (15

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U.S.C. 78c(a)(77)) being considered a the qualifying foreign futures contract is the rules and regulations thereunder; separate issuer of securities included in based or referenced (including any and the index). security used to determine the cash (2) Shall not be required to collect and (v) For purposes of determining payment due on settlement of such maintain additional data regarding whether one of the criterion in either agreement, contract or transaction), an security-based swap agreements other paragraphs (aaaa)(1)(i)(D)(1) through affiliate (as defined in the Securities Act than the data regarding swaps required (aaaa)(1)(i)(D)(4) of this section or of 1933 (15 U.S.C. 77 et seq.) and the to be collected and maintained by such paragraphs (aaaa)(1)(iv)(D)(8)(i) and rules and regulations thereunder) of the persons pursuant to section 21 of the (aaaa)(1)(iv)(D)(8)(ii) of this section is issuer, or an underwriter of such Commodity Exchange Act and the rules met, the term issuer of the security issuer’s debt securities. and regulations thereunder. included in the index includes a single ■ 3. Add §§ 1.6 through 1.9 to read as (b) A person shall not be required to issuer of securities included in the follows: keep and maintain additional books and index or a group of affiliated entities as records, including daily trading records, determined in accordance with Sec. regarding security-based swap paragraph (aaaa)(3)(i) of this section 1.6 Anti-evasion. 1.7 Books and records requirements for agreements other than the books and (with each issuing entity of an asset- security-based swap agreements. records regarding swaps required to be backed security as defined in section 1.8 Requests for interpretation of swaps, kept and maintained by such persons 3(a)(77) of the Act (15 U.S.C. 78c(a)(77)) security-based swaps, and mixed swaps. pursuant to section 4s of the Commodity being considered a separate entity). 1.9 Regulation of mixed swaps. Exchange Act and the rules and (bbbb) Futures contracts on certain * * * * * regulations thereunder if such person is foreign sovereign debt. The term registered as: security-based swap as used in section § 1.6 Anti-evasion. (1) A swap dealer under section 3(a)(68) of the Securities Exchange Act (a) It shall be unlawful to conduct 4s(a)(1) of the Commodity Exchange Act of 1934 (15 U.S.C. 78c(a)(68)), as activities outside the United States, and the rules and regulations incorporated in section 1a(42) of the including entering into agreements, thereunder; Commodity Exchange Act, does not contracts, and transactions and (2) A major swap participant under include an agreement, contract, or structuring entities, to willfully evade or section 4s(a)(2) of the Commodity transaction that is based on or attempt to evade any provision of the Exchange Act and the rules and references a qualifying foreign futures Commodity Exchange Act as enacted by regulations thereunder; contract (as defined in rule 3a12–8 Subtitle A of the Wall Street (3) A security-based swap dealer under the Securities Exchange Act of Transparency and Accountability Act of under section 15F(a)(1) of the Securities 1934 (17 CFR 240.3a12–8)) on the debt 2010 or the rules, regulations, and Exchange Act of 1934 (15 U.S.C. 78o- securities of any one or more of the orders of the Commission promulgated 10(a)(1)) and the rules and regulations foreign governments enumerated in rule thereunder (Subtitle A). thereunder; or 3a12–8 under the Securities Exchange (b) The form, label, and written (4) a major security-based swap Act of 1934 (17 CFR 240.3a12–8), documentation of an agreement, participant under section 15F(a)(2) of provided that such agreement, contract, contract, or transaction, or an entity, the Securities Exchange Act of 1934 (15 or transaction satisfies the following shall not be dispositive in determining U.S.C. 78o-10(a)(2)) and the rules and conditions: whether the agreement, contract, or regulations thereunder. (1) The futures contract that the transaction, or entity, has been entered (c) The term security-based swap agreement, contract, or transaction into or structured to willfully evade as agreement has the meaning set forth in references or upon which the provided in paragraph (a) of this section 1a(47)(A)(v) of the Commodity agreement, contract, or transaction is section. Exchange Act. based is a qualifying foreign futures (c) An activity conducted outside the contract that satisfies the conditions of United States to evade as provided in § 1.8 Requests for interpretation of swaps, security-based swaps, and mixed swaps. rule 3a12–8 under the Securities paragraph (a) of this section shall be Exchange Act of 1934 (17 CFR subject to the provisions of Subtitle A. (a) In general. Any person may submit 240.3a12–8) applicable to qualifying (d) Notwithstanding the foregoing, no a request to the Commission and the foreign futures contracts; agreement, contract, or transaction Securities and Exchange Commission to (2) The agreement, contract, or structured as a security (including a provide a joint interpretation of whether transaction is traded on or through a security-based swap) under the a particular agreement, contract, or board of trade (as defined in the securities laws (as defined in section transaction (or class thereof) is: Commodity Exchange Act); 3(a)(47) of the Securities Exchange Act (1) A swap, as that term is defined in (3) The debt securities upon which of 1934 (15 U.S.C. 78c(a)(47))) shall be section 1a(47) of the Commodity the qualifying foreign futures contract is deemed a swap pursuant to this section. Exchange Act and the rules and based or referenced and any security regulations promulgated thereunder; used to determine the cash settlement § 1.7 Books and records requirements for (2) A security-based swap, as that amount pursuant to paragraph (bbbb)(4) security-based swap agreements. term is defined in section 1a(42) of the of this section were not registered under (a) A person registered as a swap data Commodity Exchange Act and the rules the Securities Act of 1933 (15 U.S.C. 77 repository under section 21 of the and regulations promulgated et seq.) or the subject of any American Commodity Exchange Act and the rules thereunder; or depositary receipt registered under the and regulations thereunder: (3) A mixed swap, as that term is Securities Act of 1933; (1) Shall not be required to keep and defined in section 1a(47)(D) of the (4) The agreement, contract, or maintain additional books and records Commodity Exchange Act and the rules transaction may only be cash settled; regarding security-based swap and regulations promulgated and agreements other than the books and thereunder. (5) The agreement, contract or records regarding swaps required to be (b) Request process. In making a transaction is not entered into by the kept and maintained pursuant to section request pursuant to paragraph (a) of this issuer of the debt securities upon which 21 of the Commodity Exchange Act and section, the requesting person must

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provide the Commission and the within 120 days after receipt of a and where at least one party is Securities and Exchange Commission complete submission requesting a joint registered with the Commission as a with the following: interpretation under paragraph (a) or (d) swap dealer or major swap participant (1) All material information regarding of this section. and also with the Securities and the terms of the agreement, contract, or (2) The Commission and the Exchange Commission as a security- transaction (or class thereof); Securities and Exchange Commission based swap dealer or major security- (2) A statement of the economic shall consult with the Board of based swap participant, shall be subject characteristics and purpose of the Governors of the Federal Reserve to: agreement, contract, or transaction (or System prior to issuing any joint (1) The following provisions of the class thereof); interpretation as described in paragraph Commodity Exchange Act, and the rules (3) The requesting person’s (a) of this section. and regulations promulgated determination as to whether the (3) If the Commission and the thereunder: agreement, contract, or transaction (or Securities and Exchange Commission (i) Examinations and information class thereof) should be characterized as seek public comment with respect to a sharing: sections 4s(f) and 8 of the a swap, a security-based swap, or both, joint interpretation regarding an Commodity Exchange Act; (i.e., a mixed swap), including the basis agreement, contract, or transaction (or (ii) Enforcement: sections 2(a)(1)(B), for such determination; and class thereof), the 120-day period 4(b), 4b, 4c, 4s(h)(1)(A), 4s(h)(4)(A), 6(c), (4) Such other information as may be described in paragraph (e)(1) of this 6(d), 6c, 6d, 9, 13(a), 13(b), and 23 of the requested by the Commission or the section shall be stayed during the Commodity Exchange Act; Securities and Exchange Commission. pendency of the comment period, but (iii) Reporting to a swap data (c) Request withdrawal. A person may shall recommence with the business day repository: section 4r of the Commodity withdraw a request made pursuant to after the public comment period ends. Exchange Act; paragraph (a) of this section at any time (4) Nothing in this section shall (iv) Real-time reporting: section prior to the issuance of a joint require the Commission and the 2(a)(13) of the Commodity Exchange interpretation or joint proposed rule by Securities and Exchange Commission to Act; the Commission and the Securities and issue any joint interpretation. (v) Capital: section 4s(e) of the Exchange Commission in response to (5) If the Commission and the Commodity Exchange Act; and the request; provided, however, that Securities and Exchange Commission do (vi) Position Limits: section 4a of the notwithstanding such withdrawal, the not issue a joint interpretation within Commodity Exchange Act; and Commission and the Securities and the time period described in paragraph (2) The provisions of the Federal Exchange Commission may provide a (e)(1) or (e)(3) of this section, each of the securities laws, as defined in section joint interpretation of whether the Commission and the Securities and 3(a)(47) of the Securities Exchange Act agreement, contract, or transaction (or Exchange Commission shall publicly of 1934 (15 U.S.C. 78c(a)(47)), and the class thereof) is a swap, a security-based provide the reasons for not issuing such rules and regulations promulgated swap, or both (i.e., a mixed swap). a joint interpretation within the thereunder. (d) Request by the Commission or the applicable timeframes. (c) Process for determining regulatory Securities and Exchange Commission. (f) Joint proposed rule. (1) Rather than treatment for other mixed swaps—(1) In In the absence of a request for a joint issue a joint interpretation pursuant to general. Any person who desires or interpretation under paragraph (a) of paragraph (a) of this section, the intends to list, trade, or clear a mixed this section: Commission and the Securities and swap (or class thereof) that is not subject (1) If the Commission or the Securities Exchange Commission may issue a joint to paragraph (b) of this section may and Exchange Commission receives a proposed rule, in consultation with the request the Commission and the proposal to list, trade, or clear an Board of Governors of the Federal Securities and Exchange Commission to agreement, contract, or transaction (or Reserve System, to further define one or issue a joint order permitting the class thereof) that raises questions as to more of the terms swap, security-based requesting person (and any other person the appropriate characterization of such swap, or mixed swap. or persons that subsequently lists, agreement, contract, or transaction (or (2) A joint proposed rule described in trades, or clears that mixed swap) to class thereof) as a swap, a security-based paragraph (f)(1) of this section shall be comply, as to parallel provisions only, swap, or both (i.e., a mixed swap), the issued within the timeframe for issuing with specified