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2012-18003

  • Federal Register, Volume 77 Issue 156 (Monday, August 13, 2012)[Federal Register Volume 77, Number 156 (Monday, August 13, 2012)]

    [Rules and Regulations]

    [Pages 48207-48366]

    From the Federal Register Online via the Government Printing Office [www.gpo.gov]

    [FR Doc No: 2012-18003]

    [[Page 48207]]

    Vol. 77

    Monday,

    No. 156

    August 13, 2012

    Part II

    Commodity Futures Trading Commission

    17 CFR Part 1

    Securities and Exchange Commission

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    17 CFR Parts 230, 240 and 241

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    Further Definition of ``Swap,'' ``Security-Based Swap,'' and

    ``Security-Based Swap Agreement''; Mixed Swaps; Security-Based Swap

    Agreement Recordkeeping; Final Rule

    Federal Register / Vol. 77, No. 156 / Monday, August 13, 2012 / Rules

    and Regulations

    [[Page 48208]]

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    COMMODITY FUTURES TRADING COMMISSION

    17 CFR Part 1

    RIN 3038-AD46

    SECURITIES AND EXCHANGE COMMISSION

    17 CFR Parts 230, 240 and 241

    [Release No. 33-9338; 34-67453; File No. S7-16-11]

    RIN 3235-AK65

    Further Definition of ``Swap,'' ``Security-Based Swap,'' and

    ``Security-Based Swap Agreement''; Mixed Swaps; Security-Based Swap

    Agreement Recordkeeping

    AGENCY: Commodity Futures Trading Commission; Securities and Exchange

    Commission.

    ACTION: Joint final rule; interpretations; request for comment on an

    interpretation.

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    SUMMARY: In accordance with section 712(a)(8), section 712(d)(1),

    sections 712(d)(2)(B) and (C), sections 721(b) and (c), and section

    761(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act

    (``Dodd-Frank Act''), the Commodity Futures Trading Commission

    (``CFTC'') and the Securities and Exchange Commission (``SEC'')

    (collectively, ``Commissions''), in consultation with the Board of

    Governors of the Federal Reserve System (``Board''), are jointly

    adopting new rules and interpretations under the Commodity Exchange Act

    (``CEA'') and the Securities Exchange Act of 1934 (``Exchange Act'') to

    further define the terms ``swap,'' ``security-based swap,'' and

    ``security-based swap agreement'' (collectively, ``Product

    Definitions''); regarding ``mixed swaps;'' and governing books and

    records with respect to ``security-based swap agreements.'' The CFTC

    requests comment on its interpretation concerning forwards with

    embedded volumetric optionality, contained in Section II.B.2.(b)(ii) of

    this release.

    DATES: Effective date: October 12, 2012.

    Compliance date: The applicable compliance dates are discussed in

    the section of the release titled ``IX. Effective Date and

    Implementation''.

    Comment date: Comments on the interpretation regarding forwards

    with embedded volumetric optionality must be received on or before

    October 12, 2012.

    ADDRESSES: You may submit comments, identified by RIN number 3038-AD46,

    by any of the following methods:

    CFTC Web Site: via its Comments Online process: http://comments.cftc.gov. Follow the instructions for submitting comments

    through the Web site.

    Mail: Address to David A. Stawick, Secretary of the

    Commission, Commodity Futures Trading Commission, Three Lafayette

    Centre, 1155 21st Street NW., Washington, DC 20581.

    Hand Delivery/Courier: Same as mail above.

    Federal eRulemaking Portal: http://www.regulations.gov.

    Follow the instructions for submitting comments.

    All comments must be submitted in English or, if not, accompanied

    by an English translation. Comments will be posted as received to

    http://www.cftc.gov. You should submit only information that you wish

    to make available publicly. If you wish the CFTC to consider

    information that is exempt from disclosure under the Freedom of

    Information Act, a petition for confidential treatment of the exempt

    information may be submitted according to the procedures established in

    Sec. 145.9 of the CFTC's Regulations.\1\

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    \1\ 17 CFR 145.9.

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    The CFTC reserves the right, but shall have no obligation, to

    review, pre-screen, filter, redact, refuse or remove any or all of your

    submission from http://www.cftc.gov that it may deem to be

    inappropriate for publication, such as obscene language. All

    submissions that have been redacted or removed that contain comments on

    the merits of the interpretation will be retained in the public comment

    file and will be considered as required under the Administrative

    Procedure Act and other applicable laws, and may be accessible under

    the Freedom of Information Act.

    FOR FURTHER INFORMATION CONTACT: CFTC: Julian E. Hammar, Assistant

    General Counsel, at 202-418-5118, jhammar@cftc.gov, Lee Ann Duffy,

    Assistant General Counsel, at 202-418-6763, lduffy@cftc.gov; Mark

    Fajfar, Assistant General Counsel, at 202-418-6636, mfajfar@cftc.gov,

    or David E. Aron, Counsel, at 202-418-6621, daron@cftc.gov, Office of

    General Counsel, Commodity Futures Trading Commission, Three Lafayette

    Centre, 1155 21st Street NW., Washington, DC 20581; SEC: Donna M.

    Chambers, Special Counsel, at 202-551-5870, or John Guidroz, Attorney-

    Adviser, at 202-551-5870, Division of Trading and Markets, or Andrew

    Schoeffler, Special Counsel, at 202-551-3860, Office of Capital Markets

    Trends, Division of Corporation Finance, or Wenchi Hu, Senior Special

    Counsel, at 202-551-5870, Office of Compliance, Inspections and

    Examinations, Securities and Exchange Commission, 100 F Street NE.,

    Washington, DC 20549.

    SUPPLEMENTARY INFORMATION:

    Table of Contents

    I. Background

    II. Scope of Definitions of Swap and Security-Based Swap

    A. Introduction

    B. Rules and Interpretations Regarding Certain Transactions

    outside the Scope of the Definitions of the Terms ``Swap'' and

    ``Security-Based Swap''

    1. Insurance Products

    (a) Types of Insurance Products

    (b) Providers of Insurance Products

    (c) Grandfather Provision for Existing Insurance Transactions

    (d) Alternative Tests

    (e) ``Safe Harbor''

    (f) Applicability of Insurance Exclusion to Security-Based Swaps

    (g) Guarantees

    2. The Forward Contract Exclusion

    (a) Forward Contracts in Nonfinancial Commodities

    (i) Forward Exclusion From the Swap and Future Delivery

    Definitions

    (ii) Nonfinancial Commodities

    (iii) Environmental Commodities

    (iv) Physical Exchange Transactions

    (v) Fuel Delivery Agreements

    (vi) Cleared/Exchange-Traded Forwards

    (b) Commodity Options and Commodity Options Embedded in Forward

    Contracts

    (i) Commodity Options

    (ii) Commodity Options Embedded in Forward Contracts

    (iii) Certain Physical Commercial Agreements, Contracts or

    Transactions

    (iv) Effect of Interpretation on Certain Agreements, Contracts

    and Transactions

    (v) Liquidated Damages Provisions

    (c) Security Forwards

    3. Consumer and Commercial Agreements, Contracts, and

    Transactions

    C. Final Rules and Interpretations Regarding Certain

    Transactions Within the Scope of the Definitions of the Terms

    ``Swap'' and ``Security-Based Swap''

    1. In General

    2. Foreign Exchange Products

    (a) Foreign Exchange Products Subject to the Secretary's Swap

    Determination: Foreign Exchange Forwards and Foreign Exchange Swaps

    (b) Foreign Exchange Products Not Subject to the Secretary's

    Swap Determination

    (i) Foreign Currency Options

    (ii) Non-Deliverable Forward Contracts Involving Foreign

    Exchange

    (iii) Currency Swaps and Cross-Currency Swaps

    (c) Interpretation Regarding Foreign Exchange Spot Transactions

    (d) Retail Foreign Currency Options

    3. Forward Rate Agreements

    4. Combinations and Permutations of, or Options on, Swaps and

    Security-Based Swaps

    5. Contracts for Differences

    D. Certain Interpretive Issues

    1. Agreements, Contracts, or Transactions That May Be Called, or

    Documented

    [[Page 48209]]

    Using Form Contracts Typically Used for, Swaps or Security-Based

    Swaps

    2. Transactions in Regional Transmission Organizations and

    Independent System Operators

    III. The Relationship Between the Swap Definition and the Security-

    Based Swap Definition

    A. Introduction

    B. Title VII Instruments Based on Interest Rates, Other Monetary

    Rates, and Yields

    1. Title VII Instruments Based on Interest Rates or Other

    Monetary Rates That Are Swaps

    2. Title VII Instruments Based on Yields

    3. Title VII Instruments Based on Government Debt Obligations

    C. Total Return Swaps

    D. Security-Based Swaps Based on a Single Security or Loan and

    Single-Name Credit Default Swaps

    E. Title VII Instruments Based on Futures Contracts

    F. Use of Certain Terms and Conditions in Title VII Instruments

    G. The Term ``Narrow-Based Security Index'' in the Security-

    Based Swap Definition

    1. Introduction

    2. Applicability of the Statutory Narrow-Based Security Index

    Definition and Past Guidance of the Commissions to Title VII

    Instruments

    3. Narrow-Based Security Index Criteria for Index Credit Default

    Swaps

    (a) In General

    (b) Rules Regarding the Definitions of ``Issuers of Securities

    in a Narrow-Based Security Index'' and ``Narrow-Based Security

    Index'' for Index Credit Default Swaps

    (i) Number and Concentration Percentages of Reference Entities

    or Securities

    (ii) Affiliation of Reference Entities and Issuers of Securities

    With Respect to Number and Concentration Criteria

    (iii) Public Information Availability Regarding Reference

    Entities and Securities

    (iv) Affiliation of Reference Entities and Issuers of Securities

    With Respect to Certain Criteria of the Public Information

    Availability Test

    (v) Application of the Public Information Availability

    Requirements to Indexes Compiled by a Third-Party Index Provider

    (vi) Treatment of Indexes Including Reference Entities That Are

    Issuers of Exempted Securities or Including Exempted Securities

    4. Security Indexes

    5. Evaluation of Title VII Instruments on Security Indexes That

    Move From Broad-Based to Narrow-Based or Narrow-Based to Broad-Based

    (a) In General

    (b) 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

    H. Method of Settlement of Index CDS

    I. Security-Based Swaps as Securities Under the Exchange Act and

    Securities Act

    IV. Mixed Swaps

    A. Scope of the Category of Mixed Swap

    B. Regulation of Mixed Swaps

    1. Introduction

    2. Bilateral Uncleared Mixed Swaps Entered Into by Dually-

    Registered Dealers or Major Participants

    3. Regulatory Treatment for Other Mixed Swaps

    V. Security-Based Swap Agreements

    A. Introduction

    B. Swaps That Are Security-Based Swap Agreements

    C. Books and Records Requirements for Security-Based Swap

    Agreements

    VI. Process for Requesting Interpretations of the Characterization

    of a Title VII Instrument

    VII. Anti-Evasion

    A. CFTC Anti-Evasion Rules

    1. CFTC's Anti-Evasion Authority

    (a) Statutory Basis for the Anti-Evasion Rules

    2. Final Rules

    (a) Rule 1.3(xxx)(6)

    (b) Rule 1.6

    (c) Interpretation on the Final Rules

    3. Interpretation Contained in the Proposing Release

    (a) Business Purpose Test

    (b) Fraud, Deceit or Unlawful Activity

    B. SEC Position Regarding Anti-Evasion Rules

    VIII. Miscellaneous Issues

    A. Distinguishing Futures and Options From Swaps

    B. Transactions Entered Into by Foreign Central Banks, Foreign

    Sovereigns, International Financial Institutions, and Similar

    Entities

    C. Definition of the Terms ``Swap'' and ``Security-Based Swap''

    as Used in the Securities Act

    IX. Effective Date and Implementation

    X. Administrative Law Matters--CEA Revisions

    A. Paperwork Reduction Act

    B. Regulatory Flexibility Act

    C. Costs and Benefits Considerations

    XI. Administrative Law Matters--Exchange Act Revisions

    A. Economic Analysis

    B. Paperwork Reduction Act

    C. Regulatory Flexibility Act Certification

    XII. Statutory Basis and Rule Text

    I. Backbround

    On July 21, 2010, President Obama signed the Dodd-Frank Act into

    law.\2\ Title VII of the Dodd-Frank Act \3\ (``Title VII'') established

    a comprehensive new regulatory framework for swaps and security-based

    swaps. The legislation was enacted, among other reasons, to reduce

    risk, increase transparency, and promote market integrity within the

    financial system, including by: (i) Providing for the registration and

    comprehensive regulation of swap dealers, security-based swap dealers,

    major swap participants, and major security-based swap participants;

    (ii) imposing clearing and trade execution requirements on swaps and

    security-based swaps, subject to certain exceptions; (iii) creating

    rigorous recordkeeping and real-time reporting regimes; and (iv)

    enhancing the rulemaking and enforcement authorities of the Commissions

    with respect to, among others, all registered entities and

    intermediaries subject to the Commissions' oversight.

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    \2\ See Dodd-Frank Wall Street Reform and Consumer Protection

    Act, Public Law 111-203, 124 Stat. 1376 (2010). The text of the

    Dodd-Frank Act is available at http://www.cftc.gov/LawRegulation/OTCDERIVATIVES/index.htm.

    \3\ Pursuant to section 701 of the Dodd-Frank Act, Title VII may

    be cited as the ``Wall Street Transparency and Accountability Act of

    2010.''

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    Section 712(d)(1) of the Dodd-Frank Act provides that the

    Commissions, in consultation with the Board, shall jointly further

    define the terms ``swap,'' ``security-based swap,'' and ``security-

    based swap agreement'' (``SBSA'').\4\ Section 712(a)(8) of the Dodd-

    Frank Act provides further that the Commissions shall jointly prescribe

    such regulations regarding ``mixed swaps'' as may be necessary to carry

    out the purposes of Title VII. In addition, sections 721(b) and 761(b)

    of the Dodd-Frank Act provide that the Commissions may adopt rules to

    further define terms included in subtitles A and B, respectively, of

    Title VII, and sections 721(c) and 761(b) of the Dodd-Frank Act provide

    the Commissions with authority to define the terms ``swap'' and

    ``security-based swap,'' as well as the terms ``swap dealer,'' ``major

    swap participant,'' ``security-based swap dealer,'' and ``major

    security-based swap participant,'' to include transactions and entities

    that have been structured to

    [[Page 48210]]

    evade the requirements of subtitles A and B, respectively, of Title

    VII.

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    \4\ In addition, section 719(d)(1)(A) of the Dodd-Frank Act

    requires the Commissions to conduct a joint study, within 15 months

    of enactment, to determine whether stable value contracts, as

    defined in section 719(d)(2) of the Dodd-Frank Act, are encompassed

    by the swap definition. If the Commissions determine that stable

    value contracts are encompassed by the swap definition, section

    719(d)(1)(B) of the Dodd-Frank Act requires the Commissions jointly

    to determine whether an exemption for those contracts from the swap

    definition is appropriate and in the public interest. Section

    719(d)(1)(B) also requires the Commissions to issue regulations

    implementing the determinations made under the required study. Until

    the effective date of such regulations, the requirements under Title

    VII do not apply to stable value contracts, and stable value

    contracts in effect prior to the effective date of such regulations

    are not considered swaps. See section 719(d) of the Dodd-Frank Act.

    The Commissions currently are conducting the required joint study

    and will consider whether to propose any implementing regulations

    (including, if appropriate, regulations determining that stable

    value contracts: (i) Are not encompassed within the swap definition;

    or (ii) are encompassed within the definition but are exempt from

    the swap definition) at the conclusion of that study.

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    Section 712(d)(2)(B) of the Dodd-Frank Act requires the

    Commissions, in consultation with the Board, to jointly adopt rules

    governing books and records requirements for SBSAs by persons

    registered as swap data repositories (``SDRs'') under the CEA,\5\

    including uniform rules that specify the data elements that shall be

    collected and maintained by each SDR.\6\ Similarly, section

    712(d)(2)(C) of the Dodd-Frank Act requires the Commissions, in

    consultation with the Board, to jointly adopt rules governing books and

    records for SBSAs, including daily trading records, for swap dealers,

    major swap participants, security-based swap dealers, and security-

    based swap participants.\7\

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    \5\ 7 U.S.C. 1 et seq.

    \6\ The CFTC has issued final rules regarding SDRs and,

    separately, swap data recordkeeping and reporting. See Swap Data

    Repositories: Registration Standards, Duties and Core Principles, 76

    FR 54538 (Sep. 1, 2011); Swap Data Recordkeeping and Reporting

    Requirements, 77 FR 2136 (Jan. 13, 2012). The SEC has also issued

    proposed rules regarding security-based swap data repositories

    (``SBSDRs''), including rules specifying data collection and

    maintenance standards for SBSDRs, as well as rules regarding

    security-based swap data recordkeeping and reporting. See Security-

    Based Swap Data Repository Registration, Duties, and Core

    Principles, 75 FR 77306 (Dec. 10, 2010); Regulation SBSR--Reporting

    and Dissemination of Security-Based Swap Information, 75 FR 75208

    (Dec. 2, 2010).

    \7\ The CFTC has issued final rules regarding recordkeeping

    requirements for swap dealers and major swap participants. See Swap

    Dealer and Major Swap Participant Recordkeeping, Reporting, and

    Duties Rules; Futures Commission Merchant and Introducing Broker

    Conflicts of Interest Rules; and Chief Compliance Officer Rules for

    Swap Dealers, Major Swap Participants, and Futures Commission

    Merchants, 77 FR 20128 (Apr. 3, 2012).

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    Under the comprehensive framework for regulating swaps and

    security-based swaps established in Title VII, the CFTC is given

    regulatory authority over swaps,\8\ the SEC is given regulatory

    authority over security-based swaps,\9\ and the Commissions shall

    jointly prescribe such regulations regarding mixed swaps as may be

    necessary to carry out the purposes of Title VII.\10\ In addition, the

    SEC is given antifraud authority over, and access to information from,

    certain CFTC-regulated entities regarding SBSAs, which are a type of

    swap related to securities over which the CFTC is given regulatory

    authority.\11\

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    \8\ Section 721(a) of the Dodd-Frank Act defines the term

    ``swap'' by adding section 1a(47) to the CEA, 7 U.S.C. 1a(47). This

    new swap definition also is cross-referenced in new section 3(a)(69)

    of the Exchange Act, 15 U.S.C. 78c(a)(69). Citations to provisions

    of the CEA and the Exchange Act, 15 U.S.C. 78a et seq., in this

    release refer to the numbering of those provisions after the

    effective date of Title VII, except as indicated.

    \9\ Section 761(a) of the Dodd-Frank Act defines the term

    ``security-based swap'' by adding new section 3(a)(68) to the

    Exchange Act, 15 U.S.C. 78c(a)(68). This new security-based swap

    definition also is cross-referenced in new CEA section 1a(42), 7

    U.S.C. 1a(42). The Dodd-Frank Act also explicitly includes security-

    based swaps in the definition of security under the Exchange Act and

    the Securities Act of 1933 (``Securities Act''), 15 U.S.C. 77a et

    seq.

    \10\ Section 721(a) of the Dodd-Frank Act describes the category

    of ``mixed swap'' by adding new section 1a(47)(D) to the CEA, 7

    U.S.C. 1a(47)(D). Section 761(a) of the Dodd-Frank Act also includes

    the category of ``mixed swap'' by adding new section 3(a)(68)(D) to

    the Exchange Act, 15 U.S.C. 78c(68)(D). A mixed swap is defined as a

    subset of security-based swaps that also are based on the value of 1

    or more interest or other rates, currencies, commodities,

    instruments of indebtedness, indices, quantitative measures, other

    financial or economic interest or property of any kind (other than a

    single security or a narrow-based security index), or the

    occurrence, non-occurrence, or the extent of the occurrence of an

    event or contingency associated with a potential financial,

    economic, or commercial consequence (other than the occurrence, non-

    occurrence, or extent of the occurrence of an event relating to a

    single issuer of a security or the issuers of securities in a

    narrow-based security index, provided that such event directly

    affects the financial statements, financial condition, or financial

    obligations of the issuer).

    \11\ Section 761(a) of the Dodd-Frank Act defines the term

    ``security-based swap agreement'' by adding new section 3(a)(78) to

    the Exchange Act, 15 U.S.C. 78c(a)(78). The CEA includes the

    definition of ``security-based swap agreement'' in subparagraph

    (A)(v) of the swap definition in CEA section 1a(47), 7 U.S.C.

    1a(47). The only difference between these definitions is that the

    definition of SBSA in the Exchange Act specifically excludes

    security-based swaps (see section 3(a)(78)(B) of the Exchange Act,

    15 U.S.C. 78c(a)(78)(B)), whereas the definition of SBSA in the CEA

    does not contain a similar exclusion. Instead, under the CEA, the

    exclusion for security-based swaps is placed in the general

    exclusions from the swap definition (see CEA section 1a(47)(B)(x), 7

    U.S.C. 1a(47)(B)(x)). Although the statutes are slightly different

    structurally, the Commissions interpret them to have consistent

    meaning that the category of security-based swap agreements excludes

    security-based swaps.

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    To assist the Commissions in further defining the Product

    Definitions (as well as certain other definitions) and in prescribing

    regulations regarding mixed swaps as may be necessary to carry out the

    purposes of Title VII, the Commissions published an advance notice of

    proposed rulemaking (``ANPR'') in the Federal Register on August 20,

    2010.\12\ The comment period for the ANPR closed on September 20,

    2010.\13\ The Commissions received comments addressing the Product

    Definitions and/or mixed swaps in response to the ANPR, as well as

    comments in response to the Commissions' informal solicitations,\14\

    from a wide range of commenters. Taking into account comments received

    on the ANPR, the Commissions published a notice of proposed rulemaking

    in the Federal Register on May 23, 2011.\15\ The comment period for the

    Proposing Release closed on July 22, 2011.\16\ Together, the

    Commissions received approximately 86 written comment letters in

    response to the Proposing Release.

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    \12\ See Definitions Contained in Title VII of Dodd-Frank Wall

    Street Reform and Consumer Protection Act, 75 FR 51429 (Aug. 20,

    2010). The ANPR also solicited comment regarding the definitions of

    the terms ``swap dealer,'' ``security-based swap dealer,'' ``major

    swap participant,'' ``major security-based swap participant,'' and

    ``eligible contract participant.'' These definitions are the subject

    of a separate joint rulemaking by the Commissions. See Further

    Definition of ``Swap Dealer,'' ``Security-Based Swap Dealer,''

    ``Major Swap Participant,'' ``Major Security-Based Swap

    Participant'' and ``Eligible Contract Participant,'' 77 FR 30596

    (May 23, 2012) (``Entity Definitions Release''). The Commissions

    also provided the public with the ability to present their views

    more generally on implementation of the Dodd-Frank Act through their

    Web sites, dedicated electronic mailboxes, and meetings with

    interested parties. See Public Comments on SEC Regulatory

    Initiatives Under the Dodd-Frank Act/Meetings with SEC Officials,

    located at http://www.sec.gov/spotlight/regreformcomments.shtml;

    Public Submissions, located at http://comments.cftc.gov/PublicComments/ReleasesWithComments.aspx; External Meetings, located

    at http://www.cftc.gov/LawRegulation/DoddFrankAct/ExternalMeetings/index.htm.

    \13\ Copies of all comments received by the SEC on the ANPR are

    available on the SEC's Internet Web site, located at http://www.sec.gov/comments/s7-16-10/s71610.shtml. Comments are also

    available for Web site viewing and printing in the SEC's Public

    Reference Room, 100 F Street NE., Washington, DC 20549, on official

    business days between the hours of 10 a.m. and 3 p.m. Copies of all

    comments received by the CFTC on the ANPR are available on the

    CFTC's Internet Web site, located at http://www.cftc.gov/LawRegulation/DoddFrankAct/OTC_2_Definitions.html.

    \14\ See supra note 12.

    \15\ See Further Definition of ``Swap,'' ``Security-Based

    Swap,'' and ``Security-Based Swap Agreement''; Mixed Swaps;

    Security-Based Swap Agreement Recordkeeping, 76 FR 29818 (May 23,

    2011) (``Proposing Release'').

    \16\ Id.

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    The Commissions have reviewed and considered the comments received,

    and the staffs of the Commissions have met with many market

    participants and other interested parties to discuss the

    definitions.\17\ Moreover, the Commissions' staffs have consulted

    extensively with each other as required by sections 712(a)(1) and (2)

    of the Dodd-Frank Act and have consulted with staff of the Board as

    required by section 712(d) of the Dodd-Frank Act.

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    \17\ Information about meetings that CFTC staff have had with

    outside organizations regarding the implementation of the Dodd-Frank

    Act is available at http://www.cftc.gov/LawRegulation/DoddFrankAct/ExternalMeetings/index.htm. Information about meetings that SEC

    staff have had with outside organizations regarding the product

    definitions is available at http://www.sec.gov/comments/s7-16-10/s71610.shtml#meetings.

    ---------------------------------------------------------------------------

    Based on this review and consultation, the Commissions are adopting

    rules and interpretations regarding, among other things: (i) The

    regulatory treatment of insurance products; (ii) the exclusion of

    forward contracts from the swap and security-

    [[Page 48211]]

    based swap definitions; (iii) the regulatory treatment of certain

    consumer and commercial contracts; (iv) the regulatory treatment of

    certain foreign-exchange related and other instruments; (v) swaps and

    security-based swaps involving interest rates (or other monetary rates)

    and yields; (vi) total return swaps (``TRS''); (vii) Title VII

    instruments based on futures contracts; (viii) the application of the

    definition of ``narrow-based security index'' in distinguishing between

    certain swaps and security-based swaps, including credit default swaps

    (``CDS'') and index CDS; and (ix) the specification of certain swaps

    and security-based swaps that are, and are not, mixed swaps. In

    addition, the Commissions are adopting rules: (i) To clarify that there

    will not be additional books and records requirements applicable to

    SBSAs other than those required for swaps; (ii) providing a mechanism

    for requesting the Commissions to interpret whether a particular type

    of agreement, contract, or transaction (or class of agreements,

    contracts, or transactions) is a swap, security-based swap, or both

    (i.e., a mixed swap); and (iii) providing a mechanism for evaluating

    the applicability of certain regulatory requirements to particular

    mixed swaps. Finally, the CFTC is adopting rules to implement the anti-

    evasion authority provided in the Dodd-Frank Act.

    Overall Economic Considerations

    The Commissions are sensitive to the costs and benefits of their

    rules. In considering the adoption of the Product Definitions, the

    Commissions have been mindful of the costs and benefits associated with

    these rules, which provide fundamental building blocks for the Title

    VII regulatory regime. There are costs, as well as benefits, arising

    from subjecting certain agreements, contracts, or transactions to the

    regulatory regime of Title VII.\18\ Additionally, there are costs that

    parties will incur to assess whether certain agreements, contracts, or

    transactions are indeed subject to the Title VII regulatory regime,

    and, if so, the costs to assess whether such Title VII instrument is

    subject to the regulatory regime of the SEC or the CFTC.\19\

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    \18\ The Commissions refer to these costs and benefits as

    programmatic costs and benefits.

    \19\ The Commissions refer to these costs as assessment costs.

    ---------------------------------------------------------------------------

    Title VII created a jurisdictional division between the CFTC and

    SEC. The costs and benefits flowing from an agreement, contract, or

    transaction being subject to the regulatory regime of the CFTC or the

    SEC may be impacted by similarities and differences in the Commissions'

    regulatory programs for swaps and security-based swaps. Title VII calls

    on the SEC and the CFTC to consult and coordinate for the purposes of

    assuring regulatory consistency and comparability to the extent

    possible.\20\ Title VII also calls on the agencies to treat

    functionally or economically similar products or entities in a similar

    manner, but does not require identical rules.\21\ Although the

    Commissions may differ on certain rulemakings, as the relevant

    products, entities and markets are different, the Commissions believe

    that, as the CFTC and SEC regulatory regimes share a statutory basis in

    Title VII, the costs and benefits of their respective regimes should be

    broadly similar and complementary.

    ---------------------------------------------------------------------------

    \20\ See sections 712(a)(1) and (a)(2) of the Dodd-Frank Act.

    \21\ See sections 712(a)(7)(A) and (B) of the Dodd-Frank Act.

    ---------------------------------------------------------------------------

    In acknowledging the economic consequences of the final rules, the

    Commissions recognize that the Product Definitions do not themselves

    establish the scope or nature of those substantive requirements or

    their related costs and benefits. In determining the appropriate scope

    of these rules, the Commissions consider the types of agreement,

    contract, or transaction that should be regulated as a swap, security-

    based swap, or mixed swap under Title VII in light of the purposes of

    the Dodd-Frank Act. The Commissions have sought to further define the

    terms ``swap,'' ``security-based swap,'' and ``mixed swap'' to include

    agreements, contracts, and transactions only to the extent that

    capturing these agreements, contracts, and transactions is necessary

    and appropriate given the purposes of Title VII, and to exclude

    agreements, contracts, and transactions to the extent that the

    regulation of such agreements, contracts, and transactions does not

    serve the statutory purposes of Title VII, so as not to impose

    unnecessary burdens for agreements, contracts, and transactions whose

    regulation may not be necessary or appropriate to further the purposes

    of Title VII.

    II. Scope of Definitions of Swap and Security-Based Swap

    A. Introduction

    Title VII of the Dodd-Frank Act applies to a wide variety of

    agreements, contracts, and transactions classified as swaps or

    security-based swaps. The statute lists these agreements, contracts,

    and transactions in the definition of the term ``swap.'' \22\ The

    statutory definition of the term ``swap'' also has various

    exclusions,\23\ rules of construction, and other provisions for the

    interpretation of the definition.\24\ One of the exclusions to the

    definition of the term ``swap'' is for security-based swaps.\25\ The

    term ``security-based swap,'' in turn, is defined as an agreement,

    contract, or transaction that is a ``swap'' (without regard to the

    exclusion from that definition for security-based swaps) and that also

    has certain characteristics specified in the statute.\26\ Thus, the

    statutory definition of the term ``swap'' also determines the scope of

    agreements, contracts, and transactions that could be security-based

    swaps.

    ---------------------------------------------------------------------------

    \22\ See CEA section 1a(47)(A), 7 U.S.C. 1a(47)(A). This swap

    definition is also cross-referenced in new section 3(a)(69) of the

    Exchange Act, 15 U.S.C. 78c(a)(69).

    \23\ See CEA section 1a(47)(B), 7 U.S.C. 1a(47)(B), clauses (i)-

    (x).

    \24\ See CEA sections 1a(47)(C)-(F), 7 U.S.C. 1a(47)(C)-(F).

    \25\ See CEA section 1a(47)(B)(x), 7 U.S.C. 1a(47)(B)(x).

    \26\ See section 3(a)(68) of the Exchange Act, 15 U.S.C.

    78c(a)(68).

    ---------------------------------------------------------------------------

    The statutory definitions of the terms ``swap'' and ``security-

    based swap'' are detailed and comprehensive, and the Commissions

    believe that extensive ``further definition'' of the terms by rule is

    not necessary. Nevertheless, the definitions could be read to include

    certain types of agreements, contracts, and transactions that

    previously have not been considered swaps or security-based swaps, and

    nothing in the legislative history of the Dodd-Frank Act appears to

    suggest that Congress intended such agreements, contracts, or

    transactions to be regulated as swaps or security-based swaps under

    Title VII. The Commissions thus believe that it is important to further

    clarify the treatment under the definitions of certain types of

    agreements, contracts, and transactions, such as insurance products and

    certain consumer and commercial contracts.

    In addition, commenters also raised questions regarding, and the

    Commissions believe that it is important to clarify: (i) The exclusion

    for forward contracts from the definitions of the terms ``swap'' and

    ``security-based swap;'' and (ii) the status of certain commodity-

    related products (including various foreign exchange products and

    forward rate agreements) under the definitions of the terms ``swap''

    and ``security-based swap.'' Finally, the Commissions are providing

    [[Page 48212]]

    interpretations related to the definitions.\27\

    ---------------------------------------------------------------------------

    \27\ In response to the ANPR, some commenters raised concerns

    regarding the treatment of inter-affiliate swaps and security-based

    swaps. See, e.g., Letter from Edward J. Rosen, Cleary Gottlieb Steen

    & Hamilton LLP, Sep. 21, 2010 (``Cleary ANPR Letter''); Letter from

    Coalition for Derivatives End Users, Sep. 20, 2010 (``CDEU ANPR

    Letter''); Letter from Robert Pickel, Executive Vice President,

    International Swaps and Derivatives Association, Inc. (``ISDA''),

    Sep. 20, 2010; Letter from Richard A. Miller, Vice President and

    Corporate Counsel, Prudential Financial Inc., Sep. 17, 2010; Letter

    from Richard M. Whiting, The Financial Services Roundtable, Sep. 20,

    2010. A few commenters suggested that the Commissions should further

    define the term ``swap'' or ``security-based swap'' to exclude

    inter-affiliate transactions. See Cleary ANPR Letter and CDEU ANPR

    Letter. The Commissions are considering whether inter-affiliate

    swaps or security-based swaps should be treated differently from

    other swaps or security-based swaps in the context of the

    Commissions' other Title VII rulemakings.

    ---------------------------------------------------------------------------

    B. Rules and Interpretations Regarding Certain Transactions Outside the

    Scope of the Definitions of the Terms ``Swap'' and ``Security-Based

    Swap''

    1. Insurance Products

    The statutory definition of the term ``swap'' includes, in part,

    any agreement, contract or transaction ``that provides for any

    purchase, sale, payment or delivery (other than a dividend on an equity

    security) that is dependent on the occurrence, nonoccurrence, or the

    extent of the occurrence of an event or contingency associated with a

    potential financial, economic, or commercial consequence.'' \28\ As

    stated in the Proposing Release, the Commissions do not interpret this

    clause to mean that products historically treated as insurance products

    should be included within the swap or security-based swap

    definitions.\29\ The Commissions are aware of nothing in Title VII to

    suggest that Congress intended for traditional insurance products to be

    regulated as swaps or security-based swaps. Moreover, the fact that

    swaps and insurance products are subject to different regulatory

    regimes is reflected in section 722(b) of the Dodd-Frank Act which, in

    new section 12(h) of the CEA, provides that a swap ``shall not be

    considered to be insurance'' and ``may not be regulated as an insurance

    contract under the law of any State.'' \30\ Accordingly, the

    Commissions believe that state or Federally regulated insurance

    products that are provided by persons that are subject to state or

    Federal insurance supervision, that otherwise could fall within the

    definitions should not be considered swaps or security-based swaps so

    long as they satisfy the requirements of the Insurance Safe Harbor (as

    defined below). At the same time, however, the Commissions are

    concerned that certain agreements, contracts, or transactions that are

    swaps or security-based swaps might be characterized as insurance

    products to evade the regulatory regime under Title VII of the Dodd-

    Frank Act.

    ---------------------------------------------------------------------------

    \28\ CEA section 1a(47)(A)(ii), 7 U.S.C. 1a(47)(A)(ii).

    \29\ See Proposing Release at 29821. The Commissions continue to

    believe that it was not the intent of Congress through the swap and

    security-based swap definitions to preclude the provision of

    insurance to individual homeowners and small businesses that

    purchase property and casualty insurance. See section 2(e) of the

    CEA, 7 U.S.C. 2(e), and section 6(l) of the Exchange Act, 15 U.S.C.

    78f(l) (prohibiting individuals and small businesses that do not

    meet specified financial thresholds or other conditions from

    entering into swaps or security-based swaps other than on or subject

    to the rules of regulated futures and securities exchanges).

    Historically, insurance has not been regulated as such under the

    Federal securities laws or under the CEA. See infra note 1283.

    \30\ 7 U.S.C. 16(h). Moreover, other provisions of the Dodd-

    Frank Act address the status of insurance more directly, and more

    extensively, than Title VII. For example, Title V of the Dodd-Frank

    Act requires the newly established Federal Insurance Office to

    conduct a study and submit a report to Congress, within 18 months of

    enactment of the Dodd-Frank Act, on the regulation of insurance,

    including the consideration of Federal insurance regulation.

    Notably, the Federal Insurance Office's authority under Title V

    extends primarily to monitoring and information gathering; its

    ability to promulgate Federal insurance regulation that preempts

    state insurance regulation is significantly restricted. See section

    502 of the Dodd-Frank Act (codified in various sections of 31

    U.S.C.). Title V also addressed non-admitted insurance and

    reinsurance. Title X of the Dodd-Frank Act also specifically

    excludes the business of insurance from regulation by the Bureau of

    Consumer Financial Protection. See section 1027(m) of the Dodd-Frank

    Act, 12 U.S.C. 5517(m) (``The [Bureau of Consumer Financial

    Protection] may not define as a financial product or service, by

    regulation or otherwise, engaging in the business of insurance.'');

    section 1027(f) of the Dodd-Frank Act, 12 U.S.C. 5517(f) (excluding

    persons regulated by a state insurance regulator, except to the

    extent they are engaged in the offering or provision of consumer

    financial products or services or otherwise subject to certain

    consumer laws as set forth in Title X of the Dodd-Frank Act).

    ---------------------------------------------------------------------------

    Accordingly, the Commissions are adopting final rules that (i)

    clarify that certain agreements, contracts, or transactions that

    satisfy the requirements of the Insurance Safe Harbor will not be

    considered to be swaps or security-based swaps, and (ii) provide an

    Insurance Grandfather exclusion from the swap and security-based swap

    definitions for any agreement, contract, or transaction entered into on

    or before the effective date of the Product Definitions, provided that,

    when the parties entered into such agreement, contract, or transaction,

    it was provided in accordance with the Provider Test (as defined

    below), including a requirement that an agreement, contract or

    transaction that is provided in accordance with the first prong of the

    Provider Test must be regulated as insurance under applicable state law

    or the laws of the United States.

    The final rules contain four subparts: The first subpart addresses

    the agreement, contract, or transaction; the second subpart addresses

    the person \31\ providing that agreement, contract, or transaction; the

    third subpart includes a list of traditional insurance products that do

    not have to meet the requirements set out in the first subpart; and the

    fourth subpart contains the Insurance Grandfather exclusion (as defined

    below).

    ---------------------------------------------------------------------------

    \31\ In response to commenters, the Commissions are changing the

    word ``company'' from the proposal to ``person.'' Each of the CEA,

    the Securities Act, and the Exchange Act contains a definition of a

    ``person.'' See, e.g., Letter from Carl B. Wilkerson, Vice President

    & Chief Counsel, American Council of Life Insurers (``ACLI''), dated

    July 22, 2011 (``ACLI Letter'') and Letter from John P. Mulhern,

    Dewey & LeBoeuf LLP (``D&L''), dated July 22, 2011 (``D&L Letter'').

    ---------------------------------------------------------------------------

    More specifically, with respect to the first subpart, the

    Commissions are adopting paragraph (i)(A) of rule 1.3(xxx)(4) under the

    CEA and paragraph (a)(1) of rule 3a69-1 under the Exchange Act (the

    ``Product Test'') as proposed, with certain modifications to respond to

    commenters' concerns. As adopted, the Product Test provides that the

    terms ``swap'' and ``security-based swap'' will not include an

    agreement, contract, or transaction that, by its terms or by law, as a

    condition of performance:

    Requires the beneficiary of the agreement, contract, or

    transaction to have an insurable interest that is the subject of the

    agreement, contract, or transaction and thereby carry the risk of loss

    with respect to that interest continuously throughout the duration of

    the agreement, contract, or transaction;

    Requires that loss to occur and be proved, and that any

    payment or indemnification therefor be limited to the value of the

    insurable interest;

    Is not traded, separately from the insured interest, on an

    organized market or over the counter; and

    With respect to financial guaranty insurance only, in the

    event of payment default or insolvency of the obligor, any acceleration

    of payments under the policy is at the sole discretion of the insurer.

    The Commissions are also adopting paragraph (i)(B) of rule

    1.3(xxx)(4) under the CEA and paragraph (a)(2) of rule 3a69-1 under the

    Exchange Act (the ``Provider Test'') as proposed, with certain

    modifications to respond to commenters' concerns. As adopted, the

    Provider Test requires that an agreement, contract, or transaction that

    [[Page 48213]]

    satisfies the Product Test must be provided:

    By a person that is subject to supervision by the

    insurance commissioner (or similar official or agency) of any state

    \32\ or by the United States or an agency or instrumentality \33\

    thereof, and such agreement, contract, or transaction is regulated as

    insurance under applicable state law \34\ or the laws of the United

    States (the ``first prong'');

    ---------------------------------------------------------------------------

    \32\ The term ``State'' is defined in section 3(a)(16) of the

    Exchange Act, 15 U.S.C. 78c(a)(16), to mean ``any State of the

    United States, the District of Columbia, Puerto Rico, the Virgin

    Islands, or any other possession of the United States.'' The CFTC is

    incorporating this definition into rule 1.3(xxx)(4) for purposes of

    ensuring consistency between the CFTC and SEC rules further defining

    the terms ``swap'' and ``security-based swap.''

    \33\ For purposes of this release, the term ``instrumentality''

    includes publicly supported, state operated or quasi-state operated

    insurance programs that may not be subject to state regulatory

    oversight, such as the Illinois Mine Subsidence Insurance Fund and

    the Florida Hurricane Catastrophe Fund.

    \34\ For purposes of this release, the Commissions anticipate

    that the parties to an agreement, contract, or transaction will

    evaluate which state law applies prior to entering into such

    agreement, contract, or transaction. The Commissions do not

    anticipate that the parties' analysis of which state law applies

    will change as a result of the adoption of the Insurance Safe

    Harbor. In addition, the Commissions will analyze which state law

    applies (if necessary, in consultation with state insurance

    regulatory authorities) if and when such issues arise that the

    Commissions determine to address. The Commissions note that courts

    routinely determine what is the ``applicable state law'' when

    adjudicating disputes involving insurance.

    ---------------------------------------------------------------------------

    (i) Directly or indirectly by the United States, any state

    or any of their respective agencies or instrumentalities, or (ii)

    pursuant to a statutorily authorized program thereof ((i) and (ii)

    together, the ``second prong''); or

    In the case of reinsurance only \35\ by a person to

    another person that satisfies the Provider Test, provided that:

    ---------------------------------------------------------------------------

    \35\ For purposes of this release, the term ``reinsurance''

    means the assumption by an insurer of all or part of a risk

    undertaken originally by another insurer.

    ---------------------------------------------------------------------------

    (i) Such person is not prohibited by applicable state law or the

    laws of the United States from offering such agreement, contract, or

    transaction to such person that satisfies the Provider Test;

    (ii) The agreement, contract, or transaction to be reinsured

    satisfies the Product Test or is one of the Enumerated Products (as

    defined below); and

    (iii) Except as otherwise permitted under applicable state law, the

    total amount reimbursable by all reinsurers \36\ for such agreement,

    contract, or transaction may not exceed the claims or losses paid by

    the cedant \37\ ((i), (ii), and (iii), collectively, the ``third

    prong''); or

    ---------------------------------------------------------------------------

    \36\ For purposes of this release, the term ``reinsurer'' means

    any person who provides reinsurance.

    \37\ For purposes of this release, the term ``cedant'' means the

    person writing the risk being ceded or transferred to a reinsurer.

    ---------------------------------------------------------------------------

    In the case of non-admitted insurance \38\ by a person

    who:

    ---------------------------------------------------------------------------

    \38\ For purposes of this release, the term ``non-admitted

    insurance'' means any property and casualty insurance permitted to

    be placed directly or through a surplus lines broker with a non-

    admitted insurer eligible to accept such insurance.

    ---------------------------------------------------------------------------

    (i) Is located outside of the United States and listed on the

    Quarterly Listing of Alien Insurers as maintained by the International

    Insurers Department of the National Association of Insurance

    Commissioners; or

    (ii) Meets the eligibility criteria for non-admitted insurers \39\

    under applicable state law ((i) and (ii) together, the ``fourth

    prong'').

    ---------------------------------------------------------------------------

    \39\ For purposes of this release, the term ``non-admitted

    insurer'' means, with respect to any State, an insurer not licensed

    to engage in the business of insurance in such State, but does not

    include a risk retention group, as that term is defined in section

    2(a)(4) of the Liability Risk Retention Act of 1986, 15 U.S.C.

    3901(a)(4).

    ---------------------------------------------------------------------------

    In response to commenters' requests that the Commissions codify the

    proposed interpretation regarding certain enumerated types of

    traditional insurance products in the final rules,\40\ the Commissions

    are also adopting paragraph (i)(C) of rule 1.3(xxx)(4) under the CEA

    and paragraph (a)(3) of rule 3a69-1 under the Exchange Act. In

    addition, in response to comments, the Commissions are expanding and

    revising the enumerated types of traditional insurance products. As

    adopted, the rule provides that the terms ``swap'' and ``security-based

    swap'' will not include an agreement, contract, or transaction that is

    provided in accordance with the Provider Test and is any one of the

    following (collectively, ``Enumerated Products''): Surety bonds;

    fidelity bonds; life insurance; health insurance; long-term care

    insurance; title insurance; property and casualty insurance; annuities;

    disability insurance; insurance against default on individual

    residential mortgages (commonly known as private mortgage insurance, as

    distinguished from financial guaranty of mortgage pools); and

    reinsurance (including retrocession) of any of the foregoing. The

    Commissions note that the inclusion of reinsurance (including

    retrocession) as an Enumerated Product is meant to apply to traditional

    reinsurance and retrocession contracts. Specifically, traditional

    reinsurance and retrocession contracts that reinsure risks ceded under

    traditional insurance products included in the Enumerated Product list

    and provided in accordance with the Provider test do not fall within

    the swap or security-based swap definitions. An agreement, contract, or

    transaction that is labeled as ``reinsurance'' or ``retrocession'', but

    is executed as a swap or security-based swap or otherwise is structured

    to evade Title VII of the Dodd-Frank Act, would not satisfy the

    Insurance Safe Harbor, and would be a swap or security-based swap.\41\

    ---------------------------------------------------------------------------

    \40\ See infra notes 88, 89, and 90 and accompanying text.

    \41\ For example, if a person uses a weather derivative or

    catastrophe swap to assume all or part of the risks contained in a

    portfolio of property and casualty insurance policies, that weather

    derivative or catastrophe swap would be a Title VII instrument that

    is subject to regulation under Title VII.

    ---------------------------------------------------------------------------

    In order for an agreement, contract, or transaction to qualify

    under the final rules as an insurance product that would not be a swap

    or security-based swap: (i) The agreement, contract, or transaction

    must satisfy the criteria in the Product Test or be one of the

    Enumerated Products and (ii) the person providing the agreement,

    contract or transaction must satisfy one prong of the Provider

    Test.\42\ The fact that an agreement, contract, or transaction

    satisfies the Product Test or is one of the Enumerated Products does

    not exclude it from the swap or security-based swap definitions if it

    is not provided by a person that satisfies the Provider Test; nor does

    the fact that a product is provided by a person that satisfies the

    Provider Test exclude the product from the swap or security-based swap

    definitions if the agreement, contract, or transaction does not satisfy

    the criteria set forth in the Product Test or is not one of the

    Enumerated Products.\43\

    ---------------------------------------------------------------------------

    \42\ As was discussed in the Proposing Release, see Proposing

    Release at 29822 n. 31, certain variable life insurance products and

    annuities are securities and therefore are excluded from the swap

    and security-based swap definitions regardless of whether they meet

    the requirements under the final rules. See section 1a(47)(B)(v) of

    the CEA, 7 U.S.C. 1a(47)(B)(v). These securities would not be swaps

    or security-based swaps whether or not required to be registered

    under the Securities Act. See SEC v. United Benefit Life Ins. Co.,

    387 U.S. 202 (1967) (holding that the accumulation provisions of a

    ``flexible fund'' annuity contract were not entitled to exemption

    under section 3(a)(8) of the Securities Act, 15 U.S.C. 77c(a)(8),

    for insurance and annuities); SEC v. Variable Annuity Life Ins. Co.,

    359 U.S. 65 (1959) (holding that a variable annuity was not entitled

    to exemption under section 3(a)(8) of the Securities Act).

    \43\ For the purpose of determining whether an agreement,

    contract or transaction falls within the Insurance Safe Harbor,

    Title VII provides the Commissions with flexibility to address the

    facts and circumstances of new products that may be marketed or sold

    as insurance, through joint interpretations pursuant to section

    712(d)(4) of the Dodd-Frank Act.

    ---------------------------------------------------------------------------

    [[Page 48214]]

    Further, in response to commenters' concerns,\44\ the Commissions

    are confirming that the Product Test, the Provider Test and the

    Enumerated Products represent a non-exclusive safe harbor. None of the

    Product Test, the Provider Test, or the Enumerated Products

    (collectively, the ``Insurance Safe Harbor'') implies or presumes that

    an agreement, contract, or transaction that does not meet any of their

    respective requirements is a swap or security-based swap. Such an

    agreement, contract, or transaction will require further analysis of

    the applicable facts and circumstances, including the form and

    substance of such agreement, contract, or transaction, to determine

    whether it is insurance, and thus not a swap or security-based swap.

    ---------------------------------------------------------------------------

    \44\ See infra notes 178 and 179 and accompanying text.

    ---------------------------------------------------------------------------

    However, future market conditions or other developments may prompt

    the Commissions to reconsider whether a particular product that

    satisfies the requirements of the Insurance Safe Harbor should instead

    fall within the swap or security-based swap definition. Because a

    determination that such a product is a swap or security-based swap

    could potentially have an unsettling effect on the domestic insurance

    or financial markets, the Commissions would only consider making a

    determination that such a product is a swap or security-based swap

    through a rulemaking \45\ process that would provide market

    participants with an opportunity to comment.\46\

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    \45\ The Commissions can engage in rulemakings in a variety of

    ways including an advanced notice of proposed rulemaking, a notice

    of proposed rulemaking, or an interim final rule.

    \46\ When determining whether a particular product is a swap or

    security-based swap instead of insurance, if such product does not

    meet the requirements set out in the Insurance Safe Harbor, the

    Commissions will consider prior regulation as an insurance contract

    as one factor in their respective facts and circumstances analysis.

    ---------------------------------------------------------------------------

    (a) Types of Insurance Products

    Final Rules

    Product Test

    The Commissions are adopting the Product Test as proposed, with

    certain modifications to respond to commenters' concerns. The Product

    Test sets forth four criteria for an agreement, contract, or

    transaction to be considered insurance. First, the final rules require

    that the beneficiary have an ``insurable interest'' underlying the

    agreement, contract, or transaction and thereby carry the risk of loss

    with respect to that interest continuously throughout the duration of

    the agreement, contract, or transaction. The requirement that the

    beneficiary be at risk of loss (which could be an adverse financial,

    economic, or commercial consequence) with respect to the interest that

    is the subject of the agreement, contract, or transaction continuously

    throughout the duration of the agreement, contract, or transaction will

    ensure that an insurance contract beneficiary has a stake in the

    interest on which the agreement, contract, or transaction is

    written.\47\ Similarly, the requirement that the beneficiary have the

    insurable interest continuously throughout the duration of the

    agreement, contract, or transaction is designed to ensure that payment

    on the insurance product is inextricably connected to both the

    beneficiary and the interest on which the insurance product is written.

    In contrast to insurance, a credit default swap (``CDS'') (which may be

    a swap or a security-based swap) does not require the purchaser of

    protection to hold any underlying obligation issued by the reference

    entity on which the CDS is written.\48\ One commenter identified the

    existence of an insurable interest as a material element to the

    existence of an insurance contract.\49\ Because neither swaps nor

    security-based swaps require the presence of an insurable interest at

    all (although an insurable interest may sometimes be present

    coincidentally), the Commissions continue to believe that whether an

    insurable interest is present continuously throughout the duration of

    the agreement, contract, or transaction is a meaningful way to

    distinguish insurance from swaps and security-based swaps.

    ---------------------------------------------------------------------------

    \47\ Requiring that a beneficiary of an insurance policy have a

    stake in the interest traditionally has been justified on public

    policy grounds. For example, a beneficiary that does not have a

    property right in a building might have an incentive to profit from

    arson.

    \48\ Standard CDS documentation stipulates that the incurrence

    or demonstration of a loss may not be made a condition to the

    payment on the CDS or the performance of any obligation pursuant to

    the CDS. See, e.g., ISDA, 2003 ISDA Credit Derivatives Definitions,

    art. 9.1(b)(i) (2003) (``2003 Definitions'') (stating that ``the

    parties will be obligated to perform * * * irrespective of the

    existence or amount of the parties' credit exposure to a Reference

    Entity, and Buyer need not suffer any loss nor provide evidence of

    any loss as a result of the occurrence of a Credit Event'').

    \49\ See D&L Letter.

    ---------------------------------------------------------------------------

    Second, the requirement that a loss occur and be proved similarly

    ensures that the beneficiary has a stake in the insurable interest that

    is the subject of the agreement, contract, or transaction. If the

    beneficiary can demonstrate loss, that loss would ``trigger''

    performance by the insurer on the agreement, contract, or transaction

    such that, by making payment, the insurer is indemnifying the

    beneficiary for such loss. In addition, limiting any payment or

    indemnification to the value of the insurable interest aids in

    distinguishing swaps and security-based swaps (where there is no such

    limit) from insurance.\50\

    ---------------------------------------------------------------------------

    \50\ To the extent an insurance product provides for such items

    as, for example, a rental car for use while the car that is the

    subject of an automobile insurance policy is being repaired, the

    Commissions would consider such items as constituting part of the

    value of the insurable interest.

    ---------------------------------------------------------------------------

    Third, the final rules require that the insurance product not be

    traded, separately from the insured interest, on an organized market or

    over the counter. As the Commissions observed in the Proposing Release,

    with limited exceptions,\51\ insurance products traditionally have not

    been entered into on or subject to the rules of an organized exchange

    nor traded in secondary market transactions (i.e., they are not traded

    on an organized market or over the counter). While swaps and security-

    based swaps also generally have not been tradable at will in secondary

    market transactions (i.e., on an organized market or over the counter)

    without counterparty consent, the Commissions understand that all or

    part of swaps and security-based swaps are novated or assigned to third

    parties, usually pursuant to industry standard terms and documents.\52\

    In response to commenter concerns,\53\ the Commissions are clarifying

    when assignments of insurance contracts and trading on ``insurances

    exchanges'' do not constitute trading the contract separately from the

    related insurable interest, and thus would not violate the Product

    Test. The Commissions do not interpret the assignment of an insurance

    contract as described by commenters \54\

    [[Page 48215]]

    to be ``trading'' as that term is used in the Product Test.\55\ Nor do

    the Commissions find that the examples of exchanges offered by

    commenters,\56\ such as Federal Patient Protection and Affordable Care

    Act ``exchanges,'' \57\ are exchanges as that term is used in the

    Product Test, e.g., a national securities exchange or designated

    contract market. Mandated insurance exchanges are more like

    marketplaces for the purchase of insurance, and there is no trading of

    insurance policies separately from the insured interest on these

    insurance exchanges. Thus, the assignment of an insurance contract as

    permitted or required by state law, or the purchase or assignment of an

    insurance contract on an insurance exchange or otherwise, does not

    constitute trading an agreement, contract, or transaction separately

    from the insured interest and would not violate the trading restriction

    in the Product Test. For the foregoing reasons as clarified, the

    Commissions continue to believe that lack of trading separately from

    the insured interest is a feature of insurance that is useful in

    distinguishing insurance from swaps and security-based swaps.

    ---------------------------------------------------------------------------

    \51\ See, e.g., ``Life Settlements Task Force, Staff Report to

    the United States Securities and Exchange Commission'' (``In an

    effort to help make the bidding process more efficient and to

    facilitate trading of policies after the initial settlement occurs,

    some intermediaries have considered or instituted a trading platform

    for life settlements.''), available at http://www.sec.gov/news/studies/2010/lifesettlements-report.pdf (July 22, 2010).

    \52\ See, e.g., ISDA, 2005 Novation Protocol, available at

    http://www.isda.org/2005novationprot/docs/NovationProtocol.pdf

    (2005); ISDA, ISDA Novation Protocol II, available at http://www.isda.org/isdanovationprotII/docs/NPII.pdf (2005); 2003

    Definitions, Exhibits E (Novation Agreement) and F (Novation

    Confirmation).

    \53\ See infra notes 74 and 75 and accompanying text.

    \54\ See, e.g., Letter from Kim O'Brien, President & CEO,

    National Association for Fixed Annuities (``NAFA''), dated July 21,

    2011 (``NAFA Letter''); Letter from Robert Pickel, Executive Vice

    Chairman, ISDA, dated July 22, 2011 (``ISDA Letter''); ACLI Letter;

    and Letter from Letter from Stephen E. Roth, Frederick R. Bellamy

    and James M. Cain, Sutherland Asbill & Brennan LLP on behalf of the

    Committee of Annuity Insurers (``CAI''), dated July 22, 2011 (``CAI

    Letter'').

    \55\ The assignment of the benefits or proceeds of an insurance

    contract by an owner or beneficiary does not violate the trading

    restriction in the Product Test. This interpretation does not extend

    to ``stranger originated'' products. The transfer of obligations for

    policyholder benefits between two insurance companies, such as would

    occur in connection with an insurance company merger or acquisition,

    also does not violate the trading restriction contained in the

    Product Test.

    \56\ See Letter from Susan E. Voss, Commissioner Iowa Insurance

    Division & National Association of Insurance Commissioners

    (``NAIC'') President, and Therese M. Vaughan, NAIC Chief Executive

    Officer, dated July 22, 2011 (``NAIC Letter'').

    \57\ See Patient Protection and Affordable Care Act;

    Establishment of Exchanges and Qualified Health Plans, 76 FR 41866

    (Jul. 15, 2011) (proposed).

    ---------------------------------------------------------------------------

    Fourth, the final rules provide that in the case of financial

    guaranty insurance policies, also known as bond insurance or bond

    wraps, any acceleration of payment under the policy must be at the sole

    discretion of the provider of the financial guaranty insurance policy

    in order to satisfy the Product Test.\58\ Although such products can be

    economically similar to products such as CDS, they have certain key

    characteristics that distinguish them from swaps and security-based

    swaps.\59\ For example, under a financial guaranty policy, the insurer

    typically is required to make timely payment of any shortfalls in the

    payment of scheduled interest to the holders of the underlying

    guaranteed obligation. Also, for particular bonds that are covered by a

    financial guaranty policy, the indenture, related documentation, and/or

    the financial guaranty policy will provide that a default in payment of

    principal or interest on the underlying bond will not result in

    acceleration of the obligation of the insurer to make payment of the

    full amount of principal on the underlying guaranteed obligation unless

    the insurer, in its sole discretion, opts to make payment of principal

    prior to the final scheduled maturity date of the underlying guaranteed

    obligation. Conversely, under a CDS, a protection seller frequently is

    required to make payment of the relevant settlement amount to the

    protection buyer upon demand by the protection buyer after any credit

    event involving the issuer.\60\

    ---------------------------------------------------------------------------

    \58\ Financial guarantee policies are used by entities such as

    municipalities to provide greater assurances to potential purchasers

    of their bonds and thus reduce their interest costs. See ``Report by

    the United States Securities and Exchange Commission on the

    Financial Guarantee Market: The Use of the Exemption in section

    3(a)(2) of the Securities Act for Securities Guaranteed by Banks and

    the Use of Insurance Policies to Guarantee Debt Securities'' (Aug.

    28, 1987).

    \59\ See, e.g., Letter from Sean W. McCarthy, Chairman,

    Association of Financial Guaranty Insurers on the ANPR, dated Sept.

    20, 2010 (explaining the differences between financial guaranty

    policies and CDS); Letter from James M. Michener, General Counsel,

    Assured Guaranty on the ANPR, dated Dec. 14, 2010 (noting that the

    Financial Accounting Standards Board has issued separate guidance on

    accounting for financial guaranty insurance and CDS); Letter from

    Ernest C. Goodrich, Jr., Managing Director--Legal Department,

    Deutsche Bank AG on the ANPR, dated Sept. 20, 2010 (noting that

    financial guaranty policies require the incurrence of loss for

    payment, whereas CDS do not).

    \60\ While a CDS requires payment in full on the occurrence of a

    credit event, the Commissions recognize that there are other

    financial instruments, such as corporate guarantees of commercial

    loans and letters of credit supporting payments on loans or debt

    securities, that allow for acceleration of payment obligations

    without such guarantees or letters of credit being swaps or

    security-based swaps.

    ---------------------------------------------------------------------------

    As noted in the Proposing Release, the Commissions do not believe

    that financial guaranty policies, in general, should be regulated as

    swaps or security-based swaps. However, because of the close economic

    similarity of financial guaranty insurance policies guaranteeing

    payment on debt securities to CDS, in addition to the criteria noted

    above with respect to insurance generally, the final rules require

    that, in order to satisfy the Product Test, financial guaranty policies

    also must satisfy the requirement that they not permit the beneficiary

    of the policy to accelerate the payment of any principal due on the

    debt securities. This requirement further distinguishes financial

    guaranty policies from CDS because, as discussed above, the latter

    generally requires payment of the relevant settlement amount on the CDS

    after demand by the protection buyer.

    Finally, in response to comments,\61\ the Commissions are

    clarifying that reinsurance and retrocession transactions fall within

    the scope of the Product Test. The Commissions find that these

    transactions have insurable interests, as the Commissions interpret

    such interests in this context, if they have issued insurance policies

    covering the risks that they wish to insure (and reinsure). Moreover,

    the Commissions find that retrocession transactions are encompassed

    within the Product Test and the Provider Test because retrocession is

    reinsurance of reinsurance (provided the retrocession satisfies the

    other requirements of both tests). In addition, reinsurance (including

    retrocession) of certain types of insurance products is included in the

    list of Enumerated Products.\62\

    ---------------------------------------------------------------------------

    \61\ See infra note 105 and accompanying text.

    \62\ See supra note 41 and accompany text.

    ---------------------------------------------------------------------------

    Requiring all of the criteria in the Product Test will help to

    limit the application of the final rules to agreements, contracts, and

    transactions that are appropriately regulated as insurance, and help to

    assure that agreements, contracts, and transactions appropriately

    subject to the regulatory regime under Title VII of the Dodd-Frank Act

    are regulated as swaps or security-based swaps. As a result, the

    Commissions believe that these requirements will help prevent the final

    rules from being used to circumvent the applicability of the swap and

    security-based swap regulatory regimes under Title VII.

    Enumerated Products

    In the Proposing Release, the Commissions proposed an

    interpretation that certain enumerated types of insurance products

    would be outside the scope of the statutory definitions of swap and

    security-based swap under the Dodd-Frank Act if provided in accordance

    with the Provider Test and regulated as insurance. Based on comments

    received,\63\ the Commissions are adding three products to the list of

    products as proposed (fidelity bonds, disability insurance and

    insurance against default on individual residential mortgages), adding

    reinsurance (including retrocession) of any of the traditional

    insurance products included in the list, deleting a requirement

    applicable to annuities, and codifying the Enumerated Products in the

    final rules. The revised list of Enumerated Products is: Surety bonds,

    fidelity bonds, life insurance, health insurance, long-term

    [[Page 48216]]

    care insurance, title insurance, property and casualty insurance,

    annuities, disability insurance, insurance against default on

    individual residential mortgages (commonly known as private mortgage

    insurance, as distinguished from financial guaranty of mortgage pools),

    and reinsurance (including retrocession) of any of the foregoing.\64\

    The Commissions believe that the Enumerated Products, as traditional

    insurance products, are not the types of agreements, contracts, or

    transactions that Congress intended to subject to the regulatory regime

    for swaps and security-based swaps under the Dodd-Frank Act. Codifying

    the Enumerated Products in the final rules appropriately places

    traditional insurance products outside the scope of the swap and

    security-based swap definition so long as such Enumerated Products are

    provided in accordance with the Provider Test, including a requirement

    that an Enumerated Product that is provided in accordance with the

    first prong of the Provider Test must be regulated as insurance under

    applicable state law or the laws of the United States.

