May 12, 2011 Proposed Product Definitions Under Title VII of Dodd-Frank CFTC and SEC Propose Rules and Guidance to Further Define the Terms, “Swap,” “Security-Based Swap,” and “Mixed Swaps” EXECUTIVE SUMMARY The Commodity Futures Trading Commission (“CFTC”) and Securities and Exchange Commission (“SEC”, jointly with the CFTC, the “Commissions”) have issued a joint release proposing rules to define further certain terms in Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) relating to swaps, security-based swaps, mixed swaps, and security-based swap agreements, and proposing interpretive guidance with respect to those terms (the “Joint Proposed Rules”). The release accompanying the Joint Proposed Rules (the “Release”) and the Joint Proposed Rules addresses, among other things: the regulatory treatment of insurance products; the exclusion of forward contracts from the swap and security-based swap definitions; the regulatory treatment of certain consumer and commercial contracts; the regulatory treatment of loan participations; the regulatory treatment of certain foreign-exchange related and other instruments; swaps and security-based swaps involving interest rates (or other rates) and yields; the application of the definition of “narrow-based security index” in distinguishing between certain indexed swaps and security-based swaps, including credit default swaps and index credit default swaps; and the specification of certain swaps and security-based swaps that are, and are not, mixed swaps. New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney www.sullcrom.com The Commissions request comments on all aspects of these proposals, including comments that would suggest alternative approaches to defining the terms discussed in the proposing release. Comments are due within 60 days after their publication in the Federal Register, which is expected to occur shortly. For further background on Dodd-Frank provisions that these proposed rules would implement, please see our memoranda entitled “United States Adopts Historic Revision of Financial Services Regulation.” Proposed Product Definitions Under Title VII of Dodd-Frank May 12, 2011 Table of Contents I. PROPOSED GUIDANCE AND DEFINITIONS RELATING TO “SWAP” AND “SECURITY- BASED SWAP” ................................................................................................................................ 1 STATUTORY DEFINITION OF SWAP AND SECURITY-BASED SWAP ........................................................... 1 II. PRODUCTS NOT DEFINED AS SWAPS OR SECURITY-BASED SWAPS ........................................... 2 A. INSURANCE PRODUCTS ................................................................................................................ 2 B. FORWARD EXCLUSION FOR NON-FINANCIAL COMMODITIES ............................................................ 4 C. CONSUMER AND COMMERCIAL TRANSACTIONS .............................................................................. 5 D. LOAN PARTICIPATIONS ................................................................................................................. 6 III. PRODUCTS DEFINED AS SWAPS OR SECURITY-BASED SWAPS ................................................... 7 A. FOREIGN EXCHANGE PRODUCTS .................................................................................................. 7 B. FORWARD RATE AGREEMENTS ..................................................................................................... 8 C. CONTRACTS FOR DIFFERENCES .................................................................................................... 8 IV. TRANSACTIONS REGULATED BY FERC ............................................................................................. 8 V. RELATIONSHIP BETWEEN SWAP AND SECURITY-BASED SWAP DEFINITIONS ............................ 8 A. TITLE VII INSTRUMENTS BASED ON INTEREST RATES OR OTHER MONETARY RATES THAT ARE SWAPS ................................................................................................................................. 9 B. TITLE VII INSTRUMENTS BASED ON YIELDS (INCLUDING GOVERNMENT OBLIGATIONS) ...................... 9 C. TOTAL RETURN SWAPS .............................................................................................................. 10 D. SECURITY-BASED SWAPS BASED ON A SINGLE SECURITY OR LOAN AND SINGLE-NAME CREDIT DEFAULT SWAPS ........................................................................................................... 11 E. TITLE VII INSTRUMENTS BASED ON FUTURES CONTRACTS ........................................................... 11 F. USE OF CERTAIN TERMS AND CONDITIONS IN TITLE VII INSTRUMENTS .......................................... 