parallel provisions of Commission or the Securities and a joint interpretation set forth in either the Commodity Exchange Act or Exchange Commission, as applicable, paragraph (e) of this section. the Securities Exchange Act of 1934 (15 promptly shall notify the other of the U.S.C. 78a et seq.), and the rules and agreement, contract, or transaction (or § 1.9 Regulation of mixed swaps. regulations thereunder (collectively, class thereof); and (a) In general. The term mixed swap specified parallel provisions), instead of (2) The Commission or the Securities has the meaning set forth in section being required to comply with parallel and Exchange Commission, or their 1a(47)(D) of the Commodity Exchange provisions of both the Commodity Chairmen jointly, may submit a request Act. Exchange Act and the Securities for a joint interpretation as described in (b) Regulation of bilateral uncleared Exchange Act of 1934. For purposes of paragraph (a) of this section; such mixed swaps entered into by dually- this paragraph (c), parallel provisions submission shall be made pursuant to registered dealers or major participants. means comparable provisions of the paragraph (b) of this section, and may be A mixed swap that is neither executed Commodity Exchange Act and the withdrawn pursuant to paragraph (c) of on nor subject to the rules of a Securities Exchange Act of 1934 that this section. designated contract market, national were added or amended by the Wall (e) Timeframe for joint interpretation. securities exchange, swap execution Street Transparency and Accountability (1) If the Commission and the Securities facility, security-based swap execution Act of 2010 with respect to swaps and and Exchange Commission determine to facility, or foreign board of trade; that security-based swaps, and the rules and issue a joint interpretation as described will not be submitted to a derivatives regulations thereunder. in paragraph (a) of this section, such clearing organization or registered or (2) Request Process. A person joint interpretation shall be issued exempt clearing agency to be cleared; submitting a request pursuant to

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paragraph (c)(1) of this section must (5) Timeframe. (i) If the Commission section 3(a)(69) of the Securities provide the Commission and the and the Securities and Exchange Exchange Act of 1934 (15 U.S.C. Securities and Exchange Commission Commission determine to issue a joint 78c(a)(69)) and 17 CFR 240.3a69–1 with the following: order as described in paragraph (c)(4) of through 240.3a69–3. (i) All material information regarding this section, such joint order shall be (b) The term security-based swap as the terms of the specified, or specified issued within 120 days after receipt of used in section 2(a)(17) of the Act (15 class of, mixed swap; a complete request for a joint order U.S.C. 77b(a)(17)) has the same meaning (ii) The economic characteristics and under paragraph (c)(1) of this section, as provided in section 3(a)(68) of the purpose of the specified, or specified which time period shall be stayed Securities Exchange Act of 1934 (15 class of, mixed swap; during the pendency of the public U.S.C. 78c(a)(68)) and 17 CFR 240.3a68– (iii) The specified parallel provisions, comment period provided for in 1a through 240.3a68–5. and the reasons the person believes paragraph (c)(4) of this section and shall such specified parallel provisions recommence with the business day after PART 240—GENERAL RULES AND would be appropriate for the mixed the public comment period ends. REGULATIONS, SECURITIES swap (or class thereof); and (ii) Nothing in this section shall EXCHANGE ACT OF 1934 (iv) An analysis of: require the Commission and the Securities and Exchange Commission to ■ 3. The general authority citation for (A) The nature and purposes of the Part 240 is revised to read as follows: parallel provisions that are the subject issue any joint order. of the request; (iii) If the Commission and the Authority: 15 U.S.C. 77c, 77d, 77g, 77j, (B) The comparability of such parallel Securities and Exchange Commission do 77s, 77z–2, 77z–3, 77eee, 77ggg, 77nnn, 77jjj, 77kkk, 77sss, 77ttt, 78c, 78d, 78e, 78f, 78g, provisions; not issue a joint order within the time period described in paragraph (c)(5)(i) of 78i, 78j, 78j–1, 78k, 78k–1, 78l, 78m, 78n, (C) The extent of any conflicts or 78n–1, 78o, 78o–4, 78o–8, 78p, 78q, 78s, differences between such parallel this section, each of the Commission and the Securities and Exchange 78u–5, 78w, 78x, 78dd(b), 78dd(c), 78ll, provisions; and 78mm, 80a–20, 80a–23, 80a–29, 80a–37, 80b– Commission shall publicly provide the (D) Such other information as may be 3, 80b–4, 80b–11, 7201 et seq., and 8302; 18 requested by the Commission or the reasons for not issuing such a joint order U.S.C. 1350; 12 U.S.C. 5221(e)(3), and Pub. Securities and Exchange Commission. within that timeframe. L. 111–203, Sec. 712, 124 Stat. 1376 (2010), (3) Request withdrawal. A person may Securities and Exchange Commission unless otherwise noted. * * * * * withdraw a request made pursuant to Pursuant to the Securities Act, 15 paragraph (c)(1) of this section at any U.S.C. 77a et seq., and particularly, ■ 4. Add an undesignated center time prior to the issuance of a joint sections 19 and 28 thereof, and the heading and §§ 240.3a68–1a through order under paragraph (c)(4) of this Exchange Act, 15 U.S.C. 78a et seq., and 240.3a68–5 and §§ 240.3a69–1 through section by the Commission and the particularly, sections 3 and 23 thereof, 240.3a69–3 to read as follows: Securities and Exchange Commission in and sections 712(a)(8), 712(d), 721(a), Further Definition of Swap, Security-Based response to the request. 761(a) of the Dodd-Frank Act, the SEC (4) Issuance of orders. In response to Swap, and Security-Based Swap Agreement; is adopting rule 194 under the Mixed Swaps; Security-Based Swap a request under paragraph (c)(1) of this Securities Act and rules 3a68–1a section, the Commission and the Agreement Recordkeeping through 3a68–5 and 3a69–1 through 240.3a68–1a Meaning of ‘‘issuers of Securities and Exchange Commission, 3a69–3 under the Exchange Act. as necessary to carry out the purposes securities in a narrow-based security of the Wall Street Transparency and Text of Final Rules index’’ as used in section 3(a)(68)(A)(ii)(III) of the Act. Accountability Act of 2010, may issue a For the reasons stated in the 240.3a68–1b Meaning of ‘‘narrow-based joint order, after notice and opportunity preamble, the SEC is amending Title 17, security index’’ as used in section for comment, permitting the requesting Chapter II of the Code of the Federal 3(a)(68)(A)(ii)(I) of the Act. person (and any other person or persons Regulations as follows: 240.3a68–2 Requests for interpretation of that subsequently lists, trades, or clears swaps, security-based swaps, and mixed that mixed swap) to comply, as to PART 230—GENERAL RULES AND swaps. parallel provisions only, with the REGULATIONS, SECURITIES ACT OF 240.3a68–3 Meaning of ‘‘narrow-based specified parallel provisions (or another 1933 security index’’ as used in the definition subset of the parallel provisions that are of ‘‘security-based swap.’’ ■ 240.3a68–4 Regulation of mixed swaps. the subject of the request, as the 1. The authority citation for Part 230 continues to read, in part, as follows: 240.3a68–5 Regulation of certain futures Commissions determine is appropriate), contracts on foreign sovereign debt. instead of being required to comply Authority: 15 U.S.C. 77b, 77b note, 77c, 240.3a69–1 Safe Harbor Definition of with parallel provisions of both the 77d, 77f, 77g, 77h, 77j, 77r, 77s, 77z–3, 77sss, ‘‘security-based swap’’ and ‘‘swap’’ as Commodity Exchange Act and the 78c, 78d, 78j, 78l, 78m, 78n, 78o, 78o–7 note, used in sections 3(a)(68) and 3(a)(69) of Securities Exchange Act of 1934. In 78t, 78w, 78ll(d), 78mm, 80a–8, 80a–24, 80a– the Act—insurance. 28, 80a–29, 80a–30, 80a–37, and Pub. L. 111– determining the contents of such joint 240.3a69–2 Definition of ‘‘swap’’ as used in 203, § 712, 124 Stat. 1376 (2010) unless section 3(a)(69) of the Act—additional order, the Commission and the otherwise noted. Securities and Exchange Commission products. * * * * * 240.3a69–3 Books and records requirements may consider, among other things: ■ 2. Section 230.194 is added to read as for security-based swap agreements. (i) The nature and purposes of the follows: * * * * * parallel provisions that are the subject of the request; § 230.194 Definitions of the terms ‘‘swap’’ § 240.3a68–1a Meaning of ‘‘issuers of (ii) The comparability of such parallel and ‘‘security-based swap’’ as used in the securities in a narrow-based security provisions; and Act. index’’ as used in section 3(a)(68)(A)(ii)(III) (iii) The extent of any conflicts or (a) The term swap as used in section of the Act. differences between such parallel 2(a)(17) of the Act (15 U.S.C. 77b(a)(17)) (a) Notwithstanding § 240.3a68–3(a), provisions. has the same meaning as provided in and solely for purposes of determining

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whether a credit default swap is a revolving credit facilities) having a total (ii) Without taking into account any security-based swap under section remaining principal amount of at least portion of the index composed of 3(a)(68)(A)(ii)(III) of the Act (15 U.S.C. $1 billion; reference entities that are issuers of 78c(a)(68)(A)(ii)(III)), the term issuers of (E) The reference entity included in exempted securities as defined in securities in a narrow-based security the index is the issuer of an exempted section 3(a)(12) of the Act (15 U.S.C. index as used in section security as defined in section 3(a)(12) of 78c(a)(12)), as in effect on the date of 3(a)(68)(A)(ii)(III) of the Act means the Act (15 U.S.C. 78c(a)(12)) (other enactment of the Futures Trading Act of issuers of securities included in an than any municipal security as defined 1982 (other than any municipal security index (including an index referencing in section 3(a)(29) of the Act (15 U.S.C. as defined in section 3(a)(29) of the Act loan borrowers or loans of such 78c(a)(29))); (15 U.S.C. 78c(a)(29))), the remaining borrowers) in which: (F) The reference entity included in portion of the index would be within (1)(i) There are nine or fewer non- the index is a government of a foreign the term ‘‘issuer of securities in a affiliated issuers of securities that are country or a political subdivision of a narrow-based security index’’ under reference entities included in the index, foreign country; paragraph (a)(1) of this section. provided that an issuer of securities (G) If the reference entity included in (b) Paragraph (a)(1)(iv) of this section shall not be deemed a reference entity the index is an issuing entity of an asset- will not apply with respect to a included in the index for purposes of backed security as defined in section reference entity included in the index if: this section unless: 3(a)(77) of the Act (15 U.S.C. 78c(a)(77)), (1) The effective notional amounts (A) A credit event with respect to such asset-backed security was issued in allocated to such reference entity a transaction registered under the such reference entity would result in a comprise less than five percent of the Securities Act of 1933 (15 U.S.C. 77a et payment by the credit protection seller index’s weighting; and seq.) and has publicly available to the credit protection buyer under the (2) The effective notional amounts credit default swap based on the related distribution reports; and (H) For a credit default swap entered allocated to reference entities included notional amount allocated to such in the index that satisfy paragraph reference entity; or into solely between eligible contract participants as defined in section (a)(1)(iv) of this section comprise at least (B) The fact of such credit event or the 80 percent of the index’s weighting. calculation in accordance with 3(a)(65) of the Act (15 U.S.C. 78c(a)(65)): (1) The reference entity included in (c) For purposes of this section: paragraph (a)(1)(i)(A) of this section of (1) A reference entity included in the the amount owed with respect to such the index (other than a reference entity included in the index that is an issuing index is affiliated with another credit event is taken into account in reference entity included in the index determining whether to make any future entity of an asset-backed security as defined in section 3(a)(77) of the Act (15 (for purposes of paragraph (c)(4) of this payments under the credit default swap section) or another entity (for purposes with respect to any future credit events; U.S.C. 78c(a)(77))) makes available to the public or otherwise makes available of paragraph (c)(5) of this section) if it (ii) The effective notional amount controls, is controlled by, or is under allocated to any reference entity to such eligible contract participant information about the reference entity common control with, that other included in the index comprises more reference entity included in the index or than 30 percent of the index’s included in the index pursuant to § 230.144A(d)(4)) of this chapter; other entity, as applicable; provided that weighting; each reference entity included in the (iii) The effective notional amount (2) Financial information about the index that is an issuing entity of an allocated to any five non-affiliated reference entity included in the index asset-backed security as defined in reference entities included in the index (other than a reference entity included section 3(a)(77) of the Act (15 U.S.C. comprises more than 60 percent of the in the index that is an issuing entity of 78c(a)(77)) will not be considered index’s weighting; or an asset-backed security as defined in (iv) Except as provided in paragraph section 3(a)(77) of the Act (15 U.S.C. affiliated with any other reference entity (b) of this section, for each reference 78c(a)(77))) is otherwise publicly included in the index or any other entity included in the index, none of the available; or entity that is an issuing entity of an criteria in paragraphs (a)(1)(iv)(A) (3) In the case of a reference entity asset-backed security. through (a)(1)(iv)(H) of this section is included in the index that is an issuing (2) Control for purposes of this section satisfied: entity of an asset-backed security as means ownership of more than 50 (A) The reference entity included in defined in section 3(a)(77) of the Act (15 percent of the equity of a reference the index is required to file reports U.S.C. 78c(a)(77)), information of the entity included in the index (for pursuant to section 13 or section 15(d) type and level included in publicly purposes of paragraph (c)(4) of this of the Act (15 U.S.C. 78m or 78o(d)); available distribution reports for similar section) or another entity (for purposes (B) The reference entity included in asset-backed securities is publicly of paragraph (c)(5) of this section), or the index is eligible to rely on the available about both the reference entity the ability to direct the voting of more exemption provided in § 240.12g3–2(b); included in the index and such asset- than 50 percent of the voting equity of (C) The reference entity included in backed security; and a reference entity included in the index the index has a worldwide market value (2)(i) The index is not composed (for purposes of paragraph (c)(4) of this of its outstanding common equity held solely of reference entities that are section) or another entity (for purposes by non-affiliates of $700 million or issuers of exempted securities as of paragraph (c)(5) of this section). more; defined in section 3(a)(12) of the Act (15 (3) In identifying a reference entity (D) The reference entity included in U.S.C. 78c(a)(12)), as in effect on the included in the index for purposes of the index (other than a reference entity date of enactment of the Futures this section, the term reference entity included in the index that is an issuing Trading Act of 1982 (other than any includes: entity of an asset-backed security as municipal security as defined in section (i) An issuer of securities; defined in section 3(a)(77) of the Act (15 3(a)(29) of the Act (15 U.S.C. (ii) An issuer of securities that is an U.S.C. 78c(a)(77))) has outstanding 78c(a)(29))), as in effect on the date of issuing entity of an asset-backed notes, bonds, debentures, loans, or enactment of the Futures Trading Act of security as defined in section 3(a)(77) of evidences of indebtedness (other than 1982); and the Act (15 U.S.C. 78c(a)(77)); and

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(iii) An issuer of securities that is a payments under the credit default swap public or otherwise makes available to borrower with respect to any loan with respect to any future credit events; such eligible contract participant identified in an index of borrowers or (ii) The effective notional amount information about such issuer pursuant loans. allocated to the securities of any issuer to § 230.144A(d)(4)) of this chapter; (4) For purposes of calculating the included in the index comprises more (2) Financial information about the thresholds in paragraphs (a)(1)(i) than 30 percent of the index’s issuer of the security included in the through (a)(1)(iii) of this section, the weighting; index (other than an issuer of the term reference entity included in the (iii) The effective notional amount security that is an issuing entity of an index includes a single reference entity allocated to the securities of any five asset-backed security as defined in included in the index or a group of non-affiliated issuers included in the section 3(a)(77) of the Act (15 U.S.C. affiliated reference entities included in index comprises more than 60 percent 78c(a)(77))) is otherwise publicly the index as determined in accordance of the index’s weighting; or available; or with paragraph (c)(1) of this section (iv) Except as provided in paragraph (3) In the case of an asset-backed (with each reference entity included in (b) of this section, for each security security as defined in section 3(a)(77) of the index that is an issuing entity of an included in the index none of the the Act (15 U.S.C. 78c(a)(77)), asset-backed security as defined in criteria in paragraphs (a)(1)(iv)(A) information of the type and level section 3(a)(77) of the Act (15 U.S.C. through (a)(1)(iv)(H) of this section is included in public distribution reports 78c(a)(77)) being considered a separate satisfied: for similar asset-backed securities is reference entity included in the index). (A) The issuer of the security publicly available about both the issuing included in the index is required to file entity and such asset-backed security; (5) For purposes of determining reports pursuant to section 13 or section and whether one of the criterion in either 15(d) of the Act (15 U.S.C. 78m or (2)(i) The index is not composed paragraphs (a)(1)(iv)(A) through 78o(d)); solely of exempted securities as defined (a)(1)(iv)(D) of this section or paragraphs (B) The issuer of the security included in section 3(a)(12) of the Act (15 U.S.C. (a)(1)(iv)(H)(1) and (a)(1)(iv)(H)(2) of this in the index is eligible to rely on the 78c(a)(12)), as in effect on the date of section is met, the term reference entity exemption provided in § 240.12g3–2(b); enactment of the Futures Trading Act of included in the index includes a single (C) The issuer of the security included 1982 (other than any municipal security reference entity included in the index or in the index has a worldwide market as defined in section 3(a)(29) of the Act a group of affiliated entities as value of its outstanding common equity (15 U.S.C. 78c(a)(29))), as in effect on determined in accordance with held by non-affiliates of $700 million or the date of enactment of the Futures paragraph (c)(1) of this section (with more; Trading Act of 1982); and each issuing entity of an asset-backed (D) The issuer of the security included (ii) Without taking into account any security as defined in section 3(a)(77) of in the index (other than an issuer of the portion of the index composed of the Act (15 U.S.C. 78c(a)(77)) being security that is an issuing entity of an exempted securities as defined in considered a separate entity). asset-backed security as defined in section 3(a)(12) of the Act (15 U.S.C. § 240.3a68–1b Meaning of ‘‘narrow-based section 3(a)(77) of the Act (15 U.S.C. 78c(a)(12)), as in effect on the date of security index’’ as used in section 78c(a)(77))) has outstanding notes, enactment of the Futures Trading Act of 3(a)(68)(A)(ii)(I) of the Act. bonds, debentures, loans, or evidences 1982 (other than any municipal security (a) Notwithstanding § 240.3a68–3(a), of indebtedness (other than revolving as defined in section 3(a)(29) of the Act and solely for purposes of determining credit facilities) having a total remaining (15 U.S.C. 78c(a)(29))), the remaining whether a credit default swap is a principal amount of at least $1 billion; portion of the index would be within (E) The security included in the index security-based swap under section the term ‘‘narrow-based security index’’ is an exempted security as defined in 3(a)(68)(A)(ii)(I) of the Act (15 U.S.C. under paragraph (a)(1) of this section. section 3(a)(12) of the Act (15 U.S.C. 78c(a)(68)(A)(ii)(I)), the term narrow- (b) Paragraph (a)(1)(iv) of this section 78c(a)(12)) (other than any municipal based security index as used in section will not apply with respect to securities security as defined in section 3(a)(29) of 3(a)(68)(A)(ii)(I) of the Act means an of an issuer included in the index if: the Act (15 U.S.C. 78c(a)(29))); (1) The effective notional amounts index in which: (F) The issuer of the security included allocated to all securities of such issuer (1)(i) The index is composed of nine in the index is a government of a foreign included in the index comprise less or fewer securities or securities that are country or a political subdivision of a than five percent of the index’s issued by nine or fewer non-affiliated foreign country; weighting; and issuers, provided that a security shall (G) If the security included in the (2) The securities that satisfy not be deemed a component of the index is an asset-backed security as paragraph (a)(1)(iv) of this section index for purposes of this section defined in section 3(a)(77) of the Act (15 comprise at least 80 percent of the unless: U.S.C. 78c(a)(77)), the security was index’s weighting. (A) A credit event with respect to the issued in a transaction registered under (c) For purposes of this section: issuer of such security or a credit event the Securities Act of 1933 (15 U.S.C. 77a (1) An issuer of securities included in with respect to such security would et seq.) and has publicly available the index is affiliated with another result in a payment by the credit distribution reports; and issuer of securities included in the protection seller to the credit protection (H) For a credit default swap entered index (for purposes of paragraph (c)(4) buyer under the credit default swap into solely between eligible contract of this section) or another entity (for based on the related notional amount participants as defined in section purposes of paragraph (c)(5) of this allocated to such security; or 3(a)(65) of the Act (15 U.S.C. 78c(a)(65)): section) if it controls, is controlled by, (B) The fact of such credit event or the (1) The issuer of the security included or is under common control with, that calculation in accordance with in the index (other than an issuer of the other issuer or other entity, as paragraph (a)(1)(i)(A) of this section of security that is an issuing entity of an applicable; provided that each issuer of the amount owed with respect to such asset-backed security as defined in securities included in the index that is credit event is taken into account in section 3(a)(77) of the Act (15 U.S.C. an issuing entity of an asset-backed determining whether to make any future 78c(a)(77))) makes available to the security as defined in section 3(a)(77) of