    ---------------------------------------------------------------------------

    \63\ See infra notes 93 and 94 and accompanying text.

    \64\ See supra note 41 and accompanying text.

    ---------------------------------------------------------------------------

    Comments

    Insurable Interest

    Six commenters objected to the requirement in the Product Test that

    the beneficiary have an insurable interest continuously throughout the

    duration of the contract.\65\ These commenters noted that, under state

    law, an insurable interest may not always be required to be present

    continuously throughout the duration of the policy. For example,

    commenters noted that life insurance may only require an insurable

    interest at the time the policy is executed; \66\ and some property and

    casualty or liability insurance may only require an insurable interest

    at the time a loss occurs.\67\ Commenters also noted that annuities and

    health insurance do not require the existence of an insurable interest

    at all.\68\ Another commenter suggested that the Commissions modify the

    Product Test to indicate that annuities would not need to satisfy the

    ``insurable interest'' component, or to use terminology other than

    insurable interest to make clear that annuities are not swaps.\69\

    ---------------------------------------------------------------------------

    \65\ See ACLI Letter; CAI Letter; ISDA Letter (objecting to the

    requirement that the risk of loss be held continuously throughout

    the contact); NAFA Letter; NAIC Letter; and Letter from Kenneth F.

    Spence III, Executive Vice President & General Counsel, The

    Travelers Companies, Inc. (``Travelers''), dated Nov. 14, 2011

    (``Travelers Letter'').

    \66\ See ACLI Letter; CAI Letter; ISDA Letter; NAIC Letter; and

    Travelers Letter. The Commissions understand that some states may

    define what constitutes an insurable interest with reference to

    personal or emotional consequence in addition to the financial,

    economic, or commercial consequence mentioned in the statutory swap

    definition.

    \67\ See NAIC Letter and Travelers Letter. However, one

    commenter noted that the Product and Provider Tests, as proposed,

    should be an effective means of helping to distinguish between those

    contracts that qualify for exclusion from the definition of swap and

    security-based swap from those contracts that will not. See Letter

    from Michael A. Bell, Senior Counsel, Financial Policy, The Property

    Casualty Insurers Association of America, dated July 22, 2011.

    \68\ See CAI Letter; ISDA Letter; NAFA Letter; and NAIC Letter.

    \69\ See Letter from Nicholas D. Latrenta, Executive Vice

    President and General Counsel, Metropolitan Life Insurance Companies

    and its insurance affiliates (``MetLife''), dated July 22, 2011

    (``MetLife Letter'').

    ---------------------------------------------------------------------------

    As discussed above, the Commissions are retaining the insurable

    interest requirement of the Product Test. The Commissions continue to

    believe that this requirement is a useful tool to distinguish insurance

    from swaps and security-based swaps, because swaps and security-based

    swaps do not require the presence of an insurable interest (or require

    either counterparty to bear any risk of loss) at any time during the

    term of the agreement, contract, or transaction. While the Commissions

    acknowledge commenters who argued that products such as life insurance,

    property and casualty insurance, and annuities may fail the Product

    Test because of the insurable interest requirement, the Commissions do

    not interpret any such failure to mean that life insurance, property

    and casualty insurance, and annuities are not insurance products. To

    the contrary, as discussed above, these products are included in the

    list of Enumerated Products that are excluded from the swap and

    security-based swap definitions so long as they are provided in

    accordance with the Provider Test. If a life insurance, property and

    casualty insurance, or annuity is provided in accordance with the

    Provider Test, such product is not a swap or security-based swap,

    whether or not an insurable interest is present at all times during the

    term of the contract.

    Indemnification for Loss

    Five commenters objected to the requirement in the Product Test

    that a loss occur and be proven, and that any payment be limited to the

    value of the insurable interest, because payment under many insurance

    products may not be directly based upon actual losses incurred.\70\ Two

    commenters argued that annuities do not provide indemnification for

    loss and that life insurance products are not constrained by the value

    of the insurable interest.\71\ Another argued that many insurance

    policies pay fixed amounts upon the occurrence of a loss without a

    requirement that the loss be tied to the value of an insurable

    interest.\72\ Disability insurance and long-term care insurance are

    other products that commenters indicate would not be able to satisfy

    this requirement of the Product Test.\73\

    ---------------------------------------------------------------------------

    \70\ See ACLI Letter; CAI Letter; ISDA Letter; NAFA Letter; and

    Travelers Letter.

    \71\ See ACLI Letter and Travelers Letter.

    \72\ See Travelers Letter.

    \73\ See, e.g., ACLI Letter and CAI Letter.

    ---------------------------------------------------------------------------

    As discussed above, the Commissions are retaining the requirement

    in the Product Test that a loss occur and be proven and that any

    payment for such loss be limited to the value of the insurable

    interest. The Commissions continue to believe that this requirement is

    a useful tool to distinguish insurance from swaps and security-based

    swaps, because payments under swaps and security-based swaps may be

    required when neither party incurs a loss, nor is the amount of payment

    limited by any such loss. While the Commissions acknowledge commenters

    who identified various products that may fail this part of the Product

    Test, the Commissions do not interpret any such failure to mean that

    products such as annuities, disability insurance, and long-term care

    insurance are not insurance products. To the contrary, as discussed

    above, these products are included in the list of Enumerated Products

    that are excluded from the swap and security-based swap definitions so

    long as they are provided in accordance with the Provider Test. If

    long-term care insurance, disability insurance, or an annuity is

    provided in accordance with the Provider Test, such product is not a

    swap or a security-based swap, whether or not a loss occurs, is proven,

    or indemnification for loss is limited to the value of the insurable

    interest.

    Not Traded Separately

    Six commenters stated that the proposed requirement that the

    agreement, contract, or transaction not be traded, separately from the

    insured interest, on an organized market or over the counter, is not an

    effective criterion in determining whether a product is insurance.\74\

    According to commenters, this criterion is ineffective and should be

    deleted from the Product Test because many conventional insurance

    [[Page 48217]]

    products, such as annuities, are assignable (and therefore tradable),

    which may violate the trading restriction.\75\ Two commenters observed

    that the trading of insurance policies has already occurred and is

    expected to increase.\76\ One commenter stated that a number of states

    have ``insurance exchanges'' that sell reinsurance and excess or

    surplus lines, and that the Patient Protection and Affordable Care Act

    requires states or the Federal government to establish health benefit

    ``insurance exchanges'' through which insurers will sell health

    insurance to individuals and small groups.\77\ One commenter

    recommended that the trading restriction apply only to trading by the

    policyholder or beneficiary of an insurance policy.\78\

    ---------------------------------------------------------------------------

    \74\ See ACLI Letter; Letter from Chris Barnard (``Barnard''),

    dated June 28, 2011 (``Barnard Letter''); CAI Letter; NAFA Letter;

    NAIC Letter; and ISDA Letter.

    \75\ Id. ACLI stated that many conventional insurance products,

    particularly annuities, can be assigned by the owner, and often

    state insurance law requires such assignability as a condition for

    approval of the product for sale under applicable insurance law.

    ACLI also stated that insurance policies are frequently assigned

    among family members, to third parties as collateral for loans, and

    in a host of other situations, and does not believe that these

    common kinds of assignment should cause an insurance product to be

    characterized as a swap.

    \76\ See Barnard Letter and NAIC Letter.

    \77\ See NAIC Letter. The commenter explained that the

    ``insurance exchanges'' mandated by the Patient Protection and

    Affordable Care Act would be marketplaces for insurance policies.

    The commenter described them as ``cooperatives'' where people could

    go to buy insurance policies with standardized terms/actuaries. The

    commenter noted that the insurable interest would not ``trade''

    separately from the insurance policy in these cooperatives.

    \78\ See Travelers Letter.

    ---------------------------------------------------------------------------

    The Commissions are retaining the requirement in the Product Test

    that the agreement, contract, or transaction not be traded separately

    from the insured interest, on an organized market or over the counter,

    and as discussed above have provided a clarification regarding

    assignments and trading on insurance exchanges. The Commissions

    continue to believe that using this criterion is an effective way to

    distinguish insurance from swaps and security-based swaps because swaps

    and security-based swaps are traded on organized markets and over the

    counter.

    As stated above, the Commissions do not interpret the assignment of

    an insurance contract as described by commenters to be ``trading'' as

    that term is used in the Product Test.\79\ Nor do the Commissions find

    that the examples of exchanges offered by commenters, such as Federal

    Patient Protection and Affordable Care Act ``exchanges,'' are exchanges

    as that term is used in the Product Test, e.g., a national securities

    exchange or designated contract market.\80\ Mandated insurance

    exchanges are more like marketplaces for the purchase of insurance, and

    there is no trading of insurance policies separately from the insured

    interest on these insurance exchanges. Thus, the assignment of an

    insurance contract as permitted or required by state law, or the

    purchase or assignment of an insurance contract on an insurance

    exchange or otherwise, does not constitute trading an agreement,

    contract, or transaction separately from the insured interest and would

    not violate the trading restriction in the Product Test.

    ---------------------------------------------------------------------------

    \79\ See supra notes 54 and 55.

    \80\ See supra notes 56 and 57.

    ---------------------------------------------------------------------------

    Acceleration

    Three commenters believed that the proposed requirement that, in

    the event of payment default or insolvency of the obligor, any

    acceleration of payments under a financial guaranty insurance policy be

    at the sole discretion of the insurer, is not an effective criterion in

    determining whether financial guaranty insurance falls outside the swap

    and security-based swap definitions and should be deleted from the

    Product Test.\81\ However, one commenter supported its inclusion,

    observing that the proposed requirement is ``firmly based on

    substantive business realities.'' \82\ Two commenters believed that the

    acceleration of payments requirement is not useful in distinguishing

    between financial guaranty insurance and swaps or security-based swaps

    because it is designed to protect financial guaranty insurers from

    insolvency.\83\ They noted that the criterion is a regulatory

    requirement imposed by state insurance commissioners that is subject to

    change, and that a state could not change this regulatory requirement

    without converting the financial guaranty policy into a swap or

    security-based swap.\84\ One commenter stated that the acceleration of

    payments criterion has been the subject of significant analysis and

    interpretation by state insurance regulators, and including the

    requirement in the rules could result in conflicting interpretations

    and additional legal uncertainty.\85\ This commenter also stated that

    this uncertainty will impose significant burdens on financial guaranty

    insurers that insure municipal bonds.\86\

    ---------------------------------------------------------------------------

    \81\ See Letter from Bruce E. Stern, Chairman, Association of

    Financial Guaranty Insurers (``AFGI''), dated July 20, 2011 (``AFGI

    Letter''); ISDA Letter; and Letter from Kimberly M. Welsh, Vice

    President and Assistant General Counsel, Reinsurance Association of

    America (``RAA''), dated July 22, 2011 (``RAA Letter'').

    \82\ See Letter from Dennis M. Kelleher, President & CEO, Better

    Markets Inc., dated July 22, 2011 (``Better Markets Letter'').

    \83\ See ISDA Letter and RAA Letter.

    \84\ Id.

    \85\ See AFGI Letter.

    \86\ Id. The commenter argued that these burdens would (a)

    increase instability in the currently fragile municipal bond market

    and (b) decrease the availability or attractiveness of bond

    insurance to municipal issuers that would otherwise save money by

    employing bond insurance. The Commissions understand that only one

    member of AFGI is currently active in the municipal bond insurance

    market.

    ---------------------------------------------------------------------------

    The Commissions are retaining the requirement that acceleration be

    at the sole option of the provider of the financial guaranty insurance

    policy in the Product Test. In response to commenter concerns, the

    Commissions are clarifying that they plan to interpret the acceleration

    limitation in accordance with applicable state law to the extent that

    it does not contradict the Commissions' rules, interpretations and/or

    guidance regarding what is a swap or security-based swap.\87\ The

    Commissions continue to believe that, for purposes of further defining

    swaps and security-based swaps, this criterion is useful to distinguish

    between financial guaranty insurance on the one hand, and swaps and

    security-based swaps, such as CDS, on the other because, as discussed

    above, the latter generally requires payment of the relevant settlement

    amount on the CDS after demand by the protection buyer.

    ---------------------------------------------------------------------------

    \87\ One commenter noted that ``financial guarantors, for some

    time and in full compliance with state insurance laws, have issued

    insurance policies that contemplate acceleration upon events

    unrelated to an issuer default, e.g., upon the downgrade of the

    insurer.'' See AFGI Letter. In response to this comment, the

    Commissions note that the acceleration requirement in the Product

    Test refers only to ``payment default or insolvency of the obligor''

    (emphasis added), without precluding other triggers.

    ---------------------------------------------------------------------------

    Enumerated Products

    The Commissions proposed an interpretation that certain enumerated

    types of insurance products would be outside the scope of the statutory

    definitions of swap and security-based swap. Several commenters stated

    that the list of enumerated insurance products should be codified in

    order to enhance legal certainty.\88\ In particular, one commenter

    stated that it is important for the Commissions to codify the

    interpretation because the traditional insurance products included in

    the enumerated list may not satisfy the Product Test.\89\ The commenter

    also expressed concern that insurance companies and state insurance

    [[Page 48218]]

    regulators would face the possibility that the Commissions could revise

    or withdraw the interpretation in the future, with or without

    undergoing a formal rulemaking process.\90\ As noted above, in response

    to commenters' concerns, the Commissions are codifying the Enumerated

    Products in the final rules.

    ---------------------------------------------------------------------------

    \88\ See ACLI Letter; NAIC Letter; RAA Letter; AIA Letter; NAFA

    Letter; and Letter from Mark R. Thresher, Executive Vice President,

    Nationwide, dated July 19, 2011 (``Nationwide Letter'').

    \89\ See Travelers Letter.

    \90\ Id.

    ---------------------------------------------------------------------------

    One commenter further argued that the enumerated types of insurance

    products included in the list should not have to additionally satisfy

    the requirements that the person offering such product be a U.S.

    domiciled insurer and that the product be regulated in the U.S. as

    insurance.\91\ The commenter argued that this additional requirement

    would result in the Insurance Safe Harbor not applying to traditional

    insurance products offered by insurers domiciled outside of the U.S. or

    by insurers that are not organized as insurance companies. The

    Commissions are retaining the requirement that the Enumerated Products

    be provided in accordance with the Provider Test. The Commissions also

    note that, in response to commenters' concerns, the Commissions have

    revised the first prong of the Provider Test so that it is not limited

    to insurance companies or to entities that are domiciled in the U.S. A

    product that need not satisfy the Product Test must be provided in

    accordance with the Provider Test, including a requirement that

    products provided in accordance with the first prong of the Provider

    Test must be regulated as insurance.\92\

    ---------------------------------------------------------------------------

    \91\ See D&L Letter.

    \92\ See infra notes 147 and 148 and accompanying text.

    ---------------------------------------------------------------------------

    Five commenters addressed the treatment of annuities in the

    proposed interpretive guidance, with all recommending that all

    annuities be excluded from the swap and security-based definitions

    regardless of their status under the tax laws.\93\ In response to the

    comments, the Commissions are eliminating the proposed requirement that

    annuities comply with section 72 of the Internal Revenue Code in order

    to qualify as an Enumerated Product. The Commissions are persuaded that

    the proposed reference to the Internal Revenue Code is unnecessarily

    limiting and does not help to distinguish insurance from swaps and

    security-based swaps.

    ---------------------------------------------------------------------------

    \93\ See ACLI Letter; CAI Letter; MetLife Letter; Nationwide

    Letter; and RAA Letter.

    ---------------------------------------------------------------------------

    Other commenters suggested adding other products to the list of

    enumerated types of insurance products,\94\ with one suggesting that

    the Commissions' interpretation cover all transactions currently

    reportable as insurance in the provider's regulatory and financial

    reports under a state's or a foreign jurisdiction's insurance laws.\95\

    One commenter noted that the list of enumerated types of insurance

    products does not include other state-regulated products such as

    service contracts, that may not satisfy the Product Test.\96\ In

    response to requests to expand the list of enumerated products, the

    Commissions are adding fidelity bonds,\97\ disability insurance, and

    insurance against default on individual residential mortgages (commonly

    known as private mortgage insurance, as distinguished from financial

    guaranty of mortgage pools) to the list of Enumerated Products. The

    Commissions agree that these are traditional insurance products, and

    thus their inclusion in the list of Enumerated Products is appropriate.

    The Commissions have also added reinsurance (including retrocession) of

    any of the traditional insurance products to the list of Enumerated

    Products.\98\ However, the Commissions decline at this time to expand

    the list of Enumerated Products to include other types of contracts

    such as, guaranteed investment contracts (``GICs''), synthetic GICs,

    funding agreements, structured settlements, deposit administration

    contracts, immediate participation guaranty contracts, industry loss

    warrants, and catastrophe bonds.\99\ These products do not receive the

    benefit of state insurance guaranty funds; their providers are not

    limited to insurance companies. The Commissions received little detail

    on sales of these other products, and do not believe it is appropriate

    to determine whether particular complex, novel or still evolving

    products are swaps or security-based swaps in the context of a general

    definitional rulemaking. Rather these products should be considered in

    a facts and circumstances analysis. With respect to GICs, the

    Commissions have published a request for comment regarding the study of

    stable value contracts. \100\

    ---------------------------------------------------------------------------

    \94\ See ACLI Letter; AIA Letter; CAI Letter; D&L Letter; NAIC

    Letter; Letter from Michael A. Bell, Senior Counsel, Financial

    Policy, RAA Letter; and Letter from Robert J. Duke, The Surety &

    Fidelity Association of America (``SFAA''), dated July 13, 2011

    (``SFAA Letter''). ACLI, CAI and RAA requested the addition of other

    types of annuity and pension plan products, such as group annuity

    contracts, guaranteed investment contracts, funding agreements,

    structured settlements, deposit administration contracts, and

    immediate participation guarantee contracts. D&L requested the

    addition of reinsurance of any of the enumerated types of

    traditional insurance products. NAIC requested the addition of

    mortgage guaranty, accident, and disability insurance. SFAA request

    the addition of surety and fidelity bonds.

    \95\ See Letter from J. Stephen Zielezienski, Senior Vice

    President & General Counsel, American Insurance Association

    (``AIA''), dated July 22, 2011 (``AIA Letter'').

    \96\ See NAIC Letter. The Commissions note that service

    contracts, although regulated as insurance in some states, comprise

    consumer warranties, extended service plans, and buyer protection

    plans of the sort purchased with major appliances, electronics, and

    the like. The Commissions are addressing these contracts in their

    interpretation regarding consumer/commercial transactions. See infra

    part II.B.3.

    \97\ SFAA requested that the Commissions issue specific guidance

    that surety and fidelity bonds are insurance products rather than

    swaps, noting that all states include surety and fidelity bonds as

    lines of insurance subject to state oversight. Surety bonds were

    already included in the list of enumerated insurance products

    contained in the Proposing Release.

    \98\ See supra note 41 and accompanying text.

    \99\ See, e.g., RAA Letter; CAI Letter; Letter from Ian K.

    Shepherd, Managing Director, Alice Corp. Pty Ltd (``Alice Corp.''),

    dated July 22, 2011. Alice Corp. stated that industry loss warrants

    are a contingent instrument with a somewhat illiquid secondary

    market but ``are currently treated as a reinsurance product and

    require an insurable interest.'' Alice Corp. also stated that

    ``[c]atastrophe bonds may reference a specific insured portfolio or

    a set of parameters and may be traded in a secondary market and

    behave like a coupon bond if there is no triggering event but have a

    contingent element since some or all of the principal may be lost if

    the referenced event or loss occurs.'' Id. The Commissions note that

    catastrophe bonds are ``securities'' under the Federal securities

    laws and decline to provide an interpretation regarding industry

    loss warrants because it is inappropriate to determine whether a

    complex and novel product is a swap or a security-based swap in a

    general definitional rulemaking.

    \100\ See Acceptance of Public Submissions Regarding the Study

    of Stable Value Contracts, 76 FR 53162 (Aug. 25, 2011).

    ---------------------------------------------------------------------------

    Reliance on State Law Concepts

    Two commenters noted that the Product Test relies on concepts

    derived from state law, such as ``insurable interest'' and

    ``indemnification for loss,'' which do not have uniform

    definitions.\101\ This would require the

    [[Page 48219]]

    Commissions to analyze state insurance law, as well as to determine

    which state law should apply.\102\ One of these commenters also

    requested that such concepts be applied consistently with the

    historical interpretation by the applicable state.\103\

    ---------------------------------------------------------------------------

    \101\ See ACLI Letter and AFGI Letter. Some states define

    concepts such as ``insurable interest'' in statute; in other states

    definitions have developed through common law. The Commissions

    recognize that the terms denoting such concepts may vary from state

    to state; for instance, what one state calls an ``insurable

    interest'' may be referred to as a ``material interest'' in another.

    See, e.g., New York Insurance Law Section 1101 (``material

    interest''). The Commissions believe, however, that both the

    concepts and their labels are well understood by insurance

    professionals and that any such variations would not impede market

    participants from interpreting or applying the final rules. Indeed,

    one commenter acknowledged this and applied the concepts, labeled

    differently, to particular products. ``The terms used in the rule's

    criteria are different from the terms used with respect to a surety

    bond. For example, the bond is generally not referred to as a

    `policy.' In addition, the beneficiary of a bond typically is known

    as the `obligee.' Further, the bond's limit is referred to as the

    `penal sum.' Nevertheless, the criteria can be applied to surety

    bonds and fidelity bonds, and such application would exclude bonds

    from the statutory definition of swaps.'' See SFAA Letter.

    \102\ See ACLI Letter and AFGI Letter.

    \103\ See AFGI Letter.

    ---------------------------------------------------------------------------

    State law differences regarding these concepts should not impede

    the ability of market participants from interpreting or applying the

    final rules to distinguishing between insurance and swaps or security-

    based swaps, and thus the Commissions are retaining these concepts in

    the Product Test. The Commissions intend to interpret these concepts

    consistently with the existing and developing laws of the relevant

    state(s) governing the agreement, contract, or transaction in question.

    However, the Commissions note their authority to diverge from state law

    if the Commissions become aware of evasive conduct.\104\

    ---------------------------------------------------------------------------

    \104\ The Commissions may also diverge from interpretations or

    determinations of state law based on an analysis of applicable facts

    and circumstances when determining whether a particular product is a

    swap or security-based swap.

    ---------------------------------------------------------------------------

    Inclusion of Reinsurance and Retrocession Transactions

    Several commenters suggested that the Commissions amend the Product

    Test to explicitly address reinsurance and retrocession (i.e.,

    reinsurance of reinsurance) transactions.\105\

    ---------------------------------------------------------------------------

    \105\ See ACLI Letter; CAI Letter; D&L Letter; ISDA Letter; NAFA

    Letter; Nationwide Letter; and RAA Letter. ACLI noted that the

    Product Test does not include a reference to reinsurance and that

    the ``insurable interest'' requirement under state insurance law

    generally does not apply to reinsurance products which, therefore,

    would not satisfy the Product Test. ACLI and CAI state that

    reinsurance in a chain of reinsurance also should not be considered

    a swap or security-based swap. In addition to expressly referencing

    reinsurance and retrocession transactions, ACLI believes that the

    Product Test should be expanded to include reinsurance and

    retrocession of insurance risks ceded by non-U.S. insurance

    companies to domestic insurance companies. RAA recommended adding a

    new clause to the Product Test to provide that ``[a]ny agreement,

    contract, or transaction which reinsures any agreement, contract, or

    transaction meeting the criteria of paragraph (xxx)(4)(i)(A)-(C) of

    this section is also an insurance product.''

    ---------------------------------------------------------------------------

    In response to these comments, the Commissions are clarifying that

    reinsurance and retrocession transactions may fall within the Insurance

    Safe Harbor, thus, it is unnecessary for the Product Test to be

    modified as suggested by these commenters. In addition, the Commissions

    have modified the final rules to include reinsurance (including

    retrocession) of certain types of insurance products in the list of

    Enumerated Products. Reinsurance or retrocession of these Enumerated

    Products will fall within the Insurance Safe Harbor so long as such

    reinsurance or retrocession is provided in accordance with the Provider

    Test.\106\

    ---------------------------------------------------------------------------

    \106\ See supra note 41 and accompanying text.

    ---------------------------------------------------------------------------

    Payment Based on the Price, Rate, or Level of a Financial Instrument

    In the Proposing Release, the Commissions requested comment on

    whether, in order for an agreement, contract, or transaction to be

    considered insurance under the Product Test, the Commissions should

    require that payment not be based on the price, rate, or level of a

    financial instrument, asset, or interest or any commodity. The

    Commissions also requested comment on whether variable annuity

    contracts (where the income is subject to tax treatment under section

    72 of the Internal Revenue Code) and variable life insurance should be

    excepted from such a requirement, if adopted.\107\

    ---------------------------------------------------------------------------

    \107\ See Proposing Release at 29824. See also id. at 29825,

    Request for Comment 7.

    ---------------------------------------------------------------------------

    Eight commenters stated that it is inappropriate to include such a

    requirement in the final rules because a number of traditional

    insurance products would not satisfy the requirement and suggested that

    the Commissions should instead consider whether the agreement,

    contract, or transaction transfers risk and argued that such a

    requirement is not a useful marker for distinguishing insurance from

    swaps and security-based swaps.\108\ Several commenters also believed

    that the addition to the Product Test of the criterion that payment not

    be based on the price, rate, or level of a financial instrument, asset,

    or interest or any commodity would contribute to greater legal

    uncertainty.\109\

    ---------------------------------------------------------------------------

    \108\ See ACLI Letter; AIA Letter; AFGI Letter; CAI Letter; ISDA

    Letter; NAFA Letter; NAIC Letter; and Nationwide Letter (concurring

    with ACLI's comments).

    Commenters cited several examples of products that would fail a

    requirement that payment not be based on the price, rate, or level

    of a financial instrument, asset, or interest or any commodity.

    ACLI, CAI and NAFA cited registered and unregistered variable

    annuities and variable life insurance, and certain fixed annuities

    and equity indexed annuities, stating that these could be construed

    as being based on, or related to, a price, rate or level of a

    financial asset. ACLI also cited financial guaranty insurance, and

    replacement value property and casualty insurance, where the

    insurer's payment obligation may be based on the current price of

    the insured property or adjusted to reflect inflation. ACLI and ISDA

    cited crop insurance, because it could call for payment to be based

    in some way on the market price of the covered crop on the date of

    loss. ISDA and RAA cited ``dual trigger'' insurance (such as

    replacement power insurance); property and casualty policies

    purchased by some commodity producers (e.g., oil refineries, copper

    mines) with deductibles that increase or decrease based on the price

    of the commodity that the company produces; event cancellation

    insurance that uses commodity indices to determine claims; and

    weather insurance and malpractice insurance. NAIC cited guaranteed

    investment contracts, financial guaranty insurance, and mortgage

    guaranty insurance

    \109\ See AIA Letter and AFGI Letter.

    ---------------------------------------------------------------------------

    Two commenters agreed that such a requirement should be included in

    the final rules.\110\ One commenter argued that any insurance

    instrument that provides for payment based on the price, rate, or level

    of a financial instrument, asset, or interest in any commodity is in

    substance a swap or security-based, regardless of its label, and should

    be regulated as such.\111\ One of these commenters further recommended

    that the Commissions exclude annuity and variable universal life

    insurance from this requirement because these products were investments

    with some minimal level of life insurance cover or investment guarantee

    rider on top.\112\

    ---------------------------------------------------------------------------

    \110\ See Barnard Letter and Better Markets Letter.

    \111\ See Better Markets Letter.

    \112\ See Barnard Letter.

    ---------------------------------------------------------------------------

    The Commissions are not adopting an additional requirement for the

    Product Test that payment not be based on the price, rate, or level of

    a financial instrument, asset, or interest or any commodity because the

    Commissions find the requirement to be unsuitable for distinguishing

    insurance from swaps and security-based swaps. While the provision

    might work for property and casualty insurance, as many commenters

    noted, it is not an effective distinction for a number of other

    traditional insurance products.

    Accounting Standards

    In the Proposing Release, the Commissions requested comment on

    whether the proposed rules relating to insurance should include a

    provision related to whether a product is recognized at fair value on

    an ongoing basis with changes in fair value reflected in earnings under

    U.S. generally accepted accounting principles.\113\

    ---------------------------------------------------------------------------

    \113\ See Proposing Release at 29827, Request for Comment 17.

    ---------------------------------------------------------------------------

    Three commenters argued that the proposed rules should not include

    a provision that an insurance product is recognized at fair value under

    generally accepted accounting principles.\114\ One commenter argued

    that the determinants of what is an insurance product should be the

    existence of an insurable interest, transfer of risk, and

    indemnification of covered loss.\115\ Another argued that factoring

    accounting standards into the analysis of whether a product is a swap

    [[Page 48220]]

    or insurance will introduce unnecessary complexity in most cases but

    that the examination of accounting standards would be useful in cases

    where the classification of a product as insurance or swap is

    unclear.\116\

    ---------------------------------------------------------------------------

    \114\ See AFGI Letter; D&L Letter; and ISDA Letter.

    \115\ See D&L Letter.

    \116\ See ISDA Letter.

    ---------------------------------------------------------------------------

    After considering these comments, the Commissions are not including

    a reference to accounting standards in the Product Test.

    (b) Providers of Insurance Products

    Under the first prong of the Provider Test, the agreement,

    contract, or transaction must be provided by a person that is subject

    to supervision by the insurance commissioner (or similar official or

    agency) of any state\117\ or by the United States.\118\ In addition,

    such agreement, contract, or transaction also must be regulated as

    insurance under applicable state law\119\ or the laws of the United

    States.

    ---------------------------------------------------------------------------

    \117\ See supra note 32, regarding the definition of ``State''

    contained in the Proposing Release.

    \118\ This requirement in the final rules is substantially

    similar to the requirement included in section 3(a)(8) of the

    Securities Act, 15 U.S.C. 77c(a)(8).

    \119\ See supra note 34.

    ---------------------------------------------------------------------------

    The Commissions have revised the first prong of the Provider Test

    from the proposal. As proposed, the first prong of the Provider Test

    could only be satisfied by a company that was organized as an insurance

    company whose primary and predominant business activity was the writing

    of insurance or the reinsuring of risks underwritten by insurance

    companies.\120\ The Commissions have revised this prong of the Provider

    Test to address commenters' concerns that the proposed rules would

    exclude insurers that were not organized as ``insurance companies,'' as

    well as insurers that were domiciled outside of the United States.\121\

    As adopted, the first prong of the Provider Test can be satisfied by

    any person that is subject to state or Federal insurance supervision,

    regardless of that person's corporate structure or domicile. The

    Commissions understand that, with the exception of non-admitted

    insurers,\122\ foreign insurers are subject to supervision in the

    states in which they offer insurance products. The treatment of non-

    admitted insurers is addressed in the fourth prong of the Provider

    Test.

    ---------------------------------------------------------------------------

    \120\ See Proposing Release at 29824.

    \121\ See infra notes 139, 140, and 141 and accompanying text.

    \122\ The Commissions understand that the surplus lines brokers

    who place insurance on behalf of non-admitted insurers are subject

    to supervision in the states in which they offer non-admitted

    insurance products.

    ---------------------------------------------------------------------------

    The Commissions believe that the requirement that the agreement,

    contract, or transaction be provided by a person that is subject to

    state or Federal insurance supervision should help prevent regulatory

    gaps that otherwise might exist between insurance regulation and the

    regulation of swaps and security-based swaps by ensuring that products

    provided by persons that are not subject to state or Federal insurance

    supervision are not able to be offered by persons that avoid regulation

    under Title VII of the Dodd-Frank Act as well.

    The first prong of the Provider Test also requires that the

    agreement, contract, or transaction being provided is ``regulated as

    insurance'' under applicable state law or the laws of the United

    States. As stated in the Proposing Release, the purpose of this

    requirement is that an agreement, contract, or transaction that

    satisfies the other conditions of the final rules must be subject to

    regulatory oversight as an insurance product. The Commissions believe

    that this condition will help prevent products that are not regulated

    as insurance in the states in which they are offered, and that are

    swaps or security-based swaps, from being characterized as insurance

    products in order to evade the regulatory regime under Title VII of the

    Dodd-Frank Act. As noted by commenters,\123\ the Commissions recognize

    that the ``regulated as insurance'' limitation means that it is

    possible that a particular product that may not be regulated as

    insurance in a particular state may not qualify for the Insurance Safe

    Harbor.\124\

    ---------------------------------------------------------------------------

    \123\ See infra notes 145 and 146 and accompanying text.

    \124\ See infra notes 147 and 148 and accompanying text.

    ---------------------------------------------------------------------------

    As stated in the Proposing Release, the Commissions believe that it

    is appropriate to exclude, from regulation under Title VII, insurance

    that is issued by the United States or any of its agencies or

    instrumentalities, or pursuant to a statutorily authorized program

    thereof, from regulation as swaps or security-based swaps.\125\ Such

    insurance includes, for example, Federal insurance of funds held in

    banks, savings associations, and credit unions; catastrophic crop

    insurance; flood insurance; Federal insurance of certain pension

    obligations; and terrorism risk insurance. At the request of

    commenters,\126\ the Commissions are persuaded that it is also

    appropriate to provide a similar exclusion to insurance that is issued

    by a state or any of its agencies or instrumentalities, or pursuant to

    a statutorily authorized program thereof. Accordingly, the Commissions

    have revised the second prong of the Provider Test to provide that

    products meeting the Product Test are excluded from the swap and

    security-based swap definitions if they are provided (i) directly or

    indirectly by the Federal government or a state or (ii) pursuant to a

    statutorily authorized program of either.\127\

    ---------------------------------------------------------------------------

    \125\ See Proposing Release at 29824.

    \126\ See Ex Parte Communication between NAIC and CFTC and SEC

    Staff on October 5, 2011, at http://sec.gov/comments/s7-16-11/s71611-61.pdf.

    \127\ The Commissions understand that certain types of Federal

    and State insurance programs, including crop insurance, are

    administered by third parties; as a result, the Commissions have

    added ``directly or indirectly'' to the second prong of the Provider

    Test to clarify that it can be satisfied even if the agreement,

    contract, or transaction is not provided directly by the federal

    government or a state. See Id.

    ---------------------------------------------------------------------------

    As stated in the Proposing Release, the Commissions believe that

    where an agreement, contract, or transaction qualifies for the safe

    harbor and therefore is considered insurance excluded from the swap and

    security-based swap definitions, the lawful reinsurance of that

    agreement, contract, or transaction similarly should be excluded.\128\

    Accordingly, the Commissions are adopting the third prong of the

    Provider Test as proposed, with certain modifications, to provide that

    an agreement, contract, or transaction of reinsurance will be excluded

    from the swap and security-based swap definitions, provided that: (i)

    The person offering such reinsurance is not prohibited by applicable

    state law or the laws of the United States from offering such

    reinsurance to a person that satisfies the Provider Test; (ii) the

    agreement, contract, or transaction to be reinsured meets the

    requirements under the Product Test or is one of the Enumerated

    Products; and (iii) except as otherwise permitted under applicable

    state law, the total amount reimbursable by all reinsurers for such

    insurance product cannot exceed the claims or losses paid by the

    cedant.

    ---------------------------------------------------------------------------

    \128\ See Proposing Release at 29825.

    ---------------------------------------------------------------------------

    In response to commenters' concerns,\129\ the Commissions have

    revised the third prong of the Provider Test from that contained in the

    Proposing Release. As adopted, the third prong of the Provider Test

    encompasses all reinsurers wherever incorporated or organized, and not

    just those based outside of the United States. The Commissions also

    have revised the third prong of the Provider Test to clarify that the

    total amount reimbursable by all reinsurers may not exceed the claims

    or losses paid by the cedant, unless otherwise permitted by applicable

    state law. It is not the Commissions' intent to

    [[Page 48221]]

    impose requirements that conflict with state law regarding the

    calculation of amounts reimbursable under reinsurance contracts.

    ---------------------------------------------------------------------------

    \129\ See infra notes 150, 151, 152, and 153 and accompanying

    text.

    ---------------------------------------------------------------------------

    The Commissions have added a fourth prong to the Provider Test to

    address commenters' concerns that the proposed Provider Test excluded

    entities issuing insurance products on a non-admitted basis through

    surplus lines brokers.\130\ Non-admitted insurance is typically

    property and casualty insurance that is permitted to be placed through

    a surplus lines broker \131\ by an insurer that is not licensed to do

    business in the state where the product is offered.\132\ In practice, a

    provider of non-admitted insurance may not satisfy the first prong of

    the Provider Test because it may not be subject to state or Federal

    insurance supervision. The Commissions understand that non-admitted

    insurance plays a very important role in the insurance marketplace. In

    addition, Congress has explicitly recognized non-admitted insurance

    products as insurance and specified that a state cannot prohibit

    certain types of entities from offering non-admitted insurance

    products.\133\ Because Congress recognized that certain persons qualify

    as non-admitted insurers, the Commissions find that it is appropriate

    to add the fourth prong to the Provider Test.

    ---------------------------------------------------------------------------

    \130\ See infra note 146 and accompanying text.

    \131\ For the purposes of this release, the term ``surplus lines

    broker'' means an individual, firm, or corporation that is licensed

    in a state to sell, solicit, or negotiate insurance on properties,

    risks, or exposures located or to be performed in a state with non-

    admitted insurers.

    \132\ See supra note 39. With respect to domestic reinsurance,

    state insurance regulators do retain the authority to prevent or

    allow a non-admitted company from participating in a state market.

    Some states compile a list of companies that may sell as non-

    admitteds; other states list non-admitted companies that may not

    sell.

    \133\ See Subtitle B of Title V of the Dodd-Frank Act.

    ---------------------------------------------------------------------------

    A person will qualify under the fourth prong of the Provider Test

    if it satisfies any one of the following two requirements:

    It is located outside of the United States and listed on

    the Quarterly Listing of Alien Insurers that is compiled and maintained

    by the International Insurers Department of the National Association of

    Insurance Commissioners;\134\ or

    ---------------------------------------------------------------------------

    \134\ Section 524 of the Nonadmitted and Reinsurance Reform Act

    of 2010 (15 U.S.C. 8204) provides that a state cannot prohibit a

    surplus lines broker from placing non-admitted insurance with a non-

    admitted insurer that is listed on the Quarterly Listing of Alien

    Insurers. According to the NAIC the non-admitted alien insurers

    whose names appear in the Quarterly Listing of Alien Insurers have

    filed financial statements, copies of auditors' reports, the names

    of their U.S. attorneys or other representatives, and details of

    U.S. trust accounts with the NAIC's International Insurers

    Department and, based upon those documents and other information,

    appear to fulfill the criteria set forth in the International

    Insurers Department Plan of Operation for Listing of Alien

    Nonadmitted Insurers.

    ---------------------------------------------------------------------------

    It meets the eligibility criteria for non-admitted

    insurers under applicable state law.

    Comments

    General

    The Commissions received ten comment letters that addressed the

    Provider Test.\135\ A few commenters recommended that the Commissions

    retract the Provider Test.\136\ These commenters argued that if a

    product is subject to regulation as insurance in the United States, the

    regulated status of the insurer is irrelevant.\137\ The Commissions are

    retaining the Provider Test with modifications as discussed above. The

    Commissions believe that insurance products should fall outside the

    swap or security-based swap definitions only if they are offered by

    persons subject to state or Federal insurance supervision or by certain

    reinsurers.\138\ The Provider Test will help to prevent products that

    are swaps or security-based swaps from being characterized as insurance

    in order to evade the regulatory regime under Title VII of the Dodd-

    Frank Act. Other commenters suggested various modifications to the

    Provider Test and those comments are discussed in more detail below.

    ---------------------------------------------------------------------------

    \135\ See ACLI Letter; AIA Letter; CAI Letter; D&L Letter; ISDA

    Letter; NAIC Letter; NAFA Letter; Nationwide Letter; RAA Letter; and

    Travelers Letter.

    \136\ See AIA Letter; D&L Letter; and ISDA Letter.

    \137\ Id.

    \138\ See infra notes 147 and 148 and accompanying text.

    ---------------------------------------------------------------------------

    ``Insurance Company'' Limitation

    Several commenters recommended that the Commissions expand the

    first prong of the Provider Test so that it is not limited to

    ``insurance companies,'' but to all insurers because not all insurers

    are organized as ``insurance companies,''\139\ to accommodate insurers

    and reinsurers that are domiciled outside of the United States,\140\

    and to cover domestic and foreign insurance companies and other

    entities that issue insurance products on a non-admitted basis through

    surplus lines brokers.\141\

    ---------------------------------------------------------------------------

    \139\ See AIA Letter; D&L Letter; ISDA Letter; RAA Letter; NAIC

    Letter; and Travelers Letter.

    \140\ See AIA Letter; D&L Letter; RAA Letter; and Travelers

    Letter.

    \141\ See RAA Letter and Travelers Letter.

    ---------------------------------------------------------------------------

    The Commissions have revised the first prong of the Provider Test

    to remove the ``insurance company'' limitation and to clarify that any

    person that is subject to state or Federal insurance supervision will

    qualify under the first prong of the Provider Test. As noted above, the

    Commissions also believe that this revision should address commenters'

    concerns that the proposed rules could have excluded some foreign

    insurers since the revised test does not require that a person be

    domiciled in the United States; it only requires that the person be

    subject to state or Federal insurance supervision.

    Several commenters suggested that the proposed Provider Test would

    permit an insurer that is not organized as an insurance company to

    evade state insurance oversight by deliberately failing the exemption

    for insurance products (that is, by issuing a contract that would fail

    the proposed rules because it would not be issued by an insurance

    company).\142\ These commenters were concerned that if a product were

    to be considered a swap merely because it was not issued by an

    insurance company, this would render the regulation of such products

    outside of the scope of state insurance laws due to the Federal

    preemption of swaps regulation.\143\ Commenters noted that a likely

    consequence of this preemption would be that the same product would be

    subject to substantially different regulation within a state's

    jurisdiction based solely on the nature of the issuing person.\144\

    ---------------------------------------------------------------------------

    \142\ See ACLI Letter; CAI Letter; NAFA Letter; Nationwide

    Letter; RAA Letter; and Travelers Letter.

    \143\ Id.

    \144\ Id.

    ---------------------------------------------------------------------------

    The Commissions have revised the first prong of Provider Test to

    address commenters' concerns that providers of insurance products could

    evade state insurance regulation by intentionally failing the Provider

    Test, i.e., marketing the insurance products as swaps or security-based

    swaps in order to avoid state insurance supervision. As adopted, any

    person that provides insurance products (and therefore should be

    subject to state or Federal insurance supervision) must, in fact, be

    subject to state or Federal insurance supervision in order to satisfy

    the first prong of the Provider Test. Persons that are organized as

    insurance companies or whose business activity is predominantly

    insurance or reinsurance, but who are not in fact subject to state or

    Federal insurance supervision, would not satisfy the first prong of the

    Provider Test.

    Finally, as discussed below, the Commissions have added a fourth

    prong

    [[Page 48222]]

    to the Provider Test to provide relief for persons that provide

    insurance products on a non-admitted basis through surplus lines

    brokers.

    ``Regulated as Insurance'' Limitation

    Two commenters recommended that the Commissions remove the

    provision in the first prong of the Provider Test that states ``and

    such agreement, contract, or transaction is regulated as insurance

    under the laws of such state or of the United States.''\145\ These

    commenters argued that the provision should be deleted because it was

    redundant with the Product Test and may exclude certain reinsurers and

    non-admitted insurers, as well as products that may not be specifically

    ``regulated as insurance'' in all states.\146\

    ---------------------------------------------------------------------------

    \145\ See RAA Letter and Travelers Letter.

    \146\ Id. These commenters also recommended the addition of a

    new prong to the Provider Test to cover domestic or foreign entities

    that issue insurance products on a non-admitted basis through

    surplus lines brokers. See discussion below. The Commissions note

    that the first prong of the Provider Test does not apply to

    reinsurance contracts and the third prong of the Provider Test,

    which does apply to reinsurance contracts, does not contain the

    ``regulated as insurance'' limitation.

    ---------------------------------------------------------------------------

    The Commissions have retained the requirement in the first prong of

    the Provider Test that an insurance product must be regulated as

    insurance, but have revised the provision to clarify that an insurance

    product must be regulated as insurance under applicable state law or

    the laws of the United States. As discussed above, the Commissions

    believe that this condition will help prevent products that are not

    regulated as insurance and are swaps or security-based swaps from being

    characterized as insurance products in order to evade the regulatory

    regime under the Dodd-Frank Act.

    The Commissions have received conflicting comments regarding

    whether surety bonds are currently offered by persons who do not

    satisfy the Provider Test, in particular the ``regulated as insurance''

    requirement.\147\ If a person who does not satisfy the Provider Test

    sells a surety bond incidental to other business activity and is not

    subject to state or Federal insurance supervision, it does not mean

    that such surety bond is a swap or security-based swap. The surety bond

    may not satisfy the Insurance Safe Harbor, but it would be subject to a

    facts and circumstances analysis. Similarly, one commenter indicated

    that title insurance is not always subject to state insurance

    regulation.\148\ Title insurance sold in a state that does not regulate

    title insurance as insurance would be in the list of Enumerated

    Products but would not satisfy the Provider Test and, thus would not

    qualify for the Insurance Safe Harbor. However, this does not mean that

    title insurance sold in a state that does not regulate title insurance

    as insurance is a swap or security-based swap. The title insurance may

    not satisfy the Insurance Safe Harbor, but it would be subject to a

    facts and circumstances analysis. The Commissions anticipate that many

    factors would militate against a determination that such a surety bond

    or title insurance that fails the Provider Test, because it cannot meet

    the ``regulated as insurance'' requirement, is a swap or security-based

    swap rather than insurance.

    ---------------------------------------------------------------------------

    \147\ See SFAA Letter. SFAA stated that all states include

    surety and fidelity bonds as lines of insurance subject to state

    oversight. However, Travelers stated that surety bonds may not be

    ``specifically'' regulated as insurance. See Travelers Letter.

    \148\ See ACLI Letter.

    ---------------------------------------------------------------------------

    The Commissions agree that the inclusion of the ``regulated as

    insurance'' requirement in the first prong of the Provider Test will

    have the effect of causing non-admitted insurance products to fall

    within the swap and security-based swap definitions. In response to

    commenters' concerns about the ability of non-admitted insurers to

    qualify under the Provider Test, the Commissions have added a fourth

    prong to the Provider Test to address providers of non-admitted

    insurance products.\149\

    ---------------------------------------------------------------------------

    \149\ See supra notes 130, 131, and 132 and accompanying text.

    ---------------------------------------------------------------------------

    Providers of Reinsurance

    Several commenters recommended that the Commissions expand the

    third prong of the Provider Test to include domestic reinsurers.\150\

    One commenter requested that the Commissions remove the third prong of

    the Provider Test from the final rules because it appears to prohibit a

    reinsurer from offering a product in a state where it is permitted if

    any other state prohibits that product.\151\ Two commenters requested

    revisions to the portion of the third prong of the Provider Test that

    addresses a cedant's reimbursable losses.\152\ One commenter argued

    this portion of the third prong of the Provider Test may conflict with

    the state-based insurance receivership law.\153\

    ---------------------------------------------------------------------------

    \150\ See ACLI Letter; CAI Letter; NAIC Letter; and RAA Letter.

    \151\ See RAA Letter. The commenter argued that one state's

    prohibition on a reinsurance product should not affect the ability

    of the reinsurer to offer the product in a state where it is

    permitted.

    \152\ See RAA Letter and Travelers Letter. Both commenters

    suggested specific edits to the proposed rules.

    \153\ See RAA Letter. RAA stated that in an insurance

    receivership reinsurers are required to comply with the reinsurance

    contract and pay all amounts due and owing to the estate of the

    insolvent cedant even if the estate of the cedant may not

    necessarily pay the full amount of the underlying claims to the

    applicable policyholders.

    ---------------------------------------------------------------------------

    As noted above, the Commissions have revised the third prong of the

    Provider Test to remove the limitation that a reinsurance provider has

    to be located outside of the United States, and thereby address

    commenters' concerns that domestic reinsurers would not qualify under

    the reinsurance prong. In addition, in response to commenters'

    concerns, the Commissions have clarified the third prong of the

    Provider Test so that it does not prohibit a reinsurer from offering a

    product in a state where it is permitted, even if that product is

    prohibited in another state, and have revised the portion of the third

    prong of the Provider Test that addresses a cedant's reimbursable

    losses to make it subject to applicable state law so that it does not

    conflict with state-based insurance receivership law.

    (c) Grandfather Provision for Existing Insurance Transactions

    In the Proposing Release, the Commissions asked whether the

    proposed rules should include a provision similar to section 302(c)(1)

    of the Gramm-Leach-Bliley Act that any product regulated as insurance

    before the date the Dodd-Frank Act was signed into law and provided in

    accordance with the Provider Test would be considered insurance and not

    fall within the swap or security-based swap definitions.

    In response to comments,\154\ the Commissions are adding a new

    paragraph (ii) to rule 1.3(xxx)(4) under the CEA and new paragraph (b)

    to rule 3a69-1 under the Exchange Act that provides that an agreement,

    contract, or transaction entered into on or before the effective date

    of the Product Definitions will be considered insurance and not fall

    within the swap and security-based swap definitions, provided that, at

    such time it was entered into, such agreement, contract, or transaction

    was provided in accordance with the Provider Test (the ``Insurance

    Grandfather'').

    ---------------------------------------------------------------------------

    \154\ See infra notes 157, 158, 159, and 160 and accompanying

    text.

    ---------------------------------------------------------------------------

    As stated in the Proposing Release, the Commissions are aware of

    nothing in Title VII to suggest that Congress intended for traditional

    insurance products to be regulated as swaps or security-based

    swaps.\155\ The

    [[Page 48223]]

    Commissions have designed the Insurance Safe Harbor to provide greater

    assurance to market participants that traditional insurance products

    that were regulated as insurance prior to the Dodd-Frank Act will fall

    outside the swap and security-based swap definitions. Nevertheless,

    after considering comments received, the Commissions believe that it is

    appropriate to adopt the Insurance Grandfather in order to assure

    market participants that those agreements, contracts, or transactions

    that meet the conditions set out in the Insurance Grandfather will not

    fall within the swap or security-based swap definitions.

    ---------------------------------------------------------------------------

    \155\ See Proposing Release at 29821.

    ---------------------------------------------------------------------------

    In order to qualify for the Insurance Grandfather an agreement,

    contract, or transaction must meet two requirements. First, it must be

    entered into on or before the effective date of the Product

    Definitions. The Commissions are linking the Insurance Grandfather to

    the effective date of the Product Definitions, rather than the date

    that the Dodd-Frank Act was signed into law, in order to avoid

    unnecessary market disruption.\156\ Second, such agreement, contract,

    or transaction must be provided in accordance with the Provider Test.

    In other words, the provider must be subject to state or Federal

    insurance supervision or be a non-admitted insurer or a reinsurer that

    satisfies the conditions for non-admitted insurers and reinsurers that

    are set out in the Provider Test. The Commissions note that an

    agreement, contract or transaction that is provided in accordance with

    the first prong of the Provider Test must also be regulated as

    insurance under applicable state law or the laws of the United States.

    ---------------------------------------------------------------------------

    \156\ The Commissions believe that 60 days after publication of

    this release should be sufficient time for market participants to

    enter into pending agreements, contracts, or transactions for which

    the Insurance Grandfather may provide relief.

    ---------------------------------------------------------------------------

    By adopting the Insurance Grandfather and the Insurance Safe

    Harbor, the Commissions are excluding agreements, contracts, and

    transactions for which the Commissions have found no evidence that

    Congress intended them to be regulated as swaps or security-based

    swaps, and are providing greater certainty regarding the treatment of

    agreements, contracts, and transactions currently regulated as

    insurance.

    Comments

    Four commenters addressed whether the final rules should include a

    grandfather provision that would exclude certain insurance products

    from the swap or security-based swap definitions.\157\ Two commenters

    suggested that a grandfather provision for all products that were

    regulated as insurance before the Dodd-Frank Act was signed into law

    would be appropriate, stating that it would reduce confusion and

    uncertainty in applying the swap and security-based swap definitions to

    products that are traditionally regulated as insurance while addressing

    the Commissions' stated concern that products might be structured as

    insurance products to evade Dodd-Frank Act requirements.\158\ These

    commenters also stated that it is necessary to add an effective date-

    based grandfather provision to the final rule providing that any

    contract or transaction subject to state insurance regulation and

    entered into prior to any final rules necessary to implement Title VII,

    including the Product Definitions, are not swaps or security-based

    swaps.\159\ These commenters noted that a grandfather provision based

    on effective date of all the Title VII rules was needed to address

    product development and variation that occurred between the date the

    Dodd-Frank Act was enacted and the effective date of the rules mandated

    under that statute.\160\

    ---------------------------------------------------------------------------

    \157\ See ACLI Letter; AFGI Letter; CAI Letter; and D&L Letter.

    \158\ See ACLI Letter and CAI Letter. ACLI and CAI argued that

    products that were regulated as insurance prior to the effective

    date of the Dodd-Frank Act clearly were not characterized as

    insurance to avoid the Title VII regulatory regime. See also AFGI

    Letter; AFGI argued that all insurance contracts issued by state-

    regulated insurance companies should be excluded from the swap

    definition but in the alternative, all insurance products regulated

    as insurance before July 21, 2010 should be grandfathered. See also

    D&L Letter. D&L stated that prior regulation of insurance products

    before July 21, 2010 could be a consideration, but not an absolute

    determinant for exclusion from the swap or security-based swap

    definitions.

    \159\ See ACLI Letter and CAI Letter.

    \160\ Id.

    ---------------------------------------------------------------------------

    The Commissions believe that the combination of the Insurance

    Grandfather along with the Insurance Safe Harbor provides market

    participants with increased legal certainty with respect to existing

    agreements, contracts, transactions, and products. In addition, the

    fact that the Commissions are linking the Insurance Grandfather to the

    effective date of the Product Definitions, rather than the date that

    the Dodd-Frank Act was signed into law, takes into account product

    development and innovation that may have occurred between the date the

    Dodd-Frank Act was signed into law at the effective date of the Product

    Definitions. Further, the Commissions believe that a grandfather

    provision that would exclude all products regulated as insurance before

    the Dodd-Frank Act was signed into law, as recommended by some

    commenters,\161\ is unnecessary because non-grandfathered regulated

    insurance transactions generally should fall within the Insurance Safe

    Harbor. The Commissions believe that market participants could be

    incentivized to use such a broader grandfather provision to create new

    swap or security-based swap products with characteristics similar to

    those of existing categories of regulated insurance contracts for the

    purpose of evading the Dodd-Frank Act regulatory regime. The

    Commissions also believe that a broader grandfather provision would be

    contrary to the explicit direction of sections 722(b) and 767 of the

    Dodd-Frank Act which provide that swaps and security-based swaps may

    not be regulated as insurance contracts by any state.\162\

    ---------------------------------------------------------------------------

    \161\ See ACLI Letter; AGFI Letter; and CAI Letter.

    \162\ Section 722(b) of the Dodd-Frank Act provides, (B)

    Regulation of Swaps Under Federal and State Law.--Section 12 of the

    Commodity Exchange Act (7 U.S.C. 16) is amended by adding at the end

    the following: ``(h) Regulation of Swaps as Insurance Under Federal

    and State Law.--A swap--(1) Shall not be considered to be insurance;

    and (2) may not be regulated as an insurance contract under the law

    of any State.'' Section 767 of the Dodd-Frank Act amended section

    28(a) of the Exchange Act, 15 U.S.C. 78bb(a), to provide, ``A

    security-based swap may not be regulated as an insurance contract

    under any provision of State law.''

    ---------------------------------------------------------------------------

    One commenter argued that the Provider Test should not apply to

    grandfathered contracts. The commenter stated that it should be enough

    that the product is regulated as insurance.\163\ As described above,

    the grandfather provision will apply only to agreements, contracts, and

    transactions that are entered into prior to the effective date of the

    Product Definitions if they were provided in accordance with the

    Provider Test, including a requirement that an agreement, contract or

    transaction that is provided in accordance with the first prong of the

    Provider Test must be regulated as insurance under applicable State law

    or the laws of the United States. As the Commissions discussed in the

    Proposing Release, and above in describing the Provider Test, the

    Commissions believe the requirement that the agreement, contract, or

    transaction be provided in accordance with the Provider Test should

    help ensure that persons who are not subject to state or Federal

    insurance supervision are not able to avoid the oversight

    [[Page 48224]]

    provided for under Title VII of the Dodd-Frank Act.

    ---------------------------------------------------------------------------

    \163\ See CAI Letter. CAI suggested that for a product to be

    regulated as insurance it means that it was provided by an insurance

    company. See supra part II.B.1.b) for a discussion of the need for

    the Provider Test portion of the Insurance Safe Harbor.

    ---------------------------------------------------------------------------

    (d) Alternative Tests

    A number of commenters proposed that the Commissions adopt

    alternative tests to distinguish insurance from swaps and security-

    based swaps.\164\ After considering each of these alternatives, the

    Commissions are not adopting them.

    ---------------------------------------------------------------------------

    \164\ See ACLI Letter; AIA Letter; AFGI Letter; CAI Letter;

    MetLife Letter; NAFA Letter; NAIC Letter; Nationwide Letter; and

    Travelers Letter.

    ---------------------------------------------------------------------------

    Several commenters suggested that the sole test for determining

    whether an agreement, contract, or transaction is insurance should be

    whether it is subject to regulation as insurance by the insurance

    commissioner of the applicable state(s).\165\ The Commissions find this

    alternative to be unworkable because it does not provide a sufficient

    means to distinguish agreements, contracts and transactions that are

    insurance from those that are swaps or security-based swaps. Section

    712(d) of the Dodd-Frank Act directs the Commissions to ``further

    define'' the terms swap and security-based swap. Neither swaps nor

    security-based swaps may be regulated as insurance contracts under the

    laws of any state.\166\ While insurance contracts have long been

    subject to state regulation, swaps and security-based swaps were

    largely unregulated. Since the Dodd-Frank Act created a new regulatory

    regime for swaps and specifically provides that ``swaps may not be

    regulated as an insurance contract under the law of any state,\167\ the

    Commissions believe that it is important to have a test that

    distinguishes insurance from swaps and security-based swaps without

    relying entirely on the regulatory environment prior to the enactment

    of the Dodd-Frank Act. The Product Test is an important element of the

    Insurance Safe Harbor.

    ---------------------------------------------------------------------------

    \165\ See ACLI Letter; AIA Letter; AFGI Letter; MetLife Letter;

    and Travelers Letter.

    \166\ See section 12(h) of the CEA, 7 U.S.C. 16(h) (regarding

    swaps) and section 28(a)(4) of the Exchange Act, 15 U.S.C.

    78bb(a)(4) (regarding security-based swaps).

    \167\ See section 12(h)(2) of the CEA, 7 U.S.C. 16(h)(2).

    ---------------------------------------------------------------------------

    Several commenters suggested an approach in which insurance

    products that qualify for the exclusion contained in section 3(a)(8) of

    the Securities Act\168\ would be excluded from the swap

    definition.\169\ One commenter argued that ``Section 3(a)(8) has long

    been recognized as the definitive provision as to where Congress

    intends to separate securities products that are subject to SEC

    regulation from `insurance' and `annuity' products that are to be left

    to state insurance regulation'' and that the section 3(a)(8) criteria

    are well understood and have a long history of interpretation by the

    SEC and the courts.\170\ Other commenters suggest that because section

    3(a)(8) includes both a product and a provider requirement, if the

    Commissions include it in their final rules, it should be a requirement

    separate from the Product Test and the Provider Test, and should extend

    to insurance products that are securities.\171\

    ---------------------------------------------------------------------------

    \168\ Section 3(a)(8) of the Securities Act excludes the

    following from all provisions of the Securities Act: Any insurance

    or endowment policy or annuity contract or optional annuity

    contract, issued by a corporation subject to the supervision of the

    insurance commissioner, bank commissioner, or any agency or officer

    performing like functions, of any State or Territory of the United

    States or the District of Columbia.

    See infra note 1283 and accompanying text.

    \169\ See ACLI Letter; CAI Letter; NAFA Letter; and Nationwide

    Letter.

    \170\ See NAFA Letter.

    \171\ See ACLI Letter and CAI Letter.

    ---------------------------------------------------------------------------

    While the Commissions agree that the section 3(a)(8) criteria have

    a long history of interpretations by the SEC and the courts, the

    Commissions find that it is inappropriate to apply the section 3(a)(8)

    criteria in this context. Although section 3(a)(8) contains some

    conditions applicable to insurance providers that are similar to the

    prongs of the Provider Test, it does not contain any conditions that

    are similar to the prongs of the Product Test. Moreover, section

    3(a)(8) provides an exclusion from the Securities Act and the CFTC has

    no jurisdiction under the Federal securities laws. Congress directed

    both agencies to further define the terms ``swap'' and ``security-based

    swap.'' As such, the Commissions find that it is more appropriate to

    have a standalone rule that incorporates features that distinguish

    insurance products from swaps and security-based swaps and over which

    both Commissions will have joint interpretative authority.

    One commenter suggested yet another approach, recommending that

    insurance be defined as an agreement, contract, or transaction that by

    its terms:

    Exists for a specified period of time;

    Where the party (the ``insured'') to the contract promises

    to make one or more payments such as money, goods or services;

    In exchange for another party's promise to provide a

    benefit of pecuniary value for the loss, damage, injury, or impairment

    of an identified interest of the insured as a result of the occurrence

    of a specified event or contingency outside of the parties' control;

    and

    Where such payment is related to a loss occurring as a

    result of a contingency or specified event.\172\

    ---------------------------------------------------------------------------

    \172\ See NAIC Letter.

    ---------------------------------------------------------------------------

    The Commissions do not find this alternative preferable to the

    Commissions' proposal for two reasons. First, the requirements of a

    specified term and the promise to make payments are present in both

    insurance products and in agreements, contracts, or transactions that

    are swaps or security-based swaps and therefore do not help to

    distinguish between them. A test based solely on these requirements,

    then, could be over-inclusive and exclude from the Dodd-Frank Act

    regulatory regime agreements, contracts, and transactions that have not

    traditionally been considered insurance. Further, the third and fourth

    requirements of this alternative test collapse into the Product Test's

    requirement that the loss must occur and be proved, and any payment or

    indemnification therefor must be limited to the value of the insurable

    interest.

    One commenter suggested a three-part test in lieu of the Product

    and Provider Tests. Under this test, the terms ``swap'' and ``security-

    based swap'' would exclude any agreement, contract, or transaction

    that:

    Is issued by a person who is or is required to be

    organized as an insurance company and subject to state insurance

    regulation;

    Is the type of contract issued by insurance companies; and

    Is not of the type that the Commissions determine to

    regulate. \173\

    ---------------------------------------------------------------------------

    \173\ See ACLI Letter (Appendix 1). See also CAI Letter. CAI

    stated that it believes that the approach and test recommended by

    ACLI is a fundamentally sound method for determining those insurance

    products that are not swaps or security-based swaps and that should

    remain subject to state regulation, and is more appropriate than the

    Commissions' proposals. Nationwide suggested a three-part test to

    differentiate insurance products from swaps and security-based swaps

    similar to the test proposed by ACLI. See also Nationwide Letter.