12 G. THE TERM “NARROW-BASED SECURITY INDEX” IN THE SECURITY-BASED SWAP DEFINITION .......... 12 1. Applicability of the Statutory Definition of Narrow-Based Security Index and Past Guidance of the Commissions to Title VII Instruments ............................... 12 2. Narrow-Based Security Index Criteria for Index Credit Default Swaps ...................... 14 a. Proposed Rules Regarding the Definitions of “Issuers of Securities in a Narrow-Based Security Index” and “Narrow-Based Security Index” for Index Credit Default Swaps ........................................................................... 14 i. Number and Concentration Percentages of Reference Entities or Securities .......................................................................................... 15 ii. Public Information Availability Regarding Reference Entities or Securities .......................................................................................... 15 iii. Treatment of Indexes Including Reference Entities that Are Issuers of Exempted Securities or Including Exempted Securities .. 17 3. Security Indexes ......................................................................................................... 17 4. Evaluation of Title VII Instruments on Security Indexes that Move from Broad-Based to Narrow-Based or Narrow-Based to Broad-Based ............................ 18 a. Title VII Instruments on Security Indexes Traded on Designated Contract Markets, Swap Execution Facilities, Foreign Boards of Trade, Security-Based Swap Execution Facilities, and National Securities Exchanges ..................................................................................................... 19 H. METHOD OF SETTLEMENT FOR INDEX CREDIT DEFAULT SWAPS ................................................... 20 I. SECURITY-BASED SWAPS AS SECURITIES UNDER THE EXCHANGE ACT AND SECURITIES ACT ........ 21 -i- Proposed Product Definitions Under Title VII of Dodd-Frank May 12, 2011 VI. MIXED SWAPS ..................................................................................................................................... 21 A. SCOPE OF THE CATEGORY OF MIXED SWAP ................................................................................ 21 B. REGULATION OF MIXED SWAPS .................................................................................................. 21 C. REGULATION OF MIXED SWAPS ENTERED INTO BY DUALLY-REGISTERED DEALERS OR MAJOR PARTICIPANTS ................................................................................................................ 22 D. REGULATORY TREATMENT FOR OTHER MIXED SWAPS ................................................................. 22 VII. SECURITY-BASED SWAP AGREEMENTS ........................................................................................ 23 VIII. PROCESS FOR REQUESTING INTERPRETATIONS OF CHARACTERIZATION OF A TITLE VII INSTRUMENT ............................................................................................................... 24 IX. ANTI-EVASION PROVISIONS .............................................................................................................. 25 A. TREATMENT OF SWAPS BY THE CFTC ........................................................................................ 25 B. TREATMENT OF SECURITY-BASED SWAPS BY THE SEC ............................................................... 27 X. DIFFERENCES IN TREATMENT BETWEEN SWAPS AND SECURITY-BASED SWAPS UNDER THE JOINT PROPOSED RULES .................................................................................... 27 A. ANTI-EVASION PROVISIONS ........................................................................................................ 27 B. INSURANCE ON SWAPS ............................................................................................................... 27 C. FUTURES ON FOREIGN SOVEREIGN DEBT .................................................................................... 28 D. INDEX PROVIDERS FOR CREDIT DEFAULT SWAPS ........................................................................ 28 -ii- Proposed Product Definitions Under Title VII of Dodd-Frank May 12, 2011 I. PROPOSED GUIDANCE AND DEFINITIONS RELATING TO “SWAP” AND “SECURITY-BASED SWAP” Pursuant to the regulatory framework established in Dodd-Frank, the CFTC has regulatory authority over swaps under the Commodity Exchange Act (“CEA”) and the SEC has regulatory authority over security- based swaps under the Securities Exchange Act of 1934 (the “Exchange Act”). Section 712(d)(1) of Dodd-Frank provides that the Commissions, in consultation with the Board of Governors of the Federal Reserve System (the “Board”), must jointly further define the terms