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the Act (15 U.S.C. 78c(a)(77)) will not be interpretation of whether a particular as a swap, a security-based swap, or considered affiliated with any other agreement, contract, or transaction (or both (i.e., a mixed swap), the issuer of securities included in the class thereof) is: Commission or the Commodity Futures index or any other entity that is an (1) A swap, as that term is defined in Trading Commission, as applicable, issuing entity of an asset-backed section 3(a)(69) of the Act (15 U.S.C. promptly shall notify the other of the security. 78c(a)(69)) and the rules and regulations agreement, contract, or transaction (or (2) Control for purposes of this section promulgated thereunder; class thereof); and means ownership of more than 50 (2) A security-based swap, as that (2) The Commission or the percent of the equity of an issuer of term is defined in section 3(a)(68) of the Commodity Futures Trading securities included in the index (for Act (15 U.S.C. 78c(a)(68)) and the rules Commission, or their Chairmen jointly, purposes of paragraph (c)(4) of this and regulations promulgated may submit a request for a joint section) or another entity (for purposes thereunder; or interpretation as described in paragraph of paragraph (c)(5) of this section), or (3) A mixed swap, as that term is (a) of this section; such submission shall the ability to direct the voting of more defined in section 3(a)(68)(D) of the Act be made pursuant to paragraph (b) of than 50 percent of the voting equity an and the rules and regulations this section, and may be withdrawn issuer of securities included in the promulgated thereunder. pursuant to paragraph (c) of this section. index (for purposes of paragraph (c)(4) (b) Request process. In making a (e) Timeframe for joint interpretation. of this section) or another entity (for request pursuant to paragraph (a) of this (1) If the Commission and the purposes of paragraph (c)(5) of this section, the requesting person must Commodity Futures Trading section). provide the Commission and the Commission determine to issue a joint (3) In identifying an issuer of Commodity Futures Trading interpretation as described in paragraph securities included in the index for Commission with the following: (a) of this section, such joint purposes of this section, the term issuer (1) All material information regarding interpretation shall be issued within 120 includes: the terms of the agreement, contract, or days after receipt of a complete (i) An issuer of securities; and transaction (or class thereof); submission requesting a joint (ii) An issuer of securities that is an (2) A statement of the economic interpretation under paragraph (a) or (d) issuing entity of an asset-backed characteristics and purpose of the of this section. security as defined in section 3(a)(77) of agreement, contract, or transaction (or (2) The Commission and the the Act (15 U.S.C. 78c(a)(77)). class thereof); Commodity Futures Trading (4) For purposes of calculating the (3) The requesting person’s Commission shall consult with the thresholds in paragraphs (a)(1)(i) determination as to whether the Board of Governors of the Federal through (a)(1)(iii) of this section, the agreement, contract, or transaction (or Reserve System prior to issuing any term issuer of the security included in class thereof) should be characterized as joint interpretation as described in the index includes a single issuer of a swap, a security-based swap, or both paragraph (a) of this section. securities included in the index or a (i.e., a mixed swap), including the basis (3) If the Commission and the group of affiliated issuers of securities for such determination; and Commodity Futures Trading included in the index as determined in (4) Such other information as may be Commission seek public comment with accordance with paragraph (c)(1) of this requested by the Commission or the respect to a joint interpretation section (with each issuer of securities Commodity Futures Trading regarding an agreement, contract, or included in the index that is an issuing Commission. transaction (or class thereof), the 120- entity of an asset-backed security as (c) Request withdrawal. A person may day period described in paragraph (e)(1) defined in section 3(a)(77) of the Act (15 withdraw a request made pursuant to of this section shall be stayed during the U.S.C. 78c(a)(77)) being considered a paragraph (a) of this section at any time pendency of the comment period, but separate issuer of securities included in prior to the issuance of a joint shall recommence with the business day the index). interpretation or joint proposed rule by after the public comment period ends. (5) For purposes of determining the Commission and the Commodity (4) Nothing in this section shall whether one of the criterion in either Futures Trading Commission in require the Commission and the paragraphs (a)(1)(iv)(A) through response to the request; provided, Commodity Futures Trading (a)(1))(iv)(D) of this section or however, that notwithstanding such Commission to issue any joint paragraphs (a)(1)(iv)(H)(1) and withdrawal, the Commission and the interpretation. (a)(1)(iv)(H)(2) of this section is met, the Commodity Futures Trading (5) If the Commission and the term issuer of the security included in Commission may provide a joint Commodity Futures Trading the index includes a single issuer of interpretation of whether the agreement, Commission do not issue a joint securities included in the index or a contract, or transaction (or class thereof) interpretation within the time period group affiliated entities as determined is a swap, a security-based swap, or both described in paragraph (e)(1) or (e)(3) of in accordance with paragraph (c)(1) of (i.e., a mixed swap). this section, each of the Commission this section (with each issuing entity of (d) Request by the Commission or the and the Commodity Futures Trading an asset-backed security as defined in Commodity Futures Trading Commission shall publicly provide the section 3(a)(77) of the Act (15 U.S.C. Commission. In the absence of a request reasons for not issuing such a joint 78c(a)(77)) being considered a separate for a joint interpretation under interpretation within the applicable entity). paragraph (a) of this section: timeframes. (1) If the Commission or the (f) Joint proposed rule. (1) Rather than § 240.3a68–2 Requests for interpretation Commodity Futures Trading issue a joint interpretation pursuant to of swaps, security-based swaps, and mixed Commission receives a proposal to list, paragraph (a) of this section, the swaps. trade, or clear an agreement, contract, or Commission and the Commodity (a) In general. Any person may submit transaction (or class thereof) that raises Futures Trading Commission may issue a request to the Commission and the questions as to the appropriate a joint proposed rule, in consultation Commodity Futures Trading characterization of such agreement, with the Board of Governors of the Commission to provide a joint contract, or transaction (or class thereof) Federal Reserve System, to further

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define one or more of the terms swap, a security-based swap on a narrow- major swap participant, shall be subject security-based swap, or mixed swap. based security index; or to: (2) A joint proposed rule described in (ii) Such index was a narrow-based (i) The following provisions of the paragraph (f)(1) of this section shall be security index during every trading day Commodity Exchange Act (7 U.S.C. 1 et issued within the timeframe for issuing of the six full calendar months seq.), and the rules and regulations a joint interpretation set forth in preceding a date no earlier than 30 days promulgated thereunder, set forth in the paragraph (e) of this section. prior to the commencement of trading of rules and regulations of the Commodity a security-based swap on such index on Futures Trading Commission: § 240.3a68–3 Meaning of ‘‘narrow-based a market described in paragraph (c)(1)(i) (A) Examinations and information security index’’ as used in the definition of sharing: 7 U.S.C. 6s(f) and 12; ‘‘security-based swap.’’ of this section; and (B) Enforcement: 7 U.S.C. 2(a)(1)(B), (a) In general. Except as otherwise (2) The index has been a security index that is not a narrow-based 6(b), 6b, 6c, 6s(h)(1)(A), 6s(h)(4)(A), 9, provided in § 240.3a68–1a and 13b, 13a–1, 13a–2, 13, 13c(a), 13c(b), 15 § 240.3a68–1b, for purposes of section security index for no more than 45 business days over three consecutive and 26; 3(a)(68) of the Act (15 U.S.C. 78c(a)(68)), (C) Reporting to a swap data the term narrow-based security index calendar months. (d) Grace period. (1) Solely with repository: 7 U.S.C. 6r; has the meaning set forth in section (D) Real-time reporting: 7 U.S.C. respect to a swap that is traded on or 3(a)(55) of the Act (15 U.S.C. 78c(a)(55)), 2(a)(13); subject to the rules of a designated and the rules, regulations, and orders of (E) Capital: 7 U.S.C. 6s(e); and the Commission thereunder. contract market, swap execution facility (F) Position Limits: 7 U.S.C. 6a; and (b) Tolerance period for swaps traded or foreign board of trade pursuant to the (ii) The provisions of the Federal on designated contract markets, swap Commodity Exchange Act (7 U.S.C. 1 et securities laws, as defined in section execution facilities and foreign boards seq.), an index that becomes a narrow- 3(a)(47) of the Act (15 U.S.C. 78c(a)(47)), of trade. Notwithstanding paragraph (a) based security index under paragraph and the rules and regulations of this section, solely for purposes of (b) of this section solely because it was promulgated thereunder. swaps traded on or subject to the rules a narrow-based security index for more (c) Process for determining regulatory of a designated contract market, swap than 45 business days over three treatment for other mixed swaps—(1) In execution facility, or foreign board of consecutive calendar months shall not general. Any person who desires or trade pursuant to the Commodity be a narrow-based security index for the intends to list, trade, or clear a mixed Exchange Act (7 U.S.C. 1 et seq.), a following three calendar months. swap (or class thereof) that is not subject security index underlying such swaps (2) Solely with respect to a security- to paragraph (b) of this section may shall not be considered a narrow-based based swap that is traded on a national request the Commission and the security index if: securities exchange or security-based Commodity Futures Trading (1)(i) A swap on the index is traded swap execution facility, an index that Commission to issue a joint order on or subject to the rules of a designated becomes a security index that is not a permitting the requesting person (and contract market, swap execution facility, narrow-based security index under any other person or persons that or foreign board of trade pursuant to the paragraph (c) of this section solely subsequently lists, trades, or clears that Commodity Exchange Act (7 U.S.C. 1 et because it was not a narrow-based mixed swap) to comply, as to parallel seq.) for at least 30 days as a swap on security index for more than 45 business provisions only, with specified parallel an index that was not a narrow-based days over three consecutive calendar provisions of either the Act (15 U.S.C. security index; or months shall be a narrow-based security 78a et seq.) or the Commodity Exchange (ii) Such index was not a narrow- index for the following three calendar Act (7 U.S.C. 1 et seq.), and the rules based security index during every months. and regulations thereunder (collectively, trading day of the six full calendar § 240.3a68–4 Regulation of mixed swaps. specified parallel provisions), instead of months preceding a date no earlier than being required to comply with parallel 30 days prior to the commencement of (a) In general. The term mixed swap provisions of both the Act and the trading of a swap on such index on a has the meaning set forth in section Commodity Exchange Act. For purposes market described in paragraph (b)(1)(i) 3(a)(68)(D) of the Act (15 U.S.C. of this paragraph (c), parallel provisions of this section; and 78c(a)(68)(D)). means comparable provisions of the Act (2) The index has been a narrow- (b) Regulation of bilateral uncleared and the Commodity Exchange Act that based security index for no more than mixed swaps entered into by dually- were added or amended by the Wall 