    ---------------------------------------------------------------------------

    This commenter stated that its approach does not contain a

    definition of insurance, and believes that is preferable to the

    Commissions' approach, which it believes creates legal uncertainty

    because any attempted definition of insurance has the potential to be

    over- or under- inclusive.\174\ As discussed above, the Commissions'

    rules and interpretations are not intended to define insurance. Rather,

    they provide a safe harbor for certain types of traditional insurance

    products by reference to factors that may be used to distinguish

    insurance from swaps and security-based swaps, and a list of

    [[Page 48225]]

    products that do not have to satisfy a portion of the safe harbor

    factors. Agreements, contracts, and transactions that do not qualify

    for the Insurance Safe Harbor may or may not be insurance, depending

    upon the facts and circumstances regarding such agreements, contracts

    and transactions. The Commissions find the first two requirements of

    the commenter's three-part test to be tautologous, and the third

    provides no greater certainty than the Commissions' facts and

    circumstances approach. In addition, the Commissions find that this

    alternative test could exclude from the Dodd-Frank Act regulatory

    regime agreements, contracts, and transactions that have not

    traditionally been considered insurance.

    ---------------------------------------------------------------------------

    \174\ See ACLI Letter.

    ---------------------------------------------------------------------------

    Another commenter proposed different approaches for existing

    products and new products.\175\ Specifically, if an existing type of

    agreement, contract or transaction is currently reportable as insurance

    in the provider's regulatory and financial reports under a state or

    foreign jurisdiction's insurance laws, then that agreement, contract,

    or transaction would be insurance rather than a swap or security-based

    swap. On the other hand, for new products, if this approach were

    inconclusive, this commenter recommended that the Commissions use the

    Product Test of the Commissions' rules only.\176\ As discussed above,

    rather than treating existing products and new products differently,

    the Commissions are providing ``grandfather'' protection for

    agreements, contracts, and transactions entered into prior to the

    effective date of the Products Definitions.\177\ Moreover, this

    commenter's test would eliminate the Provider Test for new products,

    which the Commissions believe is important to help prevent products

    that are swaps or security-based swaps from being characterized as

    insurance.

    ---------------------------------------------------------------------------

    \175\ See AIA Letter.

    \176\ Id.

    \177\ See supra part II.B.1.c)

    ---------------------------------------------------------------------------

    In sum, the Commissions find that each of the alternatives proposed

    by commenters could exclude from the Dodd-Frank Act regulatory regime

    agreements, contracts, and transactions that have not historically been

    considered insurance, and that should, in appropriate circumstances, be

    regulated as swaps or security-based swaps. Accordingly, the

    Commissions do not find these alternatives to be appropriate for

    delineating the scope of the Insurance Safe Harbor from the swap and

    security-based swap definitions.

    (e) ``Safe Harbor''

    Five commenters recommended that the Product Test, the Provider

    Test, and related interpretations should be structured as a ``safe

    harbor'' so that they do not raise any presumption or inference that

    products that do not meet the Product Test, Provider Test and related

    interpretations are necessarily swaps or security-based swaps.\178\ One

    commenter suggested that this safe harbor approach could be modeled

    after Rule 151 under the Securities Act.\179\

    ---------------------------------------------------------------------------

    \178\ See ACLI Letter; CAI Letter; NAFA Letter (concurring with

    ACLI and CAI); Nationwide Letter; and Travelers Letter.

    \179\ See ACLI Letter.

    ---------------------------------------------------------------------------

    As discussed above, the Commissions do not intend to create a

    presumption that agreements, contracts, or transactions that do not

    fall within the Insurance Safe Harbor are necessarily swaps or

    security-based swaps. As stated above, the Commissions are instead

    adopting final rules that clarify that certain agreements, contracts,

    or transactions meeting the requirements of a non-exclusive ``safe

    harbor'' established by such rules will not be considered to be swaps

    or security-based swaps. An agreement, contract, or transaction that

    does not fall within the Insurance Safe Harbor will require further

    analysis of the applicable facts and circumstances to determine whether

    it is insurance, and thus not a swap or security-based swap.

    (f) Applicability of Insurance Exclusion to Security-Based Swaps

    Four commenters expressed concerns that the proposed rules were

    unclear in their application to both swaps and security-based

    swaps.\180\ These commenters argued that the proposed rules do not

    directly exclude insurance products from the term ``security-based

    swap'' because the rules explicitly state that ``[t]he term `swap' does

    not include'' the products that meet the Product and Provider Tests,

    but do not make the same statement as to the term ``security-based

    swap.'' \181\

    ---------------------------------------------------------------------------

    \180\ See ACLI Letter; CAI Letter; NAFA Letter (concurring with

    ACLI and CAI); and Nationwide Letter (concurring the ACLI and CAI).

    \181\ Id. The commenters suggested that this ambiguity could be

    resolved by making it clear in the final rules that an excluded

    product is neither a swap nor a security-based swap.

    ---------------------------------------------------------------------------

    The Commissions have revised rule 1.3(xxx)(4) under the CEA and

    rule 3a69-1 under the Exchange Act to clarify that the exclusion

    contained therein applies to both swaps and security-based swaps.

    (g) Guarantees

    In the Proposing Release, the Commissions requested comment on

    whether insurance of an agreement, contract, or transaction that falls

    within the swap or security-based swap definitions should itself be

    included in the swap or security-based swap definition. The Commissions

    also requested comment on whether the Commissions should provide

    guidance as to whether swap or security-based swap guarantees offered

    by non-insurance companies should be considered swaps or security-based

    swaps.\182\

    ---------------------------------------------------------------------------

    \182\ See Proposing Release at 29827.

    ---------------------------------------------------------------------------

    Guarantees of Swaps.\183\

    ---------------------------------------------------------------------------

    \183\ The discussion in this subsection relates only to swaps

    that are not security-based swaps or mixed swaps and has no effect

    on the laws or regulations applicable to security-based swaps or

    mixed swaps.

    ---------------------------------------------------------------------------

    No commenter identified any product that insures swaps (that are

    not security-based swaps or mixed swaps) other than financial guaranty

    insurance. The CFTC finds that insurance of an agreement, contract, or

    transaction that falls within the swap definition (and is not a

    security-based swap or mixed swap) is functionally or economically

    similar to a guarantee of a swap (that is not a security-based swap or

    mixed swap) offered by a non-insurance company.\184\ Therefore, the

    CFTC is treating financial guaranty insurance of swaps (that are not

    security-based swaps or mixed swaps) the same way it is treating all

    other guarantees of swaps (that are not security-based swaps or mixed

    swaps), as discussed below.\185\

    ---------------------------------------------------------------------------

    \184\ The Commissions did not express a view regarding whether

    financial guaranty insurance is a swap or security-based swap in the

    Entities Release. See Entities Release at 30689, n.1132.

    \185\ Subsequent references to ``guarantees'' in this discussion

    shall thus be deemed to include ``financial guaranty insurance

    policies.''

    ---------------------------------------------------------------------------

    The CFTC is persuaded that when a swap has the benefit of a

    guarantee,\186\ the guarantee is an integral part of that swap. The

    CFTC finds that a guarantee of a swap (that is not a security-based

    swap or mixed swap) is a term of that swap that affects the price or

    pricing attributes of that swap.\187\ When a swap

    [[Page 48226]]

    counterparty typically provides a guarantee as credit support for its

    swap obligations, the market will not trade with that counterparty at

    the same price, on the same terms, or at all without the guarantee. The

    guarantor's resources are added to the analysis of the swap; if the

    guarantor is financially more capable than the swap counterparty, the

    analysis of the swap becomes more dependent on the creditworthiness of

    the guarantor. Therefore, the CFTC is interpreting the term ``swap''

    (that is not a security-based swap or mixed swap) to include a

    guarantee of such swap, to the extent that a counterparty to a swap

    position would have recourse to the guarantor in connection with the

    position.\188\ The CFTC anticipates that a ``full recourse'' guarantee

    would have a greater effect on the price of a swap than a ``limited''

    or ``partial recourse'' guarantee; nevertheless, the CFTC is

    determining that the presence of any guarantee with recourse, no matter

    how robust, is price forming and an integral part of a guaranteed swap.

    ---------------------------------------------------------------------------

    \186\ For purposes of this release, the CFTC views a guarantee

    of a swap to be a collateral promise by a guarantor to answer for

    the debt or obligation of a counterparty obligor under a swap. A

    guarantee of a swap does not include for purposes of this release:

    (i) A ``guarantee agreement'' as defined in CFTC regulation Sec.

    1.3(nn), 17 CFR 1.3(nn); (ii) any assumption by a clearing member of

    financial or performance responsibility to a derivatives clearing

    organization (``DCO'') for swaps cleared by a DCO; or (iii) any

    guarantee by a DCO with respect to a swap that it clears.

    \187\ E.g., a swap counterparty may specify that a guarantee is

    a Credit Support Document under an ISDA Master Agreement. If the

    guarantor fails to comply with or perform under such guarantee, such

    guarantee expires or terminates, or if such guarantee ceases to be

    in full force and effect, the ``Credit Support Default'' Event of

    Default under the ISDA Master Agreement would generally be

    triggered, potentially bringing down the entire swap trading

    relationship between the parties to the ISDA Master Agreement. See

    generally the standard 1992 ISDA Master Agreement and 2002 ISDA

    Master Agreement. However, the CFTC finds the presence of a

    guarantee to be an integral part of a swap and that affects the

    price or pricing attributes of a swap whether or not such guarantee

    is a Credit Support Document under an ISDA Master Agreement.

    \188\ This interpretation is consistent with the interpretations

    of the Commissions in the Entity Definitions Release. See, e.g.,

    Entity Definitions Release at 30689 (``[A]n entity's swap or

    security-based swap positions in general would be attributed to a

    parent, other affiliate or guarantor for purposes of major

    participant analysis to the extent that counterparties to those

    positions would have recourse to that other entity in connection

    with the position. Positions would not be attributed in the absence

    of recourse.''). A swap backed by a partial or limited recourse

    guarantee will include the guarantee to the extent of such partial

    or limited recourse; a blanket guarantee that supports both swap and

    non-swap obligations will be treated as part of the guaranteed swap

    only to the extent that such guarantee backstops obligations under a

    swap or swaps.

    In the Entity Definitions Release, the Commissions stated, ``we

    do not believe that it is necessary to attribute a person's swap or

    security-based swap positions to a parent or other guarantor if the

    person is already subject to capital regulation by the CFTC or SEC

    (i.e., swap dealers, security-based swap dealers, major swap

    participants, major security-based swap participants, FCMs and

    broker-dealers) or if the person is a U.S. entity regulated as a

    bank in the United States. Positions of those regulated entities

    already will be subject to capital and other requirements, making it

    unnecessary to separately address, via major participant

    regulations, the risks associated with guarantees of those

    positions.'' Id. In a footnote, the Commissions continued, ``As a

    result of this interpretation, holding companies will not be deemed

    to be major swap participants as a result of guarantees to certain

    U.S. entities that are already subject to capital regulation.'' Id.

    As a result of interpreting the term ``swap'' (that is not a

    security-based swap or mixed swap) to include a guarantee of such

    swap, to the extent that a counterparty to a swap position would

    have recourse to the guarantor in connection with the position, and

    based on the reasoning set forth above from the Entity Definitions

    Release in connection with major swap participants, the CFTC will

    not deem holding companies to be swap dealers as a result of

    guarantees to certain U.S. entities that are already subject to

    capital regulation. It may, however, be appropriate to regulate as a

    swap dealer a parent or other guarantor who guarantees swap

    positions of persons who are not already subject to capital

    regulation by the CFTC (i.e., who are not swap dealers, major swap

    participants or FCMs). The CFTC is addressing guarantees provided to

    non-U.S. entities, and guarantees by non-U.S. holding companies, in

    its proposed interpretive guidance and policy statement regarding

    the cross-border application of the swaps provisions of the CEA, 77

    FR 41214 (Jul. 12, 2012).

    ---------------------------------------------------------------------------

    The CFTC's interpretation of the term ``swap'' to include

    guarantees of swaps does not limit or otherwise affect in any way the

    relief provided by the Insurance Grandfather. In a separate release,

    the CFTC will address the practical implications of interpreting the

    term ``swap'' to include guarantees of swaps (the ``separate CFTC

    release'').\189\

    ---------------------------------------------------------------------------

    \189\ Briefly, in the separate CFTC release the CFTC anticipates

    proposing reporting requirements with respect to guarantees of swaps

    under Parts 43 and 45 of the CFTC's regulations and explaining the

    extent to which the duties and obligations of swap dealers and major

    swap participants pertaining to guarantees of swaps, as an integral

    part of swaps, are already satisfied to the extent such obligations

    are satisfied with respect to the related guaranteed swaps. The CFTC

    also anticipates addressing in the separate CFTC release the effect,

    if any, of the interpretation regarding guarantees of swaps on

    position limits and large trader reporting requirements.

    ---------------------------------------------------------------------------

    Comments

    Three commenters provided comments regarding the treatment of

    guarantees. Two commenters \190\ opposed treating insurance or

    guarantees of swaps as swaps. Suggesting that the products are not

    economically similar, one commented that insurance wraps of swaps do

    not ``necessarily replicate the economics of the underlying swap, and

    only following default could the wrap provider end up with the same

    payment obligations as a wrapped defaulting swap counterparty.'' \191\

    This commenter also stated that the non-insurance guarantees are not

    swaps because the result of most guarantees is that the guarantor is

    responsible for monetary claims against the defaulting party, which in

    this commenter's view is a different obligation than the arrangement

    provided by the underlying swap itself.\192\

    ---------------------------------------------------------------------------

    \190\ See AFGI Letter and ISDA Letter.

    \191\ ISDA Letter.

    \192\ Id.

    ---------------------------------------------------------------------------

    One commenter supported treating financial guaranty insurance of a

    swap or security-based swap as itself a swap or a security-based swap.

    This commenter argued that financial guaranty insurance of a swap or

    security-based swap transfers the risk of counterparty non-performance

    to the guarantor, making it an embedded and essential feature of the

    insured swap or security-based swap. This commenter further argued that

    the value of such swap or security-based swap is largely determined by

    the likelihood that the proceeds from the financial guaranty insurance

    policy will be available if the counterparty does not meet its

    obligations.\193\ This commenter maintained that financial guaranty

    insurance of swaps and security-based swaps serves a very similar

    function to credit default swaps in hedging counterparty default

    risk.\194\

    ---------------------------------------------------------------------------

    \193\ See Better Markets Letter.

    \194\ See Better Markets Letter.

    ---------------------------------------------------------------------------

    The CFTC is persuaded that when a swap (that is not a security-

    based swap or mixed swap) has the benefit of a guarantee, the guarantee

    and related guaranteed swap must be analyzed together. The events

    surrounding the failure of AIG Financial Products (``AIGFP'') highlight

    how guarantees can cause major risks to flow to the guarantor.\195\ The

    CFTC finds that the regulation of swaps and the risk exposures

    associated with them, which is an essential concern of the Dodd-Frank

    Act, would be less effective if the CFTC did not interpret the term

    ``swap'' to include a guarantee of a swap.

    ---------------------------------------------------------------------------

    \195\ ``AIGFP's obligations were guaranteed by its highly rated

    parent company * * * an arrangement that facilitated easy money via

    much lower interest rates from the public markets, but ultimately

    made it difficult to isolate AIGFP from its parent, with disastrous

    consequences.'' Congressional Oversight Panel, The AIG Rescue, Its

    Impact on Markets, and the Government's Exit Strategy 20 (2010).

    ---------------------------------------------------------------------------

    Two commenters cautioned against unnecessary and duplicative

    regulation. One commented that, because the underlying swap, and the

    parties to it, will be regulated and reported to the extent required by

    Title VII, there is no need for regulation of non-insurance

    guarantees.\196\ The other commented that an insurance policy on a swap

    would be subject to state regulation; without addressing non-insurance

    guarantees, this commenter stated that additional Federal regulation

    would be duplicative.\197\ The CFTC disagrees with these arguments. As

    stated above, the CFTC is treating financial guaranty insurance of

    swaps and all other guarantees of swaps in a similar manner because

    they are functionally or

    [[Page 48227]]

    economically similar products. If a guarantee of a swap is not treated

    as an integral part of the underlying swap, price forming terms of

    swaps and the risk exposures associated with the guarantees may remain

    hidden from regulators and may not be regulated appropriately.

    Moreover, treating guarantees of swaps as part of the underlying swaps

    ensures that the CFTC will be able to take appropriate action if, after

    evaluating information collected with respect to the guarantees and the

    underlying swaps, such guarantees of swaps are revealed to pose

    particular problems in connection with the swaps markets. In the

    separate CFTC release, the CFTC will clarify the limited practical

    effects of the CFTC's interpretation, which should address concerns

    regarding duplicative regulation.

    ---------------------------------------------------------------------------

    \196\ See ISDA Letter.

    \197\ See AFGI Letter.

    ---------------------------------------------------------------------------

    One commenter also argued that regulating financial guaranty of

    swaps as swaps would cause monoline insurers to withdraw from the

    market, which could adversely affect the U.S. and international public

    finance, infrastructure and structured finance markets, given that

    insuring a related swap often is integral to the insurance of municipal

    bonds and other securities.\198\ The CFTC finds this argument

    unpersuasive. The CFTC understands that the 2008 global financial

    crisis severely affected most monolines and only one remains active in

    U.S. municipal markets. Thus, it appears that the monolines have, for

    the most part, already exited these markets. In addition, as stated

    above, the CFTC will clarify in the separate CFTC release the limited

    practical effects of the CFTC's interpretation, which should address

    these concerns.

    ---------------------------------------------------------------------------

    \198\ See AFGI Letter. Of the members of AFGI, only Assured

    Guaranty (or its affiliates) is currently writing financial guaranty

    insurance policies on U.S. municipal obligations.

    ---------------------------------------------------------------------------

    Guarantees of Security-Based Swaps

    The SEC believes that a guarantee of an obligation under a

    security-based swap, including financial guaranty insurance of a

    security-based swap, is not a separate security-based swap. Further,

    the SEC is not adopting an interpretation that a guarantee of a

    security-based swap is part of the security-based swap. Instead, the

    SEC will consider requiring, as part of its rulemaking relating to the

    reporting of security-based swaps,\199\ the reporting of information

    about any guarantees and the guarantors of obligations under security-

    based swaps in connection with the reporting of the security-based swap

    transaction itself. In addition, the SEC will consider issues involving

    cross-border guarantees of security-based swaps in a separate release

    addressing the cross-border application of Title VII. The SEC notes

    that security-based swaps are included in the definition of

    ``security'' contained in the Securities Act and the Exchange Act.\200\

    Under the Securities Act, a guarantee of a security also is a

    ``security.'' \201\ Therefore, a guarantee of a security-based swap is

    a security subject to Federal securities law regulation.\202\

    ---------------------------------------------------------------------------

    \199\ See Regulation SBSR Proposing Release infra note 1231.

    \200\ See sections 768(a)(1) and 761(a)(2) of the Dodd-Frank Act

    (amending sections 2(a)(1) of the Securities Act, 15 U.S.C.

    77b(a)(1), and 3(a)(10) of the Exchange Act, 15 U.S.C. 78c(a)(10),

    respectively).

    \201\ See section 2(a)(1) of the Securities Act, 15 U.S.C.

    77b(a)(1).

    \202\ The SEC has previously addressed the treatment of

    financial guaranty insurance under the Federal securities laws. See

    supra note 58.

    ---------------------------------------------------------------------------

    2. The Forward Contract Exclusion

    As the Commissions explained in the Proposing Release, the

    definitions of the terms ``swap'' and ``security-based swap'' do not

    include forward contracts.\203\ These definitions exclude ``any sale of

    a nonfinancial commodity or security for deferred shipment or delivery,

    so long as the transaction is intended to be physically settled.''

    \204\ The Commissions provided an interpretation in the Proposing

    Release regarding the applicability of the exclusion from the swap and

    security-based swap definition for forward contracts with respect to

    nonfinancial commodities \205\ and securities. The Commissions are

    restating this interpretation as set forth in the Proposing Release

    with certain modifications in response to commenters.

    (a) Forward Contracts in Nonfinancial Commodities

    ---------------------------------------------------------------------------

    \203\ See Proposing Release at 29827.

    \204\ CEA section 1a(47)(B)(ii), 7 U.S.C. 1a(47)(B)(ii).

    \205\ The discussion in subsections (a) and (b) of this section

    applies solely to the exclusion of nonfinancial commodity forwards

    from the swap definition in the CEA.

    ---------------------------------------------------------------------------

    The CFTC provided an interpretation in the Proposing Release

    regarding the forward contract exclusion for nonfinancial commodities

    and is restating this interpretation with certain modifications in

    response to commenters. These clarifications include that the CFTC will

    interpret the forward contract exclusion consistent with the entire

    body of CFTC precedent.\206\ The CFTC is also clarifying what

    ``commercial participant'' means under the ``Brent Interpretation.''

    \207\ In addition, while the CFTC is withdrawing its 1993 ``Energy

    Exemption'' \208\ as proposed, it is clarifying that certain

    alternative delivery procedures will not disqualify a transaction from

    the forward contract exclusion. In response to comments, the CFTC is

    providing a new interpretation regarding book-out documentation, as

    well as additional factors that may be considered in its ``facts and

    circumstances'' analysis of whether a particular contract is a forward.

    ---------------------------------------------------------------------------

    \206\ See infra part II.B.2(a)(i)(F).

    \207\ Statutory Interpretation Concerning Forward Transactions,

    55 FR 39188 (Sep. 25, 1990) (``Brent Interpretation'').

    \208\ Exemption for Certain Contracts Involving Energy Products,

    58 FR 21286-02 (Apr. 20, 1993) (``Energy Exemption'').

    ---------------------------------------------------------------------------

    (i) Forward Exclusion From the Swap and Future Delivery Definitions

    (A) Consistent Interpretation

    The wording of the forward contract exclusion from the swap

    definition with respect to nonfinancial commodities is similar, but not

    identical, to the forward exclusion from the definition of the term

    ``future delivery'' that applies to futures contracts, which excludes

    ``any sale of any cash commodity for deferred shipment or delivery.''

    \209\

    ---------------------------------------------------------------------------

    \209\ CEA section 1a(27), 7 U.S.C. 1a(27).

    ---------------------------------------------------------------------------

    In the Proposing Release, the CFTC proposed an interpretation

    clarifying the scope of the exclusion of forward contracts for

    nonfinancial commodities from the swap definition and from the ``future

    delivery'' definition in a number of respects. After considering the

    comments received, the CFTC is restating substantially all of its

    interpretation regarding these forward exclusions set forth in the

    Proposing Release, but with several clarifications in response to

    commenters.

    The CFTC is restating from the Proposing Release that the forward

    exclusion for nonfinancial commodities in the swap definition will be

    interpreted in a manner consistent with the CFTC's historical

    interpretation of the existing forward exclusion with respect to

    futures contracts, consistent with the Dodd-Frank Act's legislative

    history.\210\ In addition, in response to a

    [[Page 48228]]

    commenter, the CFTC is clarifying that the entire body of CFTC

    precedent regarding forwards should apply to the forward exclusions

    from the swap and future delivery definitions.\211\

    ---------------------------------------------------------------------------

    \210\ See 156 Cong. Rec. H5248-49 (June 30, 2010) (introducing

    into the record a letter authored by Senator Blanche Lincoln,

    Chairman of the U. S. Senate Committee on Agriculture, Nutrition and

    Forestry, and Christopher Dodd, Chairman U. S. Senate Committee on

    Banking, Housing, and Urban Affairs, stating that the CFTC is

    encouraged ``to clarify through rulemaking that the exclusion from

    the definition of swap for `any sale of a nonfinancial commodity or

    security for deferred shipment or delivery, so long as the

    transaction is intended to be physically settled' is intended to be

    consistent with the forward contract exclusion that is currently in

    the [CEA] and the CFTC's established policy and orders on this

    subject, including situations where commercial parties agree to

    `book-out' their physical delivery obligations under a forward

    contract.''). See also 156 Cong. Rec. H5247 (June 30, 2010)

    (colloquy between U. S. House Committee on Agriculture Chairman

    Collin Peterson and Representative Leonard Boswell during the debate

    on the Conference Report for the Dodd-Frank Act, in which Chairman

    Peterson stated: ``Excluding physical forward contracts, including

    book-outs, is consistent with the CFTC's longstanding view that

    physical forward contracts in which the parties later agree to book-

    out their delivery obligations for commercial convenience are

    excluded from its jurisdiction. Nothing in this legislation changes

    that result with respect to commercial forward contracts.'').

    \211\ See Letter from Craig Donahue, Chief Executive Officer,

    CME Group Inc. (``CME''), dated July 22, 2011 (``CME Letter'')

    (requesting this clarification). But see below regarding the CFTC's

    response to CME's comment concerning the Brent Interpretation that

    it may be inconsistent, in CME's view, with more recent CFTC

    adjudicatory decisions.

    ---------------------------------------------------------------------------

    The CFTC's historical interpretation has been that forward

    contracts with respect to nonfinancial commodities are ``commercial

    merchandising transactions.'' \212\ The primary purpose of a forward

    contract is to transfer ownership of the commodity and not to transfer

    solely its price risk. As the CFTC has noted and reaffirms today:

    \212\ See, e.g., Brent Interpretation, supra note 207.

    ---------------------------------------------------------------------------

    The underlying postulate of the [forward] exclusion is that the

    [CEA's] regulatory scheme for futures trading simply should not

    apply to private commercial merchandising transactions which create

    enforceable obligations to deliver but in which delivery is deferred

    for reasons of commercial convenience or necessity.\213\

    \213\ See Brent Interpretation, supra note 207. The CFTC has

    reiterated this view in more recent adjudicative orders. See, e.g.,

    In re Grain Land Coop., [2003-2004 Transfer Binder] Comm. Fut. L.

    Rep. (CCH) ] 29,636 (CFTC Nov. 25, 2003); In re Competitive

    Strategies for Agric., Ltd., [2003-2004 Transfer Binder] Comm. Fut.

    L. Rep. (CCH) ] 29,635 (CFTC Nov. 25, 2003). Courts have expressed

    this view as well. See, e.g., Salomon Forex, Inc. v. Tauber, 8 F.3d

    966, 971 (4th Cir. 1993) (``[C]ash forwards are generally

    individually negotiated sales * * * in which actual delivery of the

    commodity is anticipated, but is deferred for reasons of commercial

    convenience or necessity.''); CFTC v. Int'l Fin. Serv. (N.Y.), 323

    F. Supp. 2d 482, 495 (S.D.N.Y. 2004). See also CFTC v. Co Petro

    Mktg. Grp., Inc., 680 F.2d 573, 579-580 (9th Cir. 1982); CFTC v.

    Noble Metals Int'l, Inc., 67 F.3d 766, 772-773 (9th Cir. 1995; CFTC

    v. Am. Metal Exch. Corp., 693 F. Supp. 168, 192 (D.N.J. 1988); CFTC

    v. Morgan, Harris & Scott, Ltd., 484 F. Supp. 669, 675 (S.D.N.Y.

    1979) (forward contract exclusion does not apply to speculative

    transactions in which delivery obligations can be extinguished under

    the terms of the contract or avoided for reasons other than

    commercial convenience or necessity).

    ---------------------------------------------------------------------------

    As noted in the Proposing Release, because a forward contract is a

    commercial merchandising transaction, intent to deliver historically

    has been an element of the CFTC's analysis of whether a particular

    contract is a forward contract.\214\ In assessing the parties'

    expectations or intent regarding delivery, the CFTC consistently has

    applied a ``facts and circumstances'' test.\215\ Therefore, the CFTC

    reads the ``intended to be physically settled'' language in the swap

    definition with respect to nonfinancial commodities to reflect a

    directive that intent to deliver a physical commodity be a part of the

    analysis of whether a given contract is a forward contract or a swap,

    just as it is a part of the CFTC's analysis of whether a given contract

    is a forward contract or a futures contract.

    ---------------------------------------------------------------------------

    \214\ The CFTC observed in its decision in In re Wright that

    ``it is well-established that the intent to make or take delivery is

    the critical factor in determining whether a contract qualifies as a

    forward.'' In re Wright, CFTC Docket No. 97-02, 2010 WL 4388247 at

    *3 (CFTC Oct. 25, 2010) (citing In re Stovall, et al., [1977-1980

    Transfer Binder] Comm. Fut. L. Rep. (CCH) 20,941 (CFTC Dec. 6,

    1979); Brent Interpretation, supra note 207). In Wright, the CFTC

    noted that ``[i]n distinguishing futures from forwards, the [CFTC]

    and the courts have assessed the transaction as a whole with a

    critical eye toward its underlying purpose. Such an assessment

    entails a review of the overall effect of the transaction as well as

    a determination as to what the parties intended.'' Id. at *3

    (quoting Policy Statement Concerning Swap Transactions, 54 FR 30694

    (Jul. 21, 1989) (``Swap Policy Statement'') (citations and internal

    quotations omitted)).

    \215\ In Wright, the CFTC applied its facts and circumstances

    test in an administrative enforcement action involving hedge-to-

    arrive contracts for corn, and observed that ``[o]ur views of the

    appropriateness of a multi-factor analysis remain unchanged.''

    Wright, note 214, supra, n.13. The CFTC let stand the administrative

    law judge's conclusion that the hedge-to-arrive contracts at issue

    in the case were forward contracts. Id. at **5-6. See also Grain

    Land, supra note 213; Competitive Strategies for Agric., supra note

    213.

    ---------------------------------------------------------------------------

    (B) Brent Interpretation

    In this interpretation, the CFTC is restating, with certain

    clarifications in response to commenters, its interpretation from the

    Proposing Release that the principles underlying the CFTC's ``Brent

    Interpretation'' regarding book-outs developed in connection with the

    forward exclusion from futures apply to the forward exclusion from the

    swap definition as well. Book-out transactions meeting the requirements

    specified in the Brent Interpretation that are effectuated through a

    subsequent, separately negotiated agreement qualify for the safe harbor

    under the forward exclusions.

    As was noted in the Proposing Release, the issue of book-outs first

    arose in 1990 in the Brent Interpretation \216\ because the parties to

    the crude oil contracts in that case could individually negotiate

    cancellation agreements, or ``book-outs,'' with other parties.\217\ In

    describing these transactions, the CFTC stated:

    ---------------------------------------------------------------------------

    \216\ See Brent Interpretation, supra note 207. The CFTC issued

    the Brent Interpretation in response to a Federal court decision

    that held that certain 15-day Brent system crude oil contracts were

    illegal off-exchange futures contracts. See Transnor (Bermuda) Ltd.

    v. BP N. Am. Petroleum, 738 F. Supp. 1472 (S.D.N.Y. 1990). The Brent

    Interpretation provided clarification that the 15-day Brent system

    crude oil contracts were forward contracts that were excluded from

    the CEA definition of ``future delivery,'' and thus were not futures

    contracts. See Brent Interpretation, supra note 207.

    \217\ The Brent Interpretation described these ``book-outs'' as

    follows: ``In the course of entering into 15-day contracts for

    delivery of a cargo during a particular month, situations often

    arise in which two counterparties have multiple, offsetting

    positions with each other. These situations arise as a result of the

    effectuation of multiple, independent commercial transactions. In

    such circumstances, rather than requiring the effectuation of

    redundant deliveries and the assumption of the credit, delivery and

    related risks attendant thereto, the parties may, but are not

    obligated to and may elect not to, terminate their contracts and

    forego such deliveries and instead negotiate payment-of-differences

    pursuant to a separate, individually-negotiated cancellation

    agreement referred to as a `book-out.' Similarly, situations

    regularly arise when participants find themselves selling and

    purchasing oil more than once in the delivery chain for a particular

    cargo. The participants comprising these `circles' or `loops' will

    frequently attempt to negotiate separate cancellation agreements

    among themselves for the same reasons and with the same effect

    described above.'' Brent Interpretation, supra note 207, at 39190.

    It is noteworthy that while such [book-out] agreements may

    extinguish a party's delivery obligation, they are separate,

    individually negotiated, new agreements, there is no obligation or

    arrangement to enter into such agreements, they are not provided for

    by the terms of the contracts as initially entered into, and any

    party that is in a position in a distribution chain that provides

    for the opportunity to book-out with another party or parties in the

    chain is nevertheless entitled to require delivery of the commodity

    to be made through it, as required under the contracts.\218\

    ---------------------------------------------------------------------------

    \218\ Id. at 39192.

    Thus, in the scenario at issue in the Brent Interpretation, the

    contracts created a binding obligation to make or take delivery without

    providing any right to offset, cancel, or settle on a payment-of-

    differences basis. The ``parties enter[ed] into such contracts with the

    recognition that they may be required to make or take delivery.'' \219\

    ---------------------------------------------------------------------------

    \219\ Id. at 39189.

    ---------------------------------------------------------------------------

    On these facts, the Brent Interpretation concluded that the

    contracts were forward contracts, not futures contracts:

    Under these circumstances, the [CFTC] is of the view that

    transactions of this type which are entered into between commercial

    participants in connection with their business, which create

    specific delivery obligations that impose substantial economic risks

    of a commercial nature to these participants, but which may involve,

    in

    [[Page 48229]]

    certain circumstances, string or chain deliveries of the type

    described * * * are within the scope of the [forward contract]

    exclusion from the [CFTC's] regulatory jurisdiction.\220\

    ---------------------------------------------------------------------------

    \220\ Id. at 39192.

    Although the CFTC did not expressly discuss intent to deliver, the

    Brent Interpretation concluded that transactions retained their

    character as commercial merchandising transactions, notwithstanding the

    practice of terminating commercial parties' delivery obligations

    through ``book-outs'' as described. At any point in the chain, one of

    the parties could refuse to enter into a new contract to book-out the

    transaction and, instead, insist upon delivery pursuant to the parties'

    obligations under their contract.

    The CFTC also is clarifying that commercial market participants

    that regularly make or take delivery of the referenced commodity in the

    ordinary course of their business meet the commercial participant

    standard of the Brent Interpretation.\221\ The CFTC notes that the

    Brent Interpretation applies to ``commercial participants in connection

    with their business.'' \222\ The CFTC intends that the interpretation

    in this release be consistent with the Brent Interpretation, and

    accordingly is adding ``commercial'' before ``market participants'' in

    this final interpretation. Such entities qualify for the forward

    exclusion from both the future delivery and swap definitions for their

    forward transactions in nonfinancial commodities under the Brent

    Interpretation even if they enter into a subsequent transaction to

    ``book out'' the contract rather than make or take delivery. Intent to

    make or take delivery can be inferred from the binding delivery

    obligation for the commodity referenced in the contract and the fact

    that the parties to the contract do, in fact, regularly make or take

    delivery of the referenced commodity in the ordinary course of their

    business.

    ---------------------------------------------------------------------------

    \221\ See CME Letter (noting that, although the Brent

    Interpretation applies to ``commercial market participants,'' the

    proposed guidance in the Proposing Release was described as applying

    to ``market participants'' (omitting the word ``commercial'') who

    ``regularly make or take delivery of the referenced commodities * *

    * in the ordinary course of business.'' See also Proposing Release

    at 29829.

    \222\ Brent Interpretation, supra note 207, at 39192.

    ---------------------------------------------------------------------------

    Further, in this final interpretation, the CFTC clarifies, in

    response to a comment received, that an investment vehicle taking

    delivery of gold as part of its investment strategy would not be

    engaging in a commercial activity within the meaning of the Brent

    Interpretation.\223\ By contrast, were the investment vehicle, for

    example, to own a gold mine and sell the output of the gold mine for

    forward delivery, or own a chain of jewelry stores that produces its

    own jewelry from raw materials and purchase a supply of gold from

    another entity's gold mine in order to provide raw materials for its

    jewelry stores, such contracts could qualify as forward contracts under

    the Brent Interpretation--provided that such contracts otherwise

    satisfy the terms thereof.

    ---------------------------------------------------------------------------

    \223\ See CME Letter. In connection with its comment regarding

    ``market participants'' described above, see supra note 221, the CME

    further requests confirmation that the CFTC intends to apply the

    Brent Interpretation to market participants who can demonstrate that

    they meet the standard in the guidance as proposed, but are not

    themselves commercial actors:

    Because the Commission`s interpretation does not explicitly

    refer to commercial market participants, it would seem to cover

    financial players as long as those entities regularly make or take

    delivery of the underlying commodity in connection with their

    business. Examples of such entities would be hedge funds or other

    investment vehicles that regularly make or take delivery of

    commodities (e.g. gold) in conjunction with their line of business--

    that is, as part of their investment strategies. [CME] asks that the

    [CFTC] confirm that the Brent safe harbor would be available to

    these types of market participants that technically are not

    ``commercial'' actors.

    See CME Letter.

    ---------------------------------------------------------------------------

    In sum, the CFTC is interpreting the term ``commercial'' in the

    context of the Brent Interpretation in the same way it has done since

    1990: ``related to the business of a producer, processor, fabricator,

    refiner or merchandiser.'' \224\ While a market participant need not be

    solely engaged in ``commercial'' activity to be a ``commercial market

    participant'' within the meaning of the Brent Interpretation under this

    interpretation, the business activity in which it makes or takes

    delivery must be commercial activity for it to be a commercial market

    participant. A hedge fund's investment activity is not commercial

    activity within the CFTC's longstanding view of the Brent

    Interpretation.

    ---------------------------------------------------------------------------

    \224\ Brent Interpretation, supra note 207, at 39191. See also

    dissent of Commissioner Fowler West (stating that commercial means

    ``in the traditional sense of those who produce, process, use or * *

    * handle the underlying commodity.''). Note that being a commercial

    market participant with respect to an agreement, contract or

    transaction in one commodity, or grade of a commodity, neither makes

    an entity, nor precludes an entity from being, a commercial market

    participant with respect to an agreement, contract or transaction in

    a different grade of the commodity or a different commodity. For

    example, a West Texas Intermediate oil producer may or may not also

    be a commercial with respect to Brent. Similarly, that same West

    Texas Intermediate oil producer may or may not have commercial corn

    operations. In determining whether an entity is a commercial market

    participant with respect to an agreement, contract or transaction in

    a commodity, the CFTC will consider the facts and circumstances,

    though it is not unlikely that an entity that is a commercial market

    participant with respect to one commodity may also be a commercial

    market participant with respect to either a different grade of the

    commodity or a closely related commodity.

    ---------------------------------------------------------------------------

    In addition, the CFTC is expanding the Brent Interpretation, which

    applied only to oil, to all nonfinancial commodities, as proposed.\225\

    As a result, book-outs are permissible (where the conditions of the

    Brent Interpretation are satisfied) for all nonfinancial commodities

    with respect to the exclusions from the definition of the term ``swap''

    and the definition of the term ``future delivery'' under the CEA.\226\

    ---------------------------------------------------------------------------

    \225\ See infra part II.B.2(a)(ii), with respect to the CFTC's

    interpretation concerning nonfinancial commodities.

    \226\ The CFTC reminds market participants that this does not

    mean, as was noted in the Brent Interpretation, that these

    transactions or persons who engage in them are wholly outside the

    reach of the CEA for all purposes. See, e.g., CEA section 8(d), 7

    U.S.C. 12(d), which directs the CFTC to investigate the marketing

    conditions of commodities and commodity products and byproducts,

    including supply and demand for these commodities, cost to the

    consumer, and handling and transportation charges; CEA sections

    6(c), 6(d), and 9(a)(2), 7 U.S.C. 9, 13b, and 13(a)(2), which

    proscribe any manipulation or attempt to manipulate the price of any

    commodity in interstate commerce; and CEA section 6(c) as amended by

    section 753 of the Dodd-Frank Act, which contains prohibitions

    regarding manipulation and false reporting with respect to any

    commodity in interstate commerce, including prohibiting any person

    to (i) ``use or employ, or attempt to use or employ * * * any

    manipulative or deceptive device or contrivance'' (section 6(c)(1));

    (ii) ``to make any false or misleading statement of material fact''

    to the CFTC or ``omit to state in any such statement any material

    fact that is necessary to make any statement of material fact made

    not misleading in any material respect'' (section 6(c)(2)); and

    (iii) ``manipulate or attempt to manipulate the price of any swap,

    or of any commodity in interstate commerce * * * (section 6(c)(3)).

    See also Rule 180.1(a) under the CEA, 17 CFR 180.1(a) (broadly

    prohibiting in connection with a commodity in interstate commerce

    manipulation, false or misleading statements or omissions of

    material fact to the Commission, fraud or deceptive practices or

    courses of business, and false reporting).

    ---------------------------------------------------------------------------

    (C) Withdrawal of the Energy Exemption

    Because the CFTC has expanded the Brent Interpretation to

    nonfinancial commodities in this final interpretation, the CFTC also

    has determined to withdraw the Energy Exemption as proposed. In

    response to comments received, the CFTC is clarifying that certain

    alternative delivery procedures discussed in the Energy Exemption \227\

    will not disqualify a transaction from the Brent Interpretation safe

    harbor.

    ---------------------------------------------------------------------------

    \227\ These include pre-transaction netting agreements that

    result in offsetting physical delivery obligations, ``bona fide

    termination rights,'' and certain other methods by which parties may

    settle their delivery obligations. See Energy Exemption, supra note

    208, at 21293.

    ---------------------------------------------------------------------------

    In the Proposing Release, the CFTC proposed to withdraw the Energy

    Exemption, which, among other things,

    [[Page 48230]]

    expanded the Brent Interpretation to energy commodities other than oil,

    on the basis that the exemption was no longer necessary in light of the

    extension of the Brent Interpretation to nonfinancial commodities.\228\

    The Energy Exemption, like the Brent Interpretation, requires binding

    delivery obligations at the outset, with no right to cash settle or

    offset transactions.\229\ Each requires that book-outs be undertaken

    pursuant to a subsequent, separately negotiated agreement.

    ---------------------------------------------------------------------------

    \228\ See Proposing Release at 29829. The CFTC also noted that,

    to avoid any uncertainty, the Dodd-Frank Act supersedes the Swap

    Policy Statement. Id. at 29829 n. 74. The CFTC reaffirms that such

    is the case.

    \229\ Compare Energy Exemption, supra note 208, at 21293 with

    Brent Interpretation, supra note 207, at 39192.

    ---------------------------------------------------------------------------

    As discussed above, the CFTC is extending the Brent Interpretation

    to the swap definition and applying it to all nonfinancial commodities

    for both the swap and future delivery definitions, but is withdrawing

    the Energy Exemption. With regard to netting agreements that were

    expressly permitted by the Energy Exemption,\230\ the CFTC clarifies

    that a physical netting agreement (such as, for example, the Edison

    Electric Institute Master Power Purchase and Sale Agreement) that

    contains a provision contemplating the reduction to a net delivery

    amount of future, unintentionally offsetting delivery obligations, is

    consistent with the intent of the book out provision in the Brent

    Interpretation--provided that the parties had a bona fide intent, when

    entering into the transactions, to make or take delivery (as

    applicable) of the commodity covered by those transactions.

    ---------------------------------------------------------------------------

    \230\ See Energy Exemption, supra note 208, at 21293.

    ---------------------------------------------------------------------------

    The CFTC also has determined that, notwithstanding the withdrawal

    of the Energy Exemption, a failure to deliver as a result of the

    exercise by a party of a ``bona fide termination right'' does not

    render an otherwise binding delivery obligation as non-binding.\231\ In

    the Energy Exemption, the CFTC provided the following examples of bona

    fide termination rights: force majeure provisions and termination

    rights triggered by events of default, such as counterparty insolvency,

    default or other inability to perform.\232\ The CFTC confirms that

    market participants who otherwise qualify for the forward exclusion may

    continue to rely on the bona fide termination right concept as set

    forth in this interpretation, although, as was stated in the Energy

    Exemption, such right must be bona fide and not for the purpose of

    evasion. In this regard, the CFTC further clarifies, consistent with

    the Energy Exemption, that a bona fide termination right must be

    triggered by something not expected by the parties at the time the

    contract is entered into.\233\

    ---------------------------------------------------------------------------

    \231\ See also infra part II.B.2(b)(v) for a discussion of

    liquidated damages.

    \232\ Energy Exemption, supra note 208, at 21293.

    \233\ Id.

    ---------------------------------------------------------------------------

    The Energy Exemption also discussed a number of methods by which

    parties to energy contracts settle their obligations, including: The

    seller's passage of title and the buyer's payment and acceptance of the

    underlying commodity; taking delivery of the commodity in some

    instances and in others instead passing title to another intermediate

    purchaser in a chain; and physically exchanging (i.e., delivering) one

    quality, grade or type of physical commodity for another quality, grade

    or type of physical commodity.\234\ The CFTC clarifies that these

    settlement methods generally \235\ are not inconsistent with the Brent

    Interpretation.\236\

    ---------------------------------------------------------------------------

    \234\ Id.

    \235\ The CFTC will carefully scrutinize whether market

    participants are legitimately relying on the Brent Interpretation

    safe harbor. For example, if non-commercial market participants are

    intermediate purchasers in a delivery chain, then the transaction is

    not actually a commercial merchandising transaction, and the parties

    cannot rely on the Brent Interpretation safe harbor.

    \236\ By definition, if two parties exchange (i.e., physically

    deliver) one physical commodity for another physical commodity in

    settlement of the parties' delivery obligations, each seller has

    delivered the commodity that is the subject of its delivery

    obligation under the relevant agreement, contract or transaction.

    Depending on the settlement timing, such transactions, which

    resemble barter transactions, would be spot transactions or forward

    transactions. While the most common forward transaction involves an

    exchange of a physical commodity for cash, neither the Brent

    Interpretation nor any other CFTC authority requires payment for a

    forward delivery to be made in cash. Thus, a physical exchange of

    one quality, grade or type of physical commodity for another

    quality, grade, or type of physical commodity does not affect the

    characterization of the transaction as a spot or forward

    transaction. As for the sellers passing title and buyers, instead of

    taking delivery of the commodity, passing title to another

    intermediate purchaser in a chain, this is consistent with the

    description of Brent transactions in the Brent Interpretation,

    provided that, as set forth therein, delivery is required and ``the

    delivery obligations create substantial economic risk of a

    commercial nature to the parties required to make or take delivery *

    * * includ[ing, without limitation,] demurrage, damage, theft or

    deterioration.'' That description was based on the industry delivery

    structure as it existed prior to the Brent Interpretation. To the

    extent other industries are similarly structured for commercial

    reasons, the delivery-by-title-and-related-bill-of-lading-transfer

    delivery method would be able to rely on the Brent Interpretation if

    it otherwise satisfied the terms thereof. However, to the extent

    persons seek to establish such a delivery structure for new products

    and markets (e.g., not actually delivering the commodity to most of

    the participants in a chain), that could, depending on the

    applicable facts and circumstances, be viewed as outside the Brent

    Interpretation safe harbor or evasion. The CFTC expects that the

    limitation of counterparties eligible to rely on the Brent

    Interpretation to those with a commercial purpose for entering into

    the transaction should limit the development of such markets to

    those with commercial reasons for such a delivery structure.

    ---------------------------------------------------------------------------

    (D) Book-Out Documentation

    The CFTC has taken into consideration comments regarding the

    documentation of book-outs.\237\ Under the Brent Interpretation, what

    is relevant is that the book out occur through a subsequent, separately

    negotiated agreement. While the CFTC is sensitive to existing

    recordkeeping practices for book-outs, in order to prevent abuse of the

    safe harbor, the CFTC clarifies that in the event of an oral agreement,

    such agreement must be followed in a commercially reasonable timeframe

    by a confirmation in some type of written or electronic form.

    ---------------------------------------------------------------------------

    \237\ See Letter from R. Michael Sweeney, Jr., Hunton & Williams

    LLP, on behalf of the Working Group of Commercial Energy Firms

    (``WGCEF''), dated July 22, 2011 (``WGCEF Letter'').

    ---------------------------------------------------------------------------

    (E) Minimum Contract Size and Other Contextual Factors

    In the Proposing Release, the CFTC requested comment about

    potentially imposing additional conditions (such as, for example, a

    minimum contract size) in order for a transaction to qualify as a

    forward contract under the Brent Interpretation with respect to the

    future delivery and swap definitions.\238\ The CFTC has determined that

    a minimum contract size should not be required in order for a contract

    to qualify as a forward contract under the Brent Interpretation.\239\

    However, as suggested

    [[Page 48231]]

    by a commenter, the CFTC may consider contract size as a contextual

    factor in determining whether a particular contract is a forward.\240\

    Moreover, the CFTC may consider other contextual factors when

    determining whether a contract qualifies as a forward, such as a

    demonstrable commercial need for the product, the underlying purpose of

    the contract (e.g. whether the purpose of the claimed forward was to

    sell physical commodities, hedge risk, or speculate), the regular

    practices of the commercial entity with respect to its general

    commercial business and its forward and swap transactions more

    specifically, or whether the absence of physical settlement is based on

    a change in commercial circumstances. These contextual factors are

    consistent with the CFTC's historical facts-and-circumstances approach

    to the forward contract exclusion outside of the Brent Interpretation

    safe harbor.

    ---------------------------------------------------------------------------

    \238\ See Proposing Release at 29831, Request for Comment 27.

    \239\ Most commenters opposed adding a minimum contract size or

    other conditions to the CFTC's interpretation of the forward

    exclusion. One commenter argued that such an approach would be

    inconsistent with CFTC precedent, citing the fact that neither the

    Brent Interpretation nor subsequent CFTC precedent interpreting the

    forward exclusion mention contract size. See CME Letter. Another

    commenter pointed out that Congress did not impose such a

    requirement, and thus believes that the CFTC should not do so. See

    Letter from David M. Perlman, Partner, Bracewell & Giuliani LLP,

    Counsel to the Coalition of Physical Energy Companies (``COPE''),

    dated July 22, 2011 (``COPE Letter''). Similarly, a third commenter

    argued that the only condition Congress placed on the forward

    exclusion is intent to physically settle, and contract size is not

    relevant to such intent. See Letter from Natural Gas Supply

    Association/National Corn Growers Association (``NGSA/NCGA''), dated

    July 22, 2011 (``NGSA/NCGA Letter'').

    Two commenters questioned the reasonableness in instituting a

    minimum contract size below which a transaction would become

    regulated, but otherwise would not. See Letter from Craig G.

    Goodman, Esq., President, The National Energy Marketers Association

    (``NEMA''), dated July 21, 2011, (``NEMA Letter'') and Letter from

    Phillip G. Lookadoo on behalf of the International Energy Credit

    Association (``IECA''), dated July 28, 2011 (``IECA Letter''). Two

    commenters believed that such an approach would be contrary to the

    purposes of Dodd-Frank in regulating transactions that would affect

    systemic risk. See NEMA Letter and Letter from Dan Gilligan and

    Michael Trunzo, Petroleum Marketers Association of America and New

    England Fuel Institute (``PMAA/NEFI''), dated July 22, 2011 (``PMAA/

    NEFI Letter''). One commenter urged that the Brent Interpretation be

    applied with minimal restrictive overlay. It believed that contract

    size is a ``contextual factor'' that may be considered in evaluating

    the existence of intent to deliver, but should not be viewed as an

    independent determinant. See ISDA Letter.

    One commenter argued that the forward exclusion should be

    strengthened with additional conditions to preclude evasion. Its

    suggested conditions include defining the required regularity of

    delivery (such as a predominance, or ``more often than not''

    standard); providing a quantitative test of bona fide intent to

    deliver (such as a demonstrable commercial need for the product and

    justifying non-physical settlement based on a change in commercial

    circumstances); and re-evaluating the book-outs aspect of the Brent

    Interpretation. See Better Markets Letter.

    \240\ See ISDA Letter.

    ---------------------------------------------------------------------------

    Comments

    Several commenters believed that the CFTC should codify its

    proposed interpretation regarding the Brent Interpretation in rule text

    to provide greater legal certainty.\241\ One commenter further

    commented that the Dodd-Frank Act's legislative history expressly

    directed the CFTC to clarify through rulemaking that the nonfinancial

    commodity forward contract exclusion from the swap definition is

    intended to be consistent with the forward contract exclusion from the

    term ``future delivery.''\242\ The commenter also stated its view that

    the interpretation as proposed does not provide notice to the

    electricity industry as to how to determine whether a nonfinancial

    commodity agreement is a swap or a nonfinancial commodity forward

    contract, nor as to which factors the CFTC would consider in

    distinguishing between swaps and nonfinancial forward contracts.\243\

    Moreover, another commenter suggested that the CFTC should include in

    regulatory text a representative, non-exhaustive list of the kinds of

    contracts that are excluded from the swap definition.\244\

    ---------------------------------------------------------------------------

    \241\ See Letter from Lisa Yoho, Director, Regulatory Affairs,

    BGA, dated July 22, 2011) (``BGA Letter''); COPE Letter; Letter from

    Michael Bardee, General Counsel, Federal Energy Regulatory

    Commission (``FERC''), dated July 22, 2011 (``FERC Staff Letter'');

    Letter from Stephanie Bird, Chief Financial Officer, Just Energy,

    dated July 22, 2011 (``Just Energy Letter''); Letter from the

    Electric Trade Associations (the Electric Power Supply Association,

    National Rural Electric Cooperative Association, Large Public Power

    Council, Edison Electric Institute and American Power Association)

    (``ETA Letter''), dated July 22, 2011.

    \242\ See ETA Letter (citing the ``Lincoln-Dodd Letter'' printed

    at 156 Cong. Rec. H5248-249).

    \243\ See ETA Letter. The commenter requests that the CFTC

    ``further define the statutory term `swap' by defining relevant

    terms in the Dodd-Frank Act, reconciling the wording used in the

    various provisions in the CEA as amended by the Dodd-Frank Act, and

    setting forth in the [CFTC's] rules the factors that are

    determinative in drawing the distinction between a `swap' and a

    `nonfinancial commodity forward contract.''' The commenter suggests

    rule text to codify the CFTC's interpretation regarding the

    exclusion of nonfinancial commodity forward contracts. Id.

    \244\ See FERC Staff Letter.

    ---------------------------------------------------------------------------

    The CFTC has determined not to codify its interpretation in rule

    text. The CFTC has never codified its prior interpretations of the

    forward contract exclusion with respect to the future delivery

    definition as a rule or regulation;\245\ thus, providing an

    interpretation is consistent with the manner in which the CFTC has

    interpreted the forward exclusion in the past, which in turn is

    consistent with the Dodd-Frank Act legislative history.\246\ Moreover,

    Congress did not direct the CFTC to write rules regarding the forward

    exclusion. The Dodd-Lincoln letter, cited by a commenter in support of

    its argument, ``encourages'' the CFTC to clarify the forward exclusion

    ``through rulemaking'' in the generic sense of that term (i.e., through

    the rulemaking process of notice and comment), not specifically through

    rule text.\247\ Similarly, the CFTC is not providing in rule text a

    representative list of contracts in nonfinancial commodities that are

    excluded from the swap definition as forwards.

    ---------------------------------------------------------------------------

    \245\ See, e.g. Brent Interpretation, supra note 207; Energy

    Exemption, supra note 208; Characteristics Distinguishing Cash and

    Forward Contracts and ``Trade'' Options, 50 FR 39656 (Sep. 30, 1985)

    (``1985 CFTC OGC Interpretation'').

    \246\ See supra note 210 and accompanying text.

    \247\ See 156 Cong. Rec. H5248-49 (June 30, 2010).

    ---------------------------------------------------------------------------

    The CFTC believes that its interpretation provides sufficient

    clarity with respect to the forward contract exclusion from the swap

    and future delivery definitions.\248\ The CFTC also believes that the

    interpretation provides sufficient notice to the public regarding how

    the forward exclusions from the swap and future delivery definitions

    will be interpreted. As noted above, the CFTC's historical approach to

    the forward contract exclusion from the future delivery definition

    developed on a case-by-case basis, not by rule.

    ---------------------------------------------------------------------------

    \248\ This is particularly true given that the CFTC intends to

    interpret the forward exclusion from the swap definition

    consistently with its interpretation of the forward exclusion from

    the term ``future delivery,'' with which market participants have

    had decades of experience.

    ---------------------------------------------------------------------------

    Commenters generally supported applying the Brent Interpretation to

    the forward exclusion from the swap definition and expanding it to all

    nonfinancial commodities for purposes of the forward exclusion from

    both the definitions of the terms ``future delivery'' and ``swap.''

    \249\ However, in addition to the requests for clarification to which

    the CFTC has responded in its final interpretation provided above,

    commenters raise other requests for clarification. One commenter,\250\

    for example, believed that the CFTC's adjudicatory decisions in Grain

    Land \251\ and Wright \252\ should be construed to have expanded the

    Brent Interpretation's safe harbor. This commenter stated its view that

    in Grain Land, the CFTC recognized that cancellation provisions or an

    option to roll the delivery date within flexible hedge-to-arrive

    contracts did not render the transactions futures contracts, as opposed

    to forwards. As such, this commenter believed this case may be at odds

    with the literal terms of the Brent Interpretation regarding book-outs,

    which required that, to be a forward contract, any cancellation of

    delivery must be effected through a subsequent, separately negotiated

    agreement. The commenter argued that cases subsequent to the Brent

    Interpretation, such as Grain Land and Wright, recognized the need for

    flexibility and innovation in the commercial merchandising transactions

    that are eligible for the forward exclusion. Therefore, this commenter

    requested that the CFTC consider the body of

    [[Page 48232]]

    forward contract precedent as a whole and extend the Brent

    Interpretation's safe harbor to situations like those presented in

    Grain Land, notwithstanding the absence of a subsequent, separately-

    negotiated agreement.\253\

    ---------------------------------------------------------------------------

    \249\ See BGA Letter; COPE Letter; ISDA Letter; IECA Letter;

    Letter from Stuart J. Kaswell, Executive Vice President & Managing

    Director, Managed Funds Association (``MFA''), dated July 22, 2011

    (``MFA Letter''); NGSA/NCGA Letter; Letter from Charles F. Conner,

    President and CEO, National Council of Farmer Cooperatives

    (``NCFC''), dated July 22, 2011 (``NCFC Letter''); NEMA Letter;

    PMAA/NEFI Letter; WGCEF Letter.

    \250\ See CME Letter.

    \251\ Grain Land, supra note 213.

    \252\ Wright, supra note 214.

    \253\ See CME Letter.

    ---------------------------------------------------------------------------

    While, as noted above, the CFTC has clarified that the entire body

    of its precedent applies to its interpretation of the forward exclusion

    for nonfinancial commodities in the swap definition, the CFTC does not

    believe that there is a conflict between the Brent Interpretation and

    the Grain Land or Wright cases. In Grain Land, the CFTC concluded that

    the fact that a contract includes a termination right, standing alone,

    is not determinative of whether the contract is a forward. Rather, as

    the CFTC has always interpreted the forward exclusion, it looks to the

    facts and circumstances of the transaction. Similarly in Wright, which

    cited Grain Land with approval, the CFTC stated that ``[i]n assessing

    the parties' expectations or intent regarding delivery, the Commission

    applies a `facts and circumstances' test rather than a bright-line test

    focused on the contract's terms * * * .'' In contrast, the Brent

    Interpretation is a safe harbor that assures commercial parties that

    book-out their contracts through a subsequent, separately negotiated

    agreement that their contracts will not fall out of the forward

    exclusion. The CFTC's conclusion that application of its facts-and-

    circumstances approach demonstrated that the particular contracts at

    issue in Grain Land and Wright were forwards did not expand the scope

    of the safe harbor afforded by the Brent Interpretation.\254\

    ---------------------------------------------------------------------------

    \254\ As described above in the interpretation, the CFTC has

    addressed CME's other comments on the forward exclusion, including

    the interpretation's applicability to commercial market participants

    and CME's hedge fund example.

    ---------------------------------------------------------------------------

    Several commenters suggested that the Energy Exemption should not

    be withdrawn. One commenter noted that the Energy Exemption, along with

    the Brent Interpretation, should inform the CFTC's interpretation of

    the forward exclusion.\255\ Another commenter believed that the Energy

    Exemption appears entirely consistent with the Dodd-Frank Act and

    should be included in the rules as a non-exclusive exemption to ensure

    continued clarity.\256\ A third commenter requested clarification that

    revoking the Energy Exemption will not harm market participants,

    stating that the Proposing Release did not sufficiently explain the

    rationale for withdrawing the Energy Exemption or the possible

    consequences for energy market participants. This commenter sought

    confirmation that, despite the withdrawal of the Energy Exemption,

    market participants will be permitted to rely on the Brent

    Interpretation, as expanded by the Energy Exemption, particularly as it

    relates to alternative delivery procedures.\257\ This commenter

    expressed concern that by withdrawing the Energy Exemption, the CFTC

    would be revoking the ability of market participants to rely on pre-

    transaction netting agreements to offset physical delivery obligations

    as an alternative to separately negotiating book-outs after entering

    into the transactions.\258\ As discussed above, the CFTC has determined

    to withdraw the Energy Exemption as proposed, but has provided certain

    clarifications to address commenters' concerns.

    ---------------------------------------------------------------------------

    \255\ See COPE Letter Appendix.

    \256\ See IECA Letter.

    \257\ See MFA Letter.

    \258\ Ex Parte Communication between MFA and CFTC Staff on

    September 15, 2011, at http://comments.cftc.gov/PublicComments/ViewExParte.aspx?id=387&SearchText= .

    ---------------------------------------------------------------------------

    One commenter suggested the deletion of ``commercial merchandising

    transaction'' as a descriptive term in the interpretation. Although

    recognizing its provenance from the Brent Interpretation, this

    commenter believed that the phrase was anachronistic at that time, and

    that it is misleading and narrow in the current evolving commercial

    environment.\259\ Contrary to this commenter's suggestion, the CFTC has

    determined to retain the phrase ``commercial merchandising

    transaction'' in its final interpretation regarding forward contracts.

    The CFTC characterized forward transactions in this manner in the Brent

    Interpretation, as well as in its subsequent adjudications. Courts also

    have characterized forwards as commercial merchandising transactions or

    cited the CFTC's characterization with approval.\260\ Accordingly, the

    CFTC believes that ``commercial merchandising transaction'' continues

    to be an accurate descriptive term for characterizing forward

    transactions.

    ---------------------------------------------------------------------------

    \259\ See ISDA Letter.

    \260\ See, e.g., In re Bybee, 945 F.2d 309, 315 (9th Cir. 1991).

    ---------------------------------------------------------------------------

    Another commenter requested that the CFTC clarify that a

    subsequent, separately-negotiated agreement to effectuate a book-out

    under the Brent Interpretation may be oral or written. This commenter

    noted that the pace at which certain energy markets transact and the

    frequency with which book-outs may sometimes occur, makes formal

    written documentation of all book-outs impracticable.\261\ The CFTC has

    provided an interpretation above regarding the documentation of book-

    outs in response to this commenter's concerns.

    (ii) Nonfinancial Commodities

    ---------------------------------------------------------------------------

    \261\ See WGCEF Letter.

    ---------------------------------------------------------------------------

    In response to commenters,\262\ the CFTC is providing an

    interpretation regarding the scope of the term ``nonfinancial

    commodity'' in the forward exclusion from the swap definition.\263\

    ---------------------------------------------------------------------------

    \262\ The Commissions requested comment in the Proposing Release

    on whether they should provide guidance regarding the scope of the

    term ``nonfinancial commodity'' and, if so, how and where the line

    should be drawn between financial and nonfinancial commodities. See

    Proposing Release at 29832.

    \263\ As noted above, the CEA definition of the term ``swap''

    excludes ``any sale of a nonfinancial commodity or security for

    deferred shipment or delivery, so long as the transaction is

    intended to be physically settled.'' CEA section 1a(47)(B)(ii), 7

    U.S.C. 1a(47)(B)(ii). Thus, the forward exclusion from the swap

    definition is limited to transactions in nonfinancial commodities.

    To the extent the CFTC uses the term ``nonfinancial commodity'' in

    other contexts in this release, such as in connection with the Brent

    Interpretation (including as it applies with respect to the ``future

    delivery'' definition), the term will have the same meaning as

    discussed in this section in those contexts.

    ---------------------------------------------------------------------------

    The CFTC interprets the term ``nonfinancial commodity'' to mean a

    commodity that can be physically delivered and that is an exempt

    commodity \264\ or an agricultural commodity.\265\ Unlike excluded

    commodities, which generally are financial,\266\ exempt and

    agricultural commodities by their nature generally are nonfinancial.

    The requirement that the commodity be able to be physically delivered

    is designed to prevent market participants from relying on the forward

    exclusion to enter into swaps based on indexes of exempt or

    agricultural commodities outside of the Dodd-Frank Act and settling

    them in cash, which would be inconsistent with the historical

    limitation of the forward exclusion to commercial merchandising

    transactions. However, to the extent that a transaction is intended to

    be physically settled, otherwise meets the terms of the forward

    contract exclusion and uses an index merely to determine the price to

    be paid for the nonfinancial commodity intended to be delivered,

    [[Page 48233]]

    the transaction may qualify for the forward exclusion from the swap

    definition.

    ---------------------------------------------------------------------------

    \264\ The CEA defines an ``exempt commodity'' as ``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

    commodity as discussed below, and therefore is not an exempt

    commodity.

    \265\ The CFTC has defined the term ``agricultural commodity''

    in its regulations at Rule 1.3(zz) under the CEA, 17 CFR 1.3(zz).

    See Agricultural Commodity Definition, 76 FR 41048 (Jul. 13, 2011).

    \266\ The CEA defines an ``excluded commodity'' at CEA section

    1a(19), 7 U.S.C. 1a(19).

    ---------------------------------------------------------------------------

    In addition, the CFTC is providing an interpretation that an

    intangible commodity (that is not an excluded commodity) which can be

    physically delivered qualifies as a nonfinancial commodity if ownership

    of the commodity can be conveyed in some manner and the commodity can

    be consumed. One example of an intangible nonfinancial commodity that

    qualifies under this interpretation, as discussed in greater detail

    below, is an environmental commodity, such as an emission allowance,

    that can be physically delivered and consumed (e.g., by emitting the

    amount of pollutant specified in the allowance).\267\ The

    interpretation provided herein recognizes that transactions in

    intangible commodities can, in appropriate circumstances, qualify as

    forwards, while setting forth certain conditions to assure that the

    forward exclusion may not be abused with respect to intangible

    commodities.

    ---------------------------------------------------------------------------

    \267\ See supra part II.B.2.a)iii), regarding environmental

    commodities. An emission allowance buyer also can consume the

    allowance by retiring it without emitting the permitted amount of

    pollutant.

    ---------------------------------------------------------------------------

    Comments

    Several commenters believed that the CFTC should provide an

    interpretation regarding the meaning of the term ``nonfinancial

    commodity'' to provide clarity to market participants on the

    applicability of the forward exclusion.\268\ The CFTC is providing the

    interpretation discussed above to address these commenters' concerns

    but, contrary to one commenter's request, declines to adopt a

    regulation.\269\

    (iii) Environmental Commodities

    ---------------------------------------------------------------------------

    \268\ See Letter from Steven J. Mickelsen, Counsel, 3Degrees

    Group, Inc., dated July 22, 2011 (``3Degrees Letter''); ETA Letter;

    and Letter from Kari S. Larsen, General Counsel, Chief Regulatory

    Officer, Green Exchange LLC, dated July 22, 2011 (``GreenX

    Letter''). Each of these commenters proposed its own definition of

    ``nonfinancial commodity.'' The interpretation above incorporates

    many of their suggestions.

    \269\ See ETA Letter. This is consistent with CFTC practice in

    providing an interpretation rather than regulations where warranted.

    In this context, the CFTC is providing an interpretation rather than

    rule text because the CFTC is not limiting the definition of

    ``nonfinancial commodity'' to exempt and agricultural commodities

    (the latter category includes agricultural commodity indexes (see 17

    CFR 1.3(zz)(4))). The definition also requires physical

    deliverability and, with respect to intangible commodities,

    ownership transferability and consumability. Whether a commodity has

    these features may require interpretation. In any case, courts can

    rely on agency interpretations.

    ---------------------------------------------------------------------------

    The Commissions requested comment on whether environmental

    commodities should fall within the forward exclusion from the swap

    definition and, if so, subject to what parameters.\270\ In response to

    commenters, the CFTC is providing an interpretation regarding the

    circumstances under which agreements, contracts or transactions in

    environmental commodities will satisfy the forward exclusion from the

    swap definition.\271\ The CFTC did not propose a definition of the term

    ``environmental commodity'' in the Proposing Release and is not doing

    so in this release.\272\ The CFTC believes it is not necessary to

    define the term ``environmental commodity'' because any intangible

    commodity--environmental or otherwise--that satisfies the terms of the

    interpretation provided herein is a nonfinancial commodity, and thus an

    agreement, contract or transaction in such a commodity is eligible for

    the forward exclusion from the swap definition.\273\ The forward

    exclusion from the swap definition does not apply to commodities

    themselves, but to certain types of agreements, contracts or

    transactions in a specified type of commodity (i.e., a ``nonfinancial''

    commodity).\274\ Environmental commodities that meet the interpretation

    regarding nonfinancial commodities discussed in subsection (ii) above

    are nonfinancial commodities and, therefore, a sale for deferred

    shipment or delivery in such a commodity, so long as the transaction is

    intended to be physically settled, may qualify for the forward

    exclusion from the swap definition.

    ---------------------------------------------------------------------------

    \270\ See Proposing Release at 29832, Request for Comment 32,

    asked: Should the forward contract exclusion from the swap

    definition apply to environmental commodities such as emissions

    allowances, carbon offsets/credits, or renewable energy

    certificates? If so, please describe these commodities, and explain

    how transactions can be physically settled where the commodity lacks

    a physical existence (or lacks a physical existence other than on

    paper)? Would application of the forward contract exclusion to such

    environmental commodities permit transactions that should be subject

    to the swap regulatory regime to fall outside the Dodd-Frank Act?

    \271\ Because the CFTC has determined, as discussed elsewhere in

    this release, to interpret the forward exclusion from the swap

    definition consistently with the forward exclusion from the ``future

    delivery'' definition, the discussion in this section applies

    equally to the forward exclusion from future delivery.

    \272\ See also Letter from Gene Grace, Senior Counsel, American

    Wind Energy Association (``AWEA''), dated July 22, 2011 (``AWEA

    Letter'') (providing a general description of renewable energy

    credits (``RECs''), emission allowances, and offsets, which the

    commenter collectively termed ``environmental commodities'' for

    purposes of its letter).

    \273\ Thus, market participants should apply the interpretation

    to their facts to determine whether their specific circumstances

    support reliance on the forward exclusion from the swap definition.

    \274\ Several commenters appear to have confused these concepts.

    The term ``commodity'' is defined in CEA section 1a(9), 7 U.S.C.

    1a(9). The forward exclusion in CEA section 1a(47)(B)(ii), 7 U.S.C.

    1a(47)(B)(ii), excludes from the swap definition ``any sale of a

    nonfinancial commodity or security for deferred shipment or

    delivery, so long as the transaction is intended to be physically

    settled.''

    ---------------------------------------------------------------------------

    The intangible nature of environmental, or other, commodities does

    not disqualify contracts based on such commodities from the forward

    exclusion from the swap definition, notwithstanding that the core of

    the forward exclusion is intent to deliver the underlying

    commodity.\275\ As commenters noted, securities are intangible (with

    the exception of the rare certificated security) and yet they are

    expressly permitted by CEA section 1a(47)(B)(ii) \276\ to be the

    subject of the forward exclusion; this reflects recognition by Congress

    that the forward exclusion can apply to intangible commodities.\277\

    ---------------------------------------------------------------------------

    \275\ See supra part II.B.2.a)i)(A).

    \276\ 7 U.S.C. 1a(47)(B)(ii).

    \277\ As commenters also note, each Commission or its staff has

    previously indicated that environmental commodities, in the CFTC's

    case, and securities, in the SEC's case, can be physically settled.

    See Letter from Kyle Danish, Van Ness Feldman, P.C., on behalf of

    Coalition for Emission Reduction Policy (``CERP''), dated July 18,

    2011 (``CERP Letter'') and 3Degrees Letter. Also, the recent Carbon

    Report suggested that the forward exclusion could apply to

    agreements, contracts or transactions in environmental commodities.

    See Interagency Working Group for the Study on Oversight of Carbon

    Markets (``Interagency Working Group''), Report on the Oversight of

    Existing and Prospective Carbon Markets (January 2011) (``Carbon

    Report''). The Carbon Report specifically stated that--[n]o set of

    laws currently exist that apply a comprehensive regulatory regime--

    such as that which exists for derivatives--specifically to secondary

    market trading of carbon allowances and offsets. Thus, for the most

    part, absent specific action by Congress, a secondary market for

    carbon allowances and offsets may operate outside the routine

    oversight of any market regulator.

    ---------------------------------------------------------------------------

    The CFTC understands that market participants often engage in

    environmental commodity transactions in order to transfer ownership

    \278\ of the environmental commodity (and not solely price risk),\279\

    so that the buyer

    [[Page 48234]]

    can consume the commodity in order to comply with the terms of

    mandatory or voluntary environmental programs.\280\ Those two

    features--ownership transfer and consumption--distinguish such

    environmental commodity transactions from other types of intangible

    commodity transactions that cannot be delivered, such as temperatures

    and interest rates. The ownership transfer and consumption features

    render such environmental commodity transactions similar to tangible

    commodity transactions that clearly can be delivered, such as wheat and

    gold.\281\

    ---------------------------------------------------------------------------

    \278\ One commenter maintains that a transaction in an

    environmental allowance represents a physically-settled transaction

    because its primary purpose is to transfer ownership of the right to

    emit a specified unit of pollution. See Letter from Andrew K. Soto,

    American Gas Association (``AGA''), dated July 22, 2011 (``AGA

    Letter''). Compare to Proposing Release at 29828 (stating that

    ``[t]he primary purpose of the contract is to transfer ownership of

    the commodity'').

    \279\ Another commenter states that, from a practical

    standpoint, the buyer must take delivery to satisfy a compliance

    obligation, which typically requires surrender of allowances and

    offset credits, and likens such transactions to forward sales of

    more tangible commodities, noting they are not devices for

    transferring price risk. See CERP Letter. Compare to Proposing

    Release at 29828 (stating that ``[t]he primary purpose of the

    contract is * * * not to transfer solely * * * price risk''). This

    commenter also advises that delivery of RECs and offsets is

    typically deferred for commercial convenience, consistent with the

    Brent Interpretation, because ``not all of the purchased RECs and

    offsets are generated at the time of the transaction'' and ``long-

    term contracts with deferred delivery are important for renewable

    energy projects to ensure a consistent revenue stream over a long

    period of time.'' See CERP Letter.

    \280\ Consumption also can be part of a commercial merchandising

    transaction in the chain of commerce. See, e.g., Brent

    Interpretation, supra note 207 (dissent of Commissioner Fowler West)

    (citing the 1985 CFTC OGC Interpretation and cases cited therein for

    the proposition that ``parties to forward contracts * * * seek to

    profit in their businesses from producing, processing, distributing,

    storing, or consuming the commodity'').

    \281\ Similarly, the settlement method for the types of

    environmental commodity transactions described by commenters such as

    RECs, emission allowances, and offsets are equivalent to that of

    physical commodities where ownership is transferred by delivering a

    warehouse receipt from the seller to the buyer, thereby indicating

    the presence in the warehouse of the contracted for commodity

    volume. See GreenXLetter. See also REMA letter (averring that ``[i]n

    effect, the REC is an intangible contract right or interest in that

    specific quantity of energy; thus, it is quite analogous to a

    warehouse receipt that represents title to a physical commodity'').

    Another similarity between these environmental commodity

    transactions and tangible commodities is that it is possible to

    manipulate the deliverable supply of an environmental commodity just

    as it is for a tangible commodity. The CFTC reminds market

    participants of its continuing authority over forwards under the

    CEA's anti-manipulation provisions prohibiting manipulation, making

    false and misleading statements and omissions of material fact to

    the CFTC, fraud and deceptive practices, and false reporting. See

    supra note 226.

    ---------------------------------------------------------------------------

    For such transactions, in addition to the factors discussed above,

    intent to deliver is readily determinable,\282\ delivery failures

    generally result from frustration of the parties' intentions,\283\ and

    cash-settlement is insufficient because delivery of the commodity is

    necessary for compliance purposes.\284\ For the foregoing reasons,

    environmental commodities can be nonfinancial commodities that can be

    delivered through electronic settlement or contractual attestation.

    Therefore, an agreement, contract or transaction in an environmental

    commodity may qualify for the forward exclusion from the swap

    definition if the transaction is intended to be physically settled.

    ---------------------------------------------------------------------------

    \282\ See Letter from Jennifer Martin, Executive Director,

    Center for Research Solutions (``CRS''), dated July 22, 2011 (``CRS

    Letter'').

    \283\ See 3Degrees Letter.

    \284\ See GreenX Letter.

    ---------------------------------------------------------------------------

    Comments

    Several commenters responded to the Commission's request for

    comment regarding the applicability of the forward exclusion from the

    swap definition for agreements, contracts and transactions in

    environmental commodities.\285\

    ---------------------------------------------------------------------------

    \285\ One commenter provided a general description of renewable

    energy credits (``RECs''), emission allowances, offsets, (which the

    commenter collectively termed ``environmental commodities'' for

    purposes of its letter), and related transactions. See AWEA Letter.

    According to the commenter, RECs are created by state regulatory

    bodies in conjunction with the production of electricity from a

    qualifying renewable energy facility. The forward sale of a REC

    transfers ownership of the REC from the producing entity to another

    entity that can use the REC for compliance with an obligation to

    sell a certain percentage of renewable energy. Many times, this

    forward sale takes place prior to the construction of a project to

    enable developers to secure related project financing. See AWEA

    Letter. See also Letter from Mary Anne Mason, HoganLovells LLP on

    behalf of Southern California Edison Company, Pacific Gas and

    Electric Company and San Diego Gas and Electric Company

    (``California Utilities''), dated July 22, 2011 (``California

    Utilities Letter'') (stating that the California Utilities transact

    in allowances, under the EPA's and anticipated California cap-and-

    trade programs, as well as in RECs, in order to comply with or

    participate in various regulatory and voluntary programs).

    The CFTC understands that, in the United States, emission

    allowances and offsets are issued by the U.S. Environmental

    Protection Agency (``EPA''), state government entities and private

    entities. Emission allowances and offsets are transferred between

    counterparties, often through forward contracts, with the purchasing

    party obtaining the ability to use the allowances or offsets for

    compliance with clean air or greenhouse gas regulations. The forward

    sale of allowances and offsets allows market participants to hedge

    the compliance obligations associated with expected emissions, or to

    meet a voluntary emissions reduction commitment or make an

    environmental claim. See, e.g., AWEA Letter; Letter from Henry

    Derwent, President and CEO, International Emissions Trading

    Association, dated July 22, 2011 (defining a carbon offset as a

    ``credit[] granted by a state or regional governmental body or an

    independent standards organization in an amount equal to the

    generation of electricity from a qualifying renewable energy

    facility.'').

    ---------------------------------------------------------------------------

    Most commenters responding to the Commissions' request for comment

    concerning the appropriate treatment of agreements, contracts or

    transactions in environmental commodities asserted that emission

    allowances, carbon offsets/credits, or RECs should be able to qualify

    for the forward exclusion from the swap definition. In support of this

    view, several commenters explained that the settlement process for

    environmental commodity transactions generally involves ``the transfer

    of title via a tracking system, registry or contractual attestation, in

    exchange for a cash payment.'' \286\ One commenter stated that this

    form of settlement demonstrates that the lack of physical existence of

    a commodity is not relevant to whether a transaction in the commodity

    physically settles for purposes of the forward exclusion.\287\ Another

    commenter contended that title transfer constitutes physical delivery

    because the settlement results in the environmental commodity being

    consumed to meet an environmental obligation or goal, which occurs

    through ``retirement'' of the environmental commodity.\288\ Other

    commenters compared the settlement of a transaction in an environmental

    commodity through an electronic registry system to a warehouse receipt

    that represents title to a physical commodity.\289\

    ---------------------------------------------------------------------------

    \286\ See 3Degrees Letter. See also WGCEF Letter (advising that

    ``physical delivery takes place the moment that title and ownership

    in the environmental commodity itself is transferred from the seller

    to the buyer[,] whether through the execution of a legally binding

    contract or attestation, or submission of records to a centralized

    data base, such as a registry''); Letter from the Hons. Jeffrey A.

    Merkley, Sherrod Brown and Jeanne Shaheen, U.S. Senators, dated

    January 13, 2012 (``Senators Letter'') (relaying that ``[t]he

    purchase or sale of a REC is settled through the transfer of title

    to the REC, either electronically over a tracking system or via a

    paper attestation''); Letter from Harold Buchanan, Chief Executive

    Officer, CE2 Carbon Capital, LLC (``CE2''), dated July 22, 2011

    (``CE2 Letter''); Letter from Jason M. Rosenstock, ML Strategies LLC

    on behalf of The Business Council for Sustainable Energy (``BCSE''),

    dated January 24, 2012 (``BCSE Letter''); NEMA Letter (stating that

    RECs must be physically settled through a REC registry, which

    ``ensures that there is a physical megawatt hour from a green

    generator behind the REC'').

    \287\ See 3Degrees Letter. See also GreenX Letter (stating that

    environmental commodities share the same characteristics as tangible

    physical commodities ``in all key respects,'' including that they

    are in limited supply).

    \288\ See CRS Letter. CRS explains that retirement occurs

    through a registry or electronic tracking system by transfer into a

    retirement account (or, alternatively, an exchange of paperwork) and

    that, once retired, an environmental commodity cannot be resold. The

    CRS also argues that such environmental commodity transactions are

    commercial merchandising transactions, and thus may be forward

    contracts, because the primary purpose of the transactions is to

    transfer ownership so that the purchaser may comply with an

    applicable environmental program. See also 3Degrees Letter and AWEA

    Letter.

    \289\ See Letter from Josh Lieberman, General Manager, Renewable

    Energy Markets Association (``REMA''), dated July 22, 2011 (``REMA

    Letter'') (distinguishing RECs, which allow the buyer to own

    environmental attributes, from a pure financial swap, where only

    price risk is transferred); See also GreenX Letter (likening the

    settlement of an environmental commodity transaction (where delivery

    typically would take place by electronic delivery from the registry

    account of the seller to the registry account of the buyer) to that

    of transactions in many tangible physical commodities, such as

    agricultural commodities and metals, where settlement is evidenced

    by an electronic transfer of a warehouse receipt in the records of

    the warehouse and the underlying commodity does not move--it remains

    in the warehouse or vault--but its ownership changes)).

    ---------------------------------------------------------------------------

    [[Page 48235]]

    A few commenters also analogized environmental commodities to

    securities, which (with the exception of certificated securities) are

    intangible. Some commenters, for example, asserted that the language of

    the forward exclusion from the swap definition means that non-physical

    items can be physically settled because the exclusion, which references

    securities, ``implies that securities--which lack a strict physical

    existence--may be physically settled.'' \290\

    ---------------------------------------------------------------------------

    \290\ See CRS Letter. See also CERP Letter (claiming that

    Congress did not intend for the phrase ``physically settled'' in the

    forward exclusion to be limited to tangible commodities because,

    like environmental commodities, securities only exist ``on

    paper.''). See also AWEA Letter.

    ---------------------------------------------------------------------------

    Some commenters assured the Commissions that applying the forward

    exclusion to transactions in environmental commodities would not permit

    transactions that should be subject to the swap regulatory regime to

    fall outside it. One commenter submitted that intent to deliver with

    respect to environmental commodities will be readily determinable.\291\

    Another commenter contended that: environmental commodity contracts

    almost universally require delivery and that failure to do so is an

    event of default; to the best of its knowledge, it is rare for such a

    contract to include the right to unilaterally terminate an agreement

    under a pre-arranged contractual provision permitting financial

    settlement; \292\ and defaults generally are the result of something

    frustrating parties' intentions.\293\ Still other commenters

    distinguished environmental commodities from other intangible

    commodities, such as the nonfinancial commodities (such as interest

    rates and temperatures) that the CFTC referred to in its Adaptation

    Notice of Proposed Rulemaking,\294\ because RECs and emissions

    allowances or offsets can be physically transferred from one account to

    another, whereas ``it is not possible to move and physically transfer

    an interest rate or a temperature reading.'' \295\

    ---------------------------------------------------------------------------

    \291\ See CRS Letter (``unlike a stock or a bond, which can be

    resold for its cash value, purchasers of environmental commodities

    intend to take delivery of RECs or carbon offsets for either

    compliance purposes or in order to make an environmental claim

    regarding their renewable energy use or carbon footprint.''). See

    also GreenX Letter.

    \292\ Such a provision would preclude reliance on the forward

    exclusion.

    \293\ See 3Degrees Letter.

    \294\ See Adaptation of Regulations to Incorporate Swaps, 76 FR

    33066, June 7, 2011.

    \295\ See California Utilities Letter.

    ---------------------------------------------------------------------------

    As discussed above, the CFTC has addressed the foregoing concerns

    of commenters by providing an interpretation that agreements, contracts

    and transactions in environmental commodities may qualify for the

    forward exclusion from the swap definition.

    One commenter stated its view that the forward exclusion from the

    swap definition should not be available for carbon transactions because

    they should be standardized and conducted on open, transparent and

    regulated exchanges.\296\ This commenter acknowledged the possibility

    that carbon transactions can be physically settled (as the statute

    requires of excluded forward contracts) but argued that, in light of

    the fact that there is no cost associated with making or taking

    delivery of carbon, there is no cost to store it, and there is no delay

    in delivering it, a forward exclusion for carbon transactions may allow

    financial speculators to escape regulation otherwise required by the

    Dodd-Frank Act. The CFTC believes that if a transaction satisfies the

    terms of the statutory exclusion, the CFTC lacks the authority to

    deprive the transaction of the exclusion, absent evasion.\297\

    ---------------------------------------------------------------------------

    \296\ See Letter from Michelle Chan, Director, Economic Policy

    Programs, Friends of the Earth, dated July 22, 2011.

    \297\ While the commenter contended that ``the intangible nature

    of carbon makes it much easier for speculators or those simply

    seeking to hedge carbon price risk to take delivery of the carbon

    itself rather than enter into a derivatives transaction,'' as the

    CFTC states in section VII.A.2.c), infra, deciding to enter into a

    forward transaction rather than a swap does not constitute evasion.

    Thus, if the transaction in question is a forward contract, that is

    the end of the analysis, absent the presence of other factors that

    may indicate evasion. See AWEA Letter.

    ---------------------------------------------------------------------------

    One commenter stated that ``[i]n the solar industry, RECs are often

    traded by an individual consumer as an assignment of a right owned by

    that consumer.'' \298\ This commenter also advised that many individual

    consumers transact forward contracts through solar REC (``SREC'')

    aggregators at a fixed price. The CFTC notes \299\ that a transaction

    entered into by a consumer cannot be a forward transaction, and

    accordingly should not be the subject of an interpretation of the

    forward exclusion.\300\

    ---------------------------------------------------------------------------

    \298\ See Letter from Katherine Gensler, Director, Regulatory

    Affairs, SEIA, dated August 5, 2011 (``SEIA Letter'').

    \299\ See Proposing Release at 29832 n.104.

    \300\ However, in section II.B.3., infra, the Commissions

    provide an interpretation regarding the applicability of the swap

    definition to consumer transactions.

    ---------------------------------------------------------------------------

    One commenter takes the position that, because EPA emission

    allowances are issued in transactions with the EPA, only resales of

    such allowances (secondary market transactions) could be swaps because

    the EPA's initial issuance of allowances would be excluded from the

    swap definition under CEA section 1a(47)(B)(ix).\301\ The CFTC declines

    to address the commenter's legal conclusion regarding the application

    of CEA section 1a(47)(B)(ix), but agrees that an emission allowance

    created by the EPA is a nonfinancial commodity and that agreements,

    contracts and transactions in such allowances may fall within the

    forward exclusion from the swap definition.

    ---------------------------------------------------------------------------

    \301\ See Letter from Lauren Newberry, Jeffrey C. Fort, Jeremy

    D. Weinstein, and Christopher B. Berendt, Environmental Markets

    Association, dated July 21, 2011.

    ---------------------------------------------------------------------------

    (iv) Physical Exchange Transactions

    The Commissions received a comment letter seeking clarification

    that physical exchange transactions are forward contracts excluded from

    the swap definition.\302\ As described by the commenter, physical

    exchange transactions involve ``a gas utility entering into a

    transaction with another gas utility or other market participant to

    take delivery of natural gas at one delivery point in exchange for the

    same quantity of gas to be delivered at an alternative delivery point *

    * * for the primary purpose of transferring ownership of the physical

    commodity in order to rationalize the delivery of physical supplies to

    where they are needed'' at a price ``generally reflecting the

    difference in value at the delivery points.'' \303\ This commenter

    stated that ``exchange transactions create binding obligations on each

    party to make and take delivery of physical commodities [, i]n essence

    constituting paired forward contracts that are intended to go to

    physical delivery.'' \304\ The commenter added that, to the extent an

    exchange transaction payment is based on an index price, such pricing

    is not severable from the physical exchange.\305\

    ---------------------------------------------------------------------------

    \302\ See AGA Letter.

    \303\ Id. This commenter noted that gas utilities often can

    receive gas at more than one interconnection or delivery point on a

    pipeline.

    \304\ Id.

    \305\ Id.

    ---------------------------------------------------------------------------

    The CFTC interprets the exchange transactions described by the

    commenter, to the extent they are for deferred delivery, as examples of

    transactions in nonfinancial commodities that are within the forward

    exclusion from the definition of the terms ``swap'' and ``future

    delivery.'' Based on the information supplied by the commenter, they

    are commercial merchandising transactions, the primary purpose of which

    is to transfer

    [[Page 48236]]

    ownership of natural gas between two parties who intend to physically

    settle such transactions. That exchange transactions may involve, in

    addition to gas deliveries at two separate delivery points, a cash

    payment by one party to the other reflecting the difference in value of

    the gas at different delivery points, or that such payment may be based

    on an index, does not necessarily affect the nature of the transactions

    as forward transactions.\306\ For an exchange transaction to fall

    within the forward exclusion, though, the parties to the transaction

    must intend for the transaction to be physically settled, and the

    exchange transaction must satisfy all applicable interpretations set

    forth herein, including that relating to book-outs.\307\

    ---------------------------------------------------------------------------

    \306\ However, if such payment stems from an embedded option,

    the interpretation set forth in the embedded option section of this

    release, see infra part II.B.2(b)(v), also would be relevant to

    determining whether an exchange transaction were covered by the

    forward exclusion from the swap definition.

    \307\ While the commenter also states that ``[g]as utilities

    contract with interstate pipelines for capacity rights to have their

    gas supplies delivered to specific delivery points,'' its discussion

    of exchange transactions appears unrelated to such capacity rights.

    Therefore, the CFTC's guidance on exchange transactions does not

    address exchange transactions with capacity elements, which,

    depending on their structures, may be covered by the guidance set

    forth in the embedded option section of this release or by the

    CFTC's recent Commodity Options release. See infra note 317.

    Conversely, that parties to an exchange transaction separately enter

    into a capacity transaction with a pipeline operator to transport

    natural gas delivered via an exchange transaction is not relevant to

    today's guidance regarding exchange transactions.

    ---------------------------------------------------------------------------

    (v) Fuel Delivery Agreements

    The CFTC understands that fuel delivery agreements can generally be

    described as agreements whereby two or more parties agree to divide the

    cost of acquiring fuel for generation facilities based on some formula

    or factors, which can include, for example, their respective financial

    contributions to developing the source of the fuel (e.g., a natural gas

    field). One example of a fuel delivery agreement could involve a joint

    power agency providing to a municipal utility a long-term supply of

    natural gas from a natural gas project developed by the joint power

    agency and other entities to provide fuel for, among others, the joint

    power agency's and the municipal utility's natural gas-fired electric

    generating facilities. The municipal utility would pay the joint power

    agency through direct capital contributions to the entity formed to

    develop the natural gas project for the cost of developing it. In

    addition, the municipal utility would pay the joint power agency a

    monthly fee for the natural gas supplied from the natural gas project.

    The monthly fee would be composed of an operating cost fee component,

    an interstate pipeline transportation cost fee component and an

    operating reserve cost fee component. The municipal utility's natural

    gas-fired electric generating facility would be used to supply a

    portion of its expected retail electric load.

    Such agreements are forward transactions if they otherwise meet the

    interpretation set forth in this release regarding the forward

    exclusions (e.g., no optionality other than as permitted by the

    interpretation). Monthly or other fees that are not in the nature of

    option premiums do not convert the transactions from forwards to

    options. Because the transactions as described above do not appear to

    exhibit optionality as to delivery, and no other aspect of the

    transactions as described above seem to exhibit optionality, the fees

    would not seem to resemble option premiums.\308\

    ---------------------------------------------------------------------------

    \308\ This interpretation is limited to the facts and

    circumstances described herein; the CFTC is not opining on different

    facts or circumstances, which could change the CFTC's

    interpretation.

    ---------------------------------------------------------------------------

    (vi) Cleared/Exchange-Traded Forwards

    In the Proposing Release, the Commissions requested comment

    regarding whether forwards executed on trading platforms should fall

    within the forward exclusion from the swap definition and, if so,

    subject to what parameters.\309\ One commenter requested that the CFTC

    adopt a non-exclusive safe harbor providing that exchange-traded

    contracts with respect to which more than 50 percent of contracts, on

    average on a rolling three-month basis, go to delivery and where 100

    percent of the counterparties are commercial counterparties, are

    neither futures nor swaps (``50/100 Forward Safe Harbor'').\310\ This

    commenter further requested that the CFTC provide an appropriate

    transition period once those thresholds are breached. This commenter

    contended that two hallmarks of the exchange-traded forward markets,

    which it characterized as ``a relatively new development,'' are that

    the participants generally are commercials and a high percentage of

    contracts go to delivery, notwithstanding netting of delivery

    obligations.\311\ This commenter added that, while parties to such

    contracts intend to go to delivery when they enter into them, their

    delivery needs may change as time passes.

    ---------------------------------------------------------------------------

    \309\ See Proposing Release at 29831-29832, Request for Comment

    30.

    \310\ See Letter from Peter Krenkel, President and CEO, NGX,

    dated Nov. 4, 2010, resubmitted by email to CFTC staff on Sept. 14,

    2011 (``NGX Letter''). One other commenter addressed a related

    issue, asserting that the Commissions should clarify that cleared

    forwards between commercial participants should be permitted under

    the forward contract exclusion. See Ex Parte Communication among

    Evolution Markets Inc. (``Evolution''), Ogilvy Government Relations

    (``Ogilvy'') and CFTC staff on May 18, 2011 at http://comments.cftc.gov/PublicComments/ViewExParte.aspx?id=197&SearchText=.

    \311\ Id.

    ---------------------------------------------------------------------------

    The CFTC declines to address this request for the 50/100 Forward

    Safe Harbor, which raises policy issues that are beyond the scope of

    this rulemaking. Should the CFTC consider the implications of the

    requested 50/100 Forward Safe Harbor, including possible additional

    conditions for relief, it would be appropriate for the CFTC to obtain

    further comment from the public on this discrete proposal. For the same

    reasons, the CFTC declines to address at this time the comment

    requesting that the CFTC take the view that cleared forwards between

    commercial participants fall within the scope of the forward contract

    exclusion.

    (b) Commodity Options and Commodity Options Embedded in Forward

    Contracts

    (i) Commodity Options \312\

    ---------------------------------------------------------------------------

    \312\ As used in this release, the term ``commodity option''

    refers to an option that is subject to the CEA.

    ---------------------------------------------------------------------------

    The CFTC noted in the Proposing Release \313\ that the statutory

    swap definition explicitly provides that commodity options are swaps,

    that it had proposed revisions to its existing options rules in parts

    32 and 33 of its regulations \314\ with respect to the treatment of

    commodity options under the Dodd-Frank Act, and that it had requested

    comment on those proposed revisions in that rulemaking proceeding.\315\

    Accordingly, the CFTC did not propose an additional interpretation in

    the Proposing Release with respect to commodity options.

    ---------------------------------------------------------------------------

    \313\ See Proposing Release at 29829-30.

    \314\ 17 CFR Parts 32 and 33.

    \315\ See Commodity Options and Agricultural Swaps, 76 FR 6095

    (Feb. 3, 2011) (proposed).

    ---------------------------------------------------------------------------

    The CFTC reaffirms that commodity options are swaps under the

    statutory swap definition, and is not providing an additional

    interpretation regarding commodity options in this release. The CFTC

    recently addressed commodity options in the context of a separate final

    rulemaking and interim final rulemaking, under its plenary options

    authority in CEA section 4c(b).\316\ There, the CFTC adopted a modified

    trade option exemption, and has invited

    [[Page 48237]]

    public comment on the interim final rules.\317\

    ---------------------------------------------------------------------------

    \316\ 7 U.S.C. 6c(b).

    \317\ See Commodity Options, 77 FR 25320 (Apr. 27, 2012).

    ---------------------------------------------------------------------------

    Comments

    Several commenters in response to the Proposing Release argued that

    commodity options should not be regulated as swaps.\318\ In general,

    these commenters believed that commodity options should qualify for the

    forward exclusion from the swap definition, emphasizing similarities

    between commodity options and forward contracts on nonfinancial

    commodities.\319\

    ---------------------------------------------------------------------------

    \318\ See Letter from Brian Knapp, Policy Advisor, American

    Petroleum Institute (``API''), dated January 31, 2012 (``API

    Letter''); BGA Letter; COPE Letter; ETA Letter; Just Energy Letter;

    NGSA/NCGA Letter; and WGCEF Letter.

    \319\ For example, one commenter asserted that, similar to a

    forward contract on a nonfinancial commodity, a commodity option

    conveys no ability for a party to unilaterally require a financial

    settlement. Reasoning that both commodity options and forward

    contracts on nonfinancial commodities are intended to settle by

    physical delivery, this commenter contended that they should have

    the same regulatory treatment. See COPE Letter. Similarly, another

    commenter argued that the forward exclusion ``plainly covers''

    commodity options because they are: (i) Contracts for the sale of

    physical, nonfinancial commodities, (ii) for deferred delivery, and

    (iii) intended to be physically settled, given that purchasers have

    an absolute right to physical delivery and sellers have an absolute

    obligation to physically deliver the amounts called for by the

    purchasers if the option is exercised. See NGSA/NCGA Letter. A third

    commenter recommended that the CFTC interpret the forward exclusion

    ``broadly'' to include options that, if exercised, become forwards

    in nonfinancial commodities in light of the particular circumstances

    of the electricity industry, where electric companies use commodity

    options to efficiently meet the demands of electric customers by

    hedging or mitigating commercial risks due to seasonal and

    geographically unique weather and load patterns and fluctuations.

    See ETA letter. In the alternative, a fourth commenter requested

    that the CFTC exercise its plenary options authority under CEA

    section 4c(b), 7 U.S.C. 6c(b), to establish a separate regulatory

    regime for commodity options analogous to the trade option exemption

    under former CFTC Rule 32.4. See WGCEF Letter. See 17 CFR 32.4

    (2011).

    ---------------------------------------------------------------------------

    The CFTC is not providing an interpretation that commodity options

    qualify as forward contracts in nonfinancial commodities. Such an

    approach would be contrary to the plain language of the statutory swap

    definition, which explicitly provides that commodity options are

    swaps.\320\ This approach also would be a departure from the CFTC's and

    its staff's longstanding interpretation of the forward exclusion with

    respect to the term ``future delivery,'' \321\ which the CFTC has

    determined above to apply to the forward exclusion from the swap

    definition as well.\322\ Further, the CFTC notes that it has recently

    issued final and interim final rules adopting a modified version of the

    CFTC's existing trade option exemption.\323\

    ---------------------------------------------------------------------------

    \320\ See CEA section 1a(47)(A)(i), 7 U.S.C. 1a(47)(A)(i)

    (defining a swap as, among other things, ``a put, call * * * or

    option of any kind * * * for the purchase or sale * * * of * * *

    commodities'') and CEA section 1a(47)(B), 7 U.S.C. 1a(47)(B) (not

    excluding commodity options from the swap definition).

    \321\ See 1985 CFTC OGC Interpretation, supra note 245. In this

    regard, an option cannot be a forward under the CFTC's precedent,

    because under the terms of the contract the optionee has the right,

    but not the obligation, to make or take delivery, while under a

    forward contract, both parties must have binding delivery

    obligations: one to make delivery and the other to take delivery.

    \322\ See supra part II.B.2(a)(i)(A).

    \323\ See supra note 317.

    ---------------------------------------------------------------------------

    (ii) Commodity Options Embedded in Forward Contracts

    The CFTC is restating the interpretation regarding forwards with

    embedded options from the Proposing Release, but with certain

    modifications based on comments received. The CFTC is providing

    additional interpretations regarding forwards with embedded volumetric

    optionality, optionality in the form of evergreen and renewal

    provisions, and optionality with respect to delivery points and

    delivery dates.

    As was noted in the Proposing Release, the question of the

    application of the forward exclusion from the swap definition with

    respect to nonfinancial commodities, where commodity options are

    embedded in forward contracts (including embedded options to cash

    settle such contracts), is similar to that arising under the CEA's

    existing forward contract exclusion from the definition of the term

    ``future delivery.'' \324\ The CFTC's Office of General Counsel

    addressed forward contracts that contained embedded options in the 1985

    CFTC OGC Interpretation,\325\ which recently was adhered to by the CFTC

    in its adjudicatory Order in the Wright case.\326\ While both were

    issued prior to the effective date of the Dodd-Frank Act, the CFTC

    believes that, as was stated in the Proposing Release, it is

    appropriate to apply this interpretation to the treatment of forward

    contracts in nonfinancial commodities that contain embedded options

    under the Dodd-Frank Act.\327\

    ---------------------------------------------------------------------------

    \324\ See Proposing Release at 29830.

    \325\ See 1985 CFTC OGC Interpretation, supra note 245.

    \326\ Wright, supra note 214.

    \327\ See Proposing Release at 29830.

    ---------------------------------------------------------------------------

    In Wright, the CFTC stated that it traditionally has engaged in a

    two-step analysis of ``embedded options'' in which the first step

    focuses on whether the option operates on the price or the delivery

    term of the forward contract and the second step focuses on secondary

    trading.\328\ As was stated in the Proposing Release, these same

    principles can be applied with respect to the forward contract

    exclusion from the swap definition for nonfinancial commodities in the

    Dodd-Frank Act, too.\329\ Utilizing these principles, the CFTC is

    providing a final interpretation that a forward contract that contains

    an embedded commodity option or options \330\ will be considered an

    excluded nonfinancial commodity forward contract (and not a swap) if

    the embedded option(s):

    ---------------------------------------------------------------------------

    \328\ Wright, supra note 214, at n.5. In Wright, the CFTC

    affirmed the Administrative Law Judge's holding that an option

    embedded in a hedge-to-arrive contract did not violate CFTC rules

    regarding the sale of agricultural trade options. The CFTC first

    concluded that the puts at issue operated to adjust the forward

    price and did not render the farmer's overall obligation to make

    delivery optional. Then, turning to the next step of the analysis,

    the CFTC explained that ``the put and [hedge-to-arrive contract]

    operated as a single contract, and in most cases were issued

    simultaneously * * *. We do not find that any put was severed from

    its forward or that either of [the put or the hedge-to-arrive

    contract] was traded separately from the other. We hold that in

    these circumstances, no freestanding option came into being * * *.''

    Id. at *7.

    \329\ See Proposing Release at 29830.

    \330\ Options in the plural would include, for example, a

    situation in which the embedded optionality involves option

    combinations, such as costless collars, that operate on the price

    term of the agreement, contract, or transaction.

    ---------------------------------------------------------------------------

    1. May be used to adjust the forward contract price,\331\ but do

    not undermine the overall nature of the contract as a forward contract;

    ---------------------------------------------------------------------------

    \331\ For example, a forward with an embedded option with a

    formulaic strike price based on an index value that may not be known

    until after exercise would be a forward if it meets the rest of the

    3 components of this interpretation. Triggering an option to buy or

    sell one commodity based on the price of a different commodity

    reaching a specified level, such as in a cross-commodity

    transaction, does not constitute an adjustment to the forward

    contract price within the meaning of this 3-part interpretation.

    ---------------------------------------------------------------------------

    2. Do not target the delivery term, so that the predominant feature

    of the contract is actual delivery; and

    3. Cannot be severed and marketed separately from the overall

    forward contract in which they are embedded.\332\

    ---------------------------------------------------------------------------

    \332\ See Wright, supra note 214, at **6-7.

    In evaluating whether an agreement, contract, or transaction qualifies

    for the forward contract exclusions from the swap definition for

    nonfinancial commodities, the CFTC will look to the specific facts and

    circumstances of the transaction as a whole to evaluate whether any

    embedded optionality operates on the price or delivery term of the

    contract, and whether an embedded commodity option is marketed or

    traded separately from the underlying contract.\333\ Such an approach

    will help

    [[Page 48238]]

    assure that commodity options that should be regulated as swaps do not

    circumvent the protections established in the Dodd-Frank Act through

    the forward contract exclusion for nonfinancial commodities instead.

    ---------------------------------------------------------------------------

    \333\ This facts and circumstances approach to determining

    whether a particular embedded option takes a transaction out of the

    forward contract exclusion for nonfinancial commodities is

    consistent with the CFTC's historical approach to determining

    whether a particular embedded option takes a transaction out of the

    forward contract exclusion from the definition of the term ``future

    delivery'' in the CEA. See id. at *5 (``As we have held since

    Stovall, the nature of a contract involves a multi-factor analysis *

    * *.'').

    ---------------------------------------------------------------------------

    The CFTC also is providing an interpretation, in response to

    commenters,\334\ with respect to forwards with embedded volumetric

    optionality.\335\ Several commenters asserted that agreements,

    contracts, and transactions that contain embedded ``volumetric

    options,'' and that otherwise satisfy the terms of the forward

    exclusions, should qualify as excluded forwards, notwithstanding their

    embedded optionality.\336\ The CFTC believes that agreements,

    contracts, and transactions with embedded volumetric optionality may

    satisfy the forward exclusions from the swap and future delivery

    definitions under certain circumstances. Accordingly, the CFTC is

    providing an interpretation that an agreement, contract, or transaction

    falls within the forward exclusion from the swap and future delivery

    definitions, notwithstanding that it contains embedded volumetric

    optionality, when:

    ---------------------------------------------------------------------------

    \334\ The CFTC requested comment on, among other things: whether

    there are other factors that should be considered in determining how

    to characterize forward contracts with embedded options with respect

    to nonfinancial commodities; and whether there are provisions in

    forward contracts with respect to nonfinancial commodities, other

    than delivery and price, containing embedded optionality. See

    Proposing Release at 29832.

    \335\ One commenter characterized ``volumetric optionality'' as

    the optionality in a contract settling by physical delivery and used

    to meet varying customer demand for a commodity.'' See WGCEF Letter.

    See also BGA Letter (stating that ``it is commonplace for energy

    suppliers to enter into commercial transactions with customers

    (local distribution companies, electric utility companies,

    industrial, commercial and residential customers, power plants,

    etc.), which provide volumetric, price and delivery-related

    flexibility and variability''). BGA claims that commercial

    transactions containing embedded volumetric optionality ``include,

    but are not limited to, full requirements contracts, interruptible

    load agreements, capacity contracts, tolling agreements, energy

    management agreements, natural gas transportation contracts and

    natural gas storage contracts.'' Id.

    \336\ See, e.g., WGCEF Letter (submitting that ```volumetric

    optionality' is [a] separate and distinct concept from

    `deliverability optionality'''); BGA Letter; AGA Letter; Letter from

    Jeffrey Perryman, Director, Contracts and Compliance, Atmos Energy

    Holdings, Inc. (``Atmos''), dated July 22, 2011 (``Atmos Letter'');

    NGSA/NCGA Letter; Letter from Paul M. Architzel, Wilmer Hale LLP on

    behalf of ONEOK, Inc. (``ONEOK''), dated July 22, 2011 (``ONEOK

    Letter''); COPE Letter.

    ---------------------------------------------------------------------------

    1. The embedded optionality does not undermine the overall nature

    of the agreement, contract, or transaction as a forward contract;

    2. The predominant feature of the agreement, contract, or

    transaction is actual delivery;

    3. The embedded optionality cannot be severed and marketed

    separately from the overall agreement, contract, or transaction in

    which it is embedded; \337\

    ---------------------------------------------------------------------------

    \337\ When a forward contract includes an embedded option that

    is severable from the forward contract, the forward can remain

    subject to the forward contract exclusion, if the parties document

    the severance of the embedded option component and the resulting

    transactions, i.e. a forward and an option. Such an option would be

    subject to the CFTC's regulations applicable to commodity options.

    ---------------------------------------------------------------------------

    4. The seller of a nonfinancial commodity underlying the agreement,

    contract, or transaction with embedded volumetric optionality intends,

    at the time it enters into the agreement, contract, or transaction to

    deliver the underlying nonfinancial commodity if the optionality is

    exercised;

    5. The buyer of a nonfinancial commodity underlying the agreement,

    contract or transaction with embedded volumetric optionality intends,

    at the time it enters into the agreement, contract, or transaction, to

    take delivery of the underlying nonfinancial commodity if it exercises

    the embedded volumetric optionality;

    6. Both parties are commercial parties; \338\ and

    ---------------------------------------------------------------------------

    \338\ See discussion in section II.B.2.(a)(i)(B), supra.

    ---------------------------------------------------------------------------

    7. The exercise or non-exercise of the embedded volumetric

    optionality is based primarily on physical factors,\339\ or regulatory

    requirements,\340\ that are outside the control of the parties and are

    influencing demand for, or supply of, the nonfinancial commodity.\341\

    ---------------------------------------------------------------------------

    \339\ See, e.g., BGA Letter (advising that ``[v]ariability

    associated with an energy customer's physical demand is influenced

    by factors outside the control of * * * energy suppliers (and

    sometimes * * * consumers) * * * including, but not limited to, load

    growth, weather and certain operational considerations (e.g.,

    available transportation capacity to deliver physical natural gas

    purchased on the spot market)'').

    \340\ Volumetric optionality in this category would include, for

    example, a supply contract entered into to satisfy a regulatory

    requirement that a supplier procure, or be able to provide upon

    demand, a specified volume of commodity (e.g., electricity). To the

    extent the optionality covers an amount of the commodity in excess

    of the regulatory requirement, such optionality would not

    necessarily be covered by this aspect of the guidance, though it may

    nevertheless be covered by the guidance if such excess volumetric

    optionality is based on physical factors within the meaning of the

    guidance. For example, the California Utilities explained that the

    California Public Utilities Commission (``CPUC'') requires them to

    file a supply plan with the CPUC demonstrating that they have

    procured sufficient capacity resources (including reserves) needed

    to serve their aggregate system load on a monthly and yearly basis.

    See California Utilities Letter. Each utility's system requirement

    is 100 percent of its peak-hourly forecast load plus a 15-17 percent

    reserve margin. The California Utilities enter into resource

    adequacy agreements to procure electric power generating capacity to

    meet these requirements. The ability to call on the additional 15 to

    17% reserve reflected in such an agreement is covered by the

    regulatory requirements part of this element. To the extent the

    California Utilities may have a business need to procure additional

    capacity resources beyond the foregoing regulatory requirement

    (e.g., because they wish to maintain a slightly larger reserve

    margin than required due to a recent upswing in unscheduled plant

    outages due to aging plants), that may be covered under the

    interpretation if the additional capacity is required due to

    physical factors beyond the control of the parties (i.e., the

    unscheduled outage, in the foregoing example).

    \341\ In other words, the predominant basis for failing to

    exercise the option would be that the demand or supply (as

    applicable) that the optionality was intended to satisfy, if needed,

    never materialized, materialized at a level below that for which the

    parties contracted or changed due to physical factors or regulatory

    requirements outside the parties' control. Such failure to exercise,

    or an exercise for a reduced amount of the underlying commodity,

    could, for example, be due to colder than expected weather during

    the summer decreasing demand for air conditioning, in turn

    decreasing demand for power to run the air conditioning. The

    Commission does not interpret this to mean that absolutely all

    factors involved in the decision to exercise an option must be

    beyond the parties' control, but rather the decision must be

    predominantly driven by factors affecting supply and demand that are

    beyond a parties control. This also means that the forward contract

    with embedded volumetric optionality needs to be a commercially

    appropriate method for securing the purchase or sale of the

    nonfinancial commodity for deferred shipment at the time it is

    entered into. The CFTC cautions market participants that, to the

    extent a party relies on the forward exclusion from the swap or

    future delivery definitions, notwithstanding that there is

    volumetric optionality, if that volumetric optionality is

    inconsistent with the seventh element of the interpretation, the

    agreement, contract or transaction may be an option.

    ---------------------------------------------------------------------------

    The first two elements of the interpretation for embedded

    volumetric optionality, which mirror the CFTC's historical embedded

    option interpretation discussed above, have been modified to reflect

    that embedded volumetric optionality relates to delivery rather than

    price. As noted above, the predominant feature of a forward contract is

    a binding, albeit deferred, delivery obligation. It is essential that

    any embedded option in a forward contract as to volume must not

    undermine a forward contract's overall purpose.\342\ The CFTC

    recognizes that the nature of commercial operations are such that

    supply and demand requirements cannot always be accurately predicted

    and that forward contracts that allow for some optionality as to the

    amount of a nonfinancial commodity actually delivered offer a great

    deal of value to commercial

    [[Page 48239]]

    participants. Where an agreement, contract, or transaction requires

    delivery of a non-nominal volume of a nonfinancial commodity, even if

    an embedded volumetric option is exercised, the CFTC believes that the

    predominant feature of the contract, notwithstanding the embedded

    volumetric optionality, is actual delivery. This is the case in many

    forward contracts that have an embedded option that allows a party to

    buy or sell an additional amount of a commodity beyond the fixed amount

    called for in the underlying forward contract. For instance, a forward

    contract could call for the delivery of 10,000 bushels of wheat and

    include an option for an additional 5,000 bushels of wheat.\343\

    ---------------------------------------------------------------------------

    \342\ See discussion in part II.B.2.(a)(i)(B), supra. See also

    supra note 321.

    \343\ In evaluating whether the predominant feature of a

    transaction is actual delivery, the CFTC will look at the contract

    as a whole. Thus, with respect to this contract, the CFTC would

    consider the intent element of the forward exclusions to be

    satisfied because the contract requires the seller to deliver a non-

    nominal volume of a commodity (i.e., 10,000 bushels of wheat),

    viewing the contract as a whole. As a result, if the other elements

    of the guidance above are satisfied, this contract would be a

    forward contract, even if the party did not exercise the option for

    the additional 5,000 bushels.

    ---------------------------------------------------------------------------

    The third element is substantially the same as the third element of

    the interpretation above with respect to commodity options embedded in

    forward contracts generally.

    The fourth and fifth elements are designed to ensure that both

    parties intend to make or take delivery (as applicable), subject to the

    relevant physical factors or regulatory requirements, which may lead

    the parties to deliver more or less than originally intended. This

    distinguishes a forward contract from a commodity option, where only

    the option seller must at all times be prepared to deliver during the

    term of the option. The sixth element is intended to ensure that the

    interpretation is not abused by market participants not engaged in a

    commercial business involving the nonfinancial commodity underlying the

    embedded volumetric optionality.\344\

    ---------------------------------------------------------------------------

    \344\ The fact that the CFTC is expressly including the fourth

    through sixth elements in the embedded optionality guidance for

    volumetric options but not elsewhere does not mean that intent to

    deliver and the ability to make or take delivery expressed in these

    elements are not part of the facts and circumstances the CFTC will

    consider in the context of determining whether other agreements,

    contracts, and transactions qualify for the forward exclusions.

    Intent to deliver and the ability to make or take delivery have long

    been a part of the CFTC's facts-and-circumstances approach to making

    that determination, and they remain so. The CFTC is emphasizing

    these elements in this guidance because the CFTC has not previously

    expressed the view that an agreement, contract, or transaction with

    embedded volumetric optionality which affects the delivery term may

    qualify as a forward if these facts and circumstances are present.

    ---------------------------------------------------------------------------

    The seventh element is based on comments stating that parties to

    agreements, contracts, and transactions with embedded volumetric

    optionality intend to make or take delivery (as applicable) of a

    commodity, and that it is merely the volume of a commodity that would

    be required to be delivered if the option is exercised, that varies. It

    is designed to ensure that the volumetric optionality is primarily

    driven by physical factors or regulatory requirements that influence

    supply and demand and that are outside the parties' control, and that

    the optionality is a commercially reasonable way to address uncertainty

    associated with those factors.\345\ Element seven must be interpreted

    with the other elements set forth here. For instance, even if the

    optionality is consistent with element seven, such optionality cannot

    undermine the overall nature of the contract as a forward contract as

    discussed above.

    ---------------------------------------------------------------------------

    \345\ See, e.g., AGA Letter (advising that ``[i]n general,

    retail demand for natural gas is weather driven * * * as a result

    [of which], a gas utility's peaking supplies must have significant

    flexibility * * * [and g]as utilities * * * use a variety of

    contracts with gas suppliers to physically deal with peak periods of

    demand''); BGA Letter (citing gas supply curtailment due to a

    pipeline outage and power generation curtailment by an Independent

    System Operator for operational reasons as factors outside the

    control of energy suppliers and which could impact the amount of a

    commodity delivered). The CFTC understands BGA's comment to address

    involuntary curtailments, but also recognizes that power buyers may

    agree in advance that the relevant Regional Transmission

    Organization or Independent System Operator may, in order to

    maintain system reliability, curtail power deliveries to the buyers.

    While voluntary curtailments are within the control of the power

    buyer, the potential system reliability issue is not. Therefore,

    such voluntary curtailments would be within the guidance because, if

    triggered, they would be based on a physical factor (e.g., supply

    constraints).

    ---------------------------------------------------------------------------

    As discussed in the interpretation regarding forwards with embedded

    optionality discussed above, in evaluating whether an agreement,

    contract or transaction with embedded volumetric optionality qualifies

    for the forward exclusions, the CFTC will look to the relevant facts

    and circumstances of the transaction as a whole to evaluate whether the

    transaction qualifies for the forward exclusions from the definitions

    of the terms ``swap'' and ``future delivery.''

    The CFTC is providing further interpretations to explain how it

    would treat some of the specific contracts described in the comment

    letters. According to one commenter, a ``full requirements contract''

    can be described as a ``contract where the seller agrees to provide all

    requirements for a specific customer's location or delivery point.''

    \346\ According to another commenter, ``[a] full requirements contract

    * * * is a well-established concept in contract law'' and ``[i]n a

    requirements contract, the purchaser * * * deals exclusively with one

    supplier.'' \347\ This commenter added that, while the amount of

    commodity delivered can vary, it is based on an objective need and that

    the Uniform Commercial Code imposes on the buyer ``an obligation to act

    in good faith with respect to the varying amount that is called for

    delivery.'' \348\ Based upon this description, the CFTC believes that a

    going commercial concern with an exclusive supply contract has no

    option but to get its supply requirements met through that exclusive

    supplier consistent with the terms of the contract. Any instance where

    nominal or zero delivery occurred would have to be because the

    commercial requirements changed or did not materialize. Furthermore,

    any variability in delivery amounts under the contract appears to be

    driven directly by the buyer's commercial requirements and is not

    dependent upon the exercise of any commodity option by the contracting

    parties.

    ---------------------------------------------------------------------------

    \346\ See Letter from Keith M. Sappenfield, II, Director, US

    Regulatory Affairs, Encana Marketing (USA) Inc. (``Encana''), dated

    July 22, 2011 (``Encana Letter'').

    \347\ See ONEOK Letter. The CFTC notes that this commenter

    discussed full requirements contracts in the context of supply

    agreements between one of its affiliates and retail customers. If

    such customers are non-commercial customers, such contracts are not

    forwards, but nevertheless they may not be swaps under the

    Commissions' guidance regarding the non-exhaustive list of consumer

    transactions, or otherwise if they have characteristics or factors

    described under the consumer transaction interpretation, see infra

    part II.B.3.

    \348\ See, e.g., NY UCC Sec. 2-306(1) (stating that ``[a] term

    which measures the quantity by the output of the seller or the

    requirements of the buyer means such actual output or requirements

    as may occur in good faith.* * *''). This commenter cited Corbin on

    Contracts for the proposition that the mere fact that the quantity

    term of the contract is ``the buyer's needs or requirements'' does

    not render the requirements contract ``a mere options contract''

    because ``the buyer's promise is not illusory * * * [but] is

    conditional upon the existence of an objective need for the

    commodity.'' See ONEOK Letter (citing Corbin on Contracts Sec. 6.5

    at 240-53 (1995)).

    ---------------------------------------------------------------------------

    Accordingly, full requirements contracts, as described above,

    appear not to contain embedded volumetric options. Therefore, a full

    requirements contract may qualify for the forward exclusion under the

    same facts and circumstances analysis applicable to all other

    agreements, contracts, and transactions that might be forwards. The

    same analysis would apply to an output

    [[Page 48240]]

    contract satisfying the terms of this interpretation.\349\

    ---------------------------------------------------------------------------

    \349\ See Letter from Phillip g. Lookadoo, Esq., Reed Smith LLP

    and Jeremy D. Weinstein, Esq. on behalf of IECA dated May 23, 2012

    (suggesting that output contracts, in addition to full requirements

    contracts, should be within the forward exclusion). An output

    contract has been defined as ``a contract pursuant to which the

    obligor's duty to supply the promised commodity is quantified (and

    therefore limited) by reference to its production thereof.'' See

    Boyd v. Kmart Corp., 110 F.3d 73 (10th Cir. 1997).

    ---------------------------------------------------------------------------

    With respect to capacity contracts, transmission (or

    transportation) services agreements, and tolling agreements, the CFTC

    understands that: (i) Capacity contracts are generally products

    designed to ensure that sufficient physical generation capacity is

    available to meet the needs of an electrical system;\350\ (ii)

    transmission (or transportation) services agreements are generally

    agreements for the use of electricity transmission lines (or gas

    pipelines) that allow a power generator to transmit electricity (or gas

    supplier to transport gas) to a specific location;\351\ and (iii)

    tolling agreements, as described by commenters, provide a purchaser the

    right to the capacity, energy, ancillary services and any other product

    derived from a specified generating unit, all based upon a delivered

    fuel price and agreed heat rate.\352\

    ---------------------------------------------------------------------------

    \350\ See California Utilities Letter.

    \351\ See NEMA Letter.

    \352\ See California Utilities Letter.

    ---------------------------------------------------------------------------

    Such agreements, contracts and transactions, may have features that

    will satisfy the ``forwards with embedded volumetric optionality''

    interpretation discussed above, or, like full requirements contracts,

    may not contain embedded volumetric options and may satisfy other

    portions of the forward interpretations herein. For example, according

    to one commenter, the delivery obligations in some tolling agreements

    are not optional which is indicative that the predominant feature of

    such tolling agreements is actual delivery.\353\ It is also possible,

    based on descriptions provided to the CFTC, that tolling agreements

    could fit within the interpretation concerning certain physical

    agreements, contracts, or transactions,\354\ or other interpretations

    herein.

    ---------------------------------------------------------------------------

    \353\ Id.

    \354\ See infra part II.B.2.(b)(iii).

    ---------------------------------------------------------------------------

    Some commenters focused on forwards with embedded volumetric

    optionality in the natural gas industry. For example, one commenter

    stated that ``peaking supply'' natural gas contracts do not render

    delivery optional. Although the purchaser has the option to specify

    when and if the quantity of gas will be delivered on any given day,

    this commenter asserted that there is no cash settlement alternative.

    If the purchaser does not exercise the right to purchase, then the

    right is terminated. The seller under the transaction must deliver the

    entire quantity of gas that the purchaser specifies, or pay liquidated

    damages. Moreover, the option is not severable and cannot be marketed

    separately from the supply agreement itself.\355\ Similarly, another

    commenter said that there is no ability to sever an embedded option

    from a natural gas forward contract. Moreover, it stated that the

    ability for a gas purchaser to specify a quantity of gas for a certain

    day is not to encourage speculative activity; rather, it is because the

    exact quantity of gas to be needed on that future day is unknown, and

    many gas purchasers have weather-dependent needs that cannot accurately

    be predicted in advance.\356\

    ---------------------------------------------------------------------------

    \355\ See AGA Letter.

    \356\ See Atmos Letter.

    ---------------------------------------------------------------------------

    Depending on the relevant facts and circumstances, these types of

    agreements, contracts, and transactions--capacity contracts,

    transmission (or transportation) services agreements, tolling

    agreements, and peaking supply contracts--may satisfy the elements of

    the ``forwards with embedded volumetric options'' interpretation set

    forth above, or may satisfy other portions of this interpretation. If

    they do, they would fall within the forward exclusions from the swap

    and future delivery definitions.

    In addition, the CFTC is providing an interpretation in response to

    a comment that contracts with evergreen or extension terms should be

    considered forwards.\357\ The CFTC is clarifying that an extension term

    in a commercial contract, such as a renewal term in a five year power

    purchase agreement (which, due to the renewal, would require additional

    deliveries), is not an option on the delivery term within the meaning

    of the CFTC's interpretation, and consequently would not render such a

    contract ineligible for the forward exclusions from the definitions of

    the terms ``swap'' and ``future delivery.'' Similarly, an evergreen

    provision, which automatically renews a contract (and, as such, would

    require additional deliveries)\358\ absent the parties affirmatively

    terminating it, would not render such a contract ineligible for the

    forward exclusions from the swap or future delivery definitions.\359\

    When the Proposing Release stated that a forward contract containing an

    embedded option that does not ``target the delivery term'' is an

    excluded forward contract,\360\ it meant that the embedded option does

    not affect the delivery amount.\361\

    ---------------------------------------------------------------------------

    \357\ See IECA Letter.

    \358\ The CFTC refers in this and the prior sentence to

    ``additional deliveries'' because the IECA's example involves an

    agreement calling for delivery of a physical nonfinancial commodity.

    \359\ Using extension or evergreen provisions to avoid delivery,

    however, as was the case with the ``rolling spot'' contracts at

    issue in CFTC v. Zelener, 373 F.3d 861 (7th Cir. 2004), could

    constitute evasion or violate other provisions of the CEA (e.g., CEA

    section 4(a), 7 U.S.C. 6(a)). This interpretation does not limit the

    CFTC's other interpretations in this release regarding when delivery

    does not occur (e.g., the Brent Interpretation).

    \360\ See NGSA/NCGA Letter (requesting clarification of the

    phrase ``target the delivery term.'').

    \361\ See Proposing Release at 29830, n.81.