45 business days over three consecutive registered dealers or major participants. Street Transparency and Accountability calendar months. A mixed swap: Act of 2010 with respect to security- (c) Tolerance period for security- (1) That is neither executed on nor based swaps and swaps, and the rules based swaps traded on national subject to the rules of a designated and regulations thereunder. securities exchanges or security-based contract market, national securities (2) Request process. A person swap execution facilities. exchange, swap execution facility, submitting a request pursuant to Notwithstanding paragraph (a) of this security-based swap execution facility, paragraph (c)(1) of this section must section, solely for purposes of security- or foreign board of trade; provide the Commission and the based swaps traded on a national (2) That will not be submitted to a Commodity Futures Trading securities exchange or security-based derivatives clearing organization or Commission with the following: swap execution facility, a security index registered or exempt clearing agency to (i) All material information regarding underlying such security-based swaps be cleared; and the terms of the specified, or specified shall be considered a narrow-based (3) Where at least one party is class of, mixed swap; security index if: registered with the Commission as a (ii) The economic characteristics and (1)(i) A security-based swap on the security-based swap dealer or major purpose of the specified, or specified index is traded on a national securities security-based swap participant and class of, mixed swap; exchange or security-based swap also with the Commodity Futures (iii) The specified parallel provisions, execution facility for at least 30 days as Trading Commission as a swap dealer or and the reasons the person believes

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such specified parallel provisions comment period provided for in issuer, or an underwriter of such would be appropriate for the mixed paragraph (c)(4) of this section and shall issuer’s debt securities. swap (or class thereof); and recommence with the business day after (iv) An analysis of: the public comment period ends. § 240.3a69–1 Safe Harbor Definition of (A) The nature and purposes of the ‘‘security-based swap’’ and ‘‘swap’’ as used (ii) Nothing in this section shall in sections 3(a)(68) and 3(a)(69) of the Act— parallel provisions that are the subject require the Commission and the insurance. of the request; Commodity Futures Trading (a) This paragraph is a non-exclusive (B) The comparability of such parallel Commission to issue any joint order. provisions; safe harbor. The terms security-based (iii) If the Commission and the swap as used in section 3(a)(68) of the (C) The extent of any conflicts or Commodity Futures Trading differences between such parallel Act (15 U.S.C. 78c(a)(68)) and swap as Commission do not issue a joint order used in section 3(a)(69) of the Act (15 provisions; and within the time period described in (D) Such other information as may be U.S.C. 78c(a)(69)) do not include an paragraph (c)(5)(i) of this section, each requested by the Commission or the agreement, contract, or transaction that: of the Commission and the Commodity Commodity Futures Trading (1) By its terms or by law, as a Futures Trading Commission shall Commission. condition of performance on the (3) Request withdrawal. A person may publicly provide the reasons for not agreement, contract, or transaction: withdraw a request made pursuant to issuing such a joint order within that (i) Requires the beneficiary of the paragraph (c)(1) of this section at any timeframe. agreement, contract, or transaction to time prior to the issuance of a joint § 240.3a68–5 Regulation of certain futures have an insurable interest that is the order under paragraph (c)(4) of this contracts on foreign sovereign debt. subject of the agreement, contract, or transaction and thereby carry the risk of section by the Commission and the The term security-based swap as used loss with respect to that interest Commodity Futures Trading in section 3(a)(68) of the Act (15 U.S.C. continuously throughout the duration of Commission in response to the request. 78c(a)(68)) does not include an the agreement, contract, or transaction; (4) Issuance of orders. In response to agreement, contract, or transaction that (ii) Requires that loss to occur and to a request under paragraph (c)(1) of this is based on or references a qualifying be proved, and that any payment or section, the Commission and the foreign futures contract (as defined in indemnification therefor be limited to Commodity Futures Trading § 240.3a12–8 on the debt securities of the value of the insurable interest; Commission, as necessary to carry out any one or more of the foreign (iii) Is not traded, separately from the the purposes of the Wall Street governments enumerated in § 240.3a12– insured interest, on an organized market Transparency and Accountability Act of 8, provided that such agreement, or over the counter; and 2010, may issue a joint order, after contract, or transaction satisfies the (iv) With respect to financial guaranty notice and opportunity for comment, following conditions: permitting the requesting person (and insurance only, in the event of payment (a) The futures contract that the any other person or persons that default or insolvency of the obligor, any agreement, contract, or transaction subsequently lists, trades, or clears that acceleration of payments under the references or upon which the mixed swap) to comply, as to parallel policy is at the sole discretion of the agreement, contract, or transaction is provisions only, with the specified insurer; and based is a qualifying foreign futures parallel provisions (or another subset of (2) Is provided: contract that satisfies the conditions of the parallel provisions that are the (i)(A) By a person that is subject to § 240.3a12–8 applicable to qualifying subject of the request, as the supervision by the insurance foreign futures contracts; Commissions determine is appropriate), commissioner (or similar official or (b) The agreement, contract, or instead of being required to comply agency) of any State, as defined in transaction is traded on or through a with parallel provisions of both the Act section 3(a)(16) of the Act (15 U.S.C. board of trade (as defined in 7 U.S.C. 2); (15 U.S.C. 78a et seq.) and the 78c(a)(16)), or by the United States or an Commodity Exchange Act (7 U.S.C. 1 et (c) The debt securities upon which agency or instrumentality thereof; and seq.). In determining the contents of the qualifying foreign futures contract is (B) Such agreement, contract, or such joint order, the Commission and based or referenced and any security transaction is regulated as insurance the Commodity Futures Trading used to determine the cash settlement under applicable State law or the laws Commission may consider, among other amount pursuant to paragraph (d) of this of the United States; things: section were not registered under the (ii)(A) Directly or indirectly by the (i) The nature and purposes of the Securities Act of 1933 (15 U.S.C. 77 et United States, any State or any of their parallel provisions that are the subject seq.) or the subject of any American respective agencies or instrumentalities; of the request; depositary receipt registered under the or (ii) The comparability of such parallel Securities Act of 1933; (B) Pursuant to a statutorily provisions; and (d) The agreement, contract, or authorized program thereof; or (iii) The extent of any conflicts or transaction may only be cash settled; (iii) In the case of reinsurance only by differences between such parallel and a person to another person that satisfies provisions. (e) The agreement, contract or the conditions set forth in paragraph (5) Timeframe. (i) If the Commission transaction is not entered into by the (a)(2) of this section, provided that: and the Commodity Futures Trading issuer of the debt securities upon which (A) Such person is not prohibited by Commission determine to issue a joint the qualifying foreign futures contract is applicable State law or the laws of the order as described in paragraph (c)(4) of based or referenced (including any United States from offering such this section, such joint order shall be security used to determine the cash agreement, contract, or transaction to issued within 120 days after receipt of payment due on settlement of such such person that satisfies the conditions a complete request for a joint order agreement, contract or transaction), an set forth in paragraph (a)(2) of this under paragraph (c)(1) of this section, affiliate (as defined in the Securities Act section; which time period shall be stayed of 1933 (15 U.S.C. 77 et seq.) and the (B) The agreement, contract, or during the pendency of the public rules and regulations thereunder) of the transaction to be reinsured satisfies the

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conditions set forth in paragraph (a)(1) (iv) A foreign exchange swap; § 240.3a69–3 Books and records or (3) of this section; and (v) A forward rate agreement; and requirements for security-based swap (C) Except as otherwise permitted agreements. (vi) A non-deliverable forward under applicable State law, the total (a) A person registered as a swap data involving foreign exchange. amount reimbursable by all reinsurers repository under section 21 of the for such agreement, contract, or (2) The term swap does not include an Commodity Exchange Act (7 U.S.C. 24a) transaction may not exceed the claims agreement, contract, or transaction and the rules and regulations or losses paid by the person writing the described in paragraph (b)(1) of this thereunder: risk being ceded or transferred by such section that is otherwise excluded by (1) Shall not be required to keep and person; or section 1a(47)(B) of the Commodity maintain additional books and records (iv) In the case of non-admitted Exchange Act (7 U.S.C. 1a(47)(B)). regarding security-based swap insurance by a person who: (c) Foreign exchange forwards and agreements other than the books and (A) Is located outside of the United foreign exchange swaps. records regarding swaps required to be States and listed on the Quarterly Notwithstanding paragraph (b)(2) of this kept and maintained pursuant to section Listing of Alien Insurers as maintained section: 21 of the Commodity Exchange Act (7 by the International Insurers (1) A foreign exchange forward or a U.S.C. 24a) and the rules and Department of the National Association foreign exchange swap shall not be regulations thereunder; and of Insurance Commissioners; or considered a swap if the Secretary of the (2) Shall not be required to collect and (B) Meets the eligibility criteria for Treasury makes a determination maintain additional data regarding non-admitted insurers under applicable described in section 1a(47)(E)(i) of the security-based swap agreements other State law; or Commodity Exchange Act (7 U.S.C. than the data regarding swaps required (3) Is provided in accordance with the 1a(47)(E)(i)). to be collected and maintained by such conditions set forth in paragraph (a)(2) persons pursuant to section 21 of the (2) Notwithstanding paragraph (c)(1) of this section and is one of the Commodity Exchange Act (7 U.S.C. 24a) of this section: following types of products: and the rules and regulations (i) Surety bond; (i) The reporting requirements set thereunder. (ii) Fidelity bond; forth in section 4r of the Commodity (b) A person shall not be required to (iii) Life insurance; Exchange Act (7 U.S.C. 6r) and keep and maintain additional books and (iv) Health insurance; regulations promulgated thereunder records, including daily trading records, (v) Long term care insurance; shall apply to a foreign exchange regarding security-based swap (vi) Title insurance; forward or foreign exchange swap; and agreements other than the books and (vii) Property and casualty insurance; (ii) The business conduct standards records regarding swaps required to be (viii) Annuity; set forth in section 4s(h) of the kept and maintained by such persons (ix) Disability insurance; Commodity Exchange