    ---------------------------------------------------------------------------

    Also, in response to a commenter,\362\ the CFTC clarifies that

    embedded optionality as to delivery points and delivery dates will not

    cause a transaction that otherwise qualifies as a forward contract to

    be considered a swap. The CFTC emphasizes, however, that delivery must

    occur at some delivery point and on some date, or the lack of delivery

    must be due to the transaction being booked out or otherwise be

    consistent with the CFTC's interpretation regarding the forward

    exclusions from the swap and future delivery definitions.

    ---------------------------------------------------------------------------

    \362\ See COPE Letter.

    ---------------------------------------------------------------------------

    Comments

    Commenters generally supported the CFTC's proposed interpretation

    regarding forwards with embedded options, but many believed that it

    should be modified or expanded. As noted above, several commenters

    believed that forward contracts with embedded options that contain

    optionality as to the quantity/volume of the nonfinancial commodity to

    be delivered should qualify as forwards, and that the CFTC's proposed

    interpretation (which only mentions price optionality) should be

    modified accordingly.\363\ In this regard, several commenters focused

    on forwards with embedded volumetric options in the natural gas

    industry.\364\ One commenter noted that, although the 1985 CFTC OGC

    Interpretation distinguishes forward contracts from trade options, it

    is based on a limited number of agricultural contract examples, so

    additional guidance is needed, particularly in light of the wide range

    of cash market and commercial merchandising contracting practices in

    [[Page 48241]]

    which delivery terms and amounts vary.\365\

    ---------------------------------------------------------------------------

    \363\ See AGA Letter; API Letter; Atmos Letter; ONEOK Letter;

    NGSA/NCGA Letter; WGCEF Letter.

    \364\ See AGA Letter; Atmos Letter.

    \365\ See ONEOK Letter. This commenter noted that it offers its

    customers a number of types of contracts for delivery of natural gas

    under which the amount called for delivery may vary. In each of

    these types of contracts, this commenter stated that both parties

    intend the contracts to result in delivery of the commodity, as

    needed. The purpose of these contracts is to ensure that customers,

    most of which are gas or electric utilities, have an adequate supply

    of natural gas regardless of day-to-day changes in demand that may

    be caused by variation in weather, operational considerations, or

    other factors. They are not designed for one-way price protection as

    would be the case with an option. See ONEOK Letter.

    ---------------------------------------------------------------------------

    In addition, another commenter requested more generally that any

    embedded option (for example, price, quantity, delivery point, delivery

    date, contract term) that does not permit a unilateral election of

    financial settlement based upon the value change in an underlying cash

    market should not render the contract a swap.\366\

    ---------------------------------------------------------------------------

    \366\ See COPE Letter, Appendix.

    ---------------------------------------------------------------------------

    As discussed above, the CFTC has provided an additional

    interpretation with respect to forwards with embedded volumetric

    options to address commenters' concerns. The CFTC also has provided an

    interpretation above, regarding price optionality, optionality with

    respect to delivery points and delivery dates specifically in response

    to this commenter, and optionality as to certain contract terms (such

    as evergreen and renewal provisions) to address particular concerns

    raised by commenters. The CFTC declines to adopt a more expansive

    approach with respect to ``any'' embedded option.

    One commenter requested that an option to purchase or sell a

    physical commodity, whether embedded in a forward contract or stand

    alone, should either (i) fall within the statutory forward exclusion

    from the swap definition, or (ii) alternatively, if deemed by the CFTC

    to be a swap, should be exempt from the swap definition pursuant to a

    modified trade option exemption pursuant to CEA section 4c(b).\367\ The

    CFTC has modified its proposed interpretation regarding forwards with

    embedded options as discussed above; contracts with embedded options

    that are swaps under this final interpretation may nevertheless qualify

    for the modified trade option exemption recently adopted by the CFTC

    and discussed above.\368\

    ---------------------------------------------------------------------------

    \367\ See WGCEF Letter; 7 U.S.C. 6c(b).

    \368\ 77 FR 25320 (Aug. 27, 2012). Encana believed that the

    guidance on forwards with embedded options should include embedded

    physical delivery options because it asserted that many of the

    contracts currently used by participants in the wholesale natural

    gas market contain an option for the physical delivery of natural

    gas. See Encana Letter. To the extent that Encana's comment goes

    beyond volumetric optionality, commodity options are discussed supra

    in section II.B.2(b).

    ---------------------------------------------------------------------------

    Another commenter urged the CFTC to broadly exempt commercial

    forward contracting from swap regulation by generally excluding from

    the swap definition any forward contract with embedded optionality

    between end users ``whose primary purpose is consistent with that of an

    `end user', and in which any embedded option is directly related to

    `end use.' '' \369\ The CFTC believes that this interpretation is vague

    and overbroad, and declines to adopt it.

    ---------------------------------------------------------------------------

    \369\ See Letter from Roger Cryan, Vice President for Milk

    Marketing and Economics, National Milk Producers Federation

    (``NMPF''), dated July 22, 2011 (``NMPF Letter'').

    ---------------------------------------------------------------------------

    Another commenter believed that the CFTC's ``facts and

    circumstances'' approach to forwards with embedded options does not

    provide the legal certainty required by nonfinancial entities engaging

    in commercial contracts in the normal course of business.\370\ This

    commenter further argued that many option-like contract terms could be

    determined to ``target the delivery term'' under a facts and

    circumstances analysis.\371\

    ---------------------------------------------------------------------------

    \370\ See ETA Letter. Similarly, COPE comments that a

    nonfinancial commodity forward contract that, ``by its terms,'' is

    intended to settle physically should be permitted to contain

    optionality without being transformed into a swap unless such

    optionality negates the physical settlement element of the contract.

    That is, if one party can exercise an option to settle the contract

    financially based upon the value change in an underlying cash

    market, then the intent for physical settlement is not contained in

    ``the four corners of the contract'' and may render the contract a

    swap. See COPE Letter. As discussed elsewhere in this release, the

    CFTC historically has eschewed approaches to the forward exclusion

    that rely on the ``four corners of the contract,'' which can provide

    a roadmap to evasion of statutory requirements.

    \371\ Accordingly, this commenter believed that the CFTC should

    provide in its rules that an embedded option or embedded optionality

    will not result in a nonfinancial forward being a swap unless: (i)

    Delivery is optional; (ii) financial settlement is allowed; and

    (iii) transfer and trading of the option separately from the forward

    is permitted. See ETA Letter.

    ---------------------------------------------------------------------------

    The CFTC has long applied a facts-and-circumstances approach to the

    forward exclusion, including with respect to forwards with embedded

    options, and thus it is an approach with which market participants are

    familiar. That approach balances the need for legal certainty against

    the risk of providing opportunities for evasion.\372\ The CFTC's

    additional interpretation noted above, including clarification about

    the meaning of the phrase ``target the delivery term,'' and forwards

    with embedded volumetric optionality, provides enhanced legal certainty

    in response to the commenter's concerns. \373\

    ---------------------------------------------------------------------------

    \372\ See also NCFC Letter (supporting the CFTC's guidance

    because it provides legal certainty).

    \373\ See also Commodity Options, 77 FR 25320, 25324 n. 25 (Apr.

    27, 2012) (discussing the CFTC's conclusion that an ``option[] to

    redeem'' under the USDA Commodity Credit Corporation's marketing

    loan program constitutes a cotton producer's contractual right to

    repay its marketing loan and ``redeem'' the collateral (cotton) to

    sell in the open market).

    ---------------------------------------------------------------------------

    Request for Comment

    The CFTC's interpretation regarding forwards with volumetric

    options is an interpretation of the CFTC and may be relied upon by

    market participants. However, the CFTC believes that it would benefit

    from public comment about its interpretation, and therefore requests

    public comment on all aspects of its interpretation regarding forwards

    with embedded volumetric options,\374\ and on the following questions:

    ---------------------------------------------------------------------------

    \374\ Separately, it is expected that CFTC staff will be issuing

    no-action relief with respect to the conditions of the modified

    trade option exemption (except the enforcement provisions retained

    in Sec. 32.3(d)) until December 31, 2012. This extension will

    afford the CFTC an opportunity to review and evaluate the comments

    received on both the interpretation above regarding embedded

    volumetric optionality, and the modified trade option exemption, in

    order to determine whether any changes thereto are appropriate.

    ---------------------------------------------------------------------------

    1. Are the elements set forth in the interpretation to distinguish

    forwards with embedded volumetric optionality from commodity options

    appropriate? Why or why not?

    2. Are there additional elements that would be appropriate? Please

    describe and provide support for why such elements would serve to

    distinguish forwards with embedded volumetric optionality from

    commodity options.

    3. Is the seventh element that, to ensure that an agreement,

    contract, or transaction with embedded volumetric optionality is a

    forward and not an option, the volumetric optionality is based

    primarily on physical factors, or regulatory requirements, that are

    outside the control of the parties and are influencing demand for, or

    supply of, the nonfinancial commodity, necessary and appropriate? Why

    or why not? Is the statement of this element sufficiently clear and

    unambiguous? If not, what adjustments would be appropriate?

    4. Are there circumstances where volumetric optionality is based on

    other factors? Please describe. Would such factors, if made a part of

    the interpretation, serve to distinguish forwards with embedded

    volumetric optionality from commodity options? If so, how?

    5. Does the interpretation provide sufficient guidance as to

    whether agreements, contracts, or transactions

    [[Page 48242]]

    with embedded volumetric optionality permitting a nominal amount, or no

    amount, of a nonfinancial commodity to be delivered are forwards or

    options, viewing the agreements, contracts, or transactions as a whole,

    if they satisfy the seven elements of the interpretation? Why or why

    not? Does this interpretation encourage evasion, or do the seven

    elements sufficiently distinguish forwards from agreements, contracts,

    and transactions that may evade commodity options regulation?

    6. Is the interpretation sufficiently clear with respect to

    capacity contracts, transmission (or transportation) services

    agreements, peaking supply contracts, or tolling agreements? Why or why

    not? Do capacity contracts, transmission (or transportation) services

    agreements, peaking supply contracts, or tolling agreements generally

    have features that satisfy the forwards with volumetric options

    interpretation included in this release? If so, which ones? If not, why

    not? Could these types of agreements, contracts, and transactions

    qualify for the forward exclusions under other parts of the

    interpretation set forth above? Are there material differences in the

    structure, operation, or economic effect of these types of agreements,

    contracts, and transactions as compared to full requirements contracts

    that are relevant to whether such agreements, contracts, and

    transactions are options under the CEA? Please explain. If so, what are

    the material differences?

    7. Do the agreements, contracts, and transactions listed in

    question No. 6 above have embedded optionality in the first instance?

    Based on descriptions by commenters, it appears that they may have a

    binding obligation for delivery, but have no set amount specified for

    delivery. Instead, delivery (including the possibility of nominal or

    zero delivery) is determined by the terms and conditions contained

    within the agreement, contract, or transaction (including, for example,

    the satisfaction of a condition precedent to delivery, such as a

    commodity price or temperature reaching a level specified in the

    agreement, contract, or transaction). That is, the variation in

    delivery is not driven by the exercise of embedded optionality by the

    parties. Do the agreements, contracts, and transactions listed in

    question No. 6 exhibit these kinds of characteristics? If so, should

    the CFTC consider them in some manner other than its forward

    interpretation? Why or why not?

    (iii) Certain Physical Commercial Agreements, Contracts or Transactions

    The CFTC is providing an interpretation in response to comments

    regarding certain physical commercial agreements for the supply and

    consumption of energy that provide flexibility, such as tolls on power

    plants, transportation agreements on natural gas pipelines, and natural

    gas storage agreements.\375\ Commenters recognized that these types of

    agreements, contracts or transactions may have option-like features,

    but analogized them to leases and concluded that they were forwards

    rather than swaps. One commenter, for example, characterized taking

    power produced pursuant to a physical tolling agreement--which can

    involve one party thereto providing fuel for a generation plant and

    having the exclusive right to take the power produced by that plant

    from the fuel provided--thus, in effect, ``renting'' the plant to the

    extent the plant is used to produce power from the fuel provided--as

    more akin to a lease than to an option.\376\

    ---------------------------------------------------------------------------

    \375\ See BGA Letter and California Utilities Letter. This

    interpretation also may apply to firm transmission agreements

    pursuant to which transmission service may not be interrupted for

    any reason except during an emergency when continued delivery of

    power is not possible. See http://www.interwest.org/wiki/index.php?title=Firm_transmission_service.

    \376\ See California Utilities Letter.

    ---------------------------------------------------------------------------

    The CFTC will interpret an agreement, contract or transaction not

    to be an option if the following three elements are satisfied: (1) The

    subject of the agreement, contract or transaction is usage of a

    specified facility or part thereof rather than the purchase or sale of

    the commodity that is to be created, transported, processed or stored

    using the specified facility; (2) the agreement, contract or

    transaction grants the buyer the exclusive use of the specified

    facility or part thereof during its term, and provides for an

    unconditional obligation on the part of the seller to grant the buyer

    the exclusive use of the specified facility or part thereof; \377\ and

    (3) the payment for the use of the specified facility or part thereof

    represents a payment for its use rather than the option to use it. In

    such agreements, contracts and transactions, while there is optionality

    as to whether the person uses the specified facility, the person's

    right to do so is legally established, does not depend upon any further

    exercise of an option and merely represents a decision to use that for

    which the lessor already has paid. In this context, the CFTC would not

    consider actions such as scheduling electricity transmission, gas

    transportation or injection of gas into storage to be exercising an

    option if all three elements of the interpretation above are satisfied.

    As with the interpretation regarding forwards with embedded options

    generally, discussed above, in evaluating whether flexible physical

    commercial agreements that meet the 3-part test qualify for the forward

    exclusions, the CFTC will look to the specific facts and circumstances

    of the agreement, contract or transaction as a whole to evaluate

    whether the agreement, contract or transaction qualifies for the

    forward exclusions from the definitions of ``swap'' and ``future

    delivery.''

    ---------------------------------------------------------------------------

    \377\ In this regard, the usage rights offered for sale should

    be limited to the capacity of the specified facility. While

    overselling such capacity would not per se be inconsistent with

    satisfying the terms of this interpretation, the CFTC cautions

    market participants that overselling not based on reasonable

    commercial expectations of the use of the specified facility could

    lead the contract to be deemed evasion and lead to an agreement,

    contract or transaction being considered a swap, as it would

    undermine the ``right'' being offered. For example, given physical

    constraints of the power grid and gas pipelines, overselling

    transmission or transportation capacity would be per se inconsistent

    with satisfying the terms of this interpretation.

    ---------------------------------------------------------------------------

    However, in the alternative, if the right to use the specified

    facility is only obtained via the payment of a demand charge or

    reservation fee, and the exercise of the right (or use of the specified

    facility or part thereof) entails the further payment of actual storage

    fees, usage fees, rents, or other analogous service charges not

    included in the demand charge or reservation fee, such agreement,

    contract or transaction is a commodity option subject to the swap

    definition.

    Comments

    Two commenters addressed ``lease-like'' physical agreements,

    contracts or transactions.\378\ One of these commenters asserted that

    there are many physical commercial agreements for the supply and

    consumption of energy that effectively provide leases on flexible

    energy assets, such as tolls on power plants, transportation agreements

    on natural gas pipelines and natural gas storage agreements.\379\

    According to this commenter, these assets have the capability to be

    turned on and off to meet fluctuating demand due to weather and other

    factors; physical contracts around these assets transfer that delivery

    flexibility to the contract holder. The commenter believed that these

    types of commercial arrangements should not be considered commodity

    options, but rather should be excluded forwards. The other commenter

    described tolling agreements as having the characteristics of a lease,

    in that the

    [[Page 48243]]

    purchasing entity obtains the exclusive right to the use of the power

    plant during the term of the agreement.\380\ This commenter asserted

    that such agreements should not be considered commodity options, but

    rather forwards because the obligations are not contingent. The CFTC is

    providing the above interpretation that these types of agreements,

    contracts and transactions are not commodity options if the above

    conditions are satisfied, but may qualify for the forward exclusions

    under the facts and circumstances, in response to these commenters'

    concerns.

    ---------------------------------------------------------------------------

    \378\ See BGA Letter and California Utilities Letter.

    \379\ See BGA Letter.

    \380\ See California Utilities Letter.

    ---------------------------------------------------------------------------

    (iv) Effect of Interpretation on Certain Agreements, Contracts and

    Transactions

    In the Proposing Release,\381\ the CFTC requested comment regarding

    how its proposed interpretation concerning the forward contract

    exclusion would affect full requirements contracts, reserve sharing

    agreements, tolling agreements, energy management agreements and

    ancillary services. The CFTC asked whether such agreements, contracts

    or transactions have optionality as to delivery and, if so, whether

    they, or any other agreement, contract or transaction in a nonfinancial

    commodity, should be excluded from the swap definition.\382\

    ---------------------------------------------------------------------------

    \381\ See Request for Comment 35, which stated: How would the

    proposed interpretive guidance set forth in this section affect full

    requirements contracts, capacity contracts, reserve sharing

    agreements, tolling agreements, energy management agreements, and

    ancillary services? Do these agreements, contracts, or transactions

    have optionality as to delivery? If so, should they--or any other

    agreement, contract, or transaction in a nonfinancial commodity that

    has optionality as to delivery--be excluded from the swap

    definition? If so, please provide a detailed analysis of such

    agreements, contracts, or transactions and how they can be

    distinguished from options that are to be regulated as swaps

    pursuant to the Dodd-Frank Act. To what extent are any such

    agreements, contracts, or transactions in the electric industry

    regulated by the Federal Energy Regulatory Commission (``FERC''),

    State regulatory authorities, regional transmission organizations

    (``RTOs''), independent system operators (``ISOs'') or market

    monitoring units associated with RTOs or ISOs?

    See Proposing Release at 29832.

    \382\ Id.

    ---------------------------------------------------------------------------

    Commenters generally believed that such types of agreements,

    contracts and transactions, although they may contain delivery

    optionality, should be considered forwards rather than swaps or

    commodity options.\383\ By contrast, one commenter believed that traded

    power markets involve many types of contracts that are actually

    exchanges of cash flows based on referenced values and that have no

    relevant characteristics of physical delivery.\384\

    ---------------------------------------------------------------------------

    \383\ See Atmos Letter; BGA Letter; California Utilities Letter;

    COPE Letter; ETA Letter; Encana Letter; FERC Staff Letter; IECA

    Letter; NEMA Letter; ONEOK Letter; and Letter from Kenneth R.

    Carretta, General Regulatory Counsel--Markets, PSEG Services Corp.,

    on behalf of the Public Service Electric and Gas Company, PSEG Power

    LLC, and PSEG Energy Resources & Trade LLC (``PSEG Companies''),

    dated July 22, 2011 (``PSEG Letter'').

    \384\ See Better Markets Letter. This commenter stated that

    ancillary services are in substance swaps based on congestion costs

    between two transmission points, measured by the difference between

    actual prices assigned at those points by the grid operator.

    Capacity contracts are often documented using trading agreements for

    transactions in physicals, but this commenter believed that they

    constitute swaps that are used to hedge the price risk associated

    with periodic auctions of the contracts to provide reliable capacity

    to the grid operator. This commenter asserted that such contracts do

    not meet the CFTC's appropriate tests to exclude them, which should

    be made explicit in the guidance. This commenter stated that basic

    power contracts often do not meet the intent to deliver test because

    power buyers and sellers each schedule delivery to/from the grid,

    and such transactions can be settled based on readily available

    price differentials rather than scheduling capacity and load as a

    pair. At a minimum, this commenter believed that guidance should be

    provided to require that, in order to demonstrate intent to deliver,

    secondary delivery-related costs (e.g., congestion charges and

    penalties to which those scheduling capacity and load on the grid

    are subject) must be allocated by contract. Id.

    ---------------------------------------------------------------------------

    With the exception of energy management agreements, which are

    discussed below, the interpretations that the CFTC has already provided

    above may apply to such types of agreements, contracts and

    transactions. Specifically, to the extent that such types of

    agreements, contracts and transactions are forwards with embedded

    volumetric options, the CFTC has provided an additional interpretation

    in section II.B.2.b(iii) above. To the extent such types of agreements,

    contracts or transactions are physical commercial agreements, contracts

    or transactions discussed in section II.B.2.b(iii), supra, the CFTC has

    provided an interpretation in that section. To the extent such types of

    agreements, contracts and transactions are considered commodity

    options, the CFTC has addressed commodity options under the separate

    rulemaking establishing a modified trade option exemption.\385\ And to

    the extent that such types of agreements, contracts, and transactions,

    such as ancillary services, occur in Regional Transmission

    Organizations or Independent System Operators, or entered into between

    entities described in section 201(f) of the Federal Power Act,\386\

    they may be addressed through the public interest waiver process in CEA

    section 4(c)(6).\387\

    ---------------------------------------------------------------------------

    \385\ See supra note 317.

    \386\ 16 U.S.C. 824(f).

    \387\ 7 U.S.C. 6(c)(6).

    ---------------------------------------------------------------------------

    With regard to Energy Management Agreements (``EMAs''), in general,

    commenters expressed the view that EMAs are forwards, and not swaps,

    although they did not provide analysis to support that conclusion.\388\

    They also did not provide a working definition of EMAs. The CFTC

    understands that EMAs can cover a number of services and transactions,

    which can include spot, forward and swap transactions. EMAs can include

    services such as: (i) Acting as a financial intermediary by

    substituting one party's credit and liquidity for those of a less

    credit worthy owner of illiquid energy producing assets (i.e. the other

    party to the EMA) to facilitate the owner's purchase of fuel and sale

    of power; \389\ (ii) providing market information to assist the owner

    in developing and refining a risk-management plan for the plant; \390\

    and (iii) procuring fuel, arranging delivery and storage, selling

    excess power not needed to serve load for another party.\391\ The

    entity carrying out these activities may receive a portion of the

    revenue generated from such activities as compensation for its efforts.

    Because commenters did not provide a working definition of EMAs, the

    CFTC cannot state categorically that EMAs are or are not swaps.

    However, if the fuel acquisition, sales of excess generation and any

    other transactions executed under the auspices of an EMA are not swaps,

    nothing about the fact that the transactions are executed as a result

    of or pursuant to an EMA transforms the transactions into swaps. For

    example, if one party hires another party to enter into spot or forward

    transactions on its behalf, the fact that their relationship is

    governed by an EMA does not render those transactions swaps.\392\

    Conversely, were swaps to be executed by one party on behalf of another

    party as a result of, or pursuant to, an EMA, the parties thereto would

    need to consider their respective roles thereunder (e.g. principal

    versus agent) and whether commodity trading advisor, introducing

    broker, futures commission merchant, or other registration or other

    elements of the Dodd-Frank Act regime were implicated. At a minimum,

    the fact that a swap was executed would implicate

    [[Page 48244]]

    reporting and recordkeeping requirements.\393\

    ---------------------------------------------------------------------------

    \388\ See, e.g., Encana Letter and BGA Letter.

    \389\ See, e.g., The Royal Bank of Scotland Group plc, Order

    Approving Notice To Engage in Activities Complementary to a

    Financial Activity, 2008 Federal Reserve Bulletin volume 94.

    \390\ Id.

    \391\ See, e.g., Energy Management Agreement between Long Island

    Lighting Company and Long Island Power Authority, available at

    http://www.lipower.org/pdfs/company/papers/contract/energy.pdf.

    \392\ Similarly, using an EMA would not render swaps entered as

    a result of or pursuant to an EMA spot or forward transactions.

    \393\ This interpretation is limited to the facts and

    circumstances described herein; the CFTC is not opining on different

    facts or circumstances, which could change the CFTC's

    interpretation.

    ---------------------------------------------------------------------------

    (v) Liquidated Damages Provisions

    The Commissions also received several comments discussing

    contractual liquidated damages provisions. The CFTC is clarifying that

    the presence, in an agreement, contract, or transaction involving

    physical settlement of a nonfinancial commodity, of a liquidated

    damages provision (which may be referred to by another name, such as a

    ``cover costs'' or ``cover damages'' provision) does not necessarily

    render such an agreement, contract, or transaction ineligible for the

    forward exclusion.\394\ Such a provision in an agreement, contract, or

    transaction is consistent with the use of the forward exclusion,

    provided that the parties intend the transaction to be physically

    settled.\395\ However, liquidated damages provisions can be used to

    mask a lack of intent to deliver.\396\ In light of the possibility for

    evasion of the Dodd-Frank Act, the CFTC will continue to utilize its

    historical facts-and-circumstances approach in determining whether the

    parties to a particular agreement, contract, or transaction with a

    liquidated damage provision have the requisite intent to deliver.

    ---------------------------------------------------------------------------

    \394\ With respect to performance guarantees, the fact that a

    failure to deliver a nonfinancial commodity triggers a payment under

    a performance guaranty does not excuse the performance, nor render

    delivery optional. Accordingly, such a payment trigger would not

    itself preclude an agreement, contract, or transaction from being

    covered by the forward exclusion from the swap or future delivery

    definitions. But see supra part II.B.1.g, which provides that the

    CFTC is interpreting the term ``swap'' (that is not a security-based

    swap or mixed swap) to include a guarantee of such swap, to the

    extent that a counterparty to a swap position would have recourse to

    the guarantor in connection with the position.

    \395\ See 1985 CFTC OGC Interpretation, supra note 245 (stating

    generally that while ``[s]ome contracts provide for a liquidated

    damages of penalty clause if the producer fails to deliver, the

    presence of such clauses in a contract does not change the analysis

    of the nature of the contract [if] * * * it is intended that

    delivery of the physical crop occur, absent destruction of all or a

    portion of the crop by forces which neither party can control'').

    See generally Corbin on Contracts Sec. 58.1 (characterizing

    liquidated damages provisions as designed to ``[d]etermin[e] the

    amount of damages that are recoverable for a breach of contract'').

    \396\ In that regard, see 1985 CFTC OGC Interpretation, supra

    note 245 (stating that ``a contract provision which permitted a

    producer to avoid delivery for a reason other than for an

    intervening condition not in the control of either party could

    change any conclusion about the nature of the contract'').

    ---------------------------------------------------------------------------

    Comments

    One commenter notes that a commercial merchandising arrangement

    involving a nonfinancial commodity may provide that the remedy for a

    failure to make or take delivery is the payment of a market-rate

    replacement price, a payment on a performance guaranty, or ``cover

    damages'' to compensate the non-breaching party for the failure of the

    other party to fulfill its contractual obligations.\397\ Such a

    contractual damages or remedy provision, this commenter contended, is

    not analogous to a financial settlement option in a trading

    instrument.\398\ This commenter further asserted that one party or the

    other may be unable to perform, or excused or prevented for commercial

    reasons from performing, its contractual obligations to make or take

    delivery of a nonfinancial commodity, and therefore may be liable to

    the other party for a monetary payment, calculated in accordance with

    the contract.\399\

    ---------------------------------------------------------------------------

    \397\ See ETA Letter.

    \398\ Id. This commenter cited FERC Order No. 890, which

    recognizes that ``[w]hile any party to any contract can choose to

    fail to perform, that does not convey a contractual right to fail to

    perform'' and that the Edison Electric Institute Master Power

    Purchase and Sale Agreement (``EEI MPPSA'') clearly obligates the

    supplier to provide power, except in cases of force majeure. As the

    ETA explains, ``[t]he EEI MPPSA is a master agreement frequently

    used to document transactions for deferred delivery and receipt of

    nonfinancial electric energy, and the terms of the ISDA North

    American Power Annex contain substantially identical master

    agreement provisions * * *.'' Id.

    \399\ According to this commenter, parties typically include

    liquidated damages provisions in their agreements, contracts and

    transactions to address situations in which ``one party or the other

    may be unable, excused or prevented for commercial reasons from

    performing its contractual obligations to deliver or receive [the

    relevant commodity],'' not to serve as ``a financial settlement

    `option' analogous to a financial settlement option in a trading

    instrument.'' Id.

    ---------------------------------------------------------------------------

    Another commenter noted that physically settled gas contracts,

    including peaking contracts (both for daily and monthly supply), bullet

    day contracts and weather contracts, use the NAESB Base Contract, which

    does not provide for financial settlement other than a liquidated

    damages provision, which would compensate a utility for its cost of

    obtaining alternative supply at the prevailing market price if the

    seller fails to deliver.\400\ This commenter stated its view that the

    seller has no real opportunity to arbitrage its obligation to deliver

    based on changes in price, and the purchaser has no incentive to fail

    to take delivery of its specified quantities of gas, because they are

    needed for the physical operations of its system.\401\

    ---------------------------------------------------------------------------

    \400\ See AGA Letter.

    \401\ Id. See also Atmos Letter (stating that there is no

    financial incentive for a seller to fail to deliver natural gas

    under contracts used in the natural gas industry, as the standard

    remedy for such a failure to deliver is to pay liquidated damages

    sufficient to compensate the purchaser for having to obtain its

    required natural gas).

    ---------------------------------------------------------------------------

    The CFTC generally agrees with these comments regarding liquidated

    damages provisions, and has provided the final interpretation described

    above to address them.

    (c) Security Forwards \402\

    ---------------------------------------------------------------------------

    \402\ The discussion above regarding the exclusion from the swap

    definition for forward contracts on nonfinancial commodities does

    not apply to the exclusion from the swap and security-based swap

    definitions for security forwards or to the distinction between

    security forwards and security futures products.

    ---------------------------------------------------------------------------

    As the Commissions stated in the Proposing Release, the Commissions

    believe it is appropriate to address how the exclusions from the swap

    and security-based swap definitions apply to security forwards and

    other purchases and sales of securities.\403\ The Commissions are

    restating the interpretation set out in the Proposing Release without

    modification.

    ---------------------------------------------------------------------------

    \403\ See Proposing Release at 29830.

    ---------------------------------------------------------------------------

    The Dodd-Frank Act excludes purchases and sales of securities from

    the swap and security-based swap definitions in a number of different

    clauses.\404\ Under these exclusions, purchases and sales of securities

    on a fixed or contingent basis \405\ and sales of securities for

    deferred shipment or delivery that are intended to be physically

    delivered \406\ are explicitly excluded from the swap and security-

    based swap definitions.\407\ The exclusion from the swap and security-

    based swap definitions of a sale of a security for deferred shipment or

    delivery involves an agreement to purchase one or more securities, or

    groups or indexes of securities, at a future date at a certain price.

    ---------------------------------------------------------------------------

    \404\ See sections 1a(47)(B)(ii), (v), and (vi) of the CEA, 7

    U.S.C. 1a(47)(B)(ii), (v), and (vi).

    \405\ See section 1a(47)(B)(v) of the CEA, 7 U.S.C. 1a(47)(B)(v)

    (excluding from the swap and security-based swap definitions ``any

    agreement, contract, or transaction providing for the purchase or

    sale of 1 or more securities on a fixed basis that is subject to

    [the Securities Act and Exchange Act]''); and section 1a(47)(B)(vi)

    of the CEA, 7 U.S.C. 1a(47)(B)(vi) (excluding from the swap and

    security-based swap definitions ``any agreement, contract, or

    transaction providing for the purchase or sale of 1 or more

    securities on a contingent basis that is subject to [the Securities

    Act and Exchange Act], unless the agreement, contract, or

    transaction predicates the purchase or sale on the occurrence of a

    bona fide contingency that might reasonably be expected to affect or

    be affected by the creditworthiness of a party other than a party to

    the agreement, contract, or transaction'').

    \406\ See section 1a(47)(B)(ii) of the CEA, 7 U.S.C.

    1a(47)(B)(ii).

    \407\ The Commissions note that calling an agreement, contract,

    or transaction a swap or security-based swap does not determine its

    status. See supra part II.D.1.

    ---------------------------------------------------------------------------

    As with other purchases and sales of securities, security forwards

    are

    [[Page 48245]]

    excluded from the swap and security-based swap definitions. The sale of

    the security in this case occurs at the time the forward contract is

    entered into with the performance of the contract deferred or

    delayed.\408\ If such agreement, contract, or transaction is intended

    to be physically settled, the Commissions believe it would be within

    the security forward exclusion and therefore outside the swap and

    security-based swap definitions.\409\ Moreover, as a purchase or sale

    of a security, the Commissions believe it also would be within the

    exclusions for the purchase or sale of one or more securities on a

    fixed basis (or, depending on its terms, a contingent basis) and,

    therefore, outside the swap and security-based swap definitions.\410\

    ---------------------------------------------------------------------------

    \408\ A purchase or sale of a security occurs at the time the

    parties become contractually bound, not at the time of settlement

    (regardless of whether cash or physically settled). See Securities

    Offering Reform, 70 FR 44722 (Aug. 3, 2005).

    \409\ See section 1a(47)(B)(ii) of the CEA, 7 U.S.C.

    1a(47)(B)(ii).

    \410\ See sections 1a(47)(B)(v) and (vi) of the CEA, 7 U.S.C.

    1a(47)(B)(v) and (vi).

    ---------------------------------------------------------------------------

    In the Proposing Release, the Commissions provided the following

    specific interpretation in the context of forward sales of mortgage-

    backed securities (``MBS'') guaranteed or sold by the Federal National

    Mortgage Association (``Fannie Mae''), the Federal Home Loan Mortgage

    Corporation (``Freddie Mac''), and the Government National Mortgage

    Association (``Ginnie Mae'').\411\ The Commissions are restating their

    interpretation regarding such forward sales.

    ---------------------------------------------------------------------------

    \411\ The Commissions provided the interpretation in the

    Proposing Release in response to commenters on the ANPR. See

    Proposing Release at 29830. These commenters requested clarification

    that forward sales of MBS guaranteed or sold by Fannie Mae, Freddie

    Mac and Ginnie Mae would not be included in the swap and security-

    based swap definitions in order to provide the certainty needed to

    avoid unnecessary disruption of this market. Id.

    ---------------------------------------------------------------------------

    MBS guaranteed or sold by Fannie Mae, Freddie Mac and Ginnie Mae

    are eligible to be sold in the ``To-Be-Announced'' (``TBA'') market,

    which is essentially a forward or delayed delivery market.\412\ The TBA

    market has been described as one that ``allows mortgage lenders

    essentially to sell the loans they intend to fund even before the loans

    are closed.'' \413\ In the TBA market, the lender enters into a forward

    contract to sell MBS and agrees to deliver MBS on the settlement date

    in the future. The specific MBS that will be delivered in the future

    may not yet be created at the time the forward contract is entered

    into.\414\ In a TBA transaction, the seller and the buyer agree to five

    terms before entering into the transaction: (i) The type of security,

    which will usually be a certain type of MBS guaranteed or sold by

    Fannie Mae, Freddie Mac or Ginnie Mae and the type of mortgage

    underlying the MBS; (ii) the coupon or interest rate; (iii) the face

    value (the total dollar amount of MBS the purchaser wishes to

    purchase); (iv) the price; and (v) the settlement date.\415\ The

    purchaser will contract to acquire a specified dollar amount of MBS,

    which may be satisfied when the seller delivers one or more MBS pools

    at settlement.\416\

    ---------------------------------------------------------------------------

    \412\ Task Force on Mortgage-Backed Securities Disclosure,

    ``Staff Report: Enhancing Disclosure in the Mortgage-Backed

    Securities Markets,'' part II.E.2 (Jan. 2003), which is available at

    http://www.sec.gov/news/studies/mortgagebacked.htm (``MBS Staff

    Report'').

    \413\ Id.

    \414\ Id.

    \415\ Id.

    \416\ Id. The good delivery guidelines, titled ``Uniform

    Practices for the Clearance and Settlement of Mortgage-Backed

    Securities and Other Related Securities,'' which govern the

    mechanics of trading and settling MBS, contain specific guidelines

    for trading and settling MBS guaranteed or sold by Fannie Mae,

    Freddie Mac and Ginnie Mae in the TBA market. The good delivery

    guidelines outline the basic terms and conditions for trading,

    confirming, delivering and settling MBS. The good delivery

    guidelines set forth the basic characteristics that MBS guaranteed

    or sold by Fannie Mae, Freddie Mac and Ginnie Mae must have to be

    able to be delivered to settle an open TBA transaction. Id. The

    Securities Industry and Financial Markets Association (``SIFMA'') is

    the successor to the Bond Market Association and publishes the good

    delivery guidelines, which are available at http://www.sifma.org/services/standard-forms-and-documentation/securitized-products/.

    ---------------------------------------------------------------------------

    The Commissions are confirming that such forward sales of MBS in

    the TBA market would fall within the exclusion for sales of securities

    on a deferred settlement or delivery basis even though the precise MBS

    are not in existence at the time the forward MBS sale is entered

    into.\417\ Moreover, as the purchase or sale of a security, the

    Commissions also are confirming that such forward sales of MBS in the

    TBA market would fall within the exclusions for the purchase or sale of

    one or more securities on a fixed basis (or, depending on its terms, a

    contingent basis) and therefore would fall outside the swap and

    security-based swap definitions.\418\

    ---------------------------------------------------------------------------

    \417\ See section 1a(47)(B)(ii) of the CEA, 7 U.S.C.

    1a(47)(B)(ii).

    \418\ See sections 1a(47)(B)(v) and (vi) of the CEA, 7 U.S.C.

    1a(47)(B)(v) and (vi).

    ---------------------------------------------------------------------------

    Comments

    The Commissions received two comments on the interpretation

    regarding security forwards. One commenter recommended that the

    Commissions codify in the text of the final rules the interpretation

    regarding forward sales of MBS in the TBA market.\419\ The Commissions

    are not codifying the interpretation because codification will create a

    bright-line test. The Commissions note that the analysis as to whether

    any product falls within the exclusion for sales of securities on a

    deferred settlement or delivery basis requires flexibility, including

    the consideration of applicable facts and circumstances. Because the

    interpretation regarding forward sales of MBS in the TBA market is

    based on particular facts and circumstances, the Commissions do not

    believe that a bright-line test is appropriate.

    ---------------------------------------------------------------------------

    \419\ See Letter from Lisa M. Ledbetter, Vice President and

    General Counsel, Legislative & Regulatory Affairs, Freddie Mac, Jul.

    21, 2011.

    ---------------------------------------------------------------------------

    Another commenter suggested that the Commissions narrow the

    exclusion for contracts for the purchase and sale of securities for

    subsequent delivery as applied to security-based swaps because parties

    can use the formal characterization of a delivery contract for

    securities to disguise a transaction that is substantively a security-

    based swap.\420\ This commenter was concerned because this commenter

    believes that the securities subject to such a delivery obligation are

    often easily convertible into cash, which facilitates cash settlement

    without actual delivery.\421\ As such, this commenter suggested that

    the Commissions should provide a test for determining whether parties

    have a bona fide intent to deliver.\422\ This commenter recommended

    that such test should prohibit cash settlement options in contracts for

    subsequent delivery and should not consider a party that frequently

    unwinds physical positions with cash settlements using side agreements

    as having the requisite intent to deliver.\423\ The Commissions are not

    providing a test at this time for determining whether parties have a

    bona fide intent to deliver because the analysis as to whether sales of

    securities for deferred shipment or delivery are intended to be

    physically delivered is a facts and circumstances determination and a

    bright-line test will not allow for the flexibility needed in such

    analysis. Further, the Commissions note that the purchase and sale of a

    security occurs at the time the forward contract is entered into.\424\

    ---------------------------------------------------------------------------

    \420\ See Better Markets Letter.

    \421\ Id.

    \422\ Id.

    \423\ Id.

    \424\ See supra note 408.

    ---------------------------------------------------------------------------

    [[Page 48246]]

    3. Consumer and Commercial Agreements, Contracts, and Transactions

    The Commissions noted in the Proposing Release that ``[c]onsumers

    enter into various types of agreements, contracts, and transactions as

    part of their household and personal lives that may have attributes

    that could be viewed as falling within the swap or security-based swap

    definition.\425\ Similarly, businesses and other entities, whether or

    not for profit, also enter into agreements, contracts, and transactions

    as part of their operations relating to, among other things,

    acquisitions or sales of property (tangible and intangible), provisions

    of services, employment of individuals, and other matters that could be

    viewed as falling within the definitions.'' \426\

    ---------------------------------------------------------------------------

    \425\ See Proposing Release at 29832.

    \426\ Id.

    ---------------------------------------------------------------------------

    Commenters on the ANPR pointed out a number of areas in which a

    broad reading of the swap and security-based swap definitions could

    cover certain consumer and commercial arrangements that historically

    have not been considered swaps or security-based swaps.\427\ Examples

    of such instruments cited by those commenters included evidences of

    indebtedness with a variable rate of interest; commercial contracts

    containing acceleration, escalation, or indexation clauses; agreements

    to acquire personal property or real property, or to obtain mortgages;

    employment, lease, and service agreements, including those that contain

    contingent payment arrangements; and consumer mortgage and utility rate

    caps.\428\

    ---------------------------------------------------------------------------

    \427\ Id.

    \428\ Id.

    ---------------------------------------------------------------------------

    The Commissions also stated in the Proposing Release that they ``do

    not believe that Congress intended to include these types of customary

    consumer and commercial agreements, contracts, or transactions in the

    swap or security-based swap definition, to limit the types of persons

    that can enter into or engage in them, or to otherwise to subject these

    agreements, contracts, or transactions to the regulatory scheme for

    swaps and security-based swaps.'' \429\

    ---------------------------------------------------------------------------

    \429\ Id. If these types of arrangements were subject to Title

    VII, the persons that could enter into or engage in them could be

    restricted because Title VII imposes restrictions on entering into

    swaps and security-based swaps with persons who are not eligible

    contract participants (``ECPs''). See sections 723(1), 763(e), and

    768(b) of the Dodd-Frank Act. The Dodd-Frank Act amended the

    Securities Act and the Exchange Act to require that security-based

    swap transactions involving a person that is not an ECP must be

    registered under the Securities Act and effected on a national

    securities exchange, and also amended the CEA to require that swap

    transactions involving a person that is not an ECP must be entered

    into on, or subject to the rules of, a board of trade designated as

    a contract market. Id. The Commissions note that many consumers and

    commercial and non-profit entities may not be ECPs. See section

    1a(18) of the CEA, 7 U.S.C. 1a(18). Further, if these types of

    arrangements were subject to Title VII, they would be subject to the

    full regulatory scheme for swaps and security-based swaps created by

    Title VII. These requirements could increase costs for consumers and

    commercial and non-profit entities and potentially disrupt their

    ability to enter into these arrangements.

    ---------------------------------------------------------------------------

    Accordingly, the Commissions proposed an interpretation in the

    Proposing Release to assist consumers and commercial and non-profit

    entities in understanding whether certain agreements, contracts, or

    transactions that they enter into would be regulated as swaps or

    security-based swaps.\430\ The Commissions are adopting the

    interpretation set out in the Proposing Release with certain

    modifications in response to commenters.\431\

    ---------------------------------------------------------------------------

    \430\ See Proposing Release at 29832-33.

    \431\ See infra note 447 and accompanying text.

    ---------------------------------------------------------------------------

    With respect to consumers, the Commissions have determined that the

    types of agreements, contracts, or transactions that will not be

    considered swaps or security-based swaps when entered into by consumers

    (natural persons) as principals (or by their agents)\432\ primarily for

    personal, family, or household purposes, include:\433\

    ---------------------------------------------------------------------------

    \432\ For example, a mortgage broker may arrange a rate lock on

    behalf of a consumer borrower.

    \433\ The Commissions are not addressing here the applicability

    of any other provisions of the CEA, the Federal securities laws or

    the Commissions' regulations to such agreements, contracts or

    transactions.

    ---------------------------------------------------------------------------

    Agreements, contracts, or transactions to acquire or lease

    real or personal property, to obtain a mortgage, to provide personal

    services, or to sell or assign rights owned by such consumer (such as

    intellectual property rights);

    Agreements, contracts, or transactions to purchase

    products or services for personal, family or household purposes at a

    fixed price or a capped or collared price, at a future date or over a

    certain time period (such as agreements to purchase for personal use or

    consumption nonfinancial energy commodities, including agreements to

    purchase home heating fuel or agreements involving residential fuel

    storage, in either case, where the consumer takes delivery of and uses

    the fuel, and the counterparty is a merchant that delivers in the

    service area where the consumer resides);\434\

    ---------------------------------------------------------------------------

    \434\ These agreements, contracts, or transactions require the

    parties respectively to make and take delivery of the underlying

    commodity to each other directly; delivery may be deferred for

    convenience or necessity. But see section 2(c)(2)(D) of the CEA, 7

    U.S.C. 2(c)(2)(D), generally prohibiting certain leveraged, margined

    or financed agreements, contracts and transactions with non-ECPs

    when actual delivery does not occur within 28 days). The Commissions

    view consumer agreements, contracts, and transactions involving

    periodic or future purchases of consumer products and services as

    transactions that are not swaps. This interpretation does not extend

    to consumer agreements, contracts or transactions containing

    embedded optionality or embedded derivatives other than those

    discussed in the text associated with this footnote. This analysis

    of consumer contracts is separate from the forward contract analysis

    for commercial merchandising transactions discussed in supra part

    II.B.2. The CFTC continues to view the forward contract exclusion

    for nonfinancial commodities as limited to commercial merchandising

    transactions.

    ---------------------------------------------------------------------------

    Agreements, contracts, or transactions that provide for an

    interest rate cap or lock on a consumer loan or mortgage, where the

    benefit of the rate cap or lock is realized only if the loan or

    mortgage is made to the consumer;

    Consumer loans or mortgages with variable rates of

    interest or embedded interest rate options, including such loans with

    provisions for the rates to change upon certain events related to the

    consumer, such as a higher rate of interest following a default; \435\

    ---------------------------------------------------------------------------

    \435\ An example of a consumer loan with a variable rate of

    interest is credit card debt that includes a ``teaser'' rate. The

    teaser rate is a low, adjustable introductory interest rate that is

    temporary.

    ---------------------------------------------------------------------------

    Service agreements, contracts, or transactions that are

    consumer product warranties, extended service plans, or buyer

    protection plans, such as those purchased with major appliances and

    electronics; \436\

    ---------------------------------------------------------------------------

    \436\ One commenter indicated that such service agreements,

    contracts, or transactions may be regulated as insurance in some but

    not all states. However, the Commissions believe that it is

    appropriate to address these agreements, contracts, or transactions

    in the context of their guidance regarding consumer and commercial

    arrangements. See NAIC Letter.

    ---------------------------------------------------------------------------

    Consumer options to acquire, lease, or sell real or

    personal property, such as options to lease apartments or purchase rugs

    and paintings, and purchases made through consumer layaway plans; \437\

    ---------------------------------------------------------------------------

    \437\ The Commissions believe that options entered into by

    consumers that result in physical delivery of the commodity, if

    exercised, are not the type of agreements, contracts or transactions

    that Congress intended to regulate as swaps or security-based swaps.

    Conversely, options entered into by consumers that cash settle based

    on the difference between the market price and the contract price of

    a commodity are not within the scope of this interpretation.

    ---------------------------------------------------------------------------

    Consumer agreements, contracts, or transactions where, by

    law or regulation, the consumer may cancel the transaction without

    legal cause; \438\ and

    ---------------------------------------------------------------------------

    \438\ Examples of these types of transactions include consumer

    transactions that may be cancelled pursuant to the Federal Reserve

    Board's Regulation Z, 12 CFR Part 226 (i.e. certain consumer credit

    transactions that involve a lien on the consumer's principal

    dwelling), consumer mail/telephone orders that may be cancelled when

    orders have not been filled under 16 CFR Part 435, and other

    consumer transactions that have cancellations rights conferred by

    statute or regulation.

    ---------------------------------------------------------------------------

    [[Page 48247]]

    Consumer guarantees of credit card debt, automobile loans,

    ---------------------------------------------------------------------------

    and mortgages of a friend or relative.

    The Commissions have included in the interpretation above several

    additional examples of consumer arrangements that the Commissions do

    not consider to be swaps or security-based swaps. These additional

    examples have been included in response to commenters \439\ and the

    Commissions' determination that such additional examples would assist

    consumers in identifying other agreements, contracts, or transactions

    that they enter into that would not be regulated as swaps or security-

    based swaps.\440\

    ---------------------------------------------------------------------------

    \439\ See supra note 96 and accompanying text. See also infra

    notes 436, 454 and 455 and accompanying text.

    \440\ The additional example regarding consumer options to

    acquire, lease, or sell real or personal property was added in

    response to a commenter on the ANPR. See Letter from White & Case

    LLP, dated September 20, 2010. The Commissions also are providing as

    additional examples consumer agreements, contracts, or transactions

    where, by law or regulation, the consumer may cancel the transaction

    without legal cause, and consumer guarantees of credit card debt,

    automobile loans, and mortgages of a friend or relative.

    ---------------------------------------------------------------------------

    The types of commercial agreements, contracts, or transactions that

    involve customary business arrangements (whether or not involving a

    for-profit entity) and will not be considered swaps or security-based

    swaps under this interpretation include:

    Employment contracts and retirement benefit arrangements;

    Sales, servicing, or distribution arrangements;

    Agreements, contracts, or transactions for the purpose of

    effecting a business combination transaction; \441\

    ---------------------------------------------------------------------------

    \441\ These business combination transactions include, for

    example, a reclassification, merger, consolidation, or transfer of

    assets as defined under the Federal securities laws or any tender

    offer subject to section 13(e) and/or section 14(d) or (e) of the

    Exchange Act, 15 U.S.C. 78m(e) and/or 78n(d) or (e). These business

    combination agreements, contracts, or transactions can be contingent

    on the continued validity of representations and warranties and can

    contain earn-out provisions and contingent value rights.

    ---------------------------------------------------------------------------

    The purchase, sale, lease, or transfer of real property,

    intellectual property, equipment, or inventory;

    Warehouse lending arrangements in connection with building

    an inventory of assets in anticipation of a securitization of such

    assets (such as in a securitization of mortgages, student loans, or

    receivables); \442\

    ---------------------------------------------------------------------------

    \442\ The Commissions believe that such lending arrangements

    included in this category are traditional borrower/lender

    arrangements documented using, for example, a loan agreement or

    indenture, as opposed to a synthetic lending arrangement documented

    in the form of, for example, a total return swap. The Commissions

    also note that securitization transaction agreements also may

    contain contingent obligations if the representations and warranties

    about the underlying assets are not satisfied.

    ---------------------------------------------------------------------------

    Mortgage or mortgage purchase commitments, or sales of

    installment loan agreements or contracts or receivables;

    Fixed or variable interest rate commercial loans or

    mortgages entered into by banks \443\ and non-banks, including the

    following:

    ---------------------------------------------------------------------------

    \443\ While the Commissions have included fixed or variable

    interest rate commercial loans entered into by banks, the

    Commissions understand that the CEA does not apply to, and the CFTC

    may not exercise regulatory authority over, identified banking

    products, and that the definitions of the terms ``security-based

    swap'' and ``security-based swap agreement'' do not include

    identified banking products. See infra note 488, regarding

    identified banking products. However, such loans and mortgages

    provided by certain banks may not qualify as identified banking

    products because those banks may not satisfy the definition of

    ``bank'' for purposes of the ``identified banking products''

    definition. See 7 U.S.C. 27(a).

    ---------------------------------------------------------------------------

    Fixed or variable interest rate commercial loans or

    mortgages entered into by the Farm Credit System institutions and

    Federal Home Loan Banks;

    Fixed or variable interest rate commercial loans or

    mortgages with embedded interest rate locks, caps, or floors, provided

    that such embedded interest rate locks, caps, or floors are included

    for the sole purpose of providing a lock, cap, or floor on the interest

    rate on such loan or mortgage and do not include additional provisions

    that would provide exposure to enhanced or inverse performance, or

    other risks unrelated to the interest rate risk being addressed;

    Fixed or variable interest rate commercial loans or

    mortgages with embedded interest rate options, including such loans or

    mortgages that contain provisions causing the interest rate to change

    upon certain events related to the borrower, such as a higher rate of

    interest following a default, provided that such embedded interest rate

    options do not include additional provisions that would provide

    exposure to enhanced or inverse performance, or other risks unrelated

    to the primary reason the embedded interest rate option is included;

    and

    Commercial agreements, contracts, and transactions

    (including, but not limited to, leases, service contracts, and

    employment agreements) containing escalation clauses linked to an

    underlying commodity such as an interest rate or consumer price index.

    In response to commenters,\444\ the Commissions have included in the

    interpretation above several additional examples of commercial

    arrangements that the Commissions do not consider to be swaps or

    security-based swaps.

    ---------------------------------------------------------------------------

    \444\ See infra notes 456 and 461 and accompanying text.

    ---------------------------------------------------------------------------

    The Commissions intend for this interpretation to enable consumers

    to engage in transactions relating to their households and personal or

    family activities without concern that such arrangements would be

    considered swaps or security-based swaps. Similarly, with respect to

    commercial business arrangements, this interpretation should allow

    commercial and non-profit entities to continue to operate their

    businesses and operations without significant disruption and provide

    that the swap and security-based swap definitions are not read to

    include commercial and non-profit operations that historically have not

    been considered to involve swaps or security-based swaps.

    The types of agreements, contracts, and transactions discussed

    above are not intended to be exhaustive of the customary consumer or

    commercial arrangements that should not be considered to be swaps or

    security-based swaps. There may be other, similar types of agreements,

    contracts, and transactions that also should not be considered to be

    swaps or security-based swaps. In determining whether similar types of

    agreements, contracts, and transactions entered into by consumers or

    commercial entities are swaps or security-based swaps, the Commissions

    intend to consider the characteristics and factors that are common to

    the consumer and commercial transactions listed above:

    They do not contain payment obligations, whether or not

    contingent, that are severable from the agreement, contract, or

    transaction;

    They are not traded on an organized market or over-the-

    counter; and

    In the case of consumer arrangements, they:

    --Involve an asset of which the consumer is the owner or beneficiary,

    or that the consumer is purchasing, or they involve a service provided,

    or to be provided, by or to the consumer, or

    In the case of commercial arrangements, they are entered

    into:

    --By commercial or non-profit entities as principals (or by their

    agents) to serve an independent commercial, business, or non-profit

    purpose, and

    --Other than for speculative, hedging, or investment purposes.

    Two of the key components reflected in these characteristics that

    distinguish these agreements, contracts, and transactions from swaps

    and security-based swaps are that: (i) The payment provisions of the

    agreement, contract, or transaction are not severable; and (ii)

    [[Page 48248]]

    the agreement, contract, or transaction is not traded on an organized

    market or over-the-counter, and therefore such agreement, contract, or

    transaction does not involve risk-shifting arrangements with financial

    entities, as would be the case for swaps and security-based swaps.\445\

    In response to commenters,\446\ the Commissions clarify that merely

    because an agreement, contract, or transaction is assignable does not

    mean that it is ``traded'' or that the agreement, contract, or

    transaction is a swap or security-based swap. An assignment of a

    contractual obligation must be analyzed to assure that the result is

    not to sever the payment obligations.

    ---------------------------------------------------------------------------

    \445\ There also are alternative regulatory regimes that have

    been enacted as part of the Dodd-Frank Act specifically to provide

    enhanced protections to consumers relating to various consumer

    transactions. See, e.g., the Consumer Financial Protection Act of

    2010, Public Law 111-203, tit. X, 124 Stat. 1376 (Jul. 21, 2010)

    (establishing the Bureau of Consumer Financial Protection to

    regulate a broad category of consumer products and amending certain

    laws under the jurisdiction of the Federal Trade Commission); the

    Mortgage Reform and Anti-Predatory Lending Act, Public Law 111-203,

    tit. XIV, 124 Stat. 1376 (Jul. 21, 2010) (amending existing laws,

    and adding new provisions, related to certain mortgages). Some of

    these agreements, contracts, or transactions are subject to

    regulation by the Federal Trade Commission and other Federal

    financial regulators and state regulators.

    \446\ See infra note 470.

    ---------------------------------------------------------------------------

    This interpretation is not intended to be the exclusive means for

    consumers and commercial or non-profit entities to determine whether

    their agreements, contracts, or transactions fall within the swap or

    security-based swap definition. If there is a type of agreement,

    contract, or transaction that is not enumerated above, or does not have

    all the characteristics and factors that are listed above (including

    new types of agreements, contracts, or transactions that may be

    developed in the future), the agreement, contract, or transaction will

    be evaluated based on its particular facts and circumstances. Parties

    to such an agreement, contract or transaction may also seek an

    interpretation from the Commissions as to whether the agreement,

    contract or transaction is a swap or security-based swap.

    Comments

    Eleven commenters provided comments on the proposed interpretation

    set forth in the Proposing Release regarding consumer and commercial

    arrangements.\447\ While most commenters supported the proposed

    interpretation, these commenters suggested certain changes.

    ---------------------------------------------------------------------------

    \447\ See BGA Letter; Letter from The Coalition for Derivatives

    End-Users, Jul. 22, 2011, (``CDEU Letter''); ETA Letter; Letter from

    Robbie Boone, Vice President, Government Affairs, Farm Credit

    Council, Jul. 22, 2011 (``FCC Letter''); FERC Staff Letter; Letter

    from Warren N. Davis, Of Counsel, Sutherland Asbill & Brennan LLP,

    on behalf of the Federal Home Loan Banks, Jul. 22, 2011 (``FHLB

    Letter''); IECA Letter; ISDA Letter; Just Energy Letter; PMAA/NEFI

    Letter; and SEIA Letter.

    ---------------------------------------------------------------------------

    Four commenters recommended that the Commissions codify the

    proposed interpretation regarding consumer and commercial

    arrangements.\448\ The Commissions are not codifying the

    interpretation. The interpretation is intended to provide guidance to

    assist consumers and commercial and non-profit entities in evaluating

    whether certain arrangements that they enter into will be regulated as

    swaps or security-based swaps. The interpretation is intended to allow

    the flexibility necessary, including the consideration of the

    applicable facts and circumstances by the Commissions, in evaluating

    consumer and commercial arrangements to ascertain whether they may be

    swaps or security-based swaps. The representative characteristics and

    factors taken together are indicators that a consumer or commercial

    arrangement is not a swap or security-based swap and the Commissions

    have provided specific examples demonstrating how these characteristics

    and factors apply to some common types of consumer and commercial

    arrangements. However, as the interpretation is not intended to be a

    bright-line test for determining whether a particular consumer or

    commercial arrangement is a swap or security-based swap, if the

    particular arrangement does not meet all of the identified

    characteristics and factors, the arrangement will be evaluated based on

    its particular facts and circumstances.

    ---------------------------------------------------------------------------

    \448\ See ETA Letter; FERC Letter; IECA Letter; and Just Energy

    Letter.

    ---------------------------------------------------------------------------

    One commenter was concerned that the interpretation itself

    implicitly suggests that many types of consumer and commercial

    arrangements could be swaps, although none of these arrangements

    historically has been considered a swap.\449\ The Commissions do not

    intend to suggest that many types of consumer and commercial

    arrangements that historically have not been considered swaps are

    within the swap or security-based swap definitions. The Commissions

    provided the interpretation in response to comments received on the

    ANPR. Commenters on the ANPR identified areas in which a broad reading

    of the swap and security-based swap definitions could cover certain

    consumer and commercial arrangements that historically have not been

    considered swaps or security-based swaps.\450\ The Commissions believe

    it is appropriate to provide the interpretation to allow consumers and

    commercial and non-profit entities to engage in such transactions

    without concern that such arrangements would be considered swaps or

    security-based swaps.

    ---------------------------------------------------------------------------

    \449\ See IECA Letter.

    \450\ See Proposing Release at 29832.

    ---------------------------------------------------------------------------

    One commenter requested that the Commissions remove the term

    ``customary'' from the description of consumer and commercial

    arrangements in the interpretation.\451\ The Commissions note that the

    use of the term ``customary'' was not intended to limit the

    interpretation, but rather was used to describe certain types of

    arrangements that consumers and businesses may normally or generally

    enter into. The Commissions also note that the term ``customary'' is

    itself not a separate representative characteristic or factor for

    purposes of the interpretation.

    ---------------------------------------------------------------------------

    \451\ See ISDA Letter.

    ---------------------------------------------------------------------------

    This commenter also requested that specific examples of consumer

    and commercial arrangements that are not swaps or security-based swaps

    include ``any other similar agreements, contracts, or transactions.''

    \452\ The specific examples are not intended to be an exhaustive list

    and the Commissions do not believe that it is necessary to include a

    general catchall provision. The interpretation also includes a list of

    representative characteristics and factors to be used to analyze other

    consumer and commercial arrangements.

    ---------------------------------------------------------------------------

    \452\ Id.

    ---------------------------------------------------------------------------

    Several commenters suggested additional examples of consumer and

    commercial arrangements that the Commissions should not consider to be

    swaps or security-based swaps.\453\ One commenter suggested that the

    Commissions should expand the example of ``consumer agreements,

    contracts, or transactions to purchase products or services at a fixed

    price or a capped or collared price, at a future date or over a certain

    time period (such as agreements to purchase home heating fuel)'' to

    include all nonfinancial energy commodities in the parenthetical

    example.\454\ The Commissions have modified the identified consumer

    example to include all nonfinancial energy commodities. The

    parenthetical example was not intended to be limited to agreements to

    purchase home heating fuel.

    ---------------------------------------------------------------------------

    \453\ See CDEU Letter; FCC Letter; FERC Letter; FHLB Letter;

    ISDA Letter; Just Energy Letter; PMAA/NEFI Letter; and SEIA Letter.

    \454\ See Just Energy Letter.

    ---------------------------------------------------------------------------

    One commenter suggested that the Commissions should include as an

    [[Page 48249]]

    additional example residential fuel storage contracts.\455\ The

    Commissions agree that these arrangements should not be considered

    swaps or security-based swaps, provided that they are residential fuel

    storage contracts where the consumer takes delivery of and consumes the

    fuel, and the counterparty is a merchant (or agent of a merchant) that

    delivers in the service area where the consumer's residence is located.

    Although the consumer may not immediately consume the fuel contracted

    for, because it will ultimately consume the fuel for personal, family,

    or household purposes, such a transaction is a type of customary

    consumer transaction excluded from the swap and security-based swap

    definitions.

    ---------------------------------------------------------------------------

    \455\ See PMAA/NEFI Letter.

    ---------------------------------------------------------------------------

    Three commenters requested clarification that commercial loans and

    mortgages would fall within the interpretation regardless of whether

    entered into by a bank or non-bank.\456\ Two of these commenters were

    concerned that the specific example was limited to commercial loans and

    mortgages entered into by non-banks and did not address commercial

    loans and mortgages entered into by financial institutions that are

    banks but whose loans and mortgages do not qualify as identified

    banking products.\457\ The Commissions are revising the example to

    clarify that it includes fixed or variable interest rate commercial

    loans or mortgages entered into by both banks and non-banks, including

    such loans and mortgages entered into by the Farm Credit System

    institutions and Federal Home Loan Banks. The Commissions understand

    that the CEA does not apply to, and the CFTC may not exercise

    regulatory authority over, and the definitions of the terms ``security-

    based swap'' and ``security-based swap agreement'' do not include, any

    fixed or variable interest rate commercial loan or mortgage entered

    into by a bank that is an identified banking product.\458\ However,

    loans and mortgages provided by certain banks may not qualify as

    identified banking products because those banks do not satisfy the

    definition of ``bank'' for purposes of the ``identified banking

    products'' definition.\459\ According to commenters,\460\ while this

    definition of ``bank'' includes insured depository institutions,

    certain foreign banks, credit unions, institutions regulated by the

    Federal Reserve and trust companies, it does not include certain other

    financial institutions that provide commercial loans or mortgages, such

    as government-sponsored enterprises (including the Federal Home Loan

    Banks) and certain cooperatives (including the Farm Credit System

    institutions).

    ---------------------------------------------------------------------------

    \456\ See CDEU Letter; FCC Letter; and FHLB Letter.

    \457\ See FCC Letter and FHLB Letter.

    \458\ See infra note 488, regarding identified banking products.

    \459\ See 7 U.S.C. 27(a). See also FCC Letter and FHLB Letter.

    \460\ See supra note 457.

    ---------------------------------------------------------------------------

    Three commenters suggested that the Commissions should include as

    additional examples commercial rate lock agreements and commercial

    loans with interest rate caps, floors, or options.\461\ The Commissions

    agree that these arrangements should not be considered swaps or

    security-based swaps, provided that the interest rate locks, caps, or

    floors, or interest rate options are embedded in the commercial loans

    or mortgages and not entered into separately from the commercial loans

    and mortgages, and are including these arrangements as examples in the

    interpretation. However, the Commissions are limiting the

    interpretation to embedded interest rate locks, caps, or floors, and

    interest rate options because interest rate locks, caps, or floors, or

    interest rate options that are entered into separately from the

    commercial loans and mortgages fall within the swap definition.\462\ In

    order to further distinguish these arrangements from swaps and

    security-based swaps, the interpretation provides the following: (i)

    The embedded interest rate lock, cap, or floor must be included for the

    sole purpose of providing a lock, cap, or floor on the interest rate on

    such loan or mortgage and may not include additional provisions that

    would provide exposure to enhanced or inverse performance, or other

    risks unrelated to the interest rate risk being addressed, and (ii) the

    embedded interest rate option may not include additional provisions

    that would provide exposure to leverage, inverse performance, or other

    risks unrelated to the primary reason the embedded interest rate option

    is included in the commercial loan or mortgage.

    ---------------------------------------------------------------------------

    \461\ See CDEU Letter; FCC Letter; and FHLB Letter. These

    commenters indicated that such arrangements are similar to the

    arrangements included in the list of examples of consumer

    arrangements that the Commissions would not consider to be swaps or

    security-based swaps.

    \462\ See section 1a(47)(A)(i) of the CEA, 7 U.S.C.

    1a(47)(A)(i). Similarly, with respect to consumer agreements,

    contracts and transactions providing for an interest rate cap or an

    interest rate lock on a consumer loan or mortgage, the Commissions

    are limiting this example to interest rate caps and interest rate

    locks entered into in connection with the consumer loan or mortgage

    and prior to closing on the loan or mortgage. For this purpose, both

    because obtaining a consumer loan or mortgage can involve a great

    deal of documentation, which can be entered into at different times

    during the process, and because consumers may have some flexibility

    as to their deadline for deciding when to include or exclude an

    interest rate cap or lock in their consumer loans or mortgages, the

    Commissions will consider an interest rate cap or lock to be entered

    into in connection with a consumer loan or mortgage if it is

    included in the final terms of the loan at closing.

    ---------------------------------------------------------------------------

    Four commenters suggested additional examples of commercial

    arrangements that relate to nonfinancial energy commodities.\463\ These

    arrangements are more appropriately addressed in the context of the

    forward contract exclusion for nonfinancial commodities \464\ or the

    trade option exemption.\465\

    ---------------------------------------------------------------------------

    \463\ See BGA Letter (commercial physical transactions in the

    natural gas and electric power markets should also fall under the

    category of exemptions from the swap definition); FERC Letter

    (commercial transactions executed or traded on RTOs/ISOs should be

    included in the interpretation); Just Energy Letter (commercial

    arrangements to purchase products or services at a fixed price or a

    capped or collared price, at a future date or over a certain time

    period); and PMAA/NEFI Letter (petroleum fuel and gas storage

    contracts between bona fide commercial market participants or

    entities other than financial entities).

    \464\ See supra part II.B.2. The Commissions note that they

    provided the interpretation regarding consumer arrangements because

    the CFTC in the past has not interpreted the forward contract

    exclusion for nonfinancial commodities to apply to consumer

    arrangements. See supra note 434.

    \465\ See supra note 317 and accompanying text.

    ---------------------------------------------------------------------------

    One commenter supported the representative characteristics and

    factors the Commissions set forth to distinguish consumer and

    commercial arrangements from swaps and security-based swaps.\466\ Two

    commenters were concerned with certain of these characteristics and

    factors because these commenters believed that such characteristics and

    factors are common in a wide variety of consumer and commercial

    arrangements.\467\ Both commenters suggested that the Commissions

    remove ``for other than speculative, hedging or investment purposes''

    from the interpretation because many of the types of transactions

    listed as examples may be undertaken for speculative, hedging or

    investment purposes and because all commercial merchandising

    transactions are ``risk-shifting'' of commercial obligations and risks,

    and ``hedge'' the enterprise's commercial risks.\468\ The Commissions

    are not revising the interpretation to remove or otherwise modify this

    representative characteristic and factor. The Commissions believe that

    commercial arrangements undertaken for speculative, hedging or

    investment purposes may be a swap or a security-based swap depending on

    the particular facts and circumstances of the arrangement.

    ---------------------------------------------------------------------------

    \466\ See FCC Letter.

    \467\ See ETA Letter and ISDA Letter.

    \468\ Id.

    ---------------------------------------------------------------------------

    [[Page 48250]]

    One of these commenters also suggested the Commissions remove ``do

    not contain payment obligations that are severable'' from the

    interpretation because assignment of rights and delegation of

    obligations are common in a wide variety of consumer and commercial

    transactions.\469\ The Commissions are not revising the interpretation

    to remove or otherwise modify this representative characteristic and

    factor. The Commissions believe that the severability of payment

    obligations could be indicative of a consumer or commercial arrangement

    that may be a swap or a security-based swap depending on the particular

    facts and circumstances of the arrangement because the severability of

    payment obligations could be indicative of an instrument that is merely

    an exchange of payments, such as is the case with swaps and security-

    based swaps.

    ---------------------------------------------------------------------------

    \469\ See ISDA Letter.

    ---------------------------------------------------------------------------

    One of these commenters also suggested that the Commissions remove

    ``not traded on an organized market or over the counter'' from the

    interpretation because many of the types of contracts listed as

    examples are assignable and frequently assigned or traded.\470\ The

    other commenter did not suggest removing this factor, but requested

    that the factor be modified to provide that the arrangement is not

    traded on a ``registered entity'' in order not to include transactions

    on organized wholesale electricity markets.\471\ The Commissions are

    not revising the interpretation to remove or otherwise modify this

    representative characteristic and factor. The Commissions believe that

    the trading of an instrument on an organized market or over the counter

    could be indicative of a consumer or commercial arrangement that may be

    a swap or a security-based swap depending on the particular facts and

    circumstances of the arrangement. However, as noted above, the

    Commissions are clarifying that merely because an arrangement is

    assignable does not mean that it is ``traded'' or that the arrangement

    is a swap or security-based swap. An assignment of a contractual

    obligation must be analyzed to assure that the result is not to sever

    the payment obligations.

    ---------------------------------------------------------------------------

    \470\ Id.

    \471\ See ETA Letter.

    ---------------------------------------------------------------------------

    Further, as noted above, the representative characteristics and

    factors are not intended to be a bright-line test for determining

    whether a particular consumer or commercial arrangement is a swap or

    security-based swap. These representative characteristics and factors

    taken together are indicators that a consumer or commercial arrangement

    is not a swap or security-based swap. These representative

    characteristics and factors also do not imply or presume that a

    consumer or commercial arrangement that does not meet all of these

    characteristics and factors is a swap or security-based swap. As noted

    above, if a particular arrangement does not meet all of these

    characteristics and factors, the parties will need to evaluate the

    arrangement based on the particular facts and circumstances. Moreover,

    as noted above, if there is a type of consumer or commercial

    arrangement that does not meet all of these characteristics and

    factors, a party to the arrangement can seek an interpretation from the

    Commissions as to whether the arrangement is outside the scope of the

    swap and security-based swap definitions.

    Residential Exchange Program

    One commenter requested that the CFTC further define the term

    ``swap'' to exclude consumer benefits under the Pacific Northwest

    Electric Power Planning and Conservation Act of 1980 (``Northwest Power

    Act'') \472\ and transactions under the ``Residential Exchange

    Program'' (``REP'').\473\ According to this commenter, the REP was

    established by Congress ``[t]o extend the benefits of low cost Federal

    System hydro power to residential and small farm electric power

    consumers throughout the Pacific Northwest Region.'' \474\ Based on the

    commenter's description, REP transactions do not appear to be among the

    types of transactions historically considered swaps or security-based

    swaps. Although the REP transactions described by the commenter share

    some features with spread options (e.g., they settle in cash based on

    the difference between two price sources),\475\ in both swaps and

    security-based swaps, each party assumes market risk.\476\ By contrast,

    neither party assumes or hedges risk in an REP transaction.\477\

    Instead, the Commissions view an REP transaction essentially as a

    subsidy provided to residential and small farm utility customers.\478\

    Accordingly, the Commissions do not consider the REP transactions

    described by the commenter to be swaps or security-based swaps.

    ---------------------------------------------------------------------------

    \472\ 16 U.S.C. Chapter 12H.

    \473\ Letter from Virginia K. Schaeffer, Attorney, Office of

    General Counsel, Bonneville Power Administration, Jul. 22, 2011

    (``BPA Letter''). This commenter refers to the implementation of

    Section 5(c) of the Northwest Power Act, 16 U.S.C. 839c(c), as the

    ``Residential Exchange Program.'' See Id.

    \474\ See BPA Letter. This commenter explained that, under the

    REP: ``A Pacific Northwest electric utility has a right to * * *

    sell power to Bonneville at the utility's average system cost (ASC)

    of providing that power * * * Bonneville[] is required to purchase

    that power at the utility's ASC, and then sell an equivalent amount

    of power back to the utility at Bonneville's rates[,] which are

    based in substantial part on low cost Federal hydro power. As

    required by the Residential Exchange Statute, the amount of such

    power ``exchanged'' is based on the related utility's residential

    and small farm customer's power needs (also known as ``loads'') in

    the Pacific Northwest Region. Under this ``exchange,'' no actual

    power is transferred to or from Bonneville. Instead, consistent with

    Congressional intent, the exchange transaction is implemented as an

    accounting device that avoids the costs and burdens associated with

    a physical exchange of power and that results in the payment of

    funds by Bonneville to the REP exchanging utilities. Reduced to the

    essentials, the Residential Exchange Statute as implemented in * * *

    REP contracts results in Bonneville making cash payments for the

    positive difference between the utility's ASC and Bonneville's lower

    rate multiplied by the qualifying residential and small farm loads.

    And, as required under the Residential Exchange Statute, the entire

    monetary benefit Bonneville provides to the REP exchanging utilities

    is in turn passed through to the residential and small farm power

    consumers of that utility.'' Id.

    \475\ A spread option is ``an option in which the payout is

    based on the difference in performance between two assets.''

    Superderivatives, ``Spread option in EQ'' definition, available at

    http://www.sdgm.com/Support/Glossary.aspx?letter=S. See also S.J.

    Denga and S.S. Oren, Electricity derivatives and risk management,

    Science Direct at 945 (2006), available at http://

    www.ieor.berkeley.edu/~oren/pubs/Deng%20and%20Oren-86.pdf (defining

    a spark spread options as ``cross-commodity options paying out the

    difference between the price of electricity sold by generators and

    the price of the fuels used to generate it''); Chicago Mercantile

    Exchange, Soybean-Corn Price Ratio Options Fact Card (describing its

    soybean-corn price ratio option contract as ``an option on the ratio

    between the price of the referencing Soybean futures contract and

    the price of the referencing Corn futures contract * * *''),

    available at http://www.cmegroup.com/trading/agricultural/files/AC-440-Soybean-CornRatioOptionsFC.pdf.

    \476\ Even a hedging party assumes the risk that the market can

    move against its hedging position, causing the hedge to reduce the

    profit it otherwise would have made on an unhedged position.

    \477\ The fact that the Commissions are relying in part on this

    aspect of REP transactions to interpret such transactions to be

    neither swaps nor security-based swaps does not mean that market

    participants should conclude, in other contexts, that a lack of

    market risk removes an agreement, contract, or transaction from the

    swap and security-based swap definitions. The Commissions'

    conclusion as to REP transactions is based on the unique facts and

    circumstances presented by the commenter.

    \478\ See, e.g., Paul M. Murphy, Northwest Public Power

    Association, Background and Summary of the Residential Exchange

    Program Settlement Agreement, March 16, 2011, available at http://www.nwppa.org/cwt/external/wcpages/wcmedia/documents/background_and_summary_of_rep_settlement_agreement.pdf (characterizing the

    REP as ``require[ing] BPA to subsidize the residential and small

    farm consumers of the higher cost utilities in the Pacific

    Northwest'').

    ---------------------------------------------------------------------------

    Loan Participations

    The Commissions provided an interpretation in the Proposing Release

    regarding the treatment of loan participations.\479\ The Commissions

    are

    [[Page 48251]]

    restating the interpretation set out in the Proposing Release with

    certain modifications in response to commenters.\480\

    ---------------------------------------------------------------------------

    \479\ See Proposing Release at 29834.

    \480\ See infra note 504 and accompanying text.

    ---------------------------------------------------------------------------

    Loan participations arise when a lender transfers or offers a

    participation in the economic risks and benefits of all or a portion of

    a loan or commitment it has entered into with a borrower to another

    party as an alternative or precursor to assigning to such person the

    loan or commitment or an interest in the loan or commitment.\481\ The

    Commissions understand that two types of loan participations exist in

    the market today,\482\ LSTA-style participations\483\ and LMA-style

    participations.\484\ LSTA-style participations transfer a beneficial

    ownership interest in the underlying loan or commitment to the

    participant.\485\ LMA-style participations do not transfer a beneficial

    ownership interest in the underlying loan or commitment to the

    participant, but rather create a debtor-creditor relationship between

    the grantor and the participant under which a future beneficial

    ownership interest is conveyed.\486\

    ---------------------------------------------------------------------------

    \481\ See Loan Market Association, ``Guide to Syndicated

    Loans,'' section 6.2.4 (``A [loan] participation * * * is made

    between the existing lender and the participant. This creates new

    contractual rights between the existing lender and the participant

    which mirror existing contractual rights between the existing lender

    and the borrower. However this is not an assignment of those

    existing rights and the existing lender remains in a direct

    contractual relationship with the borrower.''), available at http://www.lma.eu.com/uploads/files/Introductory_Guides/Guide_to_Par_Syndicated_Loans.pdf.

    \482\ See Letter from R. Bram Smith, Executive Director, The

    Loan Syndications and Trading Association, Jan. 25, 2011 (``January

    LSTA Letter''); Letter from Elliot Ganz, General Counsel, The Loan

    Syndications and Trading Association, Mar. 1, 2011 (``March LSTA

    Letter''); and Letter from Clare Dawson, Managing Director, The Loan

    Market Association, Feb. 23, 2011. The Commissions understand that

    neither type of loan participation is a ``synthetic'' transaction.

    See March LSTA Letter. Both types of loan participations are merely

    transfers of cash loan positions and the ratio of underlying loan to

    participation is always one to one. Id.

    \483\ The LSTA is The Loan Syndications and Trading Association.

    \484\ The LMA is The Loan Market Association.

    \485\ See Letter from Clare Dawson, Managing Director, The LMA,

    Jul. 22, 2011 (``July LMA Letter'').

    \486\ See Id. The participant may exercise an ``elevation''

    right and request that the grantor use commercially reasonable

    efforts to cause the participant to become the legal owner, by

    assignment, of the underlying loan or commitment. Id.

    ---------------------------------------------------------------------------

    Depending on the facts and circumstances, a loan participation may

    be a security under the Federal securities laws and, as such, the loan

    participation would be excluded from the swap definition as the

    purchase and sale of a security on a fixed or contingent basis.\487\ In

    addition, depending on the facts and circumstances, a loan

    participation may be an identified banking product and, as such, would

    be excluded from CFTC jurisdiction and from the security-based swap and

    security-based swap agreement definitions.\488\

    ---------------------------------------------------------------------------

    \487\ See sections 1a(47)(B)(v) and (vi) of the CEA, 7 U.S.C.

    1a(47)(b)(v) and (vi), as amended by section 721(a)(21) of the Dodd-

    Frank Act (excluding purchases and sales of a security on a fixed or

    contingent basis, respectively from the swap definition).

    \488\ See section 403(a) of the Legal Certainty for Bank

    Products Act of 2000, 7 U.S.C. 27a(a), as amended by section

    725(g)(2) of the Dodd-Frank Act (providing that, under certain

    circumstances, the CEA shall not apply to, and the CFTC shall not

    exercise regulatory authority over, identified banking products, and

    the definitions of the terms ``security-based swap'' and ``security-

    based swap agreement'' shall not include identified banking

    products).

    ---------------------------------------------------------------------------

    The Commissions believe it is important to provide further guidance

    as to the other circumstances in which certain loan participations

    would not fall within the swap and security-based swap definitions.

    Consistent with the proposal, the Commissions do not interpret the swap

    and security-based swap definitions to include loan participations that

    reflect an ownership interest in the underlying loan or commitment. The

    Commissions believe that for a loan participation to not be considered

    a swap or security-based swap, the loan participation must represent a

    current or future direct or indirect ownership interest in the loan or

    commitment that is the subject of the loan participation.

    In evaluating whether the loan participation represents such an

    ownership interest, the Commissions believe the following

    characteristics should be present:

    The grantor of the loan participation is a lender under,

    or a participant or sub-participant in, the loan or commitment that is

    the subject of the loan participation.

    The aggregate participation in the loan or commitment that

    is the subject of the loan participation does not exceed the principal

    amount of such loan or commitment. Further, the loan participation does

    not grant, in the aggregate, to the participant in such loan

    participation a greater interest than the grantor holds in the loan or

    commitment that is the subject of the loan participation.

    The entire purchase price for the loan participation is

    paid in full when acquired and not financed. The Commissions believe a

    purchase price would not be paid in full if the grantor of the loan

    participation extends financing to the participant or if such

    participant levers its purchase, including by posting collateral to

    secure a future payment obligation.

    The loan participation provides the participant all of the

    economic benefit and risk of the whole or part of the loan or

    commitment that is the subject of the loan participation.

    These characteristics, which were identified by commenters,\489\

    are intended to distinguish loan participations from swaps and

    security-based swaps based on loans. The first characteristic above

    addresses the ownership of the underlying loan or commitment. Swaps and

    security-based swaps may be created using a synthetic or derivative

    structure that does not require ownership of the underlying loan.\490\

    The second characteristic above addresses the ratio of the

    participation to the underlying loan or commitment. Swaps and security-

    based swaps based on loans may involve synthetic exposure to a loan

    that is a multiple of the principal amount.\491\ The third

    characteristic above addresses leverage in the financing of a loan

    participation. Leverage could be indicative of an instrument that is

    merely an exchange of payments and not a transfer of the ownership of

    the underlying loan or commitment, such as may be the case with a swap

    or security-based swap.\492\ The fourth characteristic above addresses

    the level of participation in the economic benefits and risks of the

    underlying loan or commitment. This characteristic is indicative of

    ownership when analyzed with the other characteristics and, as noted

    above, swaps and security-based swaps may be created using a synthetic

    or derivative structure that does not require ownership of the

    underlying loan.

    ---------------------------------------------------------------------------

    \489\ See infra note 504 and accompanying text. See also infra

    notes 490, 491, and 492 and accompanying text.

    \490\ See July LMA Letter.

    \491\ Id.

    \492\ Id.

    ---------------------------------------------------------------------------

    The Commissions agree with commenters that the loan participation

    does not have to be a ``true participation,'' as the Commissions had

    stated in their interpretation in the Proposing Release,\493\ in order

    for the loan participation to fall outside the swap and security-based

    swap definitions.\494\ The Commissions note that the ``true

    participation'' analysis is used to determine whether a transaction has

    resulted in the underlying assets being legally isolated from a

    transferor's creditors for U.S. bankruptcy law

    [[Page 48252]]

    purposes.\495\ This analysis is unrelated to and does not inform

    whether a loan participation is a swap or security-based swap. This

    analysis also may be subject to varying interpretations.\496\ Further,

    the Commissions understand that this analysis could result in certain

    loan participations that reflect an ownership interest in the

    underlying loan or commitment being included in the swap and security-

    based swap definitions, which the Commissions do not intend.\497\

    ---------------------------------------------------------------------------

    \493\ Proposing Release at 29834.

    \494\ See infra note 503 and accompanying text.

    \495\ Id.

    \496\ Id.

    \497\ Id.

    ---------------------------------------------------------------------------

    Rather, as noted above, the Commissions believe that the analysis

    as to whether a loan participation is outside the swap and security-

    based swap definitions should be based on whether the loan

    participation reflects an ownership interest in the underlying loan or

    commitment. The Commissions understand that the characteristics noted

    above are indicative, based on comments received,\498\ of whether a

    loan participation represents such an ownership interest. Further, in

    response to commenters,\499\ the Commissions are clarifying that the

    interpretation applies to loan participations that are entered into

    both with respect to outstanding loans and with respect to a lender's

    commitments to lend and fund letters of credit (e.g., under a revolving

    credit facility).

    ---------------------------------------------------------------------------

    \498\ See supra note 482. See infra note 501.

    \499\ See infra note 506 and accompanying text.

    ---------------------------------------------------------------------------

    The Commissions believe that the interpretation will prevent

    disruption in the syndicated loan market for loan participations. Loan

    participations facilitate a lender's diversification of its portfolio

    holdings, provide a key component of the efficient settlement process,

    and enhance liquidity in the global syndicated loan market.\500\ The

    interpretation will enable this market to continue operating as it did

    prior to the enactment of Title VII.

    ---------------------------------------------------------------------------

    \500\ See January LSTA Letter.

    ---------------------------------------------------------------------------

    Comments

    Commenters supported the interpretation that certain loan

    participations should not be included in the swap and security-based

    swaps definitions.\501\ Commenters agreed with the proposal that a loan

    participation should represent a current and future direct or indirect

    ownership interest in the loan or commitment that is the subject of the

    loan participation.\502\ However, commenters disagreed with the

    proposal that a loan participation should be required to be a ``true

    participation'' in order for the loan participation to fall outside the

    swap and security-based swap definitions because LMA-style

    participations do not represent a beneficial ownership in the

    underlying loan or commitment such that they would be considered a true

    participation.\503\ Commenters requested that the Commissions remove

    this factor and instead recognize additional factors.\504\ The

    Commissions agree that a loan participation does not have to be a true

    participation in order for the loan participation to fall outside the

    swap and security-based swap definitions and are revising the

    interpretation as noted above.

    ---------------------------------------------------------------------------

    \501\ See FCC Letter; Letter from Richard M. Whiting, Executive

    Director and General Counsel, Financial Services Roundtable, Jul.

    22, 2011 (``FSR Letter''); July LMA Letter; Letter from R. Bram

    Smith, Executive Director, The LSTA, Jul. 22, 2011 (``July LSTA

    Letter''); MFA Letter; and Letter from Kenneth E. Bentsen, Jr.,

    Executive Vice President, Public Policy and Advocacy, SIFMA, Jul.

    22, 2011 (``SIFMA Letter'').

    \502\ See FSR Letter; July LMA Letter; July LSTA Letter; MFA

    Letter; and SIFMA Letter. Commenters indicated that both LSTA-style

    participations and LMA-style participations represent a current or

    future direct or indirect ownership interest in the related loan or

    commitment. Id.

    \503\ See July LMA Letter; July LSTA Letter; MFA Letter; and

    SIFMA Letter. These commenters indicated that neither LMA-style

    participations nor certain LSTA-style participations are true

    participations. See July LMA Letter; July LSTA Letter; and SIFMA

    Letter. Further, according to the July LSTA Letter, ``[l]oan market

    participants in the United States will likely interpret the `true

    participation' requirement as a requirement that loan participations

    must qualify for `true sale' treatment in order to avoid

    classification as a `swap.' A `true sale' or `true participation'

    analysis is a test aimed at determining whether a transaction has

    resulted in the underlying assets being legally isolated from the

    transferor's creditors for U.S. bankruptcy law purposes. Its

    underlying purpose is to distinguish between a sale and a financing,

    not between a sale and a swap.'' If this is the case, certain LSTA-

    style participations, which typically are offered in the United

    States, could be determined under a ``true sale'' analysis to be a

    financing and not a true participation. See July LSTA Letter.

    \504\ See July LMA Letter; July LSTA Letter; MFA Letter; and

    SIFMA Letter. Commenters recommended that the Commissions revise the

    interpretation by providing that the Commissions do not interpret

    the swap and security-based swap definitions to include loan

    participations in which (1) the participant is acquiring a current

    or future direct or indirect ownership interest in the related loan

    or commitment, and (2) the agreement pursuant to which the

    participant is acquiring such an interest (i) is a participation

    agreement that is, or any similar agreement of a type that has been,

    is presently, or in the future becomes, customarily entered into in

    the primary or secondary loan markets, (ii) requires the grantor to

    represent that it is a lender under, or a participant or sub-

    participant in, the loan or commitment, (iii) provides that the

    participant is entitled to receive from the grantor all of the

    economic benefit of the whole or part of a loan or commitment to the

    extent of payments received by the grantor in respect of such loan

    or commitment, and (iv) requires that 100% of the purchase price

    calculated with respect to the loan or commitment is paid on the

    settlement date. See id. The characteristics identified by these

    commenters are reflected in the Commission's revised interpretation.

    ---------------------------------------------------------------------------

    One commenter also indicated that loan participations are entered

    into both with respect to outstanding loans and with respect to a

    lender's commitments to lend and fund letters of credit (e.g., under a

    revolving credit facility).\505\ This commenter requested that the

    Commissions revise the proposed interpretation to reflect both

    outstanding loans and a lender's commitments.\506\ The Commissions

    agree and are revising the interpretation to reflect both outstanding

    loans and loan commitments as noted above.

    ---------------------------------------------------------------------------

    \505\ See July LMA Letter.

    \506\ Id.

    ---------------------------------------------------------------------------

    C. Final Rules and Interpretations Regarding Certain Transactions

    Within the Scope of the Definitions of the Terms ``Swap'' and

    ``Security-Based Swap''

    1. In General

    In light of provisions in the Dodd-Frank Act that specifically

    address certain foreign exchange products, the Commissions in the

    Proposing Release proposed rules to clarify the status of products such

    as foreign exchange forwards, foreign exchange swaps, foreign exchange

    options, non-deliverable forwards involving foreign exchange

    (``NDFs''), and cross-currency swaps. The Commissions also proposed a

    rule to clarify the status of forward rate agreements and provided

    interpretations regarding: (i) Combinations and permutations of, or

    options on, swaps or security-based swaps; and (ii) contracts for

    differences (``CFDs'').

    The Commissions are adopting the rules as proposed without

    modification and are restating the interpretations provided in the

    Proposing Release without modification. In addition, the Commissions

    are providing additional interpretations regarding foreign exchange

    spot transactions and retail foreign currency options.

    As adopted, rule 1.3(xxx)(2) under the CEA and rule 3a69-2 under

    the Exchange Act explicitly define the term ``swap'' to include certain

    foreign exchange-related products and forward rate agreements unless

    such products are excluded by the statutory exclusions in subparagraph

    (B) of the swap definition.\507\ In adopting these rules, the

    Commissions do not mean to suggest that the list of agreements,

    contracts, and transactions set forth in rule 1.3(xxx)(2) under the CEA

    and rule

    [[Page 48253]]

    3a69-2(b) under the Exchange Act is an exclusive list.

    ---------------------------------------------------------------------------

    \507\ See section 1a(47)(B) of the CEA, 7 U.S.C. 1a(47)(B).

    ---------------------------------------------------------------------------

    2. Foreign Exchange Products

    (a) Foreign Exchange Products Subject to the Secretary's Swap

    Determination: Foreign Exchange Forwards and Foreign Exchange Swaps

    The CEA, as amended by the Dodd-Frank Act, provides that ``foreign

    exchange forwards'' and ``foreign exchange swaps'' shall be considered

    swaps under the swap definition unless the Secretary of the Treasury

    (``Secretary'') issues a written determination that either foreign

    exchange swaps, foreign exchange forwards, or both: (i) Should not be

    regulated as swaps; and (ii) are not structured to evade the Dodd-Frank

    Act in violation of any rule promulgated by the CFTC pursuant to

    section 721(c) of the Dodd-Frank Act.\508\ A foreign exchange forward

    is defined in the CEA as ``a transaction that solely involves the

    exchange of two different currencies on a specific future date at a

    fixed rate agreed upon on the inception of the contract covering the

    exchange.'' \509\ A foreign exchange swap, in turn, is defined as ``a

    transaction that solely involves an exchange of 2 different currencies

    on a specific date at a fixed rate that is agreed upon on the inception

    of the contract covering the exchange; and a reverse exchange of the 2

    currencies described in subparagraph (A) at a later date and at a fixed

    rate that is agreed upon on the inception of the contract covering the

    exchange.'' \510\

    ---------------------------------------------------------------------------

    \508\ See section 1a(47)(E)(i) of the CEA, 7 U.S.C.

    1a(47)(E)(i). The Secretary published in the Federal Register a

    request for comment as to whether an exemption from the swap

    definition for foreign exchange swaps, foreign exchange forwards, or

    both, is warranted, and on the application of the statutory factors

    that the Secretary must consider in making a determination regarding

    whether to exempt these products. See Determinations of Foreign

    Exchange Swaps and Forwards, 75 FR 66829 (Oct. 28, 2010).

    Subsequently, the Secretary published in the Federal Register a

    proposed determination to exempt both foreign exchange swaps and

    foreign exchange forwards from the definition of the term ``swap''

    in the CEA. See Determination of Foreign Exchange Swaps and Foreign

    Exchange Forwards Under the Commodity Exchange Act, Notice of

    Proposed Determination, 76 FR 25774 (May 5, 2011) (``Notice of

    Proposed Determination''). The comment period on the Secretary's

    proposed determination closed on June 6, 2011. A final determination

    has not yet been issued.

    \509\ See section 1a(24) of the CEA, 7 U.S.C. 1a(24).

    \510\ See section 1a(25) of the CEA, 7 U.S.C. 1a(25).

    ---------------------------------------------------------------------------

    Under the Dodd-Frank Act, if foreign exchange forwards or foreign

    exchange swaps are no longer considered swaps due to a determination by

    the Secretary, nevertheless, certain provisions of the CEA added by the

    Dodd-Frank Act would continue to apply to such transactions.\511\

    Specifically, those transactions still would be subject to certain

    requirements for reporting swaps, and swap dealers and major swap

    participants engaging in such transactions still would be subject to

    certain business conduct standards.\512\

    ---------------------------------------------------------------------------

    \511\ The Secretary's determination also does not affect the

    CFTC's jurisdiction over retail foreign currency agreements,

    contracts, or transactions pursuant to section 2(c)(2) of the CEA, 7

    U.S.C. 2(c)(2). See section 1a(47)(F)(ii) of the CEA, 7 U.S.C.

    1a(47)(F)(ii).

    \512\ See, e.g., sections 1a(47)(E)(iii) and (iv) of the CEA, 7

    U.S.C. 1a(47)(E)(iii) and (iv) (reporting and business conduct

    standards, respectively). In addition, a determination by the

    Secretary does not exempt any foreign exchange forward or foreign

    exchange swap traded on a designated contract market or a swap

    execution facility, or cleared by a derivatives clearing

    organization, from any applicable antifraud or anti-manipulation

    provision under the CEA. See sections 1a(47)(F)(i) and 1b(c) of the

    CEA, 7 U.S.C. 1a(47)(F)(i) and 1b(c).

    ---------------------------------------------------------------------------

    The Commissions are adopting the rules as proposed to explicitly

    define by rule the term ``swap'' to include foreign exchange forwards

    and foreign exchange swaps (as those terms are defined in the

    CEA),\513\ in order to include in one rule the definitions of those

    terms and the related regulatory authority with respect to foreign

    exchange forwards and foreign exchange swaps.\514\ The final rules

    incorporate the provision of the Dodd-Frank Act that foreign exchange

    forwards and foreign exchange swaps will no longer be considered swaps

    if the Secretary issues the written determination described above to

    exempt such products from the swap definition.\515\ The final rules

    also reflect the continuing applicability of certain reporting

    requirements and business conduct standards in the event that the

    Secretary makes such a determination.\516\

    ---------------------------------------------------------------------------

    \513\ See rules 1.3(xxx)(3)(iii) and (iv) under the CEA and rule

    3a69-2(c)(3) and (4) under the Exchange Act.

    \514\ See rules 1.3(xxx)(2)(i)(C) and (D) under the CEA and

    rules 3a69-2(b)(1)(iii) and (iv) under the Exchange Act. The rules

    further provide that foreign exchange forwards and forward exchange

    swaps are not swaps if they fall within one of the exclusions set

    forth in subparagraph (B) of the statutory swap definition. See rule

    1.3(xxx)(2)(ii) under the CEA and rule 3a69-2(b)(2) under the

    Exchange Act.

    \515\ See rule 1.3(xxx)(3) under the CEA and rule 3a69-2(c)

    under the Exchange Act.

    \516\ See rule 1.3(xxx)(3)(ii) under the CEA and rule 3a69-

    2(c)(2) under the Exchange Act. The exclusion of foreign exchange

    forwards and foreign exchange swaps would become effective upon the

    Secretary's submission of the determination to exempt to the

    appropriate Congressional Committees. See sections 1a(47)(E)(ii) and

    1b of the CEA, 7 U.S.C. 1a(46)(E)(ii) and 1b.

    ---------------------------------------------------------------------------

    Comments

    Two commenters recommended that the Commissions defer action on

    defining foreign exchange swaps and foreign exchange forwards in their

    regulations until the Secretary has made his final determination about

    whether to exempt them.\517\ One commenter believed that finalizing the

    Commissions' proposal prior to the Secretary's final determination

    would be ``premature.'' \518\ The other commenter believed that the

    industry will be ``better positioned'' to assess the need to clarify

    the scope of the swap definition with respect to foreign exchange

    derivatives after the Secretary has made his determination.\519\ The

    Commissions understand that, if the final rules are effective before

    the Secretary issues a written determination, market participants

    entering into foreign exchange forwards and foreign exchange swaps

    might incur costs in order to comply with the requirements of the CEA

    (as amended by the Dodd-Frank Act) that could be rendered unnecessary

    if the Secretary subsequently were to issue a written determination to

    exempt.\520\ The Commissions, however, believe the final rules are

    necessary because in the event the Secretary issues a written

    determination to exempt, certain reporting requirements and business

    conduct standards will continue to apply to the exempted instruments,

    and the final rules set forth those requirements that will continue to

    apply.

    ---------------------------------------------------------------------------

    \517\ See CME Letter and SIFMA Letter.

    \518\ See CME Letter. This commenter also believes that if the

    Secretary exempts foreign exchange swaps and foreign exchange

    forwards from the swap definition, it would create an ``awkward''

    situation both for the CFTC and market participants, given that

    options on such products would be swaps but the products into which

    they exercise would not be swaps, and would result in a lack of

    clarity and consistency for market participants. Id.

    \519\ See SIFMA Letter.

    \520\ These costs market participants may incur relate to the

    upfront and ongoing costs associated with the regulation of Title

    VII instruments generally. See infra parts X and XI, for a

    discussion of these costs. The Commissions also note that the final

    rules will reduce (and may eliminate), the costs of determining

    whether foreign exchange swaps and foreign exchange forwards are

    subject to Title VII, as well as the costs associated with

    determining which provisions of the new Title VII regulatory regime

    will apply to these instruments. Id.

    ---------------------------------------------------------------------------

    Further, the Commissions do not believe that adopting the rules is

    premature, as the Secretary may issue a determination at any time, and

    the Secretary's authority to do so is independent of the Commissions'

    authority to issue these rules to further define the term ``swap.''

    \521\ The

    [[Page 48254]]

    Commissions' final rules are consistent with this statutory framework

    by specifically providing that, in the event a determination to exempt

    is issued, foreign exchange swaps and foreign exchange forwards will

    not be considered swaps, and will be subject only to those CEA

    requirements that are specified in the statute.\522\ As such, the final

    rules accommodate the possibility of (rather than the certainty of) an

    exemptive determination made by the Secretary.

    ---------------------------------------------------------------------------

    \521\ Compare section 712(d)(1) of the CEA (Commissions' joint

    rulemaking authority to further define the term ``swap''), with

    section 1a(47)(E) and 1b of the CEA (Secretary's authority to

    determine to exempt foreign exchange swaps and foreign exchange

    forwards from the definition of ``swap.'').

    \522\ See rule 1.3(xxx)(3)(ii) under the CEA and rule 3a69-

    2(c)(2) under the Exchange Act. The statutory requirements that

    remain applicable, notwithstanding a written determination by the

    Secretary to exempt, are that foreign exchange swaps and foreign

    exchange forwards shall be reported to either a swap data

    repository, or, if there is no swap data repository that would

    accept such swaps or forwards, to the CFTC pursuant to section 4r of

    the CEA, 7 U.S.C. 6r, within such time period as the CFTC may by

    rule or regulation prescribe, and any party to a foreign exchange

    swap or forward that is a swap dealer or major swap participant

    shall conform to the business conduct standards contained in section

    4s(h) of the CEA, 7 U.S.C. 6s(h). Section 1a(47)(E)(iii) and (iv) of

    the CEA, 7 U.S.C. 1a(47)(E)(iii) and (iv).

    ---------------------------------------------------------------------------

    Moreover, commenters provided no support for the assertion that the

    situation would be awkward for market participants because options on

    foreign exchange forwards and foreign exchange swaps will be swaps,

    regardless of whether the Secretary determines to exempt the underlying

    transactions from the swap definition. The Commissions note that

    Congress drew the distinction in the statute between foreign currency

    options and foreign exchange forwards and foreign exchange swaps. The

    Commissions conclude that adopting these final rules would not

    contribute to a lack of clarity or consistency for market participants,

    regardless of any determination the Secretary makes.

    (b) Foreign Exchange Products Not Subject to the Secretary's Swap

    Determination

    The Commissions are adopting rules as proposed stating that a

    determination by the Secretary that foreign exchange forwards or

    foreign exchange swaps, or both, should not be regulated as swaps would

    not affect certain other products involving foreign currency, such as

    foreign currency options, NDFs, currency swaps and cross-currency

    swaps.\523\ The rules explicitly define the term ``swap'' to include

    such products, irrespective of whether the Secretary makes a

    determination to exempt foreign exchange forwards or foreign exchange

    swaps from the swap definition.\524\

    ---------------------------------------------------------------------------

    \523\ See rule 1.3(xxx)(3)(v) under the CEA and rule 3a69-

    2(c)(5) under the Exchange Act.

    \524\ See rule 1.3(xxx)(2)(i) under the CEA and rule 3a69-

    2(b)(1) under the Exchange Act. The final rules provide, however,

    that none of these products are swaps if they fall within one of the

    exclusions set forth in subparagraph (B) of the statutory swap

    definition. See rule 1.3(xxx)(2)(ii) under the CEA and rule 3a69-

    2(b)(2) under the Exchange Act. Also, the rules do not define the

    term ``swap'' to include currency swaps because they are already

    included in the statutory definition, but the rules clarify that

    currency swaps are not subject to the Secretary's determination. See

    section 1a(47)(A)(iii)(VII) of the CEA, 7 U.S.C.

    1a(47)(A)(iii)(VII); rule 1.3(xxx)(3)(v)(A) under the CEA; and rule

    3a69-2(c)(5)(i) under the Exchange Act.

    ---------------------------------------------------------------------------

    (i) Foreign Currency Options \525\

    ---------------------------------------------------------------------------

    \525\ This discussion is not intended to address, and has no

    bearing on, the CFTC's jurisdiction over foreign currency options in

    other contexts. See, e.g., CEA sections 2(c)(2)(A)(iii) and

    2(c)(2)(B)-(C), 7 U.S.C. 2(c)(2)(A)(iii) and 2(c)(2)(B)-(C) (off-

    exchange options in foreign currency offered or entered into with

    retail customers).

    ---------------------------------------------------------------------------

    As discussed above, the statutory swap definition includes options,

    and it expressly enumerates foreign currency options. It encompasses

    any agreement, contract, or transaction that is a put, call, cap,

    floor, collar, or similar option of any kind that is for the purchase

    or sale, or based on the value, of 1 or more interest or other rates,

    currencies, commodities, securities, instruments of indebtedness,

    indices, quantitative measures, or other financial or economic

    interests or property of any kind.\526\ Foreign exchange options traded

    on a national securities exchange (``NSE''), however, are securities

    under the Federal securities laws and not swaps or security-based

    swaps.\527\

    ---------------------------------------------------------------------------

    \526\ See section 1a(47)(A)(i) of the CEA, 7 U.S.C.

    1a(47)(A)(i).

    \527\ See section 1a(47)(B)(iv) of the CEA, 7 U.S.C.

    1a(47)(B)(iv).

    ---------------------------------------------------------------------------

    Any determination by the Secretary, discussed above, that foreign

    exchange forwards or foreign exchange swaps should not be regulated as

    swaps would not impact foreign currency options because a foreign

    currency option is neither a foreign exchange swap nor a foreign

    exchange forward, as those terms are defined in the CEA. The

    Commissions did not receive any comments either on the proposed rule

    further defining the term ``swap'' to include foreign currency options

    or the proposed rule clarifying that foreign currency options are not

    subject to the Secretary's determination to exempt foreign exchange

    swaps and foreign exchange forwards.\528\ Consequently, the Commissions

    are adopting rules to explicitly define the term ``swap'' to include

    foreign currency options (other than foreign currency options traded on

    an NSE).\529\ The rules also state that foreign currency options are

    not foreign exchange forwards or foreign exchange swaps under the

    CEA.\530\

    ---------------------------------------------------------------------------

    \528\ A comment regarding the CFTC's jurisdiction over retail

    foreign currency options is discussed below.

    \529\ See rule 1.3(xxx)(2)(ii) under the CEA and rule 3a69-

    2(b)(1) under the Exchange Act. The final rules treat the terms

    foreign currency options, currency options, foreign exchange

    options, and foreign exchange rate options as synonymous. Moreover,

    for purposes of the final rules, foreign currency options include

    options to enter into or terminate, or that otherwise operate on, a

    foreign exchange swap or foreign exchange forward, or on the terms

    thereof. As discussed above, foreign exchange options traded on an

    NSE are securities and therefore are excluded from the swap

    definition. See supra note 527 and accompanying text.

    \530\ See rule 1.3(xxx)(3)(v) under the CEA and rule 3a69-

    2(c)(5) under the Exchange Act.

    ---------------------------------------------------------------------------

    (ii) Non-Deliverable Forward Contracts Involving Foreign Exchange

    As explained by the Commissions in the Proposing Release,\531\ an

    NDF generally is similar to a forward foreign exchange contract,\532\

    except that at maturity the NDF does not require physical delivery of

    currencies; rather, the contract typically is settled in a reserve

    currency, such as U.S. dollars. One of the currencies involved in the

    transaction, usually an emerging market currency, may be subject to

    capital controls or similar restrictions, and is therefore said to be

    ``nondeliverable.'' \533\ If the spot market exchange rate on the

    settlement date is greater (in foreign currency per dollar terms) than

    the previously agreed forward exchange rate, the party to the contract

    that is long the nondeliverable (e.g. emerging market) currency must

    pay its counterparty the difference between the contracted forward

    price and the spot market rate, multiplied by the notional amount.\534\

    ---------------------------------------------------------------------------

    \531\ See Proposing Release at 29836.

    \532\ A deliverable forward foreign exchange contract is an

    obligation to buy or sell a specific currency on a future settlement

    date at a fixed price set on the trade date. See Laura Lipscomb,

    Federal Reserve Bank of New York, ``An Overview of Non-Deliverable

    Foreign Exchange Forward Markets,'' 1 (May 2005) (citation omitted)

    (``Fed NDF Overview'').

    \533\ See id. at 1-2 (citation omitted).

    \534\ See id. at 2. Being long the emerging market currency

    means that the holder of the NDF contract is the ``buyer'' of the

    emerging market currency and the ``seller'' of dollars. Conversely,

    if the emerging market currency appreciates relative to the

    previously agreed forward rate, the holder of the contract that is

    short the emerging market currency must pay its counterparty the

    difference between the spot market rate and the contracted forward

    price, multiplied by the notional amount. See id. at 2, n.4.

    ---------------------------------------------------------------------------

    NDFs are not expressly enumerated in the swap definition, but as

    was stated in the Proposing Release,\535\ they satisfy clause (A)(iii)

    of the swap definition because they provide for a future

    [[Page 48255]]

    (executory) payment based on an exchange rate, which is an ``interest

    or other rate[ ]'' within the meaning of clause (A)(iii).\536\ Each

    party to an NDF transfers to its counterparty the risk of the exchange

    rate moving against the counterparty, thus satisfying the requirement

    that there be a transfer of financial risk associated with a future

    change in rate. This financial risk transfer in the context of an NDF

    is not accompanied by a transfer of an ownership interest in any asset

    or liability. Thus, an NDF is a swap under clause (A)(iii) of the swap

    definition.\537\

    ---------------------------------------------------------------------------

    \535\ See Proposing Release at 29836.

    \536\ See section 1a(47)(A)(iii) of the CEA, 7 U.S.C.

    1a(47)(A)(iii) (providing that a swap is an agreement, contract, or

    transaction ``that provides on an executory basis for the exchange,

    on a fixed or contingent basis, of 1 or more payments based on the

    value or level of 1 or more interest or other rates, currencies,

    commodities, securities, instruments of indebtedness, indices,

    quantitative measures, or other financial or economic interests or

    property of any kind, or any interest therein or based on the value

    thereof, and that transfers, as between the parties to the

    transaction, in whole or in part, the financial risk associated with

    a future change in any such value or level without also conveying a

    current or future direct or indirect ownership interest in an asset

    (including any enterprise or investment pool) or liability that

    incorporates the financial risk so transferred * * * .'').

    \537\ In addition, as was noted in the Proposing Release, at

    least some market participants view NDFs as swaps today, and thus

    NDFs also may fall within clause (A)(iv) of the swap definition as

    ``an agreement, contract, or transaction that is, or in the future

    becomes, commonly known to the trade as a swap.'' See Proposing

    Release at 29836. See also section 1a(47)(A)(iv) of the CEA, 7

    U.S.C. 1a(47)(A)(iv). Cf. rule 35.1(b)(1)(i) under the CEA, 17 CFR

    35.1(b)(1)(i) (providing that the definition of ``swap agreement''

    includes a ``forward foreign exchange agreement,'' without reference

    to convertibility or delivery).

    ---------------------------------------------------------------------------

    Moreover, the Commissions have determined that NDFs do not meet the

    definitions of ``foreign exchange forward'' or ``foreign exchange

    swap'' set forth in the CEA.\538\ NDFs do not involve an ``exchange''

    of two different currencies (an element of the definition of both a

    foreign exchange forward and a foreign exchange swap); instead, they

    are settled by payment in one currency (usually U.S. dollars).\539\

    ---------------------------------------------------------------------------

    \538\ In the Notice of Proposed Determination, the Secretary

    stated that his authority to issue a determination ``is limited to

    foreign exchange swaps and forwards and does not extend to other

    foreign exchange derivatives'' and noted that ``NDFs may not be

    exempted from the CEA's definition of ``swap'' because they do not

    satisfy the statutory definitions of a foreign exchange swap or

    forward.'' See Notice of Proposed Determination.

    \539\ Likewise, the Commissions have determined that a foreign

    exchange transaction, which initially is styled as or intended to be

    a ``foreign exchange forward,'' and which is modified so that the

    parties settle in a reference currency (rather than settle through

    the exchange of the 2 specified currencies), does not conform with

    the definition of ``foreign exchange forward'' in the CEA. See infra

    note 626.

    ---------------------------------------------------------------------------

    Notwithstanding their ``forward'' label, NDFs also do not fall

    within the forward contract exclusion of the swap definition because

    currency is outside the scope of the forward contract exclusion for

    nonfinancial commodities.\540\ Nor have NDFs traditionally been

    considered commercial merchandising transactions. Rather, as the

    Commissions observed in the Proposing Release,\541\ NDF markets appear

    to be driven in large part by speculation \542\ and hedging,\543\ which

    features are more characteristic of swap markets than forward markets.

    ---------------------------------------------------------------------------

    \540\ Currency is an excluded commodity under the CEA. See

    section 1a(19)(i) of the CEA, 7 U.S.C. 1a(19)(i). In accordance with

    the interpretation regarding nonfinancial commodities, which as

    discussed above, see supra part II.B.2(a), are exempt and

    agricultural commodities that can be physically delivered, currency

    does not qualify as a nonfinancial commodity for purposes of the

    forward exclusion from the swap definition.

    \541\ See Proposing Release at 29836.

    \542\ See Fed NDF Overview at 5 (``[E]stimates vary but many

    major market participants estimate as much as 60 to 80 percent of

    NDF volume is generated by speculative interest, noting growing

    participation from international hedge funds.'') and 4 (``[D]ealers

    note that much of the volume in Chinese yuan NDFs is generated by

    speculative positioning based on expectations for an alteration in

    China's current, basically fixed exchange rate.'') (italics in

    original).

    \543\ See id. at 4 (noting that ``[much of the] Korean won NDF

    volume[,] * * * estimated to be the largest of any currency, * * *

    is estimated to originate with international investment portfolio

    managers hedging the currency risk associated with their onshore

    investments'').

    ---------------------------------------------------------------------------

    Comments

    Commenters who addressed the nature of NDFs believed that NDFs

    should not be considered swaps, but rather should be categorized as

    foreign exchange forwards. In general, commenters maintained that NDFs

    are functionally and economically equivalent to foreign exchange

    forwards, and therefore should be treated in the same manner for

    regulatory purposes.\544\ In support of this view, commenters made

    several arguments, including that both NDFs and foreign exchange

    forwards require the same net value to be transferred between

    counterparties; the purpose for using them is the same--to cover

    foreign currency exchange risk; both are typically short term

    transactions; and both may be cleared by CLS Bank.\545\

    ---------------------------------------------------------------------------

    \544\ See CDEU Letter; Letter from The Committee on Investment

    of Employee Benefit Assets, dated Jul. 22, 2011 (``CIEBA Letter'');

    Letter from Bruce C. Bennett, Covington & Burling LLP, dated Jul.

    22, 2011 (``Covington Letter''); and Letter from Karrie McMillan and

    Cecelia Calaby, the Investment Company Institute/American Bar

    Association Securities Association, dated Jul. 22, 2011 (``ICI/ABASA

    Letter'').

    \545\ See Covington Letter and ICI/ABASA Letter. CLS Bank

    operates the largest multi-currency cash settlement system to

    eliminate settlement risk in the foreign exchange market.

    ---------------------------------------------------------------------------

    In addition, commenters believed that not treating NDFs as foreign

    exchange forwards or foreign exchange swaps would be contrary to both

    domestic and international market practices. As specific examples,

    commenters noted that NDFs typically are traded as part of a bank's or

    broker's foreign exchange desk; the Federal Reserve Bank of New York

    has described an NDF in a 1998 publication as an instrument ``similar

    to an outright forward,'' except that there is no physical delivery or

    transfer of the local currency; the Bank for International Settlements

    (``BIS'') categorizes NDFs in its ``outright forward'' category;

    various European regulations do not distinguish between the two

    transaction types; standard foreign exchange trading documentation

    includes both net- and physically-settled foreign exchange transactions

    in general definitions of foreign exchange transactions; and special

    rules under the U.S. tax code apply equally to physically settled and

    cash settled foreign exchange forwards.\546\

    ---------------------------------------------------------------------------

    \546\ See Covington Letter and ICI/ABASA Letter.

    ---------------------------------------------------------------------------

    Commenters also raised potential negative consequences to certain

    U.S. market participants if NDFs are not considered to be foreign

    exchange forwards. For example, one commenter argued that treating NDFs

    as swaps will put U.S. corporations doing business in emerging markets

    at a disadvantage relative to U.S. corporations doing business solely

    in developed markets.\547\ This commenter stated that NDFs are widely

    used by U.S. corporations that do business in emerging markets to hedge

    their exposure to the currencies of those markets, and that regulating

    NDFs as swaps would significantly increase the cost of hedging those

    exposures.\548\

    ---------------------------------------------------------------------------

    \547\ See Covington Letter.

    \548\ See supra note 520.

    ---------------------------------------------------------------------------

    With respect to the Commissions' legal conclusion that NDFs are not

    foreign exchange forwards, and thus are not subject to the Secretary's

    determination, one commenter stated that the Commissions' reading of

    the definition of the term ``foreign exchange forward'' as not

    including NDFs is ``too restrictive.'' \549\ In this regard, this

    commenter believed that the term ``exchange'' should be read to include

    ``the economic exchange that occurs in net settlement rather than being

    narrowly read as the physical `exchange' of two different currencies.''

    ---------------------------------------------------------------------------

    \549\ See ICI/ABASA Letter.

    ---------------------------------------------------------------------------

    One commenter, in contrast, agreed with the Commissions'

    interpretation that NDFs are not encompassed within the definition of

    the term ``foreign

    [[Page 48256]]

    exchange forward.'' \550\ This commenter requested, though, that the

    CFTC exempt NDFs from the swap definition, using its exemptive

    authority under section 4(c) of the CEA.\551\

    ---------------------------------------------------------------------------

    \550\ See CIEBA Letter.

    \551\ 7 U.S.C. 6(c).

    ---------------------------------------------------------------------------

    While commenters raised a number of objections to the Commissions'

    proposal to define NDFs as swaps, these objections primarily raise

    policy arguments. No commenter has provided a persuasive, alternative

    interpretation of the statute's plain language in the definition of the

    term ``foreign exchange forward'' to overcome the Commissions'

    conclusion that, under the CEA, NDFs are swaps, not foreign exchange

    forwards.

    One commenter believed that the Commissions' interpretation of

    ``exchange of 2 different currencies'' as used in the foreign exchange

    forward definition is too restrictive, and that the phrase should be

    read broadly to mean an economic exchange of value in addition to

    physical exchange; the Commissions believe that this contention is

    misplaced.\552\ This commenter essentially asks the Commissions to

    interpret the statutory language to mean an exchange of foreign

    currencies themselves, as well as an exchange based on the value of

    such currencies. However, only the word ``exchange'' appears in the

    relevant definitions, reinforcing the conclusion that Congress intended

    the definition of ``foreign exchange forward'' to be distinct from

    other types of transactions covered by the definition of ``swap'' in

    the CEA. Moreover, the language of each definition emphasizes that

    these transactions may ``solely'' involve an exchange. The ordinary

    meaning of the verb ``exchange'' is to ``barter'' \553\ or ``part with,

    give or transfer for an equivalent,'' \554\ i.e., each party is both

    giving to and receiving from the other party. This does not occur under

    an NDF, in which only a single party makes a payment.

    ---------------------------------------------------------------------------

    \552\ See ICI/ABASA Letter.

    \553\ See Webster's New World Dictionary (3d College Ed. 1988).

    \554\ See Black's Law Dictionary.

    ---------------------------------------------------------------------------

    Elsewhere in the CEA, Congress used explicit language that

    potentially could provide support for a broader interpretation of the

    type advocated by this commenter, but such language is absent from the

    definition of the term ``foreign exchange forward.'' For example,

    section 2(a)(1)(C)(ii) confers exclusive jurisdiction on the CFTC over

    ``contracts of sale for future delivery of a group or index of

    securities (or any interest therein or based upon the value thereof)

    [that meet certain requirements]''. If the phrase ``exchange of 2

    different currencies'' had been intended to include economic exchanges

    of value, as suggested by this commenter, that phrase would have

    included language similar to ``based on the value thereof'' to indicate

    that other mechanisms of transferring value may occur in these

    particular types of transactions. Instead, as noted above, Congress

    limited the scope of each of these particular transactions by using the

    words ``solely involves the exchange of 2 different currencies''. The

    Commissions conclude that the use of the word ``solely'' provides

    further support for the Commissions' interpretation that exchange means

    an actual interchange of the 2 different currencies involved in the

    transaction.\555\

    ---------------------------------------------------------------------------

    \555\ This commenter's request that the CFTC exempt NDFs from

    the swap definition using its exemptive authority under section 4(c)

    of the CEA, 7 U.S.C. 6(c), and that the SEC exercise its exemptive

    authority under section 36 of the Exchange Act, 78 U.S.C. 78mm, with

    respect to NDFs, is beyond the scope of this rulemaking.

    ---------------------------------------------------------------------------

    (iii) Currency Swaps and Cross-Currency Swaps

    A currency swap \556\ and a cross-currency swap \557\ each

    generally can be described as a swap in which the fixed legs or

    floating legs based on various interest rates are exchanged in

    different currencies. Such swaps can be used to reduce borrowing costs,

    to hedge currency exposure, and to create synthetic assets \558\ and

    are viewed as an important tool, given that they can be used to hedge

    currency and interest rate risk in a single transaction.

    ---------------------------------------------------------------------------

    \556\ A swap that exchanges a fixed rate against a fixed rate is

    known as a currency swap. See Federal Reserve System, ``Trading and

    Capital-Markets Activities Manual,'' section 4335.1 (Jan. 2009).

    \557\ Cross-currency swaps with a fixed leg based on one rate

    and a floating leg based on another rate, where the two rates are

    denominated in different currencies, are generally referred to as

    cross-currency coupon swaps, while those with a floating leg based

    on one rate and another floating leg based on a different rate are

    known as cross-currency basis swaps. Id. Cross-currency swaps also

    include annuity swaps and amortizing swaps. In cross-currency

    annuity swaps, level cash flows in different currencies are

    exchanged with no exchange of principal; annuity swaps are priced

    such that the level payment cash flows in each currency have the

    same net present value at the inception of the transaction. An

    amortizing cross-currency swap is structured with a declining

    principal schedule, usually designed to match that of an amortizing

    asset or liability. Id.

    See also Derivatives ONE, ``Cross Currency Swap Valuation'' (``A

    cross currency swap is swap of an interest rate in one currency for

    an interest rate payment in another currency * * * This could be

    considered an interest rate swap with a currency component.''),

    available at http://www.derivativesone.com/cross-currency-swap-valuation/; Financial Accounting Standards Board, ``Examples

    Illustrating Application of FASB Statement No. 138,'' Accounting for

    Certain Derivative Instruments and Certain Hedging Activities,

    section 2, Example 1, at 3 (``The company designates the cross-

    currency swap as a fair value hedge of the changes in the fair value

    of the loan due to both interest and exchange rates.''), available

    at http://www.fasb.org/derivatives/examples.pdf.

    \558\ BMO Capital Markets, ``Cross Currency Swaps,'' available

    at http://www.bmocm.com/products/marketrisk/intrderiv/cross/default.aspx.

    ---------------------------------------------------------------------------

    Currency swaps and cross-currency swaps are not foreign exchange

    swaps as defined in the CEA because, although they may involve an

    exchange of foreign currencies, they also require contingent or

    variable payments in different currencies. Because the CEA defines a

    foreign exchange swap as a swap that ``solely'' involves an initial

    exchange of currencies and a reversal thereof at a later date, subject

    to certain parameters, currency swaps and cross-currency swaps would

    not be foreign exchange swaps. Similarly, currency swaps and cross-

    currency swaps are not foreign exchange forwards because foreign

    exchange forwards ``solely'' involve an initial exchange of currencies,

    subject to certain parameters, while currency swaps and cross-currency

    swaps contain additional elements, as discussed above.

    Currency swaps are expressly enumerated in the statutory definition

    of the term ``swap.'' \559\ Cross-currency swaps, however, are

    not.\560\ Accordingly, based on the foregoing considerations, the

    Commissions are adopting rules explicitly defining the term ``swap'' to

    include cross-currency swaps.\561\ The rules also state that neither

    currency swaps nor cross-currency swaps are foreign exchange forwards

    or foreign exchange swaps as those terms are defined in the CEA. The

    Commissions did not receive any comments either on the rule further

    defining the term ``swap'' to include cross-currency swaps or the rule

    clarifying that cross-currency swaps and currency swaps are not subject

    to the Secretary's determination to exempt foreign exchange swaps and

    foreign exchange forwards.

    ---------------------------------------------------------------------------

    \559\ See section 1a(47)(A)(iii)(VII) of the CEA, 7 U.S.C.

    1a(47)(A)(iii)(VII).

    \560\ Clause (A)(iii) of the swap definition expressly refers to

    a cross-currency rate swap. See section 1a(47)(A)(iii)(V) of the

    CEA, 7 U.S.C. 1a(47)(A)(iii)(V). Although the swap industry appears

    to use the term ``cross-currency swap,'' rather than ``cross-

    currency rate swap'' (the term used in section 1a(47)(A)(iii)(V) of

    the CEA), the Commissions interpret these terms as synonymous.

    \561\ See rule 1.3(xxx)(2)(i)(A) under the CEA and rule 3a69-

    2(b)(1)(i) under the Exchange Act.

    ---------------------------------------------------------------------------

    (c) Interpretation Regarding Foreign Exchange Spot Transactions

    The CEA generally does not confer regulatory jurisdiction on the

    CFTC with respect to spot transactions.\562\ In

    [[Page 48257]]

    the context of foreign currency, spot transactions typically settle

    within two business days after the trade date (``T+2'').\563\ The

    accepted market practice of a two-day settlement for spot foreign

    currency transactions has been recognized by the CFTC \564\ and the

    courts.\565\

    ---------------------------------------------------------------------------

    \562\ But see supra note 227.

    \563\ Bank for International Settlements, Triennial Central Bank

    Survey, Report on Global Foreign Exchange Market Activity in 2010 at

    32 (Dec. 2010) (defining a foreign exchange spot transaction to

    provide for cash settlement within 2 business days); Sam Y. Cross,

    Federal Reserve Bank of New York, ``All About * * *. The Foreign

    Exchange Market in the United States'' at 31-32 (1998).

    \564\ See CFTC Division of Trading and Markets, Report on

    Exchange of Futures for Physicals at 124-127 (1987) (noting that

    foreign currency spot transactions settle in 2 days).

    \565\ See CFTC v. Frankwell Bullion, Ltd., 99 F.3d 299, 300 (9th

    Cir. 1996) (``Spot transactions in foreign currencies call for

    settlement within two days.''); CFTC v. Int'l Fin. Servs. (NewYork),

    Inc., 323 F. Supp. 2d 482, 495 (S.D.N.Y. 2004) (noting that spot

    transactions ordinarily call for settlement within two days); Bank

    Brussels Lambert, S.A. v. Intermetals Corp., 779 F.Supp. 741, 742

    (S.D.N.Y. 1991) (same). But the Commissions understand that the

    settlement cycle for spot transactions exchanging Canadian dollars

    for U.S. dollars (or vice versa) is T+1. See Cross, supra 563, at

    31.

    ---------------------------------------------------------------------------

    The Commissions recognize that the new foreign exchange forward

    definition in the CEA, which was added by the Dodd-Frank Act and which

    applies to an exchange of two different currencies ``on a specific

    future date,'' could be read to apply to any foreign exchange

    transaction that does not settle on the same day. Such a reading could

    render most foreign exchange spot transactions foreign exchange

    forwards under the CEA; as a result, such transactions would be subject

    to the CEA reporting and business conduct standards requirements

    applicable to foreign exchange forwards even if the Secretary

    determines to exempt foreign exchange forwards from the definition of

    ``swap.'' The Commissions do not believe that Congress intended, solely

    with respect to foreign exchange transactions, to extend the reach of

    the CEA to transactions that historically have been considered spot

    transactions. At the same time, however, the Commissions do not want to

    enable market participants simply to label as ``spot'' foreign exchange

    transactions that regularly settle after the relevant foreign exchange

    spot market settlement deadline, or with respect to which the parties

    intentionally delay settlement, both of which would be properly

    categorized as foreign exchange forwards, or CEA section 2(c)(2)

    transactions (discussed separately below), in order to avoid applicable

    foreign exchange regulatory requirements.