Act (7 U.S.C. 6s) pursuant to section 4s of the Commodity (x) Insurance against default on and regulations promulgated thereunder Exchange Act (7 U.S.C. 6s) and the rules individual residential mortgages; and shall apply to a swap dealer or major and regulations thereunder if such (xi) Reinsurance of any of the swap participant that is a party to a person is registered as: foregoing products identified in foreign exchange forward or foreign (1) A swap dealer under section paragraphs (i) through (x) of this exchange swap. 4s(a)(1) of the Commodity Exchange Act (7 U.S.C. 6s(a)(1)) and the rules and section. (3) For purposes of section 1a(47)(E) regulations thereunder; (b) The terms security-based swap as of the Commodity Exchange Act (7 (2) A major swap participant under used in section 3(a)(68) of the Act (15 U.S.C. 1a(47)(E)) and this section, the section 4s(a)(2) of the Commodity U.S.C. 78c(a)(68)) and swap as used in term foreign exchange forward has the Exchange Act (7 U.S.C. 6s(a)(2)) and the section 3(a)(69) of the Act (15 U.S.C. meaning set forth in section 1a(24) of 78c(a)(69)) do not include an agreement, rules and regulations thereunder; the Commodity Exchange Act (7 U.S.C. (3) A security-based swap dealer contract, or transaction that was entered 1a(24)). into on or before the effective date of under section 15F(a)(1) of the Act (15 this section and that, at such time that (4) For purposes of section 1a(47)(E) U.S.C. 78o–10(a)(1)) and the rules and it was entered into, was provided in of the Commodity Exchange Act (7 regulations thereunder; or accordance with the conditions set forth U.S.C. 1a(47)(E)) and this section, the (4) A major security-based swap in paragraph (a)(2) of this section. term foreign exchange swap has the participant under section 15F(a)(2) of meaning set forth in section 1a(25) of the Act (15 U.S.C. 78o–10(a)(2)) and the § 240.3a69–2 Definition of ‘‘swap’’ as used the Commodity Exchange Act (7 U.S.C. rules and regulations thereunder. in section 3(a)(69) of the Act—additional 1a(25)). (c) The term security-based swap products. (5) For purposes of sections 1a(24) agreement has the meaning set forth in (a) In general. The term swap has the and 1a(25) of the Commodity Exchange section 3(a)(78) of the Act (15 U.S.C. meaning set forth in section 3(a)(69) of Act (7 U.S.C. 1a(24) and (25)) and this 78c(a)(78)). the Act (15 U.S.C. 78c(a)(69)). section, the following transactions are (b) Inclusion of particular products. not foreign exchange forwards or foreign PART 241—INTERPRETATIVE (1) The term swap includes, without exchange swaps: RELEASES RELATING TO THE limiting the meaning set forth in section SECURITIES EXCHANGE ACT OF 1934 (i) A currency swap or a cross- 3(a)(69) of the Act (15 U.S.C. 78c(a)(69)), AND GENERAL RULES AND currency swap; the following agreements, contracts, and REGULATIONS THEREUNDER transactions: (ii) A currency option, foreign (i) A cross-currency swap; currency option, foreign exchange ■ 5. Part 241 is amended by adding (ii) A currency option, foreign option, or foreign exchange rate option; Release No. 34–67453 and the release currency option, foreign exchange and date of July 18, 2012, to the list of option and foreign exchange rate option; (iii) A non-deliverable forward interpretative releases. (iii) A foreign exchange forward; involving foreign exchange. Dated: July 18, 2012.

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By the Commodity Futures Trading commenters, is providing increased clarity explaining the circumstances leading to non- Commission. on the forward exclusion from futures delivery. This safe harbor, in my view, would regulation. The final release provides encourage market participants to submit David A. Stawick, guidance regarding forwards with embedded information that would vastly improve the Secretary. volumetric options, like those used within ability of the Commission to ensure that By the Securities and Exchange the electricity markets, and is requesting market participants claiming the forward Commission. comment on this interpretation. contract exclusion are doing so Dated: July 18, 2012. Further, consistent with the Dodd-Frank appropriately, consistent with the law and Act, insurance products will not be regulated Commission and staff interpretation of the Elizabeth M. Murphy, as swaps. Similarly, this final rulemaking law. Secretary. clarifies that certain consumer and Second, the Commission has failed to Product Definitions Contained in Title commercial arrangements that historically provide adequate legal certainty to market have not been considered swaps, such as participants engaging in contracts with VII of the Dodd-Frank Wall Street consumer mortgage rate locks, contracts to embedded volumetric commodity options, Reform and Consumer Protection Act— lock in the price of home heating oil and particularly those that can terminate without CFTC Voting Summary and Statements contracts relating to inventory or equipment, physical delivery. Contracts with embedded of CFTC Commissioners also will not be regulated as swaps. commodity options that can negate the The rule provides clarity on the dividing physical delivery term have optionality that Note: The following appendices will not line between ‘‘swaps’’ and ‘‘security-based targets the delivery term of the contract and appear in the Code of Federal Regulations. swaps’’ or both, i.e. mixed swaps. The rule therefore cannot be seen as having as a also provides a process for requesting joint predominant feature actual delivery, a CFTC Voting Summary interpretations in circumstances where there necessary element in any forward contract On this matter, Chairman Gensler and are questions. These dividing lines and the under applicable Commission precedent. The Commissioners Sommers, O’Malia and process will benefit market participants, as Commission has failed to perform an analysis Wetjen voted in the affirmative; they will provide greater clarity as to what of these types of contracts in an excess of Commissioner Chilton voted in the negative. regulatory requirements apply when they caution that may invite confusion, at best, transact in the derivatives markets. and evasion, at worst. Statement of CFTC Chairman Gary Gensler Lastly, the final release includes specific The Dodd-Frank Wall Street Reform and I support the final rulemaking to provisions that guard against transactions Consumer Protection Act (‘‘Dodd-Frank implement the Dodd-Frank Wall Street that are willfully structured to evade Dodd- Act’’) 1 imposes new safeguards on hitherto Reform and Consumer Protection Act (Dodd- Frank Act swaps market reforms. unregulated markets. These safeguards Frank Act) requirement to further define I’d like to express my appreciation for their increase the integrity of the markets by, e.g., ‘‘swap’’ and other products that come under dedication to completing this rule to improving market transparency and thereby swaps market reform. The Commodity Chairman Mary Schapiro and her fellow deterring abuses of the sorts seen in recent Futures Trading Commission (CFTC) worked Commissioners at the SEC, as well as the decades. These safeguards inevitably increase closely with the Securities and Exchange staff, including Robert Cook, Brian Bussey, compliance costs, particularly in the initial Commission (SEC), in consultation with the Amy Starr, Donna Chambers, Christie March, phase of implementation. As I can predict Federal Reserve, on the final rules and Andy Schoeffler, Wenchi Hu, John Guidroz with absolute certainty, bad actors (a` la interpretations to further define ‘‘swaps,’’ and Sarah Otte. Amaranth) will be drawn to dark markets in ‘‘security-based swaps,’’ ‘‘mixed swaps’’ and I’d also like to thank the CFTC’s search of spoils. Less ill-intentioned or ‘‘security-based swap agreements.’’ hardworking staff: Julian Hammar, Lee Ann ‘‘grey’’ actors may follow them in search of The statutory definition as laid out by Duffy, David Aron, Terry Arbit, Eric Juzenas lower compliance costs. The Commission Congress of swap is very detailed. These final and Stephen Kane. should not cede swaths of jurisdiction rules and interpretations are consistent with because such markets have not hitherto given that detailed definition and Congressional Dissent of CFTC Commissioner Chilton on rise to concerns.2 3 intent. For example, interest rate swaps, Further Definition of ‘‘Swap,’’ ‘‘Security- The Commission proposed and is now currency swaps, commodity swaps, Based Swap,’’ and ‘‘Security-Based Swap adopting an approach to the forward contract including energy, metals and agricultural Agreement;’’ Mixed Swaps; Security-Based exclusion that draws on ‘‘the principles 4 swaps, and broad-based index swaps, such as Swap Agreement Recordkeeping underlying’’ the Brent Interpretation. I agree index credit default swaps, are all swaps. I respectfully dissent from this joint final Consistent with Congress’s definition of rule and interpretive guidance because I have 1 See Dodd-Frank Wall Street Reform and swaps, the rule also defines options as swaps. reservations about certain aspects of the Consumer Protection Act, Public Law 111–203, 124 In preparing this final rulemaking, staff Commodity Futures Trading Commission’s Stat. 1376 (2010). The text of the Dodd-Frank Act may be accessed at http://www.cftc.gov/ worked to address the more than 140 (‘‘Commission’’) interpretive guidance on LawRegulation/OTCDERIVATIVES/index.htm. comments that were submitted by the public forward contracts. Apart from this specific 2 See Financial Crisis Inquiry Commission, ‘‘The in response to the product further definition area, I agree with the joint release and would Financial Crisis Inquiry Report: Final Report of the proposal. Many of the commenters asked the support its adoption. National Commission on the Causes of the Commissions to specifically provide I am dissenting from the interpretive Financial and Economic Crisis in the United guidance on what is not a swap or security- guidance for two chief reasons. First, I States,’’ Jan. 2011, at 25, available at http:// based swap. believe that the Commission should make www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO- For example, under the Commodity stronger efforts to ensure market participants FCIC.pdf (‘‘concluding that ‘‘enactment of * * * Exchange Act, the CFTC does not regulate claim the forward contract exclusion only [the Commodity Futures Modernization Act of 2000 (‘‘CFMA’’)] to ban the regulation by both the forward contracts. Over the decades, there under appropriate circumstances, consistent Federal and State governments of over-the-counter have been a series of orders, interpretations with its interpretive guidance. The (OTC) derivatives was a key turning point in the and cases that market participants have come Commission should apply a rebuttable march toward the financial crisis.’’). to rely upon regarding the exception from presumption that contracts do not have as 3 See Further Definition of ‘‘Swap,’’ ‘‘Security- futures regulation for forwards and forwards their predominant feature actual delivery in Based Swap,’’ and ‘‘Security-Based Swap with embedded options. Consistent with that instances where market participants often do Agreement’’; Mixed Swaps; Security-Based Swap history, the Dodd-Frank Act excluded from not follow the delivery settlement term in a Agreement Recordkeeping, 76 FR 29818, 29829, the definition of a swap ‘‘any sale of a contract. The Commission should set forth May 23, 2011. nonfinancial commodity or security for the conditions for a safe harbor, consistent 4 Further Definition of ‘‘Swap,’’ ‘‘Security-Based deferred shipment or delivery, so long as the with its interpretation of the forward contract Swap,’’ and ‘‘Security-Based Swap Agreement’’; Mixed Swaps; Security-Based Swap Agreement transaction is intended to be physically exclusion, for market participants that often Recordkeeping, 77 FR ___, ___ (‘‘Adopting settled.’’ The Commission is interpreting that do not terminate ‘‘forward’’ contracts through Release’’); Statutory Interpretation Concerning exclusion in a manner that is consistent with physical delivery that includes some Forward Transactions, 55 FR 39188, Sept. 25, 1990 Commission precedent and, in response to affirmative statement to the Commission Continued

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generally with this approach (I voted in the transactions that market participants claim as No person shall offer to enter into, enter affirmative on releasing the proposal). In being subject to the forward contract into or confirm the execution of, any addition, the Commission recognizes that the exclusion. I believe the Commission should transaction involving any commodity underlying purpose of a transaction is a be more active when it comes to ensuring regulated under this chapter which is of the critical factor in determining whether a given that the forward contract exclusion is character of, or is commonly known to the transaction is more appropriately classified properly applied, particularly in instances trade as, an ‘‘option’’, ‘‘privilege’’’, as a forward or swap (or commodity option).5 where an ostensible ‘‘forward’’ closely ‘‘indemnity’’, ‘‘bid’’, ‘‘offer’’, ‘‘put’’, ‘‘call’’, I commend this clarification and hope it is resembles, in form, purpose, or economic ‘‘advance guaranty’’, or ‘‘decline guaranty’’, applied or further clarified in a way that substance regulated products. contrary to any rule, regulation, or order of affirms the principles underlying the Brent The Commission has endorsed the purpose the Commission prohibiting any such Interpretation without endorsing the outcome of a transaction as a factor in determining a transaction or allowing any such transaction of the Brent Interpretation. contract’s eligibility for the forward contract under such terms and conditions as the exclusion.7 The Brent Interpretation or the Commission shall prescribe. Any such order, 1. Safe Harbor for ‘‘Forwards’’ That Often Commission’s re-interpretation of it rule, or regulation may be made only after Do Not Terminate With Actual Delivery notwithstanding, I believe that when few notice and opportunity for hearing, and the I believe that the Commission should make ‘‘forward’’ contracts for a given market Commission may set different terms and stronger efforts to ensure market participants participant result in delivery, then there is conditions for different markets.8 claim the forward contract exclusion only sufficient ground for the Commission to have Through this decades-old provision, under appropriate circumstances. I am doubt about the appropriateness of the Congress gave the Commission jurisdiction concerned that the forward contract forward contract exclusion claim. Moreover, and plenary rulemaking authority over exclusion may be abused if not intentionally under such circumstances the Commission physical commodity option transactions.9 evaded by the lack of safeguards to ensure its should have doubt about the underlying The Dodd-Frank Act not only preserved this appropriate application.6 This concern is purpose of the claimed ‘‘forwards.’’ plenary authority over commodity options, exacerbated by the fact that actors claiming Therefore, the Commission should apply a but also reaffirmed the reach of the CEA over the forward contract exclusion are not subject rebuttable presumption that the market commodity options. Section 721 of the Dodd- to any reporting requirements, nor have we participant may not be engaging in Frank Act added section 1a(47) to the CEA, even provided for a safe harbor that transactions that have as their predominant defining ‘‘swap’’ to include not only ‘‘any encourages such reporting. In light of the feature actual delivery. agreement, contract, or transaction transparency the CEA now provides for At the same time, the Commission should commonly known as,’’ among other things, futures, options, and swaps markets, the specify the means by which this presumption ‘‘a commodity swap,’’ 10 but also ‘‘[an] option regulatory differential between these may be rebutted. I believe that the of any kind that is for the purchase or sale, regulated markets and unregulated markets, Commission provide for a safe harbor for or based on the value, of 1 or more * * * like forward markets, is going to encourage market participants that regularly engage in commodities * * *,’’11 i.e. commodity regulatory arbitrage. Despite substantial transactions they believe to qualify for the options.12 While commodity options are progress in improving the Commission’s forward contract exclusion that, nonetheless, subject to the Commission’s plenary visibility into regulated markets, the often do not terminate with delivery (e.g., in jurisdiction, the Commission has limited Commission has failed to set forth less than 20% of instances as measured by jurisdiction over forward contracts.13 interpretive guidance that ensures that, at the number of ‘‘forward’’ contracts or by minimum, it can see and understand the potential total quantity under all ‘‘forward’’ 8 CEA section 4c(b), 7 U.S.C. 6c(b). contracts). This non-delivery could be of the 9 CEA section 4c(b) has been in the Act in (‘‘Brent Interpretation’’). I note that the Commission result of, for example, exercised embedded substantially the same form since it was added by did not endorse the outcome of the Brent volumetric optionality or through book-outs. the Commodity Futures Trading Commission Act of Interpretation. Market participants claiming this safe harbor 1974. See Public Law 93–463, October 23, 1974. 5 I recognize (and perhaps the Commission has should include a brief, periodic statement 10 See CEA section 1a(47)(A)(iii), 7 U.S.C. quietly recognized as well) the merit in the dissent that explains the reason why their forward 1a(47)(A)(iii). 11 of former Commissioner Fowler West to the Brent transactions, in general terms or with more See CEA section 1a(47)(A)(i), 7 U.S.C. 1a(47)(A)(i). Note that the swap definition excludes Interpretation and am heartened to find elements of specificity as is necessary for the his analytical approach in this release. options on futures (which must be traded on a DCM Commissioner West, among other things, Commission to determine whether the pursuant to part 33 of the Commission’s emphasized the importance of the underlying presumption that the market participant is regulations) (see CEA section 1a(47)(B)(i), 7 U.S.C. purpose of a transaction in a forward contract inappropriately claiming the forward 1a(47)(B)(i)), but it includes options on physical analysis. Id., Dissent of Commissioner Fowler West, contract exclusion is rebutted. commodities (whether or not traded on a DCM) (see available at http://www.cftc.gov/ucm/groups/ I request comment on my proposed safe CEA section 1a(47)(A)(i), 7 U.S.C. 1a(47)(A)(i)). public/@aboutcftc/documents/file/ harbor concept. I encourage the Commission 12 The Commission’s regulations define a fwestdissent092090.pdf (because, among other to adopt some version of this safe harbor in commodity option transaction or commodity option things, 15-day Brent contracts are entered into for order to allay the very real concerns I and, as ‘‘any transaction or agreement in interstate the purpose of hedging or speculation rather than commerce which is or is held out to be of the for the purpose of transferring ownership in crude indeed, many market participants and many character of, or is commonly known to the trade as, oil they do not sufficiently resemble forward in the public have expressed to me that an ‘option,’ ‘privilege,’ ‘indemnity,’ ‘bid,’ ‘offer,’ contracts to be excluded from the CEA) citing CFTC unregulated forwards markets could become ‘call,’ ‘put,’ ‘advance guaranty’ or ‘decline v. Co. Petro Marketing Group, Inc., 680 F.2d 573, a refuge for those that thrive in opacity. Our guaranty’.’’ 17 CFR 1.3(hh). 580 (9th Cir. 1982). Commissioner West’s dissent regulations implementing the Dodd-Frank 13 See CEA section 1a(47)(B)(ii), 7 U.S.C. presaged the Brent market aberrations of the 1990s Act will vastly improve transparency in 1a(47)(B)(ii) (excluding from the definition of and early 2000s that some tied to squeezes of the regulated futures, options, and swaps ‘‘swap’’ contracts involving ‘‘any sale of a Brent delivery complex through a hoarding of markets. Unfortunately, our interpretive nonfinancial commodity or security for deferred ‘‘forwards’’ that made leveraged cash-settled guidance today does little to ensure even any shipment or delivery, so long as the transaction is contract positions designed to benefit from such intended to be physically settled.’’). See also CEA aberrations very profitable. While I endorse the visibility for regulators in how players in the section 8(d), 7 U.S.C. 12(d), which directs the CFTC Commission’s approach to affirming the principles physical commodity markets, so critical to to investigate the marketing conditions of contained in the Brent Interpretation, I believe the Commission’s mission, are claiming the commodities and commodity products and future interpretive guidance should apply the forward contract exclusion: the unwatched byproducts, including supply and demand for these lessons of the past two-plus decades of market and back door out of the transparency-related commodities, cost to the consumer, and handling regulatory history and apply the Brent requirements of the CEA. and transportation charges; CEA sections 6(c), 6(d) Interpretation principles in that light. In this and 9(a)(2), 7 U.S.C. 9, 13b, and 13(a)(2), which dissent, however, I do not need to go so far as to 2. Legal Certainty for Certain Commodity proscribe any manipulation or attempt to reinterpret the principles underlying the Brent Options manipulate the price of any commodity in interstate Interpretation: even based on a conservative review commerce; and CEA section 6(c) as amended by of our precedent I feel we did not provide the Section 4c(b) of the CEA provides: section 753 of the Dodd-Frank Act, which contains market adequate clarity. prohibitions regarding manipulation and false 6 See Adopting Release. 7 See Adopting Release. reporting with respect to any commodity in

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In the Brent Interpretation, the types of contracts shares a common purpose 2. The predominant feature of the Commission found certain Brent oil contracts with commodity options: To provide market agreement, contract, or transaction is actual to be eligible for the forward contract participants a means to hedge commodity delivery; exclusion, notwithstanding the fact that such quantity risk of a commercial nature. The 3. The embedded optionality cannot be transactions ‘‘may ultimately result in Commission should therefore clarify, in any severed and marketed separately from the performance through the payment of cash as future interpretive guidance, that zero- overall agreement, contract, or transaction in an alternative to actual physical transfer or delivery embedded volumetric options are which it is embedded; delivery of the commodity.’’ The generally commodity options because the 4. The seller of a nonfinancial commodity Commission found that when delivery delivery obligation is not obligatory. underlying the agreement, contract, or obligations under a forward were terminated The confluence of these features, as transaction with embedded volumetric pursuant to a separate and individually analyzed under a conservative reading of the optionality intends, at the time it enters into negotiated ‘‘book-out’’ agreement, the parties Brent Interpretation, leads me to conclude the agreement, contract, or transaction, to escaped the physical delivery obligation that contracts with embedded zero-delivery deliver the underlying nonfinancial traditionally required to claim the forward option components cannot be said to have commodity if the optionality is exercised; contract exclusion. The Commission also actual delivery as their essential feature. 