    Accordingly, the Commissions are providing an interpretation that a

    bona fide foreign exchange spot transaction, i.e., a foreign exchange

    transaction that is settled on the customary timeline of the relevant

    spot market, is not within the definition of the term ``swap.'' In

    general, a foreign exchange transaction will be considered a bona fide

    spot transaction if it settles via an actual delivery of the relevant

    currencies within two business days. In certain circumstances, however,

    a foreign exchange transaction with a longer settlement period

    concluding with the actual delivery of the relevant currencies may be

    considered a bona fide spot transaction depending on the customary

    timeline of the relevant market.\566\ In particular, as discussed

    below, the Commissions will consider a foreign exchange transaction

    that is entered into solely to effect the purchase or sale of a foreign

    security to be a bona fide spot transaction where certain conditions

    are met.

    ---------------------------------------------------------------------------

    \566\ In this regard, while the Commissions will look at the

    relevant facts and circumstances, they will not expect that an

    unintentional settlement failure or delay for operational reasons or

    due to a market disruption will undermine the character of a bona

    fide spot foreign exchange transaction as such.

    ---------------------------------------------------------------------------

    The CFTC will consider the following to be a bona fide spot foreign

    exchange transaction: An agreement, contract or transaction for the

    purchase or sale of an amount of foreign currency equal to the price of

    a foreign security with respect to which (i) the security and related

    foreign currency transactions are executed contemporaneously in order

    to effect delivery by the relevant securities settlement deadline and

    (ii) actual delivery of the foreign security and foreign currency

    occurs by such deadline (such transaction, a ``Securities Conversion

    Transaction'').\567\ For Securities Conversion Transactions, the CFTC

    will consider the relevant foreign exchange spot market settlement

    deadline to be the same as the securities settlement deadline. As noted

    above, while the CFTC will look at the relevant facts and

    circumstances, it does not expect that an unintentional settlement

    failure or delay for operational reasons or due to a market disruption

    will undermine the character of a bona fide spot foreign exchange

    transaction as such.

    ---------------------------------------------------------------------------

    \567\ The interpretation herein with respect to Security

    Conversion Transactions is limited to such transactions.

    ---------------------------------------------------------------------------

    The CFTC also will interpret a Securities Conversion Transaction as

    not leveraged, margined or financed within the meaning of section

    2(c)(2)(C) of the CEA.\568\ While it is possible to view the fact that

    the buyer of a currency in such a transaction does not pay for the

    currency until it is delivered as leverage (in that the buyer puts

    nothing down until taking delivery, thus achieving 100% leverage) or a

    financing arrangement, the CFTC does not interpret it as such for

    purposes of CEA section 2(c)(2)(C).\569\ Congress recognized that

    settlement of bona fide spot foreign exchange transactions typically

    takes two days.\570\ The fact that Congress expressly excluded these

    types of bona fide spot foreign exchange transactions does not mean

    that Congress intended to subject Security Conversion Transactions to

    regulation under the retail foreign exchange regime.\571\ For the

    foregoing reasons, the CFTC will interpret a Securities Conversion

    Transaction as not leveraged, margined or financed within the meaning

    of section 2(c)(2)(C) of the CEA.\572\

    ---------------------------------------------------------------------------

    \568\ 7 U.S.C. 2(c)(2)(C). Similarly, a Securities Conversion

    Transaction is not an option, option on a futures contract or

    futures contract and thus would not be subject to CEA section

    2(c)(2)(B), 7 U.S.C. 2(c)(2)(B). Of course, optionality as to

    settlement would render the transaction an option and is

    inconsistent with a ``spot'' characterization.

    \569\ Cf. 12 CFR 220.8(b)(1) under Regulation T (12 CFR Part

    220) (generally permits a customer to purchase a security (including

    a foreign security) in a cash account, rather than a margin account,

    even if the customer has no collateral in the account, if payment

    for the security is made within the appropriate payment period).

    Similarly, if a foreign exchange buyer in a Securities Conversion

    Transaction posts no margin or collateral on the trade date, the

    CFTC does not consider that transaction to be ``margined'' within

    the meaning of 7 U.S.C. 2(c)(2)(C)(i)(I)(bb).

    \570\ See section 2(c)(2)(C)(i)(II) of the CEA, 7 U.S.C.

    2(c)(2)(C) (``[s]ubclause (I) of this clause shall not apply to * *

    * a contract of sale that * * * results in delivery within 2

    days'').

    \571\ The CFTC notes, for example, that Congress recognized that

    settlement in various spot markets in commodities other than foreign

    exchange can be longer than two days. See CEA section

    2(c)(2)(D)(ii)(III)(aa) (disapplying the DCM-trading requirement for

    certain commodity transactions with non-ECPs when the contract

    ``results in actual delivery within 28 days or such other longer

    period as the [CFTC] may determine by rule or regulation based on

    the typical commercial practice in cash or spot markets for the

    commodity involved'').

    \572\ This interpretation is not intended to address, and has no

    bearing on, the CFTC's interpretation of the term ``actual

    delivery'' as set forth in section 2(c)(2)(D)(ii)(III)(aa), 7 CFR

    2(c)(2)(D)(ii)(III)(aa). See Retail Commodity Transactions under the

    Commodity Exchange Act, 76 FR 77670, Dec. 14, 2011.

    ---------------------------------------------------------------------------

    Comments

    One commenter requested clarification regarding the status of

    foreign exchange spot transactions.\573\ This commenter recommended

    that the Commissions clarify that foreign exchange spot transactions,

    which this commenter defined as ``transactions of

    [[Page 48258]]

    one currency into another that settle within a customary settlement

    cycle,'' are neither foreign exchange forwards nor swaps.\574\ Another

    commenter indicated that the customary settlement cycle for purchases

    of most non-U.S. denominated securities is ``T+3'' (in some securities

    markets, such as South Africa, the settlement cycle can take up to

    seven days), and requires the buyer to pay for the foreign securities

    in the relevant foreign currency.\575\ Typically, according to this

    commenter, a broker-dealer or bank custodian acting on behalf of the

    buyer or seller will enter into a foreign currency transaction to

    settle on a T+3 basis (or the relevant settlement period) as well.

    Timing the foreign exchange transaction to settle at the same time as

    the securities transaction benefits the customer by reducing his or her

    exposure to currency risk on the securities transaction between trade

    date and settlement date. The Commissions have provided the

    interpretation described above regarding the interplay between the

    foreign exchange forward definition, the meaning of ``leveraged,

    margined or financed'' under section 2(c)(2)(C) of the CEA, and bona

    fide foreign exchange spot transactions to address these commenters'

    concerns.

    ---------------------------------------------------------------------------

    \573\ See SIFMA Letter.

    \574\ Id. In this commenter's view, such clarification is

    necessary to avoid the statutory foreign exchange forward definition

    ``unwittingly captur[ing] many typical foreign exchange spot

    transactions * * * settl[ing] within a customary settlement cycle,''

    which this commenter stated is generally ``T+2'' in the United

    States, but can be ``T+3'' in some other countries.

    \575\ See Letter from Phoebe A. Papageorgiou, Senior Counsel,

    American Bankers Ass'n and James Kemp, Managing Director, Global

    Foreign Exchange Division, dated April 18, 2012 (``ABA/Global FX

    Letter''). This commenter requested clarification that the purchase,

    sale or exchange of a foreign currency by a bank on behalf of a

    retail customer for the sole purpose of effecting a purchase or sale

    of a foreign security or in order to clear or settle such purchase

    or sale, when the settlement period for such FX transaction is

    within the settlement cycle for such foreign security, is excluded

    from the retail foreign exchange under the CEA. The CFTC has

    provided the clarification regarding the meaning of ``leveraged,

    margined or financed'' under section 2(c)(2)(C) of the CEA to

    address this commenter's concern.

    ---------------------------------------------------------------------------

    (d) Retail Foreign Currency Options

    The CFTC is providing an interpretation regarding the status of

    retail foreign currency options that are described in section

    2(c)(2)(B) of the CEA.\576\ As noted above, the Commissions proposed to

    include foreign currency options generally within the definition of the

    term ``swap,'' subject to the statutory exclusions in subparagraph (B)

    of the definition. The statutory exclusions from the swap definition

    encompass transactions described in sections 2(c)(2)(C) and (D) of the

    CEA, but not those in section 2(c)(2)(B) of the CEA.\577\ Section

    2(c)(2)(B) of the CEA applies to futures, options on futures and

    options on foreign currency (other than foreign currency options

    executed or traded on a national securities exchange), and permits such

    transactions to be entered into with counterparties who are not ECPs

    \578\ on an off-exchange basis by certain enumerated regulated

    entities.\579\ No issue arises with respect to futures or options on

    futures in foreign currency that are covered by section 2(c)(2)(B) of

    the CEA, because they are expressly excluded from the statutory swap

    definition.\580\ Commodity options, including options on foreign

    currency, however, are not excluded from the swap definition (other

    than foreign currency options executed or traded on a national

    securities exchange).

    ---------------------------------------------------------------------------

    \576\ 7 U.S.C. 2(c)(2)(B).

    \577\ See section 1a(47)(B)(i) of the CEA, 7 U.S.C.

    1a(47)(B)(i). Sections 2(c)(2)(B), (C), and (D) of the CEA, 7 U.S.C.

    2(c)(2)(B), (C), and (D), govern certain types of off-exchange

    transactions in commodities, including foreign currency, in which

    one of the parties to the transaction is not an ECP.

    \578\ ECPs are defined in section 1a(18) of the CEA, 7 U.S.C.

    1a(18).

    \579\ Section 2(c)(2)(B)(i) of the CEA provides: (i) This Act

    applies to, and the Commission shall have jurisdiction over, an

    agreement, contract, or transaction in foreign currency that--(I) is

    a contract of sale of a commodity for future delivery (or an option

    on such a contract) or an option (other than an option executed or

    traded on a national securities exchange registered pursuant to

    section 6(a) of the Securities Exchange Act of 1934, 15 U.S.C.

    78f(a)); and (II) is offered to, or entered into with, a person that

    is not an eligible contract participant, unless the counterparty, or

    the person offering to be the counterparty, of the person is

    [certain regulated counterparties enumerated in the statute.] 7

    U.S.C. 2(c)(2)(B)(i). Thus, under section 2(c)(2)(B)(i) of the CEA,

    the CEA's exchange-trading requirement generally applies with

    respect to futures, options on futures, and options on foreign

    currency. See section 4(a) of the CEA, 7 U.S.C. 6(a) (generally

    requiring futures contracts to be traded on or subject to the rules

    of a DCM); section 4c(b) of the CEA, 7 U.S.C. 6c(b) (prohibiting

    trading options subject to the CEA contrary to CFTC rules,

    regulations or orders permitting such trading); Part 32 of the

    CFTC's rules, 17 CFR Part 32 (generally prohibiting entering into

    options subject to the CEA (other than options on futures) other

    than on or subject to the rules of a DCM); and CFTC Rule 33.3(a), 17

    CFR 33.3(a) (prohibiting entering into options on futures other than

    on or subject to the rules of a DCM). However, if the counterparty

    to the non-ECP is an enumerated regulated entity identified in

    section 2(c)(2)(B)(i)(II) of the CEA, 7 U.S.C. 2(c)(2)(B)(i)(II),

    the CEA's exchange-trading requirement does not apply. Accordingly,

    an enumerated regulated entity--including a banking institution

    regulated by the OCC--can, pursuant to section 2(c)(2)(B) of the

    CEA, lawfully enter into a future, an option on a future, or an

    option on foreign currency with a non-ECP counterparty on an off-

    exchange basis.

    \580\ See section 1a(47)(B)(i) of the CEA, 7 U.S.C.

    1a(47)(B)(i).

    ---------------------------------------------------------------------------

    The CFTC notes that, in further defining the term ``swap'' to

    include foreign currency options, the Proposing Release stated that the

    proposal was not intended to address, and had no bearing on, the CFTC's

    jurisdiction over foreign currency options in other contexts,

    specifically citing section 2(c)(2)(B) of the CEA.\581\ Nonetheless,

    the CFTC acknowledges the ambiguity in the statute regarding the status

    of off-exchange foreign currency options with non-ECPs that are subject

    to section 2(c)(2)(B) of the CEA. While foreign currency options are

    swaps, they also are subject to section 2(c)(2)(B) of the CEA when

    entered into off-exchange with non-ECPs, and there is no statutory

    exclusion from the swap definition for section 2(c)(2)(B) transactions.

    If foreign currency options were deemed to be swaps, then, pursuant to

    section 2(e) of the CEA, as added by the Dodd-Frank Act,\582\ they

    could not be entered into by non-ECP counterparties, except on a DCM.

    This would render the provisions of section 2(c)(2)(B) of the CEA,

    permitting off-exchange foreign currency options with non-ECPs by

    enumerated regulated entities, a nullity.

    ---------------------------------------------------------------------------

    \581\ See Proposing Release at 29835 n.125.

    \582\ 7 U.S.C. 2(e).

    ---------------------------------------------------------------------------

    The CFTC believes that Congress did not intend the swap definition

    to overrule and effectively repeal another provision of the CEA in such

    an oblique fashion.\583\ Nor is there anything in the legislative

    history of the Dodd-Frank Act to suggest a congressional intent to

    prohibit only one type of off-exchange foreign currency transaction

    with non-ECPs (out of the three types of off-exchange foreign currency

    transactions with non-ECPs that are addressed in CEA section

    2(c)(2)(B)). The omission of section 2(c)(2)(B) of the CEA from the

    exclusions set forth in the statutory swap definition appears to be a

    scrivener's error.\584\ Accordingly, the CFTC is applying the exclusion

    from the swap definition to foreign currency options described in CEA

    section 2(c)(2)(B).

    ---------------------------------------------------------------------------

    \583\ The CFTC notes in this regard that repeals by implication

    are strongly disfavored by the courts. See, e.g., Village of

    Barrington, Ill. v. Surface Transp. Bd., 636 F.3d 650, 662 (D.C.

    Cir. 2011) (``Repeals by implication, however, are strongly

    disfavored `absent a clearly expressed congressional intention' '')

    (quoting Branch v. Smith, 538 U.S. 254, 273, 123 S.Ct. 1429 (2003));

    Agri Processor Co., Inc. v. N.L.R.B., 514 F.3d 1, 4 (D.C. Cir. 2008)

    (``[a]mendments by implication, like repeals by implication, are not

    favored'' and ``will not be found unless an intent to repeal [or

    amend] is `clear and manifest.' '') (quoting United States v.

    Welden, 377 U.S. 95, 102 n. 12, 84 S.Ct. 1082 (1964) and Rodriguez

    v. United States, 480 U.S. 522, 524, 107 S.Ct. 1391 (1987)).

    \584\ See, e.g., Singer and Singer, Sutherland Statutes and

    Statutory Construction Sec. 47:38 (7th ed. 2011) (``Words may be

    supplied in a statute * * * where omission is due to inadvertence,

    mistake, accident, or clerical error'').

    ---------------------------------------------------------------------------

    [[Page 48259]]

    3. Forward Rate Agreements

    The Commissions are adopting rules as proposed to explicitly define

    the term ``swap'' to include forward rate agreements (``FRAs'').\585\

    The Commissions did not receive any comments on the proposed rules

    regarding the inclusion of FRAs in the swap definition.

    ---------------------------------------------------------------------------

    \585\ See rules 1.3(xxx)(2)(i)(E) under the CEA and rule 3a69-

    2(b)(1)(v) under the Exchange Act.

    ---------------------------------------------------------------------------

    In general, an FRA is an over-the-counter contract for a single

    cash payment, due on the settlement date of a trade, based on a spot

    rate (determined pursuant to a method agreed upon by the parties) and a

    pre-specified forward rate. The single cash payment is equal to the

    product of the present value (discounted from a specified future date

    to the settlement date of the trade) of the difference between the

    forward rate and the spot rate on the settlement date multiplied by the

    notional amount. The notional amount itself is not exchanged.\586\

    ---------------------------------------------------------------------------

    \586\ See generally ``Trading and Capital-Markets Activities

    Manual,'' supra note 556, section 4315.1 (``For example, in a six-

    against-nine-month (6x9) FRA, the parties agree to a three-month

    rate that is to be netted in six months' time against the prevailing

    three-month reference rate, typically LIBOR. At settlement (after

    six months), the present value of the net interest rate (the

    difference between the spot and the contracted rate) is multiplied

    by the notional principal amount to determine the amount of the cash

    exchanged between the parties * * * . If the spot rate is higher

    than the contracted rate, the seller agrees to pay the buyer the

    differences between the prespecified forward rate and the spot rate

    prevailing at maturity, multiplied by a notional principal amount.

    If the spot rate is lower than the forward rate, the buyer pays the

    seller.'').

    ---------------------------------------------------------------------------

    An FRA provides for the future (executory) payment based on the

    transfer of interest rate risk between the parties as opposed to

    transferring an ownership interest in any asset or liability.\587\

    Thus, the Commissions believe that an FRA satisfies clause (A)(iii) of

    the swap definition.\588\

    ---------------------------------------------------------------------------

    \587\ It appears that at least some in the trade view FRAs as

    swaps today. See, e.g., The Globecon Group, Ltd., ``Derivatives

    Engineering: A Guide to Structuring, Pricing and Marketing

    Derivatives,'' 45 (McGraw-Hill 1995) (``An FRA is simply a one-

    period interest-rate swap.''); DerivActiv, Glossary of Financial

    Derivatives Terms (``A swap is * * * a strip of FRAs.''), available

    at http://www.derivactiv.com/definitions.aspx?search=

    forward+rate+agreements. Cf. Don M. Chance, et al., ``Derivatives in

    Portfolio Management,'' 29 (AIMR 1998) (``[An FRA] involves one

    specific payment and is basically a one-date swap (in the sense that

    a swap is a combination of FRAs[,] with some variations).''). Thus,

    FRAs also may fall within clause (A)(iv) of the swap definition, as

    ``an agreement, contract, or transaction that is, or in the future

    becomes, commonly known to the trade as a swap.'' See section

    1a(47)(a)(iv) of the CEA, 7 U.S.C. 1a(47)(a)(iv).

    \588\ See section 1a(47)(A)(iii) of the CEA, 7 U.S.C.

    1a(47)(A)(iii). CFTC regulations have defined FRAs as swap

    agreements. See rule 35.1(b)(1)(i) under the CEA, 17 CFR

    35.1(b)(1)(i); Exemption for Certain Swap Agreements, 58 FR 5587

    (Jan. 22, 1993). The CFTC recently repealed that rule and amended

    Part 35 of its rules in light of the enactment of Title VII of the

    Dodd-Frank Act. See Agricultural Swaps, 76 FR 49291 (Aug. 10, 2011).

    ---------------------------------------------------------------------------

    Notwithstanding their ``forward'' label, FRAs do not fall within

    the forward contract exclusion from the swap definition. FRAs do not

    involve nonfinancial commodities and thus are outside the scope of the

    forward contract exclusion. Nor is an FRA a commercial merchandising

    transaction, as there is no physical product to be delivered in an

    FRA.\589\ Accordingly, the Commissions believe that the forward

    contract exclusion from the swap definition for nonfinancial

    commodities does not apply to FRAs.\590\

    ---------------------------------------------------------------------------

    \589\ See Regulation of Hybrid and Related Instruments, 52 FR

    47022, 47028 (Dec. 11, 1987) (stating ``[FRAs] do not possess all of

    the characteristics of forward contracts heretofore delineated by

    the [CFTC]'').

    \590\ The Commissions note that Current European Union law

    includes FRAs in the definition of ``financial instruments.'' See

    Markets in Financial Instruments Directive (MiFID), ``Directive

    2004/39/EC of the European Parliament and of the Council,'' Annex

    I(C), 4, 5, 10 (Apr. 21, 2004), available at http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CONSLEG:2004L0039:20070921:EN:PDF 20070921:EN:PDF. European Commission legislation on derivatives,

    central clearing, and trade repositories applies to FRAs that are

    traded over-the-counter and, thus, would subject such transactions

    to mandatory clearing, reporting and other regulatory requirements.

    See Regulation of the European Parliament and of the Council on OTC

    derivatives, central counterparties and trade repositories, tit. I,

    art. 2 (1(3b)), 7509/1/12 REV 1 (Mar. 19, 2012).

    ---------------------------------------------------------------------------

    Based on the foregoing considerations, the Commissions are adopting

    rules to provide greater clarity by explicitly defining the term

    ``swap'' to include FRAs. As with the foreign exchange-related products

    discussed above, the final rules provide that FRAs are not swaps if

    they fall within one of the exclusions set forth in subparagraph (B) of

    the swap definition.

    4. Combinations and Permutations of, or Options on, Swaps and Security-

    Based Swaps

    Clause (A)(vi) of the swap definition provides that ``any

    combination or permutation of, or option on, any agreement, contract,

    or transaction described in any of clauses (i) through (v)'' of the

    definition is a swap.\591\ The Commissions provided an interpretation

    regarding clause (A)(vi) in the Proposing Release.\592\ The Commissions

    received no comments on the interpretation provided in the Proposing

    Release regarding combinations and permutations of, or options on,

    swaps and security-based swaps and are restating their interpretation

    of clause (A)(vi) of the swap definition with one technical correction

    and one clarification.

    ---------------------------------------------------------------------------

    \591\ See section 1a(47)(vi) of the CEA, 7 U.S.C. 1a(47)(vi).

    Clause (A)(vi) of the swap definition refers specifically to other

    types of swaps in the swap definition. However, because section

    3(a)(68) of the Exchange Act defines a security-based swap as a swap

    [with some connection to a security], clause (A)(vi) of the swap

    definition is relevant to determining whether any combination or

    permutation of, or option on, a security-based swap is a security-

    based swap.

    \592\ See Proposing Release at 29838.

    ---------------------------------------------------------------------------

    Clause (A)(vi) means, for example, that an option on a swap or

    security-based swap (commonly known as a ``swaption'') would itself be

    a swap or security-based swap, respectively. The Commissions also

    interpret clause (A)(vi) to mean that a ``forward swap'' would itself

    be a swap or security-based swap, respectively.\593\ By listing

    examples here, the Commissions do not intend to limit the broad

    language of clause (A)(vi) of the swap definition, which is designed to

    capture those agreements, contracts and transactions that are not

    expressly enumerated in the CEA swap definition but that nevertheless

    are swaps.\594\

    ---------------------------------------------------------------------------

    \593\ Forward swaps are also commonly known as forward start

    swaps, or deferred or delayed start swaps. A forward swap can

    involve two offsetting swaps that both start immediately, but one of

    which ends on the deferred start date of the forward swap itself.

    For example, if a counterparty wants to hedge its risk for four

    years, starting one year from today, it could enter into a one-year

    swap and a five-year swap, which would partially offset to create a

    four-year swap, starting one year forward. A forward swap also can

    involve a contract to enter into a swap or security-based swap at a

    future date or with a deferred start date. A forward swap is not a

    nonfinancial commodity forward contract or security forward, both of

    which are excluded from the swap definition and discussed elsewhere

    in this release.

    \594\ This category could include categories of agreements,

    contracts or transactions that do not yet exist as well as more

    esoteric swaps that exist but that Congress did not refer to by name

    in the statutory swap definition.

    ---------------------------------------------------------------------------

    5. Contracts for Differences

    As the Proposing Release notes, the Commissions have received

    inquiries over the years regarding the treatment of CFDs under the CEA

    and the Federal securities laws.\595\ A CFD generally is an agreement

    to exchange the difference in value of an underlying asset between the

    time at which a CFD position is established and the time at which it is

    terminated.\596\ If the value increases, the

    [[Page 48260]]

    seller pays the buyer the difference; if the value decreases, the buyer

    pays the seller the difference. CFDs can be traded on a number of

    products, including treasuries, foreign exchange rates, commodities,

    equities, and stock indexes. Equity CFDs closely mimic the purchase of

    actual shares. The buyer of an equity CFD receives cash dividends and

    participates in stock splits.\597\ In the case of a long position, a

    dividend adjustment is credited to the client's account. In the case of

    a short position, a dividend adjustment is debited from the client's

    account. CFDs generally are traded over-the-counter (though they also

    are traded on the Australian Securities Exchange) in a number of

    countries outside the United States.

    ---------------------------------------------------------------------------

    \595\ See Proposing Release at 29838.

    \596\ See Ontario Securities Commission, Staff Notice 91-702,

    ``Offerings of Contracts for Difference and Foreign Exchange

    Contracts to Investors in Ontario,'' at part IV.1 (defining a CFD as

    ``a derivative product that allows an investor to obtain economic

    exposure (for speculative, investment or hedging purposes) to an

    underlying asset * * * such as a share, index, market sector,

    currency or commodity, without acquiring ownership of the underlying

    asset''), available at http://www.osc.gov.on.ca/documents/en/Securities-Category9/sn_20091030_91-702_cdf.pdf (Oct. 30, 2009);

    Financial Services Authority, Consultation Paper 7/20, ``Disclosure

    of Contracts for Difference--Consultation and draft Handbook text,''

    at part 2.2 (defining a CFD on a share as ``a derivative product

    that gives the holder an economic exposure, which can be long or

    short, to the change in price of a specific share over the life of

    the contract''), available at http://www.fsa.gov.uk/pubs/cp/cp07_20.pdf (Nov. 2007).

    \597\ See, e.g., Int'l Swaps and Derivatives Ass'n, ``2002 ISDA

    Equity Derivatives Definitions,'' art. 10 (Dividends) and 11

    (Adjustments and Modifications Affecting Indices, Shares and

    Transactions).

    ---------------------------------------------------------------------------

    The Commissions provided an interpretation in the Proposing Release

    regarding the treatment of CFDs. The Commissions are restating the

    interpretation set out in the Proposing Release without modification.

    CFDs, unless otherwise excluded, fall within the scope of the swap

    or security-based swap definition, as applicable.\598\ Whether a CFD is

    a swap or security-based swap will depend on the underlying product of

    that particular CFD transaction. Because CFDs are highly variable and a

    CFD can contain a variety of elements that would affect its

    characterization, the Commissions believe that market participants will

    need to analyze the features of the underlying product of any

    particular CFD in order to determine whether it is a swap or a

    security-based swap. The Commissions are not adopting rules or

    additional interpretations at this time regarding CFDs.

    ---------------------------------------------------------------------------

    \598\ In some cases, depending on the facts and circumstances,

    the SEC may determine that a particular CFD on an equity security,

    for example, should be characterized as constituting a purchase or

    sale of the underlying equity security and, therefore, be subject to

    the requirements of the Federal securities laws applicable to such

    purchases or sales.

    ---------------------------------------------------------------------------

    Comments

    Two commenters requested that the Commissions clarify that non-

    deliverable forward contracts are not CFDs.\599\ These commenters

    requested that the Commissions determine that NDFs involving foreign

    exchange are not swaps. Given that the Commissions are defining NDFs as

    swaps and that CFDs involving foreign currency also would be swaps,

    there is no need to distinguish NDFs involving foreign exchange from

    CFDs involving foreign exchange.

    ---------------------------------------------------------------------------

    \599\ See Covington Letter and ICI/ABASA Letter.

    ---------------------------------------------------------------------------

    D. Certain Interpretive Issues

    1. Agreements, Contracts, or Transactions That May Be Called, or

    Documented Using Form Contracts Typically Used for, Swaps or Security-

    Based Swaps

    The Commissions are restating the interpretation provided in the

    Proposing Release regarding agreements, contracts, or transactions that

    may be called, or documented using form contracts typically used for,

    swaps or security-based swaps with one modification in response to a

    commenter.\600\

    ---------------------------------------------------------------------------

    \600\ See infra note 606.

    ---------------------------------------------------------------------------

    As was noted in the Proposing Release,\601\ individuals and

    companies may generally use the term ``swap'' to refer to certain of

    their agreements, contracts, or transactions. For example, they may use

    the term ``swap'' to refer to an agreement to exchange real or personal

    property between the parties or to refer to an agreement for two

    companies that produce fungible products and with delivery obligations

    in different locations to perform each other's delivery obligations

    instead of their own.\602\ However, the name or label that the parties

    use to refer to a particular agreement, contract, or transaction is not

    determinative of whether it is a swap or security-based swap.\603\

    ---------------------------------------------------------------------------

    \601\ See Proposing Release at 29839.

    \602\ For example, a company obligated to deliver its product to

    a customer in Los Angeles would instead deliver the product in

    Albany to a different company's customer on behalf of that other

    company. In return, the company with the obligation to deliver a

    product to its customer in Albany would deliver the product instead

    in Los Angeles to the customer of the company obligated to deliver

    its product to that customer in Los Angeles.

    \603\ See, e.g., Haekel v. Refco, 2000 WL 1460078, at *4 (CFTC

    Sept. 29, 2000) (``[T]he labels that parties apply to their

    transactions are not necessarily controlling''); Reves v. Ernst &

    Young, 494 U.S. 56, 61 (1990) (stating that the purpose of the

    securities laws is ``to regulate investments, in whatever form they

    are made and by whatever name they are called'') (emphasis in

    original).

    ---------------------------------------------------------------------------

    It is not dispositive that the agreement, contract, or transaction

    is documented using an industry standard form agreement that is

    typically used for swaps and security-based swaps,\604\ but it may be a

    relevant factor.\605\ The key question is whether the agreement,

    contract, or transaction falls within the statutory definitions of the

    term ``swap'' or ``security-based swap'' (as further defined and

    interpreted pursuant to the final rules and interpretations herein)

    based on its terms and other characteristics. Even if one effect of an

    agreement is to reduce the risk faced by the parties (for example, the

    ``swap'' of physical delivery obligations described above may reduce

    the risk of non-delivery), the agreement would not be a swap or

    security-based swap unless it otherwise meets one of those statutory

    definitions, as further defined by the Commissions. If the agreement,

    contract, or transaction satisfies the swap or security-based swap

    definitions, the fact that the parties refer to it by another name

    would not take it outside the Dodd-Frank Act regulatory regime.

    Conversely, if an agreement, contract, or transaction is not a swap or

    security-based swap, as those terms are defined in the CEA and the

    Exchange Act and the rules and regulations thereunder, the fact that

    the parties refer to it, or document it, as a swap or security-based

    swap will not subject that agreement, contract, or transaction to

    regulation as a swap or a security-based swap.

    ---------------------------------------------------------------------------

    \604\ As noted in the Proposing Release, the CFTC consistently

    has found that the form of a transaction is not dispositive in

    determining its nature, citing Grain Land, supra note 213, at *16

    (CFTC Nov. 25, 2003) (holding that contract substance is entitled to

    at least as much weight as form); In the Matter of First Nat'l

    Monetary Corp., [1984-1986 Transfer Binder] Comm. Fut. L. Rep. (CCH)

    ] 22,698 at 30,974 (CFTC Aug. 7, 1985) (``When instruments have been

    determined to constitute the functional equivalent of futures

    contracts neither we nor the courts have hesitated to look behind

    whatever self-serving labels the instruments might bear.'');

    Stovall, supra note 63 (holding that the CFTC ``will not hesitate to

    look behind whatever label the parties may give to the

    instrument''). As also noted in the Proposing Release, the form of a

    transaction is not dispositive in determining whether an agreement,

    contract, or transaction falls within the regulatory regime for

    securities. See SEC v. Merch. Capital, LLC, 483 F.3d 747, 755 (11th

    Cir. 2007) (``The Supreme Court has repeatedly emphasized that

    economic reality is to govern over form and that the definitions of

    the various types of securities should not hinge on exact and

    literal tests.'') (quoting Williamson v. Tucker, 645 F.2d 404, 418

    (5th Cir. 1981)); Robinson v. Glynn, 349 F.3d 166, 170 (4th Cir.

    2003) (``What matters more than the form of an investment scheme is

    the `economic reality' that it represents. * * *'') (internal

    citation omitted); Caiola v. Citibank, N.A., New York, 295 F.3d 312,

    325 (2d Cir. 2002) (quoting United Housing Foundation v. Foreman,

    421 U.S. 837, 848 (1975) (``In searching for the meaning and scope

    of the word `security' * * * the emphasis should be on economic

    reality'')). See Proposing Release at 29839 n. 152.

    \605\ The Commissions note, though, that documentation is not

    controlling in evaluating whether an agreement, contract or

    transaction is a swap, security-based swap, or neither.

    ---------------------------------------------------------------------------

    [[Page 48261]]

    Comments

    The Commissions requested comment regarding what agreements,

    contracts, or transactions that are not swaps or security-based swaps

    are documented using industry standard form agreements that are

    typically used for swaps and security-based swaps, and asked for

    examples thereof and details regarding their documentation, including

    why industry standard form agreements typically used for swaps and

    security-based swaps are used. One commenter stated its view that

    documentation can be a relevant factor in determining whether an

    agreement, contract or transaction is a swap or security-based

    swap.\606\ The Commissions are persuaded by the commenter and are

    modifying the interpretation to clarify that in determining whether an

    agreement, contract or transaction is a swap or security-based swap,

    documentation may be a relevant (but not dispositive) factor.

    ---------------------------------------------------------------------------

    \606\ See IECA Letter. This commenter noted that ``[e]ven though

    swaps are commonly documented on the ISDA Master Agreements without

    annexes, physical transactions under such agreements with power or

    natural gas annexes are not swaps because they are physically

    settled forward contracts that are exempt under 1a47(B)''). Id.

    ---------------------------------------------------------------------------

    2. Transactions in Regional Transmission Organizations and Independent

    System Operators

    The CFTC declines to address the status of transactions in Regional

    Transmission Organizations (``RTOs'') and Independent System Operators

    (``ISOs''), including financial transmission rights (``FTRs'') and

    ancillary services, within this joint definitional rulemaking. As was

    noted in the Proposing Release, section 722 of the Dodd-Frank Act

    specifically addresses certain instruments and transactions regulated

    by FERC that also may be subject to CFTC jurisdiction. Section 722(f)

    added CEA section 4(c)(6),\607\ which provides that, if the CFTC

    determines that an exemption for FERC-regulated instruments or other

    specified electricity transactions would be in accordance with the

    public interest, then the CFTC shall exempt such instruments or

    transactions from the requirements of the CEA. Given that specific

    statutory directive, the treatment of these FERC-regulated instruments

    and transactions should be considered under the standards and

    procedures specified in section 722 of the Dodd-Frank Act for a public

    interest waiver, rather than through this joint rulemaking to further

    define the terms ``swap'' and ``security-based swap.'' \608\

    ---------------------------------------------------------------------------

    \607\ 7 U.S.C. 6(c)(6).

    \608\ The Commissions note that this approach should not be

    taken to suggest any finding by the Commissions as to whether or not

    FTRs or any other FERC-regulated instruments or transactions are

    swaps (or futures contracts).

    ---------------------------------------------------------------------------

    The CFTC notes that it has been engaged in discussions with a

    number of RTOs and ISOs regarding the possibility of a petition seeking

    an exemption pursuant to CEA section 4(c)(6) for certain RTO and ISO

    transactions. The CFTC also notes that the status of some RTO and ISO

    transactions may have been addressed in the interpretation above

    regarding embedded options and the forward exclusion from the swap

    definition,\609\ and/or indirectly through the CFTC's recent interim

    final rulemaking relating to trade options.\610\

    ---------------------------------------------------------------------------

    \609\ See supra part II.B.2(a).

    \610\ See supra note 317.

    ---------------------------------------------------------------------------

    Comments

    The CFTC received a number of comments discussing transactions in

    RTOs and ISOs.\611\ These commenters argued that the CFTC should

    further define the term ``swap'' to exclude transactions executed or

    traded on RTOs and ISOs.\612\ One commenter argued that the CEA section

    4(c)(6) exemptive approach will leave regulatory ambiguity for market

    participants, since the CFTC might not grant an exemption, later revoke

    an existing exemption, grant a partial or conditional exemption, or

    limit an exemption to existing products.\613\ This commenter also noted

    that FERC has complete regulatory authority over RTOs and ISOs and

    their transactions, and that Congress expected the CFTC and FERC to

    avoid duplicative, unnecessary regulation.\614\ Another commenter

    argued that the CFTC should exclude RTO and ISO transactions in the

    same manner as insurance has been excluded.\615\ A third commenter

    stated that RTO and ISO transactions are commercial merchandising

    transactions and thus forwards or, alternatively, that defining them as

    swaps is inconsistent with the text, goals, and purpose of the Dodd-

    Frank Act.\616\

    ---------------------------------------------------------------------------

    \611\ See COPE Letter; ETA Letter; and FERC Staff Letter.

    \612\ Id.

    \613\ See COPE Letter.

    \614\ Id.

    \615\ See ETA Letter.

    \616\ See FERC Staff Letter.

    ---------------------------------------------------------------------------

    By contrast, one commenter asserted that FTRs are in substance

    swaps and should be regulated as such.\617\

    ---------------------------------------------------------------------------

    \617\ See Better Markets Letter.

    ---------------------------------------------------------------------------

    Two commenters supported the CFTC's use of its section 722(f)

    authority to exempt FERC-regulated transactions and other transactions

    in RTOs or ISOs.\618\ As discussed above, section 722(f) of the Dodd-

    Frank Act added new section 4(c)(6) to the CEA specifically addressing

    how the CFTC should approach certain instruments and transactions

    regulated by FERC that also may be subject to CFTC jurisdiction. The

    CFTC continues to believe, as was stated in the Proposing Release, that

    such an approach is the more appropriate means of considering issues

    relating to the instruments and transactions specified in CEA section

    4(c)(6). One commenter's argument that the CEA section 4(c)(6)

    exemptive approach will cause regulatory ambiguity is not a convincing

    basis on which to forego a process specifically designated by Congress

    for the issue at hand.\619\ The CFTC also believes that the ability to

    tailor exemptive relief, after notice and public comment, to the

    complex issues presented by transactions on RTOs and ISOs, is further

    reason to favor such an approach over the more general directive to

    further define the terms ``swap'' and ``security-based swap'' that is

    the subject of this rulemaking.

    ---------------------------------------------------------------------------

    \618\ See NEMA Letter and WGCEF Letter.

    \619\ See COPE Letter.

    ---------------------------------------------------------------------------

    In response to one commenter's contentions that FERC has complete

    regulatory authority over RTOs and ISOs and their transactions, and

    that Congress expected the CFTC and FERC to avoid duplicative,

    unnecessary regulation, the CFTC notes that Congress addressed this

    issue not by excluding RTO and ISO transactions from the comprehensive

    regime for swap regulation, but rather by enacting the exemptive

    process in CEA section 4(c)(6).

    And in response to another commenter's contention that the CFTC

    should exclude RTO and ISO transactions in the same manner as insurance

    has been excluded, the CFTC notes that Congress provided neither an

    exemptive process equivalent to CEA section 4(c)(6) for insurance, nor

    an energy market-equivalent to the McCarran-Ferguson Act.\620\

    ---------------------------------------------------------------------------

    \620\ 15 U.S.C. 1011-1015.

    ---------------------------------------------------------------------------

    As noted above, FERC staff opines that defining RTO and ISO

    transactions as swaps would be inconsistent with the text, goals, and

    purpose of the Dodd-Frank Act. The CFTC can consider concerns of the

    sort expressed by FERC staff in connection with any petition for a CEA

    section 4(c)(6) exemption that

    [[Page 48262]]

    may be submitted to the CFTC.\621\ Interested parties on all sides of

    the issue would receive an opportunity to comment on the scope and

    other aspects of any proposed exemptive relief at that time.

    ---------------------------------------------------------------------------

    \621\ CEA section 4(c)(6) requires the CFTC to determine that an

    exemption pursuant to such section ``is consistent with the public

    interest and the purposes of th[e CEA].'' 7 U.S.C. 6(c)(6).

    ---------------------------------------------------------------------------

    III. The Relationship Between the Swap Definition and the Security-

    Based Swap Definition

    A. Introduction

    Title VII of the Dodd-Frank Act defines the term ``swap'' under the

    CEA,\622\ and also defines the term ``security-based swap'' under the

    Exchange Act.\623\ Pursuant to the regulatory framework established in

    Title VII, the CFTC has regulatory authority over swaps and the SEC has

    regulatory authority over security-based swaps. The Commissions are

    further defining the terms ``swap'' and ``security-based swap'' to

    clarify whether particular agreements, contracts, or transactions are

    swaps or security-based swaps based on characteristics including the

    specific terms and conditions of the instrument and the nature of,

    among other things, the prices, rates, securities, indexes, or

    commodities upon which the instrument is based.

    ---------------------------------------------------------------------------

    \622\ See section 1a(47) of the CEA, 7 U.S.C. 1a(47).

    \623\ See section 3(a)(68) of the Exchange Act, 15 U.S.C.

    78c(a)(68).

    ---------------------------------------------------------------------------

    Because the discussion below is focused on whether particular

    agreements, contracts, or transactions are swaps or security-based

    swaps, the Commissions use the term ``Title VII instrument'' in this

    release to refer to any agreement, contract, or transaction that is

    included in either the definition of the term ``swap'' or the

    definition of the term ``security-based swap.'' Thus, the term ``Title

    VII instrument'' is synonymous with ``swap or security-based swap.''

    \624\

    ---------------------------------------------------------------------------

    \624\ In some cases, the Title VII instrument may be a mixed

    swap. Mixed swaps are discussed further in section IV below.

    ---------------------------------------------------------------------------

    The determination of whether a Title VII instrument is either a

    swap or a security-based swap should be made based on the facts and

    circumstances relating to the Title VII instrument prior to execution,

    but no later than when the parties offer to enter into the Title VII

    instrument.\625\ If the Title VII instrument itself is not amended,

    modified, or otherwise adjusted during its term by the parties, its

    characterization as a swap or security-based swap will not change

    during its duration because of any changes that may occur to the

    factors affecting its character as a swap or security-based swap.\626\

    ---------------------------------------------------------------------------

    \625\ The determination must be made no later than when the

    parties offer to enter into the Title VII instrument because persons

    are prohibited from offering to sell, offering to buy or purchase,

    or selling a security-based swap to any person who is not an ECP

    unless a registration statement is in effect as to the security-

    based swap. See section 5(e) of the Securities Act. This analysis

    also would apply with respect to mixed swaps and security-based swap

    agreements. With respect to swaps, the determination also would need

    to be made no later than the time that provisions of the CEA and the

    regulations thereunder become applicable to a Title VII Instrument.

    For instance, certain duties apply to swaps prior to execution. See

    Daily Trading Records under Rule 23.202 under the CEA, 17 CFR

    23.202, and Subpart H of Part 23 of the CFTC's regulations, 17 CFR

    Part 23, Subpart H (Business Conduct Standards for Swap Dealers and

    Major Swap Participants Dealing with Counterparties, Including

    Special Entities).

    \626\ See infra part III.G.5(a), for a discussion regarding the

    evaluation of Title VII Instruments on security indexes that move

    from broad-based to narrow-based or narrow-based to broad-based.

    ---------------------------------------------------------------------------

    Classifying a Title VII instrument as a swap or security-based swap

    is straightforward for most instruments. However, the Commissions

    provided an interpretation in the Proposing Release to clarify the

    classification of swaps and security-based swaps in certain areas and

    to provide an interpretation regarding the use of certain terms and

    conditions in Title VII instruments. The Commissions are restating the

    interpretation set out in the Proposing Release with certain

    modifications to the interpretation regarding TRS.

    B. Title VII Instruments Based on Interest Rates, Other Monetary Rates,

    and Yields

    Parties frequently use Title VII instruments to manage risks

    related to, or to speculate on, changes in interest rates, other

    monetary rates or amounts, or the return on various types of assets.

    Broadly speaking, Title VII instruments based on interest or other

    monetary rates would be swaps, whereas Title VII instruments based on

    the yield or value of a single security, loan, or narrow-based security

    index would be security-based swaps. However, market participants and

    financial professionals sometimes use the terms ``rate'' and ``yield''

    in different ways. The Commissions proposed an interpretation in the

    Proposing Release regarding whether Title VII instruments that are

    based on interest rates, other monetary rates, or yields would be swaps

    or security-based swaps and are restating the interpretation, but with

    a modification to the list of examples of reference rates to include

    certain secured lending rates under money market rates.\627\ The

    Commissions find that this interpretation is an appropriate way to

    address Title VII instruments based on interest rates, other monetary

    rates, or yields and is designed to reduce costs associated with

    determining whether such instruments are swaps or security-based

    swaps.\628\

    ---------------------------------------------------------------------------

    \627\ These secured lending rates are the Eurepo, The Depository

    Trust & Clearing Corporation's General Collateral Finance Repo

    Index, the Repurchase Overnight Index Average Rate and the Tokyo

    Repo Rate.

    \628\ See supra part I, under ``Overall Economic

    Considerations''.

    ---------------------------------------------------------------------------

    1. Title VII Instruments Based on Interest Rates or Other Monetary

    Rates That Are Swaps

    The Commissions believe that when payments exchanged under a Title

    VII instrument are based solely on the levels of certain interest rates

    or other monetary rates that are not themselves based on one or more

    securities, the instrument would be a swap and not a security-based

    swap.\629\ Often swaps on interest rates or other monetary rates

    require the parties to make payments based on the comparison of a

    specified floating rate (such as the London Interbank Offered Rate

    (``LIBOR'')) to a fixed rate of interest agreed upon by the parties. A

    rate swap also may require payments based on the differences between

    two floating rates, or it may require that the parties make such

    payments when any agreed-upon events with respect to interest rates or

    other monetary rates occur (such as when a specified interest rate

    crosses a threshold, or when the spread between two such rates reaches

    a certain point). The rates referenced for the parties' obligations are

    varied, and examples of such rates include the following:

    ---------------------------------------------------------------------------

    \629\ See infra part III.F, regarding the use of certain terms

    and conditions.

    ---------------------------------------------------------------------------

    Interbank Offered Rates: An average of rates charged by a group of

    banks for lending money to each other or other banks over various

    periods of time, and other similar interbank rates,\630\ including, but

    not limited to, LIBOR (regardless of currency); \631\ the Euro

    [[Page 48263]]

    Interbank Offered Rate (``Euribor''); the Canadian Dealer Offered Rate

    (``CDOR''); and the Tokyo Interbank Offered Rate (``TIBOR''); \632\

    ---------------------------------------------------------------------------

    \630\ Interbank lending rates are measured by surveys of the

    loan rates that banks offer other banks, or by other mechanisms. The

    periods of time for such loans may range from overnight to 12 months

    or longer.

    The interbank offered rates listed here are frequently called

    either a ``reference rate,'' the rate of ``reference banks,'' or by

    a designation that is specific to the service that quotes the rate.

    For some of the interbank offered rates listed here, there is a

    similar rate that is stated as an interbank bid rate, which is the

    average rate at which a group of banks bid to borrow money from

    other banks. For example, the bid rate similar to LIBOR is called

    LIBID.

    \631\ Today, LIBOR is used as a rate of reference for the

    following currencies: Australian Dollar, Canadian Dollar, Danish

    Krone, Euro, Japanese Yen, New Zealand Dollar, Pound Sterling,

    Swedish Krona, Swiss Franc, and U.S. Dollar.

    \632\ Other interbank offered rates include the following (with

    the country or city component of the acronym listed in parentheses):

    AIDIBOR (Abu Dhabi); BAIBOR (Buenos Aires); BKIBOR (Bangkok);

    BRAZIBOR (Brazil); BRIBOR/BRIBID (Btatislava); BUBOR (Budapest);

    CHIBOR (China); CHILIBOR (Chile); CIBOR (Copenhagen); COLIBOR

    (Columbia); HIBOR (Hong Kong); JIBAR (Johannesburg); JIBOR

    (Jakarta); KAIBOR (Kazakhstan); KIBOR (Karachi); KLIBOR (Kuala

    Lumpur); KORIBOR ((South) Korea); MEXIBOR (Mexico); MIBOR (Mumbai);

    MOSIBOR (Moscow); NIBOR (Norway); PHIBOR (Philippines); PRIBOR

    (Prague); REIBOR/REIBID (Reykjavik); RIGIBOR/RIGIBID (Riga); SHIBOR

    (Shanghai); SIBOR (Singapore); SOFIBOR (Sofia); STIBOR (Stockholm);

    TAIBOR (Taiwan); TELBOR (Tel Aviv); TRLIBOR and TURKIBOR (Turkey);

    VILIBOR (Vilnius); VNIBOR (Vietnam); and WIBOR (Warsaw).

    ---------------------------------------------------------------------------

    Money Market Rates: A rate established or determined based on

    actual lending or money market transactions, including, but not limited

    to, the Federal Funds Effective Rate; the Euro Overnight Index Average

    (``EONIA'' or ``EURONIA'') (which is the weighted average of overnight

    unsecured lending transactions in the Euro-area interbank market); the

    EONIA Swap Index; the Eurepo (the rate at which, at 11.00 a.m. Brussels

    time, one bank offers, in the euro-zone and worldwide, funds in euro to

    another bank if in exchange the former receives from the latter the

    best collateral within the most actively-traded European repo market);

    the Australian dollar RBA 30 Interbank Overnight Cash Rate; the

    Canadian Overnight Repo Rate Average (``CORRA''); The Depository Trust

    & Clearing Corporation's General Collateral Finance (``GCF'') Repo

    Index (an average of repo rates collateralized by U.S. Treasury and

    certain other securities); the Mexican interbank equilibrium interest

    rate (``TIIE''); the NZD Official Cash Rate; the Sterling Overnight

    Interbank Average Rate (``SONIA'') (which is the weighted average of

    unsecured overnight cash transactions brokered in London by the

    Wholesale Markets Brokers' Association (``WMBA'')); the Repurchase

    Overnight Index Average Rate (``RONIA'') (which is the weighted average

    rate of all secured overnight cash transactions brokered in London by

    WMBA); the Swiss Average Rate Overnight (``SARON''); the Tokyo

    Overnight Average Rate (``TONAR'') (which is based on uncollateralized

    overnight average call rates for interbank lending); and the Tokyo Repo

    Rate (average repo rate of active Japanese repo market participants).

    Government Target Rates: A rate established or determined based on

    guidance established by a central bank including, but not limited to,

    the Federal Reserve discount rate, the Bank of England base rate and

    policy rate, the Canada Bank rate, and the Bank of Japan policy rate

    (also known as the Mutan rate);

    General Lending Rates: A general rate used for lending money,

    including, but not limited to, a prime rate, rate in the commercial

    paper market, or any similar rate provided that it is not based on any

    security, loan, or group or index of securities;

    Indexes: A rate derived from an index of any of the foregoing or

    following rates, averages, or indexes, including but not limited to a

    constant maturity rate (U.S. Treasury and certain other rates),\633\

    the interest rate swap rates published by the Federal Reserve in its

    ``H.15 Selected Interest Rates'' publication, the ISDAFIX rates, the

    ICAP Fixings, a constant maturity swap, or a rate generated as an

    average (geometric, arithmetic, or otherwise) of any of the foregoing,

    such as overnight index swaps (``OIS'')--provided that such rates are

    not based on a specific security, loan, or narrow-based group or index

    of securities;

    ---------------------------------------------------------------------------

    \633\ A Title VII instrument based solely on the level of a

    constant maturity U.S. Treasury rate would be a swap because U.S.

    Treasuries are exempted securities that are excluded from the

    security-based swap definition. Conversely, a Title VII instrument

    based solely on the level of a constant maturity rate on a narrow-

    based index of non-exempted securities under the security-based swap

    definition would be a security-based swap.

    ---------------------------------------------------------------------------

    Other Monetary Rates: A monetary rate including, but not limited

    to, the Consumer Price Index (``CPI''), the rate of change in the money

    supply, or an economic rate such as a payroll index; and

    Other: The volatility, variance, rate of change of (or the spread,

    correlation or difference between), or index based on any of the

    foregoing rates or averages of such rates, such as forward spread

    agreements, references used to calculate the variable payments in index

    amortizing swaps (whereby the notional principal amount of the

    agreement is amortized according to the movement of an underlying

    rate), or correlation swaps and basis swaps, including but not limited

    to, the ``TED spread'' \634\ and the spread or correlation between

    LIBOR and an OIS.

    ---------------------------------------------------------------------------

    \634\ The TED spread is the difference between the interest

    rates on interbank loans and short-term U.S. government debt

    (Treasury bills or ``T-bills''). The latter are exempted securities

    that are excluded from the statutory definition of the term

    ``security-based swap.'' Thus, neither any aspect of U.S. Treasuries

    nor interest rates on interbank loans can form the basis of a

    security-based swap. For this reason, a Title VII instrument on a

    spread between interbank loan rates and T-bill rates also would be a

    swap, not a security-based swap.

    ---------------------------------------------------------------------------

    As discussed above, the Commissions believe that when payments

    under a Title VII instrument are based solely on any of the foregoing,

    such Title VII instrument would be a swap.

    Comments

    Two commenters believed that constant maturity swaps always should

    be treated as swaps, rather than mixed swaps, because they generally

    are viewed by market participants as rates trades instead of trades on

    securities.\635\ According to the commenters, the ``bulk'' of constant

    maturity swaps are based on exempted securities, but the commenters

    noted that the constant maturity leg may be based on a number of

    different rates or yields, including, among other things, U.S. Treasury

    yields, Treasury auction rates, yields on debt of foreign governments,

    and debt related to indices of mortgage-backed securities.\636\ As

    discussed above, the Commissions are adopting the interpretation as

    proposed. The statutory language of the swap and security-based swap

    definitions explicitly states that a Title VII instrument that is based

    on a non-exempted security should be a security-based swap and not a

    swap.\637\

    ---------------------------------------------------------------------------

    \635\ See CME Letter and SIFMA Letter.

    \636\ Id.

    \637\ See supra note 633.

    ---------------------------------------------------------------------------

    2. Title VII Instruments Based on Yields

    The Commissions proposed an interpretation in the Proposing Release

    clarifying the status of Title VII instruments in which one of the

    underlying references of the instrument is a ``yield.'' The Commissions

    received no comments on the interpretation set out in the Proposing

    Release regarding Title VII instruments based on yields and are

    restating the interpretation without modification. In cases when a

    ``yield'' is calculated based on the price or changes in price of a

    debt security, loan, or narrow-based security index, it is another way

    of expressing the price or value of a debt security, loan, or narrow-

    based security index. For example, debt securities often are quoted and

    traded on a yield basis rather than on a dollar price, where the yield

    relates to a specific date, such as the date of maturity of the debt

    security (i.e., yield to maturity) or the date upon which the debt

    security may be redeemed or called by the issuer (e.g., yield to first

    whole issue call).\638\

    ---------------------------------------------------------------------------

    \638\ See, e.g., Securities Confirmations, 47 FR 37920 (Aug. 27,

    1982).

    ---------------------------------------------------------------------------

    Except in the case of certain exempted securities, when one of the

    underlying

    [[Page 48264]]

    references of the Title VII instrument is the ``yield'' of a debt

    security, loan, or narrow-based security index in the sense where the

    term ``yield'' is used as a proxy for the price or value of the debt

    security loan, or narrow-based security index, the Title VII instrument

    would be a security-based swap. And, as a result, in cases where the

    underlying reference is a point on a ``yield curve'' generated from the

    different ``yields'' on debt securities in a narrow-based security

    index (e.g., a constant maturity yield or rate), the Title VII

    instrument would be a security-based swap. However, where certain

    exempted securities, such as U.S. Treasury securities, are the only

    underlying reference of a Title VII instrument involving securities,

    the Title VII instrument would be a swap. Title VII instruments based

    on exempted securities are discussed further below.

    The above interpretation would not apply in cases where the

    ``yield'' referenced in a Title VII instrument is not based on a debt

    security, loan, or narrow-based security index of debt securities but

    rather is being used to reference an interest rate or monetary rate as

    outlined above in subsection one of this section. In these cases, this

    ``yield'' reference would be considered equivalent to a reference to an

    interest rate or monetary rate and the Title VII instrument would be,

    under the interpretation in this section, a swap (or mixed swap

    depending on other references in the instrument).

    3. Title VII Instruments Based on Government Debt Obligations

    The Commissions provided an interpretation in the Proposing Release

    regarding instances in which the underlying reference of the Title VII

    instrument is a government debt obligation. The Commissions received no

    comments on the interpretation provided regarding instances in which

    the underlying reference of the Title VII instrument is a government

    debt obligation and are restating such interpretation without

    modification.

    The security-based swap definition specifically excludes any

    agreement, contract, or transaction that meets the definition of a

    security-based swap only because it ``references, is based upon, or

    settles through the transfer, delivery, or receipt of an exempted

    security under [section 3(a)(12) of the Exchange Act], as in effect on

    the date of enactment of the Futures Trading Act of 1982 (other than

    any municipal security as defined in [section 3(a)(29) of the Exchange

    Act] * * *), unless such agreement, contract, or transaction is of the

    character of, or is commonly known in the trade as, a put, call, or

    other option.'' \639\

    ---------------------------------------------------------------------------

    \639\ Section 3(a)(68)(C) of the Exchange Act, 15 U.S.C.

    76c(a)(68)(C).

    ---------------------------------------------------------------------------

    As a result of this exclusion in the security-based swap definition

    for ``exempted securities,''\640\ if the only underlying reference of a

    Title VII instrument involving securities is, for example, the price of

    a U.S. Treasury security and the instrument does not have any other

    underlying reference involving securities, then the instrument would be

    a swap. Similarly, if the Title VII instrument is based on the

    ``yield'' of a U.S. Treasury security and does not have any other

    underlying reference involving securities, then the instrument also

    would be a swap, regardless of whether the term ``yield'' is a proxy

    for the price of the security.

    ---------------------------------------------------------------------------

    \640\ As of January 11, 1983, the date of enactment of the

    Futures Trading Act of 1982, Public Law 97-444, 96 Stat. 2294,

    section 3(a)(12) of the Exchange Act, 15 U.S.C. 78c(a)(12), provided

    that, among other securities, ``exempted securities'' include: (i)

    Securities which are direct obligations of, or obligations

    guaranteed as to principal or interest by, the United States; (ii)

    certain securities issued or guaranteed by corporations in which the

    United States has a direct or indirect interest as designated by the

    Secretary of the Treasury; and (iii) certain other securities as

    designated by the SEC in rules and regulations.

    ---------------------------------------------------------------------------

    Foreign government securities, by contrast, were not ``exempted

    securities'' as of the date of enactment of the Futures Trading Act of

    1982 \641\ and thus do not explicitly fall within this exclusion from

    the security-based swap definition. Therefore, if the underlying

    reference of the Title VII instrument is the price, value, or ``yield''

    (where ``yield'' is a proxy for price or value) of a foreign government

    security, or a point on a yield curve derived from a narrow-based

    security index composed of foreign government securities, then the

    instrument is a security-based swap.

    ---------------------------------------------------------------------------

    \641\ Public Law 97-444, 96 Stat. 2294 (1983).

    ---------------------------------------------------------------------------

    C. Total Return Swaps

    The Commissions are restating the interpretation regarding TRS set

    out in the Proposing Release with certain changes with respect to

    quanto and compo equity TRS and loan TRS based on two or more loans,

    and to reflect that TRS can overlie reference items other than

    securities, loans, and indexes of securities or loans.\642\ The

    Commissions find that this interpretation is an appropriate way to

    address TRS and is designed to reduce the cost associated with

    determining whether a TRS is a swap or a security-based swap.\643\

    ---------------------------------------------------------------------------

    \642\ While this guidance focuses on TRS overlying securities

    and loans, TRS also may overlie other commodities. Such TRS may be

    structured differently due to the nature of the underlying.

    \643\ See supra part I, under ``Overall Economic

    Considerations.''

    ---------------------------------------------------------------------------

    As was described in the Proposing Release,\644\ a TRS is a Title

    VII instrument in which one counterparty, the seller of the TRS, makes

    a payment that is based on the price appreciation and income from an

    underlying security or security index.\645\ A TRS also can overlie a

    single loan, two or more loans and other underliers. The other

    counterparty, the buyer of the TRS, makes a financing payment that is

    often based on a variable interest rate, such as LIBOR (or other

    interbank offered rate or money market rate, as described above), as

    well as a payment based on the price depreciation of the underlying

    reference. The ``total return'' consists of the price appreciation or

    depreciation, plus any interest or income payments.\646\ Accordingly,

    where a TRS is based on a single security or loan, or a narrow-based

    security index, the TRS would be a security-based swap.\647\

    ---------------------------------------------------------------------------

    \644\ See Proposing Release at 29842.

    \645\ Where the underlying security is an equity security, a TRS

    is also known as an ``equity swap.'' A bond may also be the

    underlying security of a TRS.

    \646\ If the total return is negative, the seller receives this

    amount from the buyer. TRS can be used to synthetically reproduce

    the payoffs of a position. For example, two counterparties may enter

    into a 3-year TRS where the buyer of the TRS receives the positive

    total return on XYZ security, if any, and the seller of the TRS

    receives LIBOR plus 30 basis points and the absolute value of the

    negative total return on XYZ security, if any.

    \647\ However, if the underlying reference of the TRS is a

    broad-based security index, it is a swap (and an SBSA) and not a

    security-based swap. In addition, a TRS on an exempted security,

    such as a U.S. Treasury, under section 3(a)(12) of the Exchange Act,

    15 U.S.C. 78c(a)(12), as in effect on the date of enactment of the

    Futures Trading Act of 1982 (other than any municipal security as

    defined in section 3(a)(29) of the Exchange Act, 15 U.S.C.

    78c(a)(29), as in effect on the date of enactment of the Futures

    Trading Act of 1982), is a swap (and an SBSA), and not a security-

    based swap. Similarly, and as discussed in more detail below, an

    LTRS based on two or more loans that are not securities (``non-

    security loans'') are swaps, and not security-based swaps.

    ---------------------------------------------------------------------------

    In addition, the Commissions are providing a final interpretation

    providing that, generally, the use of a variable interest rate in the

    TRS buyer's payment obligations to the seller is incidental to the

    purpose of, and the risk that the counterparties assume in, entering

    into the TRS, because such payments are a form of financing reflecting

    the seller's (typically a security-based swap dealer) cost of financing

    the position or a related hedge, allowing the TRS buyer to receive

    payments based on the price appreciation and income of a security or

    security index without purchasing the security or security index. As

    stated in

    [[Page 48265]]

    the Proposing Release, the Commissions believe that when such interest

    rate payments act merely as a financing component in a TRS, or in any

    other security-based swap, the inclusion of such interest rate terms

    would not cause the TRS to be characterized as a mixed swap.\648\

    Financing terms may also involve adding or subtracting a spread to or

    from the financing rate,\649\ or calculating the financing rate in a

    currency other than that of the underlying reference security or

    security index.\650\

    ---------------------------------------------------------------------------

    \648\ See infra part IV.

    \649\ See, e.g., Moorad Chowdry, ``Total Return Swaps: Credit

    Derivatives and Synthetic Funding Instruments,'' at 3-4 (noting that

    the spread to the TRS financing rate is a function of: The credit

    rating of the counterparty paying the financing rate; the amount,

    value, and credit quality of the reference asset; the dealer's

    funding costs; a profit margin; and the capital charge associated

    with the TRS), available at http://www.yieldcurve.com/Mktresearch/LearningCurve/TRS.pdf.

    \650\ For example, a security-based swap on an equity security

    priced in U.S. dollars in which payments are made in Euros based on

    the U.S. dollar/Euro spot rate at the time the payment is made would

    not be a mixed swap. As the Commissions stated in the Proposing

    Release, under these circumstances, the currency is merely

    referenced in connection with the method of payment, and the

    counterparties are not hedging the risk of changes in currency

    exchange rates during the term of the security-based swap See

    Proposing Release at 29842, n. 176.