5. The buyer of a nonfinancial commodity emphasized two features (among others) of Other relevant Commission precedent is underlying the agreement, contract or the Brent oil contracts at issue: (1) The consistent with this analysis. Most recently, transaction with embedded volumetric absence of a contractual right to offset (or to in In re Wright, a forward contract containing optionality intends, at the time it enters into terminate without delivery) the transaction pricing optionality was found to be a forward the agreement, contract, or transaction, to ‘‘by the terms of the contracts as initially contract because the optionality: take delivery of the underlying nonfinancial entered into’’ and (2) the counterparties had (i) May be used to adjust the forward commodity if it exercises the embedded to incur ‘‘substantial economic risks of a contract price, but do not undermine the volumetric optionality; commercial nature’’ relating to actual overall nature of the contract as a forward 6. Both parties are commercial parties; and delivery in order to claim the exclusion. contract; (ii) do not target the delivery term, 7. The exercise or non-exercise of the Underlying the Brent Interpretation, other so that the predominant feature of the embedded volumetric optionality is based CFTC precedent, and the Commission’s contract is actual delivery; and (iii) cannot be primarily on physical factors, or regulatory approach to the interpretive guidance on the severed and marketed separately from the requirements, that are outside the control of forward contract exclusion is the essential overall forward contract in which they are the parties and are influencing demand for, feature of forward contracts: actual delivery embedded.15 or supply of, the nonfinancial commodity. (and not potential delivery).14 In re Wright is distinguishable because it The first two elements, in particular, The Commission has failed to provide involves pricing optionality, not volumetric invoke the Brent Interpretation and related adequate legal certainty to market optionality–the latter a feature the precedent.17 The seventh and most participants engaging in contracts with Commission has not hitherto opined on in problematic element seems to imply that embedded volumetric commodity options, the context of the forward contract exclusion. supply and demand, i.e., economic factors, particularly those that can terminate without As the emphasized section of the block quote could be a primary factor in the exercise or physical delivery. Contracts that are immediately above discusses, the non-exercise of an embedded volumetric composed of a forward delivery obligation interpretation there turned on the fact that option. I fear how broadly this element could component combined with an embedded the optionality in the In re Wright options did be interpreted by those predisposed to commodity option that can render delivery ‘‘not target the delivery term.’’ Optionality interpret the CEA in an opportunistic light. optional (‘‘zero-delivery’’ embedded that can result in zero delivery ‘‘targets the When can supply and demand factors not be volumetric options) are not forwards because delivery term,’’ in direct contrast to the In re correlated with physical factors? Does this the predominant feature of the contract Wright options. I commend the Commission mean that if delivery renders such a contract cannot be actual delivery under these for not overextending (to put it charitably) In unprofitable for a party to such a contract circumstances (more literally, the re Wright to cover zero-delivery volumetric that they can elect not to deliver? If that is predominant feature is potential delivery optionality, as argued by some commenters. the case, then the contract is a commodity which is an essential characteristic of Nonetheless, the Commission did not clarify option.18 commodity options). Such contracts include that a contract that provides for optionality I would amend the seventh element by a contractual right to offset through the that can render delivery optional cannot making it clear the exercise or non-exercise exercise of the volumetric option that can therefore have as its predominant feature for physical factors that influence demand extinguish the delivery obligation. Because actual delivery because the optionality and supply can negate the delivery obligation such contracts have a commodity option ‘‘targets the delivery term.’’16 only in exceptional circumstances. If delivery component that mitigates the risk incurred Instead of, in my opinion, a proper renders a contract merely unprofitable and from an underlying forward delivery application of the statute and precedent, the the contract permits a party to elect not to obligation, these contracts may fail to meet Commission has adopted a seven-element deliver, such a contract is not a forward and the incurring ‘‘economic risks of a interpretation that applies to contracts with is a commodity option. commercial nature’’ element. Moreover, the embedded volumetric optionality. This In addition, I would require, consistent purpose of the delivery optionality in these interpretative approach would potentially with the third, ‘‘severability,’’ element, that allow contracts with zero-delivery option in order to claim the forward contract exclusion where the contract at issue interstate commerce, including prohibiting any components to nonetheless claim the forward person to (i) ‘‘use or employ, or attempt to use or contract exclusion when: contains a zero-delivery embedded employ * * * any manipulative or deceptive 1. The embedded optionality does not volumetric option, the parties must sever the device or contrivance’’ (section 6(c)(1)); (ii) ‘‘to undermine the overall nature of the forward contract component, which has as its make any false or misleading statement of material agreement, contract, or transaction as a purpose the delivery of commodities, from fact’’ to the CFTC or ‘‘omit to state in any such forward contract; the remaining commodity option component, statement any material fact that is necessary to which has as its purpose the management of make any statement of material fact made not the commodity quantity risk associated with 15 misleading in any material respect’’ (section See In re Wright, CFTC Docket No. 97–02, 2010 operating a commercial enterprise.19 The 6(c)(2)); and (iii) ‘‘manipulate or attempt to WL 4388247 (Oct. 25, 2010) (emphasis added). See manipulate the price of any swap, or of any also Characteristics Distinguishing Cash and commodity in interstate commerce * * *’’ (section Forward Contracts and ‘‘Trade’’ Options, 50 FR 17 See Adopting Release. 6(c)(3)). See also Rule 180.1(a) under the CEA, 17 39656 (Sept. 30, 1985) (finding that hedge-to-arrive 18 See, e.g., 50 FR 39656, 39660. CFR 180.1(a) (broadly prohibiting in connection contracts with pricing optionality could be 19 These forward contract and commodity option with a commodity in interstate commerce categorized as forwards so long as it created a hybrid contracts can, as I understand it, generally manipulation, false or misleading statements or binding delivery obligation that could only be be severed into two separate forward and omissions of material fact to the Commission, fraud annulled in the event of a crop failure, in which commodity option contracts. Some commenters or deceptive practices or courses of business, and case liquidated damages may apply). suggested that many ‘‘peaking’’ contracts involve false reporting). 16 In re Wright, CFTC Docket No. 97–02, 2010 WL volumetric optionality that cannot be severed, but 14 See Adopting Release. 4388247 (Oct. 25, 2010). Continued

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commodity option component of these economic risks of a commercial nature.’’ 22 In welcome comments on this statement too, of transactions could be eligible for a trade the absence of the Commission’s courage to course, particularly as it relates to zero- option exemption 20 that exempts (and provide for more legal certainty on these delivery embedded volumetric options. I am importantly, does not exclude) them from kinds of transactions, I stress the application particularly interested in understanding many CEA requirements.21 of the third, severability, element in the under what circumstances such embedded Moreover, while the Adopting Release’s Commission’s seven-element interpretation option contracts and other contracts can be guidance is the first of its kind and therefore and note that as long as a market participant structured to evade Dodd-Frank Act an incremental step toward more legal can decompose a pre-Dodd-Frank Act requirements in a way that creates plausible certainty, it doesn’t directly address transaction into components, such action deniability for one or both counterparties that would not be in violation of the CEA if the embedded zero-delivery volumetric they did not ‘‘willfully’’ intend to structure resulting agreements, contracts, or optionality specifically or any of the a transaction in a manner intended to evade. transactions (1) neatly fall into forward, conceivable specific variations of such Should the Commission, instead of my commodity option, or other swap contract proposed approach, follow a rebuttable contracts. I believe this to be a flaw; a flaw buckets and (2) are dealt with as such.23 that did not exist in a previous version of this presumption approach with respect to zero- I look forward to receiving and reviewing delivery embedded option contracts whereby document. comments on the Commission’s The Commission should affirm in any the presumption can be rebutted by a interpretation, in particular those submitted certification of facts that indicate a true relevant future interpretive guidance the in response to Question Seven.24 I also formal features in the Brent Interpretation’s commercial purpose for the transaction? [FR Doc. 2012–18003 Filed 8–10–12; 8:45 am] forward contract exclusion, e.g., that the 22 The Commission’s inclusion of the underlying delivery obligation cannot be offset based on purpose of a transaction as a factor in determining BILLING CODE 8011–01– 6351–01–P terms contained in the contract, that any its classification as a forward, commodity option, or delivery obligation be appropriately booked- other form of swap. The Commission will, under on descriptions by commenters, it appears that they out (in a separate transaction), or that the the interpretive guidance, consider the ‘‘purpose of may have a binding obligation for delivery, but have the claimed forward’’ and whether its purpose is to contract involve incurring ‘‘substantial no set amount specified for delivery. Instead, sell physical commodities, hedge risk, or speculate. delivery (including the possibility of nominal or See Adopting Release. zero delivery) is determined by the terms and I have yet to be convinced that the same party that 23 See Adopting Release, fn 337 (‘‘When a forward is the ‘‘seller’’ under these contracts cannot simply contract includes an embedded option that is conditions contained within the agreement, become the appropriate counterparty when such severable from the forward contract, the forward contract, or transaction (including, for example, the contracts are severed into a forward contract can remain subject to the forward contract satisfaction of a condition precedent to delivery, component and a commodity option component exclusion, if the parties document the severance of such as a commodity price or temperature reaching that can offset or book-out the buyer’s obligation to the embedded option component and the resulting a level specified in the agreement, contract, or take delivery. transactions, i.e. a forward and an option. Such an transaction). That is, the variation in delivery is not 20 Commodity Options, 77 FR 25320, Apr. 27, option would be subject to the CFTC’s regulations driven by the exercise of embedded optionality by 2012, codified at 17 CFR 32.3. applicable to commodity options.’’). the parties. Do the agreements, contracts, and 21 24 As of July 10, 2012, the Commission has Id. (‘‘Do the agreements, contracts, and transactions listed in question no. 6 exhibit these received 12 comments on the interim final rule transactions listed in question no. 6 above have kinds of characteristics? If so, should the CFTC setting forth the trade option exemption. embedded optionality in the first instance? Based consider them in some manner other than its forward interpretation? Why or why not?’’).

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