    ---------------------------------------------------------------------------

    However, where such payments incorporate additional elements that

    create additional interest rate or currency exposures that are

    unrelated to the financing of the security-based swap, or otherwise

    shift or limit risks that are related to the financing of the security-

    based swap, those additional elements may cause the security-based swap

    to be a mixed swap. For example, where the counterparties embed

    interest-rate optionality (e.g., a cap, collar, call, or put) into the

    terms of a security-based swap in a manner designed to shift or limit

    interest rate exposure, the inclusion of these terms would cause the

    TRS to be both a swap and a security-based swap (i.e., a mixed swap).

    Similarly, if a TRS is also based on non-security-based components

    (such as the price of oil, or a currency), the TRS would also be a

    mixed swap.\651\

    ---------------------------------------------------------------------------

    \651\ See Mixed Swaps, infra part IV.

    ---------------------------------------------------------------------------

    The Commissions also are providing an additional interpretation

    regarding a quanto equity swap, in response to comments raised by one

    commenter,\652\ and for illustrative purposes, a similar but

    contrasting product, a compo equity swap. A quanto equity swap, which

    ``can provide a U.S. investor with currency-protected exposure to a

    non-U.S. equity index by translating the percentage equity return in

    the currency of such non-U.S. equity index into U.S. dollars,'' \653\

    can be described as:

    ---------------------------------------------------------------------------

    \652\ See SIFMA Letter.

    \653\ Id.

    An equity swap in which [(1)] the underlying is denominated in a

    currency (the foreign currency) other than that in which the equity

    swap is denominated (the domestic currency) * * * [and (2) t]he

    final value of the underlying is denominated in the foreign currency

    and is converted into the domestic currency using the exchange rate

    prevailing at inception[,] result[ing in] the investor * * * not

    [being] exposed to currency risk.\654\

    ---------------------------------------------------------------------------

    \654\ Handbook of Corporate Equity Derivatives and Equity

    Capital Markets (``Corporate Equity Derivatives Handbook''), Sec.

    1.2.10, at 23, available at http://media.wiley.com/product_data/excerpt/05/11199759/1119975905-83.pdf last visited May 4, 2012.

    While a quanto equity swap, therefore, effectively ``exposes the

    dealer on the foreign leg of the correlation product to a variable

    notional principal amount that changes whenever the exchange rate or

    the foreign index fluctuates,'' \655\ such exposure results from the

    choice of hedges for the quanto equity swap, not from the cash flows of

    the quanto equity swap itself.\656\ Thus, that exposure could be viewed

    as created in the seller by the act of entering into the quanto equity

    swap, rather than as a transfer between the parties, as is required by

    the third prong of the statutory swap definition. Consequently, the

    dealer's exchange rate exposure could be seen as incidental to the

    securities exposure desired by the party initiating the quanto equity

    swap.

    ---------------------------------------------------------------------------

    \655\ James M. Mahoney, Correlation Products and Risk Management

    Issues, FRBNY Economic Policy Review/October 1995 at 2, available at

    http://www.ny.frb.org/research/epr/95v01n3/9510maho.pdf last visited

    May 4, 2012.

    \656\ While applicable in general, this logic, which merely

    expands upon the principle that the character of a Title VII

    instrument as either a swap or a security-based swap should follow

    the underlying factors which are incorporated into the cash flows of

    the instrument--a security, yield, loan, or other trigger for SEC

    jurisdiction or as a commodity triggering CFTC jurisdiction (or both

    for joint jurisdiction), should not be extrapolated to other Title

    VII instruments, for which other principles may override.

    ---------------------------------------------------------------------------

    The Commissions view a quanto equity swap as a security-based swap,

    and not a mixed swap, where (i) the purpose of the quanto equity swap

    is to transfer exposure to the return of a security or security index

    without transferring exposure to any currency or exchange rate risk;

    and (ii) any exchange rate or currency risk exposure incurred by the

    dealer due to a difference in the currency denomination of the quanto

    equity swap and of the underlying security or security index is

    incidental to the quanto equity swap and arises from the instrument(s)

    the dealer chooses to use to hedge the quanto equity swap and is not a

    direct result of any expected payment obligations by either party under

    the quanto equity swap.\657\

    ---------------------------------------------------------------------------

    \657\ Although the SIFMA Letter describes quanto equity swaps in

    terms of equity indexes, if the underlying reference of a quanto

    equity swap is a single security, the result would be the same. The

    Commissions also note that if a security index underlying a quanto

    equity swap is not narrow-based, the quanto equity swap is a swap.

    In that event, it is not a mixed swap because no element of the

    quanto equity swap is a security-based swap and, to be a mixed swap,

    a Title VII instrument must have both swap and security-based swap

    components.

    ---------------------------------------------------------------------------

    By contrast, in a compo equity swap, the parties assume exposure

    to, and the total return is calculated based on, both the performance

    of specified foreign stocks and the change in the relevant exchange

    rate.\658\ Because the counterparty initiating a transaction can choose

    to avoid currency exposure by entering into a quanto equity swap, the

    currency exposure obtained via a compo equity swap is not incidental to

    the equity exposure for purposes of determining mixed swap status. In

    fact, investors seeking synthetic exposure to foreign securities via a

    TRS may also be seeking exposure to the exchange rate between the

    currencies, as evidenced by the fact that a number of mutual funds

    exist in both hedged and unhedged versions to provide investors

    exposure to the same foreign securities with or without the attendant

    currency

    [[Page 48266]]

    exposure.\659\ Consequently, a compo equity swap is a mixed swap.\660\

    ---------------------------------------------------------------------------

    \658\ See generally Corporate Equity Derivatives Handbook, supra

    note 654, Sec. 1.2.9, at 21-23.

    \659\ See, e.g., Descriptive Brochure: The Tweedy, Browne Global

    Value Fund II--Currency Unhedged at 1, available at http://www.tweedy.com/resources/gvf2/TBGVF-II_verJuly2011.pdf (last

    visited May 4, 2012) (comparing the Tweedy, Browne Global Value Fund

    II--Currency Unhedged and the Tweedy, Browne Global Value Fund

    (which hedges its currency exposure) and stating that ``[t]he only

    material difference [between the funds] is that the Unhedged Global

    Value Fund generally does not hedge currency risk [and] is designed

    for long-term value investors who wish to focus their investment

    exposure on foreign stock markets, and their associated non-U.S.

    currencies'' and ``[b]y establishing the Tweedy, Browne Global Value

    Fund II--Currency Unhedged, we were acknowledging that many

    investors may view exposure to foreign currency as another form of

    diversification when investing outside the U.S., and/or may have

    strong opinions regarding the future direction of the U.S.

    dollar.''). See also the PIMCO Foreign Bond Fund (Unhedged) Fact

    Sheet at 1 (stating that ``[t]he fund seeks to capture the returns

    of non-U.S. bonds including potential returns due to changes in

    exchange rates. In a declining dollar environment foreign currency

    appreciation may augment the returns generated by investments in

    foreign bonds.''), available at http://investments.pimco.com/ShareholderCommunications/External%20Documents/Foreign%20Bond%20Fund%20(Unhedged)%20Institutional.pdf last visited

    May 4, 2012 and the PIMCO Foreign Bond Fund (U.S. Dollar-Hedged)

    INSTL Fact Sheet at 1 (stating that ``[t]he fund seeks to capture

    the returns of non-U.S. bonds but generally hedges out most currency

    exposure in order to limit the volatility of returns.''), available

    at http://investments.pimco.com/ShareholderCommunications/External%20Documents/Foreign%20Bond%20Fund%20(U.S.%20Dollar-

    Hedged)%20Institutional.pdf (last visited May 4, 2012).

    \660\ Such swaps are examples of swaps with payments that

    ``incorporate additional elements that create additional * * *

    currency exposures * * * unrelated to the financing of the security-

    based swap * * * that may cause the security-based swap to be a

    mixed swap.'' See Proposing Release at 29842.

    ---------------------------------------------------------------------------

    In response to comments,\661\ the Commissions also are providing an

    interpretation with respect to the treatment of loan TRS (``LTRS'') on

    two or more loans. As noted above, the second prong of the security-

    based swap definition includes a swap that is based on ``a single

    security or loan, including any interest therein or on the value

    thereof.'' Thus, an LTRS based on a single loan, as mentioned above, is

    a security-based swap. The Commissions believe, however, that an LTRS

    based on two or more non-security loans are swaps, and not security-

    based swaps.\662\ An LTRS on a group or index of such non-security

    loans is not covered by the first prong of the security-based swap

    definition--swaps based on a narrow-based security index--because the

    definition of the term ``narrow-based security index'' in both the CEA

    and the Exchange Act only applies to securities, and not to non-

    security loans.\663\ An LTRS, moreover, is not covered by the third

    prong of the security-based swap definition because it is based on the

    total return of such loans, and not events related thereto.

    Accordingly, an LTRS on two or more loans that are non-security loans

    is a swap and not a security-based swap.\664\

    ---------------------------------------------------------------------------

    \661\ See infra note 667 and accompanying text.

    \662\ Depending on the facts and circumstances loans may be

    notes or evidences of indebtedness that are securities. See section

    3(a)(10) of the Exchange Act. In this section, the Commissions

    address only groups or indexes of loans that are not securities.

    \663\ See CEA section 1a(35), 7 U.S.C. 1a(35), and section

    3(a)(55) of the Exchange Act, 15 U.S.C. 78c(a)(55).

    \664\ The same would be true with respect to swaps (e.g.,

    options, CFDs, NDFs), other than LTRS or loan index credit default

    swaps, on two or more loans that are not securities.

    ---------------------------------------------------------------------------

    Comments

    The Commissions received three comments with respect to the

    interpretation provided on TRS in the Proposing Release.\665\ One of

    these commenters addressed the Commissions' interpretation on security-

    based TRS.\666\ The other two commenters requested that the Commissions

    clarify the treatment of LTRS on two or more loans.\667\

    ---------------------------------------------------------------------------

    \665\ See July LSTA Letter; Letter from David Lucking, Allen &

    Overy LLP, dated May 26, 2011 (``Allen & Overy Letter''); and SIFMA

    Letter.

    \666\ See SIFMA Letter.

    \667\ See Allen & Overy Letter and July LSTA Letter.

    ---------------------------------------------------------------------------

    One commenter asserted that the terms of a TRS that create interest

    rate or currency exposures incidental to the primary purpose of the TRS

    should not cause a transaction that otherwise would be deemed to be a

    security-based swap to be characterized as a mixed swap.\668\ This

    commenter agreed with the Commissions that the scope of the mixed swap

    category of Title VII instruments is intended to be narrow and that,

    when variable interest rates are used for financing purposes incidental

    to counterparties' purposes, and risks assumed, in entering into a TRS,

    the TRS is a security-based swap and not a mixed swap.\669\

    ---------------------------------------------------------------------------

    \668\ See SIFMA Letter.

    \669\ Id.

    ---------------------------------------------------------------------------

    This commenter also opined that the Commissions' interpretation

    that ``where such payments incorporate additional elements that create

    additional interest rate or currency exposures * * * unrelated to the

    financing of the [TRS], or otherwise shift or limit risks that are

    related to the financing of the [TRS], those additional elements may

    cause the [TRS] to be a mixed swap'' could be seen as requiring a

    quantitative analysis to determine whether a reference to interest

    rates or currencies in a TRS is solely for financing purposes or

    creates additional exposure that might be construed as extending beyond

    those purposes.\670\

    ---------------------------------------------------------------------------

    \670\ Id. SIFMA added that such a determination could require

    market participants to determine whether a specific interest rate or

    spread referenced in the TRS is sufficiently in line with market

    rates to constitute a financing leg of a transaction under the

    proposed test. SIFMA continues by noting that there are a number of

    examples where a TRS can provide for some interest rate or currency

    exposure incidental to the primary purpose of the TRS, describing a

    quanto equity swap as an example.

    ---------------------------------------------------------------------------

    The Commissions are clarifying that a quantitative analysis is not

    necessarily required in order to determine whether a TRS is a mixed

    swap. Any analysis, quantitative or qualitative, clearly demonstrating

    the nature of a payment (solely financing-related, unrelated to

    financing or a combination of the two) can suffice.\671\

    ---------------------------------------------------------------------------

    \671\ To the extent a market participant is uncertain as to the

    results of such an analysis, it may seek informal guidance from the

    Commissions' staffs or use the process established in this release,

    see infra part VI, for seeking formal guidance from the Commissions

    as to the nature of a Title VII instrument as a swap, security-based

    swap or mixed swap.

    ---------------------------------------------------------------------------

    The Commissions also are clarifying that market participants are

    not necessarily required to compare their financing rates to market

    financing rates in order to determine whether the financing leg of a

    TRS is merely a financing leg or is sufficient to render the TRS a

    mixed swap. Because a number of factors can influence how a particular

    TRS is structured,\672\ the Commissions cannot provide an

    interpretation applicable to all situations. If the financing leg of a

    TRS reflects the dealer's financing costs on a one-to-one basis, the

    Commissions would view such leg as a financing leg. Adding a spread

    would not alter that conclusion if the spread is consistent with the

    dealer's course of dealing generally, with respect to a particular type

    of TRS or with respect to a particular counterparty. The Commissions

    believe that this would be the case even if the spread is ``off-

    market,'' if the deviance from a market spread is explained by factors

    unique to the dealer (e.g., the dealer has high financing costs), to

    the TRS (e.g., the underlying securities are highly illiquid, so

    financing them is more costly than would be reflected in a ``typical''

    market spread for other TRS) or to then-current market conditions

    (e.g., a share repurchase might make shares harder

    [[Page 48267]]

    for a dealer to procure in order to hedge its obligations under a TRS

    to pay its counterparty the capital appreciation of a security,

    resulting in higher financing costs due to the decrease in shares

    outstanding, assuming demand for the shares does not change). If the

    spread is designed to provide exposure to an underlying reference other

    than securities, however, rather than to reflect financing costs, such

    a TRS is a mixed swap.

    ---------------------------------------------------------------------------

    \672\ For example, the Commissions would expect a dealer

    perceived by the market to constitute a higher counterparty risk to

    have higher funding costs generally, which might affect its TRS

    financing costs. To the extent such a dealer passed through its

    higher TRS financing costs to its TRS counterparty, such a pass-

    through simply would reflect the dealer's specific circumstances,

    and would not transform the TRS from a security-based swap into a

    mixed swap.

    ---------------------------------------------------------------------------

    Market participants are better positioned than are the Commissions

    to determine what analysis, and what supporting information and

    materials, best establish whether the nature of a particular payment

    reflects financing costs alone, or something more. Moreover, the

    Commissions expect that a dealer would know if the purpose of the

    payment(s) in question is to cover its cost of financing a position or

    a related hedge.\673\ In such cases, a detailed analysis should not be

    necessary.

    ---------------------------------------------------------------------------

    \673\ The Commissions expect that dealers know their financing

    costs and can readily explain the components of the financing leg

    paid by their TRS counterparties.

    ---------------------------------------------------------------------------

    One commenter noted the nature of quanto equity swaps as TRS and

    maintained that such a transaction ``is equivalent to a financing of a

    long position in the underlying non-U.S. equity index[]'' and that the

    currency protection is incidental to the financing element, which is

    the primary purpose of the TRS.\674\ As discussed above, the

    Commissions have provided a final interpretation regarding the

    appropriate classification of Title VII instruments that are quanto

    equity swaps and compo equity swaps.

    ---------------------------------------------------------------------------

    \674\ Id. SIFMA distinguished quanto equity swaps from the

    examples of mixed swaps that the Commissions provided in the

    Proposing Release, characterizing them as ``very different.''

    ---------------------------------------------------------------------------

    Two commenters requested that the Commissions clarify the status of

    LTRS on two or more loans.\675\ Both commenters stated that while the

    statutory definition of the term ``security-based swap'' provides that

    swaps based on a single loan are security-based swaps, it does not

    explicitly provide whether swaps on indexes of loans are security-based

    swaps.\676\ They requested clarification regarding the treatment of

    loan based swaps, including both LTRS and loan index credit default

    swaps.\677\

    ---------------------------------------------------------------------------

    \675\ See Allen & Overy Letter and July LSTA Letter.

    \676\ See Allen & Overy Letter. Allen & Overy notes that a Title

    VII Instrument that references two securities is a security-based

    swap. It believes that treating an LTRS on two or more loans as a

    swap would result in functionally and potentially economically

    similar products being treated in an arbitrarily different way,

    contrary to the spirit of the Dodd-Frank Act.

    \677\ The Commissions address the comments regarding loan index

    credit default swaps below. See infra note 768 and accompanying

    text.

    ---------------------------------------------------------------------------

    The Commissions have provided the final interpretation discussed

    above regarding LTRS based on two or more loans that are not

    securities. The Commissions acknowledge that this interpretation

    results in different treatment for an LTRS on two non-security loans (a

    swap), as opposed to a Title VII instrument based on two securities (a

    security-based swap). This result, however, is dictated by the statute.

    D. Security-Based Swaps Based on a Single Security or Loan and Single-

    Name Credit Default Swaps

    The Commissions provided an interpretation in the Proposing Release

    regarding security-based swaps based on a single security or loan and

    single-name CDS \678\ and are restating such interpretation with

    certain modifications in response to commenters.\679\ The second prong

    of the statutory security-based swap definition includes a swap that is

    based on ``a single security or loan, including any interest therein or

    on the value thereof.'' \680\ The Commissions believe that under this

    prong of the security-based swap definition, a single-name CDS that is

    based on a single reference obligation would be a security-based swap

    because it would be based on a single security or loan (or any interest

    therein or on the value thereof).

    ---------------------------------------------------------------------------

    \678\ See Proposing Release at 29843.

    \679\ See infra note 689 and accompanying text.

    \680\ Section 3(a)(68)(A)(ii)(II) of the Exchange Act, 15 U.S.C.

    78c(a)(68)(A)(ii)(II). The first prong of the security-based swap

    definition is discussed below. See infra part III.G.

    ---------------------------------------------------------------------------

    In addition, the third prong of the security-based swap definition

    includes a swap that is based on the occurrence of an event relating to

    a ``single issuer of a security,'' provided that such event ``directly

    affects the financial statements, financial condition, or financial

    obligations of the issuer.'' \681\ This provision applies generally to

    event-triggered swap contracts. With respect to a CDS, such events

    could include, for example, the bankruptcy of an issuer, a default on

    one of an issuer's debt securities, or the default on a non-security

    loan of an issuer.\682\

    ---------------------------------------------------------------------------

    \681\ Section 3(a)(68)(A)(ii)(III) of the Exchange Act, 15

    U.S.C. 78c(a)(68)(A)(ii)(III).

    \682\ The Commissions understand that in the context of credit

    derivatives on asset-backed securities or MBS, the events include

    principal writedowns, failure to pay principal and interest

    shortfalls.

    ---------------------------------------------------------------------------

    The Commissions believe that if the payout on a CDS on a single

    issuer of a security is triggered by the occurrence of an event

    relating to that issuer, the CDS is a security-based swap under the

    third prong of the statutory security-based swap definition.\683\

    ---------------------------------------------------------------------------

    \683\ The Commissions understand that some single-name CDS now

    trade with fixed coupon payments expressed as a percentage of the

    notional amount of the transaction and payable on a periodic basis

    during the term of the transaction. See Markit, ``The CDS Big Bang:

    Understanding the Changes to the Global CDS Contract and North

    American Conventions,'' 3, available at http://www.markit.com/cds/announcements/resource/cds_big_bang.pdf. The Commissions are

    restating their view that the existence of such single-name CDS does

    not change their interpretation.

    ---------------------------------------------------------------------------

    In relation to aggregations of transactions under a single ISDA

    Master Agreement,\684\ the Commissions are revising the example that

    was included in the Proposing Release referring to single-name CDS to

    clarify that the interpretation regarding aggregations of transactions

    is non-exclusive and thus not limited to either CDS or single-reference

    instruments.\685\

    ---------------------------------------------------------------------------

    \684\ See Proposing Release at 29843.

    \685\ See infra note 689 and accompanying text.

    ---------------------------------------------------------------------------

    The Commissions believe that each transaction under an ISDA Master

    Agreement would need to be analyzed to determine whether it is a swap

    or security-based swap. For example, the Commissions believe that a

    number of Title VII instruments that are executed at the same time and

    that are documented under one ISDA Master Agreement, but in which a

    separate confirmation is sent for each instrument, should be treated as

    an aggregation of such Title VII instruments, each of which must be

    analyzed separately under the swap and security-based swap

    definitions.\686\ The Commissions believe that, as a practical and

    economic matter, each such Title VII instrument would be a separate and

    independent transaction. Thus, such an aggregation of Title VII

    instruments would not constitute a Title VII instrument based on one

    ``index or group'' \687\ under the security-based swap definition but

    instead would constitute multiple Title VII instruments. The

    Commissions find that this interpretation is an appropriate way to

    address CDS, TRS or other Title VII instruments referencing a single

    security or loan or entity that is documented under a Master Agreement

    or Master Confirmation and is designed to reduce the cost associated

    with determining

    [[Page 48268]]

    whether such instruments are swaps or security-based swaps.\688\

    ---------------------------------------------------------------------------

    \686\ See infra note 691.

    \687\ The security-based swap definition further defines ``index

    to include an ``index or group of securities.'' See section

    3(a)(68)(E) of the Exchange Act, 15 U.S.C. 78c(a)(68)(E).

    \688\ See supra part I, under ``Overall Economic

    Considerations''.

    ---------------------------------------------------------------------------

    Comments

    The Commissions received two comments regarding the interpretation

    regarding aggregation of Title VII instruments under a single ISDA

    Master Agreement. One commenter requested that the Commissions clarify

    that the interpretation applies to other types of instruments, such as

    TRS, in addition to CDS.\689\ The commenter also stated that the

    interpretation should be helpful with respect to use of a ``Master

    Confirmation'' structure, which the commenter described as use of

    general terms in a ``Master Confirmation'' that apply to a number of

    instruments with separate underlying references but for which a

    separate ``Supplemental Confirmation'' is sent for each separate

    component.\690\

    ---------------------------------------------------------------------------

    \689\ See July LSTA Letter.

    \690\ Id.

    ---------------------------------------------------------------------------

    A second commenter agreed with the Commissions' interpretation that

    a number of single-name CDS that are executed at the same time and that

    are documented under one ISDA Master Agreement, but in which a separate

    confirmation is sent for each CDS, should not be treated as a single

    index CDS and stated that this approach is consistent with market

    practice.\691\

    ---------------------------------------------------------------------------

    \691\ See Letter from Richard M. McVey, Chairman and Chief

    Executive Officer, MarketAxess Holdings, Inc. (``MarketAxess''),

    July 22, 2011 (``MarketAxess Letter'').

    ---------------------------------------------------------------------------

    As discussed above, in response to comments the Commissions are

    expanding the example so it is clear that it applies beyond just

    CDS.\692\

    ---------------------------------------------------------------------------

    \692\ The Commissions believe, based on the July LSTA Letter,

    that the ``Master Confirmation'' structure the commenter described

    is the same general structure as the aggregation of single-name CDS

    the Commissions provided as an example in the Proposing Release, but

    that a ``Master Confirmation'' structure may not be limited to

    single-reference instruments or to CDS and instead may be used for a

    broader range of instruments. See July LSTA Letter. The Commissions

    note that the following are examples of ``Master Confirmation''

    structure to which the interpretive guidance would apply: 2009

    Americas Master Equity Derivatives Confirmation Agreement, Stand-

    alone 2007 Americas Master Variance Swap Confirmation Agreement, and

    2004 Americas Interdealer Master Equity Derivatives Confirmation

    Agreement and March 2004 Canadian Supplement to the Master

    Confirmation. The Commissions believe the broader example in this

    release provides the clarification the commenter requested.

    ---------------------------------------------------------------------------

    E. Title VII Instruments Based on Futures Contracts

    The Commissions proposed an interpretation in the Proposing Release

    regarding the treatment, generally, of swaps based on futures

    contracts.\693\ The Commissions are restating the interpretation they

    provided in the Proposing Release without modification. The Commissions

    also discussed in the Proposing Release the unique circumstance

    involving certain futures contracts on foreign government debt

    securities and requested comment as to how Title VII instruments on

    these futures contracts should be treated.\694\ In response to

    commenters,\695\ the Commissions are adopting a rule regarding the

    treatment of Title VII instruments on certain futures contracts on

    foreign government debt securities.\696\

    ---------------------------------------------------------------------------

    \693\ See Proposing Release at 29843-44.

    \694\ Id.

    \695\ See infra note 718 and accompanying text.

    \696\ See rule 1.3(bbbb) under the CEA and rule 3a68-5 under the

    Exchange Act.

    ---------------------------------------------------------------------------

    A Title VII instrument that is based on a futures contract will

    either be a swap or a security-based swap, or both (i.e., a mixed

    swap), depending on the nature of the futures contract, including the

    underlying reference of the futures contract. Thus, a Title VII

    instrument where the underlying reference is a security future is a

    security-based swap.\697\ In general, a Title VII instrument where the

    underlying reference is a futures contract that is not a security

    future is a swap.\698\ As the Commissions noted in the Proposing

    Release,\699\ Title VII instruments involving certain futures contracts

    on foreign government debt securities present a unique circumstance,

    which is discussed below.

    ---------------------------------------------------------------------------

    \697\ A security future is defined in both the CEA and the

    Exchange Act as a futures contract on a single security or a narrow-

    based security index, including any interest therein or based on the

    value thereof, except an exempted security under section 3(a)(12) of

    the Exchange Act, 15 U.S.C. 78c(a)(12), as in effect on the date of

    enactment of the Futures Trading Act of 1982 (other than any

    municipal security as defined in section 3(a)(29) of the Exchange

    Act, 15 U.S.C. 78c(a)(29), as in effect on the date of enactment of

    the Futures Trading Act of 1982).

    The term security future does not include any agreement,

    contract, or transaction excluded from the CEA under sections 2(c),

    2(d), 2(f), or 2(g) of the CEA, 7 U.S.C. 2(c), 2(d), 2(f), or 2(g),

    as in effect on the date of enactment of the Commodity Futures

    Modernization Act of 2000 (``CFMA'') or Title IV of the CFMA. See

    section 1a(44) of the CEA, 7 U.S.C. 1a(44), and section 3(a)(55) of

    the Exchange Act, 15 U.S.C. 78c(a)(55).

    \698\ Depending on the underlying reference of the futures

    contract, though, such swaps could be SBSAs. For example, a swap on

    a future on the S&P 500 index would be an SBSA.

    \699\ See Proposing Release at 29843.

    ---------------------------------------------------------------------------

    Rule 3a12-8 under the Exchange Act exempts certain foreign

    government debt securities, for purposes only of the offer, sale, or

    confirmation of sale of futures contracts on such foreign government

    debt securities, from all provisions of the Exchange Act which by their

    terms do not apply to an ``exempted security,'' subject to certain

    conditions.\700\ To date, the SEC has enumerated within rule 3a12-8 the

    debt securities of 21 foreign governments solely for purposes of

    futures trading (``21 enumerated foreign governments'').\701\

    ---------------------------------------------------------------------------

    \700\ Specifically, rule 3a12-8 under the Exchange Act requires

    as a condition to the exemption that the foreign government debt

    securities not be registered under the Securities Act (or be the

    subject of any American depositary receipt registered under the

    Securities Act) and that futures contracts on such foreign

    government debt securities ``require delivery outside the United

    States, [and] any of its possessions or territories, and are traded

    on or through a board of trade, as defined in [section 2 of the CEA,

    7 U.S.C. 2].'' See rules 3a12-8(a)(2) and 3a12-8(b) under the

    Exchange Act, 17 CFR 240.3a12-8(a)(2) and 240.3a12-8(b). These

    conditions were ``designed to minimize the impact of the exemption

    on securities distribution and trading in the United States. * * *''

    See Exemption for Certain Foreign Government Securities for Purposes

    of Futures Trading, 49 FR 8595 (Mar. 8, 1984) at 8596-97 (citing

    Futures Trading Act of 1982).

    \701\ See rule 3a12-8(a)(1) under the Exchange Act (designating

    the debt securities of the governments of the United Kingdom,

    Canada, Japan, Australia, France, New Zealand, Austria, Denmark,

    Finland, the Netherlands, Switzerland, Germany, Ireland, Italy,

    Spain, Mexico, Brazil, Argentina, Venezuela, Belgium, and Sweden).

    ---------------------------------------------------------------------------

    The Commissions recognize that as a result of rule 3a12-8, futures

    contracts on the debt securities of the 21 enumerated foreign

    governments that satisfy the conditions of rule 3a12-8 are subject to

    the CFTC's exclusive jurisdiction and are not considered security

    futures. As a result, applying the interpretation above to a Title VII

    instrument that is based on a futures contract on the debt securities

    of these 21 enumerated foreign governments would mean that the Title

    VII instrument would be a swap.\702\ The Commissions note, however,

    that the conditions in rule 3a12-8 were established specifically for

    purposes of the offer and sale of ``qualifying foreign futures

    contracts'' (as defined in rule 3a12-8) \703\ on the debt securities of

    the 21 enumerated foreign governments,\704\ not Title VII instruments

    based on futures contracts on the debt securities

    [[Page 48269]]

    of the 21 enumerated governments. Further, the Commissions note that

    the Dodd-Frank Act did not exclude swaps on foreign government debt

    securities generally from the definition of the term ``security-based

    swap.'' Accordingly, a Title VII instrument that is based directly on

    foreign government debt securities, including those of the 21

    enumerated governments, is a security-based swap or a swap under the

    same analysis as any other Title VII instruments based on securities.

    ---------------------------------------------------------------------------

    \702\ The Commissions note, by contrast, that a Title VII

    instrument that is based on the price or value of, or settlement

    into, a futures contract on the debt securities of one of the 21

    enumerated foreign governments and that also has the potential to

    settle directly into such debt securities would be a security-based

    swap and, depending on other features of the Title VII instrument,

    possibly a mixed swap.

    \703\ Rule 3a12-8(b) under the Exchange Act defines ``qualifying

    foreign futures contracts'' as ``contracts for the purchase or sale

    of a designated foreign government security for future delivery, as

    `future delivery' is defined in 7 U.S.C. 2, provided such contracts

    require delivery outside the United States, any of its possessions

    or territories, and are traded on or through a board of trade, as

    defined at 7 U.S.C. 2.'' 17 CFR 240.3a12-8(b).

    \704\ See supra note 700.

    ---------------------------------------------------------------------------

    The Commissions indicated in the Proposing Release that they would

    evaluate whether Title VII instruments based on futures contracts on

    the debt securities of the 21 enumerated foreign governments that

    satisfy the conditions of rule 3a12-8 should be characterized as swaps,

    security-based swaps, or mixed swaps.\705\ In response to

    commenters,\706\ the Commissions are adopting rule 1.3(bbbb) under the

    CEA and rule 3a68-5 under the Exchange Act, which address the treatment

    of these Title VII instruments.

    ---------------------------------------------------------------------------

    \705\ See Proposing Release at 29844.

    \706\ See infra note 718 and accompanying text.

    ---------------------------------------------------------------------------

    The final rules provide that a Title VII instrument that is based

    on or references a qualifying foreign futures contract on the debt

    securities of one or more of the 21 enumerated foreign governments is a

    swap and not a security-based swap, provided that the Title VII

    instrument satisfies the following conditions:

    The futures contract on which the Title VII instrument is

    based or that is referenced is a qualifying foreign futures contract

    (as defined in rule 3a12-8) \707\ on the debt securities of any one or

    more of the 21 enumerated foreign governments that satisfies the

    conditions of rule 3a12-8;

    ---------------------------------------------------------------------------

    \707\ See supra note 703.

    ---------------------------------------------------------------------------

    The Title VII instrument is traded on or through a board

    of trade (as defined in section 1a(6) of the CEA);

    The debt securities on which the qualifying foreign

    futures contract is based or referenced and any security used to

    determine the cash settlement amount pursuant to the fourth condition

    below are not covered by an effective registration statement under the

    Securities Act or the subject of any American depositary receipt

    covered by an effective registration statement under the Securities

    Act;

    The Title VII instrument may only be cash settled; and

    The Title VII instrument is not entered into by the issuer

    of the securities upon which the qualifying foreign futures contract is

    based or referenced (including any security used to determine the cash

    payment due on settlement of such Title VII instrument), an affiliate

    (as defined in the Securities Act and the rules and regulations

    thereunder) \708\ of the issuer, or an underwriter with respect to such

    securities.

    ---------------------------------------------------------------------------

    \708\ See, e.g., rule 405 under the Securities Act, 17 CFR

    230.405.

    ---------------------------------------------------------------------------

    Under the first condition, the final rules provide that the futures

    contract on which the Title VII instrument is based or referenced must

    be a qualifying foreign futures contract that satisfies the conditions

    of rule 3a12-8 and may only be based on the debt of any one or more of

    the enumerated 21 foreign governments. If the conditions of rule 3a12-8

    are not satisfied, then there cannot be a qualifying foreign futures

    contract, the futures contract is a security future, and a swap on such

    a security future is a security-based swap.

    The second condition of the final rules provides that the Title VII

    instrument on the qualifying foreign futures contract must itself be

    traded on or through a board of trade because a qualifying foreign

    futures contract on the debt securities of one or more of the 21

    enumerated foreign governments itself is required to be traded on a

    board of trade. The Commissions believe that swaps on such futures

    contracts should be traded subject to rules applicable to such futures

    contracts themselves.

    The third condition of the final rules provides that the debt

    securities on which the qualifying foreign futures contract is based or

    referenced and any security used to determine the cash settlement

    amount pursuant to the fourth condition cannot be registered under the

    Securities Act or be the subject of any American depositary receipt

    registered under the Securities Act. This condition is intended to

    prevent circumvention of registration and disclosure requirements of

    the Securities Act applicable to foreign government issuances of their

    securities. This condition is similar to a condition included in rule

    3a12-8.\709\

    ---------------------------------------------------------------------------

    \709\ See supra note 700.

    ---------------------------------------------------------------------------

    The fourth condition of the final rules provides that the Title VII

    instrument must be cash settled. Although, as the Commissions

    recognize, rule 3a12-8 permits a qualifying foreign futures contract to

    be physically settled so long as delivery is outside the United States,

    any of its possessions or territories,\710\ in the context of Title VII

    instruments, only cash settled Title VII instruments based on

    qualifying foreign futures contracts on the debt securities of the 21

    enumerated foreign governments will be considered swaps. The

    Commissions believe that this condition is appropriate in order to

    provide consistent treatment of Title VII instruments based on

    qualifying foreign futures contracts on the debt securities of the 21

    enumerated foreign governments with the Commissions' treatment of swaps

    and security-based swaps generally.\711\

    ---------------------------------------------------------------------------

    \710\ Id.

    \711\ See infra part III.H.

    ---------------------------------------------------------------------------

    The fifth condition of the final rules provides that for a Title

    VII instrument to be a swap under such rules, it cannot be entered into

    by the issuer of the securities upon which the qualifying foreign

    futures contract is based or referenced (including any security used to

    determine the cash payment due on settlement of such Title VII

    instrument), an affiliate of the issuer, or an underwriter of the

    issuer's securities. The Commissions have included this condition to

    address the concerns raised by the SEC in the Proposing Release that

    the characterization of a Title VII instrument that is based on a

    futures contract on the debt securities of one of the 21 enumerated

    foreign governments may affect Federal securities law provisions

    relating to the distribution of the securities upon which the Title VII

    instrument is based or referenced.\712\

    ---------------------------------------------------------------------------

    \712\ See Proposing Release at 29844.

    ---------------------------------------------------------------------------

    The Dodd-Frank Act included provisions that would not permit

    issuers, affiliates of issuers, or underwriters to use security-based

    swaps to offer or sell the issuers' securities underlying a security-

    based swap without complying with the requirements of the Securities

    Act.\713\ This provision applies regardless of whether the Title VII

    instrument allows the parties to physically settle any such security-

    based swap. In addition, the Dodd-Frank Act provided that any offer or

    sale of security-based swaps to non-ECPs would have to be registered

    under the Securities Act.\714\ For example, if a Title VII instrument

    that is based on a futures contract on the debt securities of one of

    the 21 enumerated foreign governments is characterized as a swap, and

    not a security-based swap, then the provisions of the Dodd-Frank Act

    enacted to ensure that there could not be offers and sales of

    securities made without compliance with the Securities Act, either by

    issuers, their affiliates, or underwriters or to non-ECPs, would not

    apply to such swap transactions.

    ---------------------------------------------------------------------------

    \713\ See section 2(a)(3) of the Securities Act, 15 U.S.C.

    77b(a)(3), as amended by the Dodd-Frank Act.

    \714\ See section 5 of the Securities Act, 15 U.S.C. 77e, as

    amended by the Dodd-Frank Act.

    ---------------------------------------------------------------------------

    Only those Title VII instruments that are based on qualifying

    foreign futures contracts on the debt securities of the 21

    [[Page 48270]]

    enumerated foreign governments and that satisfy these five conditions

    will be swaps, not security-based swaps. The Commissions note that the

    final rules are intended to provide consistent treatment (other than

    with respect to method of settlement) of qualifying foreign futures

    contracts and Title VII instruments based on qualifying foreign futures

    contracts on the debt securities of the 21 enumerated foreign

    governments.\715\ The Commissions understand that many of the

    qualifying foreign futures contracts on the debt securities of the 21

    enumerated foreign governments trade with substantial volume through

    foreign trading venues under the conditions set forth in rule 3a12-8

    \716\ and permitting swaps on such futures contracts subject to similar

    conditions would not raise concerns that such swaps could be used to

    circumvent the conditions of rule 3a12-8 and the Federal securities

    laws concerns that such conditions are intended to protect.\717\

    Further, providing consistent treatment for qualifying foreign futures

    contracts on the debt securities of the 21 enumerated foreign

    governments and Title VII instruments based on futures contracts on the

    debt securities of the 21 enumerated foreign governments will allow

    trading of these instruments through designated contract markets on

    which such futures are listed.

    ---------------------------------------------------------------------------

    \715\ The Commissions note that the final rules provide

    consistent treatment of qualifying foreign futures contracts on the

    debt securities of the 21 enumerated foreign governments and Title

    VII instruments based on qualifying foreign futures contracts on the

    debt securities of the 21 enumerated foreign governments unless the

    Title VII instrument is entered into by the issuer of the securities

    upon which the qualifying foreign futures contract is based or

    referenced (including any security used to determine the cash

    payment due on settlement of such Title VII instrument), an

    affiliate of the issuer, or an underwriter with respect to such

    securities.

    \716\ For the quarter that ended December 31, 2011, the trading

    volume reported to the CFTC of qualifying foreign futures contracts

    on the debt securities of the 21 enumerated foreign governments made

    available for trading by direct access from the U.S. on foreign

    trading venues granted direct access no-action relief by the CFTC

    that exceeded 100,000 contracts per quarter from the U.S. were as

    follows: (i) 7,985,959 contracts for 3 Year Treasury Bond Futures on

    the Australian Securities Exchange's ASX Trade24 platform; (ii)

    1,872,592 contracts for 10-Year Government of Canada Bond Futures on

    the Bourse de Montreal; (iii) 47,874,911 contracts for Euro Bund

    Futures on Eurex Deutschland (``Eurex''); (iv) 26,434,713 contracts

    for Euro Bobl Futures on Eurex; (v) 30,489,427 contracts for Euro

    Schatz Futures on Eurex; and (vi) 8,292,222 contracts for Long Gilt

    Futures on the NYSE LIFFE.

    \717\ See supra note 712 and accompanying text.

    ---------------------------------------------------------------------------

    The Commissions recognize that the rules may result in a different

    characterization of a Title VII instrument that is based directly on a

    foreign government debt security and one that is based on a qualifying

    foreign futures contract on a debt security of one of the 21 enumerated

    foreign governments. However, the Commissions note that this is the

    case today (i.e., different treatments) with respect to other

    instruments subject to CFTC regulation and/or SEC regulation, such as

    futures on broad-based security indexes and futures on a single

    security or narrow-based security index.

    Comments

    Commenters did not address the interpretation as it applied to

    Title VII instruments based on futures contracts generally. Two

    commenters addressed Title VII instruments based on futures contracts

    on debt securities of the 21 enumerated foreign governments.\718\ Both

    commenters requested that the Commissions treat these Title VII

    instruments as swaps.\719\ The Commissions agree that these instruments

    should be treated as swaps under certain conditions and, therefore, are

    adopting rule 1.3(bbbb) under the CEA and rule 3a68-5 under the

    Exchange Act as discussed above to treat Title VII instruments based on

    qualifying foreign futures contracts on the debt securities of the 21

    enumerated foreign governments as swaps, provided such Title VII

    instruments satisfy certain conditions.

    ---------------------------------------------------------------------------

    \718\ See CME Letter and SIFMA Letter.

    \719\ Id. Both commenters stated their belief that the range of

    factors considered by the SEC in designating the debt securities of

    the 21 enumerated foreign governments as exempted securities

    indicated that there is sufficient disclosure about the 21

    enumerated foreign governments and their securities such that the

    further disclosure should not be necessary. Both commenters also

    indicated that subjecting futures contracts on the debt securities

    of the 21 enumerated foreign governments to CFTC regulation, while

    subjecting Title VII instruments based on these futures contracts to

    SEC regulation, would be problematic. Id.

    ---------------------------------------------------------------------------

    F. Use of Certain Terms and Conditions in Title VII Instruments

    The Commissions provided an interpretation in the Proposing Release

    regarding the use of certain fixed terms in Title VII instruments and

    are restating that interpretation without modification.\720\ The

    Commissions are aware that market participants' setting of certain

    fixed terms or conditions of Title VII instruments may be informed by

    the value or level of a security, rate, or other commodity at the time

    of the execution of the instrument. The Commissions believe that, in

    evaluating whether a Title VII instrument with such a fixed term or

    condition is a swap or security-based swap, the nature of the security,

    rate, or other commodity that informed the setting of such fixed term

    or condition should not itself impact the determination of whether the

    Title VII instrument is a swap or a security-based swap, provided that

    the fixed term or condition is set at the time of execution and the

    value or level of that fixed term or condition may not vary over the

    life of the Title VII instrument.\721\

    ---------------------------------------------------------------------------

    \720\ See Proposing Release at 29845.

    \721\ This interpretation relates solely to the determination

    regarding whether a Title VII instrument is a swap or security-based

    swap. The Commissions are not expressing a view regarding whether

    such Title VII instrument would be a security-based swap agreement.

    ---------------------------------------------------------------------------

    For example, a Title VII instrument, such as an interest rate swap,

    in which floating payments based on three-month LIBOR are exchanged for

    fixed rate payments of five percent would be a swap, and not a

    security-based swap, even if the five percent fixed rate was informed

    by, or quoted based on, the yield of a security, provided that the five

    percent fixed rate was set at the time of execution and may not vary

    over the life of the Title VII instrument.\722\ Another example would

    be where a private sector or government borrower that issues a five-

    year, amortizing $100 million debt security with a semi-annual coupon

    of LIBOR plus 250 basis points also, at the same time, chooses to enter

    into a five-year interest rate swap on $100 million notional in which

    this same borrower, using the same amortization schedule as the debt

    security, receives semi-annual payments of LIBOR plus 250 basis points

    in exchange for five percent fixed rate payments. The fact that the

    specific terms of the interest rate swap (e.g., five-year, LIBOR plus

    250 basis points, $100 million notional, fixed amortization schedule)

    were set at the time of execution to match related terms of a debt

    security does not cause the interest rate swap to become a security-

    based swap. However, if the interest rate swap contained additional

    terms that were in fact contingent on a characteristic of the debt

    security that may change in the future, such as an adjustment to future

    interest rate swap payments based on the future price or yield of the

    debt security, then this Title VII instrument would be a security-based

    swap that would be a mixed swap.

    ---------------------------------------------------------------------------

    \722\ However, to the extent the fixed term or condition is set

    at a future date or at a future value or level of a security, rate,

    or other commodity rather than the value or level of such security,

    rate, or other commodity at the time of execution of the Title VII

    instrument, the discussion above would not apply, and the nature of

    the security, rate, or other commodity used in determining the terms

    or conditions would be considered in evaluating whether the Title

    VII instrument is a swap or security-based swap.

    ---------------------------------------------------------------------------

    [[Page 48271]]

    Comments

    One commenter agreed with the Commissions' interpretation

    generally, but believed that the Commissions should broaden the

    interpretation to allow a swap to reflect ``resets,'' or changes in the

    referenced characteristic of a security, where those ``resets'' or

    changes are ``intended to effect a purpose other than transmitting the

    risk of changes in the characteristic itself,'' without causing a Title

    VII instrument that is not a security-based swap to become a security-

    based swap.\723\

    ---------------------------------------------------------------------------

    \723\ See ISDA Letter.

    ---------------------------------------------------------------------------

    The Commissions are not expanding the interpretation to allow

    ``resets'' of a fixed rate derived from a security. The interpretation

    is consistent with the statutory swap and security-based swap

    definitions. The Commissions believe that a Title VII instrument based

    on a rate that follows a security, and that may ``reset'' or change in

    the future based on changes in that security, is a security-based swap.

    Further, any amendment or modification of a material term of a Title

    VII instrument would result in a new Title VII instrument and a

    corresponding reassessment of the instrument's status as either a swap

    or a security-based swap.\724\

    ---------------------------------------------------------------------------

    \724\ See infra part III.G.5(a).

    ---------------------------------------------------------------------------

    G. The Term ``Narrow-Based Security Index'' in the Security-Based Swap

    Definition

    1. Introduction

    As noted above, a Title VII instrument in which the underlying

    reference of the instrument is a ``narrow-based security index'' is a

    security-based swap subject to regulation by the SEC, whereas a Title

    VII instrument in which the underlying reference of the instrument is a

    security index that is not a narrow-based security index (i.e., the

    index is broad-based) is a swap subject to regulation by the CFTC. The

    Commissions proposed an interpretation and rules regarding usage of the

    term ``narrow-based security index'' in the security-based swap

    definition, including:

    The existing criteria for determining whether a security

    index is a narrow-based security index and the applicability of past

    guidance of the Commissions regarding those criteria to Title VII

    instruments;

    New criteria for determining whether a CDS where the

    underlying reference is a group or index of entities or obligations of

    entities (typically referred to as an ``index CDS'') is based on an

    index that is a narrow-based security index;

    The meaning of the term ``index'';

    Rules governing the tolerance period for Title VII

    instruments on security indexes traded on DCMs, SEFs, foreign boards of

    trade (``FBOTs''), security-based SEFs, or NSEs, where the security

    index temporarily moves from broad-based to narrow-based or from

    narrow-based to broad-based; and

    Rules governing the grace period for Title VII instruments

    on security indexes traded on DCMs, SEFs, FBOTs, security-based SEFs,

    or NSEs, where the security index moves from broad-based to narrow-

    based or from narrow-based to broad-based and the move is not

    temporary.\725\

    ---------------------------------------------------------------------------

    \725\ See Proposing Release at 29845-58.

    ---------------------------------------------------------------------------

    As discussed below, the Commissions are restating the

    interpretation set forth in the Proposing Release with certain further

    clarifications and adopting the rules as proposed with certain

    modifications.

    2. Applicability of the Statutory Narrow-Based Security Index

    Definition and Past Guidance of the Commissions to Title VII

    Instruments

    The Commissions provided an interpretation in the Proposing Release

    regarding the applicability of the statutory definition of the term

    ``narrow-based security index'' and past guidance of the Commissions

    relating to such term to Title VII instruments.\726\ The Commissions

    are restating the interpretation set out in the Proposing Release

    without modification.

    ---------------------------------------------------------------------------

    \726\ See Proposing Release at 29845-48.

    ---------------------------------------------------------------------------

    As defined in the CEA and Exchange Act,\727\ an index is a narrow-

    based security index if, among other things, it meets any one of the

    following four criteria:

    ---------------------------------------------------------------------------

    \727\ Sections 3(a)(55)(B) and (C) of the Exchange Act, 15

    U.S.C. 78c(a)(55)(B) and (C), include a definition of ``narrow-based

    security index'' in the same paragraph as the definition of security

    future. See also sections 1a(35)(A) and (B) of the CEA, 7 U.S.C.

    1a(35)(A) and (B). A security future is a contract for future

    delivery on a single security or narrow-based security index

    (including any interest therein or based on the value thereof). See

    section 3(a)(55) of the Exchange Act, 15 U.S.C. 78c(a)(55), and

    section 1a(44) of the CEA, 7 U.S.C. 1a(44).

    ---------------------------------------------------------------------------

    It has nine or fewer component securities;

    A component security comprises more than 30 percent of the

    index's weighting;

    The five highest weighted component securities in the

    aggregate comprise more than 60 percent of the index's weighting; or

    The lowest weighted component securities comprising, in

    the aggregate, 25 percent of the index's weighting have an aggregate

    dollar value of average daily trading volume of less than $50,000,000

    (or in the case of an index with more than 15 component securities,

    $30,000,000), except that if there are two or more securities with

    equal weighting that could be included in the calculation of the lowest

    weighted component securities comprising, in the aggregate, 25 percent

    of the index's weighting, such securities shall be ranked from lowest

    to highest dollar value of average daily trading volume and shall be

    included in the calculation based on their ranking starting with the

    lowest ranked security.\728\

    ---------------------------------------------------------------------------

    \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 (B) of the CEA, 7

    U.S.C. 1a(35)(A) and (B).

    ---------------------------------------------------------------------------

    The first three criteria apply to the number and concentration of

    the ``component securities'' in the index. The fourth criterion applies

    to the average daily trading volume of an index's ``component

    securities.'' \729\

    ---------------------------------------------------------------------------

    \729\ The narrow-based security index definition in the CEA and

    Exchange Act also excludes from its scope security indexes that

    satisfy certain specified criteria. See sections 3(a)(55)(C)(i)-(vi)

    of the Exchange Act, 15 U.S.C. 78c(a)(55)(C)(i)-(vi), and sections

    1a(35)(B)(i)-(vi) of the CEA, 7 U.S.C. 1a(35)(B)(i)-(vi).

    ---------------------------------------------------------------------------

    This statutory narrow-based security index definition focuses on

    indexes composed of equity securities and certain aspects of the

    definition, in particular the evaluation of average daily trading

    volume, are designed to take into account the trading patterns of

    individual stocks.\730\ However, the Commissions, pursuant to authority

    granted in the CEA and the Exchange Act,\731\ previously have extended

    the definition to other categories of indexes but modified the

    definition to take into account the characteristics of those other

    categories. Specifically, the Commissions have previously provided

    guidance regarding the application of the narrow-based security index

    definition to futures contracts on volatility indexes \732\ and debt

    security indexes.\733\ Today, then, there exists guidance for

    determining what constitutes a narrow-based security index.

    ---------------------------------------------------------------------------

    \730\ See Joint Order Excluding Indexes Comprised of Certain

    Index Options From the Definition of Narrow-Based Security Index, 69

    FR 16900 (Mar. 31, 2004) (``March 2004 Index Options Joint Order'').

    \731\ See section 1a(35)(B)(vi) of the CEA, 7 U.S.C.

    1a(35)(B)(vi), and section 3(a)(55)(C)(vi) of the Exchange Act, 15

    U.S.C. 78c(a)(55)(C)(vi).

    \732\ See March 2004 Index Options Joint Order.

    \733\ See Joint Final Rules: Application of the Definition of

    Narrow-Based Security Index to Debt Securities Indexes and Security

    Futures on Debt Securities, 71 FR 39434 (Jul. 13, 2006) (``July 2006

    Debt Index Release'').

    ---------------------------------------------------------------------------

    Volatility indexes are indexes composed of index options. The

    Commissions issued a joint order in

    [[Page 48272]]

    2004 to define when a volatility index is not a narrow-based security

    index. Under this joint order, a volatility index is not a narrow-based

    security index if the index meets all of the following criteria:

    The index measures the magnitude of changes (as calculated

    in accordance with the order) in the level of an underlying index that

    is not a narrow-based security index pursuant to the statutory criteria

    for equity indexes discussed above;

    The index has more than nine component securities, all of

    which are options on the underlying index;

    No component security of the index comprises more than 30

    percent of the index's weighting;

    The five highest weighted component securities of the

    index in the aggregate do not comprise more than 60 percent of the

    index's weighting;

    The average daily trading volume of the lowest weighted

    component securities in the underlying index (those comprising, in the

    aggregate, 25 percent of the underlying index's weighting) have a

    dollar value of more than $50,000,000 (or $30,000,000 in the case of an

    underlying index with 15 or more component securities), except if there

    are 2 or more securities with equal weighting that could be included in

    the calculation of the lowest weighted component securities comprising,

    in the aggregate, 25 percent of the underlying index's weighting, such

    securities shall be ranked from lowest to highest dollar value of

    average daily trading volume and shall be included in the calculation

    based on their ranking starting with the lowest ranked security;

    Options on the underlying index are listed and traded on

    an NSE registered under section 6(a) of the Exchange Act; \734\ and

    ---------------------------------------------------------------------------

    \734\ 15 U.S.C. 78f(a).

    ---------------------------------------------------------------------------

    The aggregate average daily trading volume in options on

    the underlying index is at least 10,000 contracts calculated as of the

    preceding 6 full calendar months.\735\

    ---------------------------------------------------------------------------

    \735\ See March 2004 Index Options Joint Order. In 2009, the

    Commissions issued a joint order that provided that, instead of the

    index options having to be listed on an NSE, the index options must

    be listed on an exchange and pricing information for the index

    options, and the underlying index, must be computed and disseminated

    in real time through major market data vendors. See Joint Order To

    Exclude Indexes Composed of Certain Index Options From the

    Definition of Narrow-Based Security Index, 74 FR 61116 (Nov. 23,

    2009) (expanding the criteria necessary for exclusion under the

    March 2004 Index Options Joint Order to apply to volatility indexes

    for which pricing information for the underlying broad-based

    security index, and the options that compose such index, is current,

    accurate, and publicly available).

    ---------------------------------------------------------------------------

    With regard to debt security indexes, the Commissions issued joint

    rules in 2006 (``July 2006 Debt Index Rules'') to define when an index

    of debt securities \736\ is not a narrow-based security index. The

    first three criteria of that definition are similar to the statutory

    definition for equities and the order regarding volatility indexes in

    that a debt security index would not be narrow-based if:

    ---------------------------------------------------------------------------

    \736\ Under the rules, debt securities include notes, bonds,

    debentures or evidence of indebtedness. See rule 41.15(a)(1)(i)

    under the CEA, 17 CFR 41.15(a)(1)(i) and rule 3a55-4(a)(1)(i) under

    the Exchange Act, 17 CFR 240.3a55-4(a)(1)(i). See also July 2006

    Debt Index Release.

    ---------------------------------------------------------------------------

    It is comprised of more than nine debt securities that are

    issued by more than nine non-affiliated issuers;

    The securities of any issuer included in the index do not

    comprise more than 30 percent of the index's weighting; and

    The securities of any five non-affiliated issuers in the

    index do not comprise more than 60 percent of the index's weighting.

    In the July 2006 Debt Index Rules, instead of the statutory average

    daily trading volume test, however, the Commissions adopted a public

    information availability requirement. Under this requirement, assuming

    the aforementioned number and concentration criteria were satisfied, a

    debt security index would not be a narrow-based security index if the

    debt securities or the issuers of debt securities in the index met any

    one of the following criteria:

    The issuer of the debt security is required to file

    reports pursuant to section 13 or section 15(d) of the Securities

    Exchange Act of 1934; \737\

    ---------------------------------------------------------------------------

    \737\ 15 U.S.C. 78m or 78o(d).

    ---------------------------------------------------------------------------

    The issuer of the debt security has a worldwide market

    value of its outstanding common equity held by non-affiliates of $700

    million or more;

    The issuer of the debt security has outstanding securities

    that are notes, bonds, debentures, or evidence of indebtedness having a

    total remaining principal amount of at least $1 billion;

    The security is an exempted security as defined in section

    3(a)(12) of the Securities Exchange Act of 1934 \738\ and the rules

    promulgated thereunder; or

    ---------------------------------------------------------------------------

    \738\ 15 U.S.C. 78c(a)(12).

    ---------------------------------------------------------------------------

    The issuer of the security is a government of a foreign

    country or a political subdivision of a foreign country.\739\

    ---------------------------------------------------------------------------

    \739\ See July 2006 Debt Index Rules. The July 2006 Debt Index

    Rules also provided that debt securities in the index must satisfy

    certain minimum outstanding principal balance criteria, established

    certain exceptions to these criteria and the public information

    availability requirement, and provided for the treatment of indexes

    that include exempted securities (other than municipal securities).

    ---------------------------------------------------------------------------

    In the Dodd-Frank Act, Congress included the term ``narrow-based

    security index'' in the security-based swap definition, and thus the

    statutory definition of the term ``narrow-based security index'' \740\

    also applies in distinguishing swaps (on security indexes that are not

    narrow-based, also known as ``broad-based'') and security-based swaps

    (on narrow-based security indexes).\741\ The Commissions have

    determined that their prior guidance with respect to what constitutes a

    narrow-based security index in the context of volatility indexes \742\

    and debt security indexes \743\ applies in determining whether a Title

    VII instrument is a swap or a security-based swap, except as the rules

    the Commissions are adopting provide for other treatment with respect

    to index CDS as discussed below.\744\

    ---------------------------------------------------------------------------

    \740\ See sections 3(a)(55)(B) and (C) of the Exchange Act, 15

    U.S.C. 78c(a)(55)(B) and (C). See also sections 1a(35)(A) and (B) of

    the CEA, 7 U.S.C. 1a(35)(A) and (B).

    \741\ The statutory definition of the term ``narrow-based

    security index'' for equities, and the Commissions' subsequent

    guidance as to what constitutes a narrow-based security index with

    respect to volatility and debt indexes, is applicable in the context

    of distinguishing between futures contracts and security futures

    products.

    \742\ See March 2004 Index Options Joint Order.

    \743\ See July 2006 Debt Index Rules.

    \744\ See infra part III.G.3.

    ---------------------------------------------------------------------------

    To make clear that the Commissions are applying the prior guidance

    and rules to Title VII instruments, the Commissions are adopting rules

    to further define the term ``narrow-based security index'' in the

    security-based swap definition. Under paragraph (1) of rule 1.3(yyy)

    under the CEA and paragraph (a) of rule 3a68-3 under the Exchange Act,

    for purposes of the security-based swap definition, the term ``narrow-

    based security index'' has the same meaning as the statutory definition

    set forth in section 1a(35) of the CEA and section 3(a)(55) of the

    Exchange Act,\745\ and the rules, regulations, and orders issued by the

    Commissions relating to such definition. As a result, except as the

    rules the Commissions are adopting provide for other treatment with

    respect to index CDS as discussed below,\746\ market participants

    generally may use the Commissions' past guidance in determining whether

    certain Title VII instruments based on a security index are swaps or

    security-based swaps.

    ---------------------------------------------------------------------------

    \745\ 7 U.S.C. 1a(35) and 15 U.S.C. 78c(a)(55).

    \746\ See infra part III.G.3.

    ---------------------------------------------------------------------------

    The Commissions also are providing an interpretation and adopting

    additional rules establishing criteria for indexes composed of

    securities, loans, or issuers of securities referenced by an

    [[Page 48273]]

    index CDS.\747\ The interpretation and rules also address the

    definition of an ``index'' \748\ and the treatment of broad-based

    security indexes that become narrow-based and narrow-based indexes that

    become broad-based, including rule provisions regarding tolerance and

    grace periods for swaps on security indexes that are traded on CFTC-

    regulated trading platforms and security-based swaps on security

    indexes that are traded on SEC-regulated trading platforms.\749\ These

    rules and interpretation are discussed below.

    ---------------------------------------------------------------------------

    \747\ Id.

    \748\ See infra part III.G.4.

    \749\ See infra part III.G.5.

    ---------------------------------------------------------------------------

    3. Narrow-Based Security Index Criteria for Index Credit Default Swaps

    (a) In General

    The Commissions provided an interpretation in the Proposing Release

    regarding the narrow-based security index criteria for index CDS and

    are restating it without modification.\750\ While the Commissions

    understand that the underlying reference for most cleared CDS is a

    single entity or an index of entities rather than a single security or

    an index of securities, the underlying reference for CDS also could be

    a single security or an index of securities.\751\ A CDS where the

    underlying reference is a single entity (i.e., a single-name CDS), a

    single obligation of a single entity (e.g., a CDS on a specific bond,

    loan, or asset-backed security, or any tranche or series of any bond,

    loan, or asset-backed security), or an index CDS where the underlying

    reference is a narrow-based security index or the issuers of securities

    in a narrow-based security index is a security-based swap. An index CDS

    where the underlying reference is not a narrow-based security index or

    the issuers of securities in a narrow-based security index (i.e., a

    broad-based index) is a swap.\752\

    ---------------------------------------------------------------------------

    \750\ See Proposing Release at 29847-48.

    \751\ See, e.g., Markit, ``Markit CDX'' (describing the Markit

    CDX indexes and the number of ``names'' included in each index),

    available at http://www.markit.com/en/products/data/indices/credit-and-loan-indices/cdx/cdx.page; Markit, ``Markit iTraxx Indices,''

    (stating that the ``Markit iTraxx indices are comprised of the most

    liquid names in the European and Asian markets'') (emphasis added),

    available at http://www.markit.com/en/products/data/indices/credit-and-loan-indices/itraxx/itraxx.page . Examples of indexes based on

    securities include the Markit ABX.HE and CMBX indexes. See Markit,

    ``Markit ABX.HE,'' (describing the Markit ABX.HE index as ``a

    synthetic tradeable index referencing a basket of 20 subprime

    mortgage-backed securities''), available at http://www.markit.com/en/products/data/indices/structured-finance-indices/abx/abx.page;

    and Markit, ``Markit CMBX,'' (describing the Markit CMBX index as

    ``a synthetic tradeable index referencing a basket of 25 commercial

    mortgage-backed securities''), available at http://www.markit.com/en/products/data/indices/structured-finance-indices/cmbx/cmbx.page.

    \752\ Similarly, an option to enter into a single-name CDS or a

    CDS referencing a narrow-based security index as described above

    would be a security-based swap, while an option to enter into a CDS

    on a broad-based security index or the issuers of securities in a

    broad-based security index would be a swap. Index CDS where the

    underlying reference is a broad-based security index would be SBSAs.

    The SEC has enforcement authority with respect to swaps that are

    SBSAs, as discussed further in section V., infra.

    ---------------------------------------------------------------------------

    The statutory definition of the term ``narrow-based security

    index,'' as explained above, was designed with the U.S. equity markets

    in mind.\753\ Thus, the statutory definition is not necessarily

    appropriate for determining whether an index underlying an index CDS is

    broad or narrow-based. Nor is the guidance that the Commissions have

    previously issued with respect to the narrow-based security index

    definition discussed above necessarily appropriate, because that

    guidance was designed to address and was uniquely tailored to the

    characteristics of volatility indexes and debt security indexes in the

    context of futures. Accordingly, the Commissions are clarifying that

    the guidance that the Commissions have previously issued with respect

    to the narrow-based security index definition discussed above does not

    apply to index CDS. Instead, the Commissions are adopting rules as

    discussed below that include separate criteria for determining whether

    an index underlying an index CDS is a narrow-based security index.

    ---------------------------------------------------------------------------

    \753\ See July 2006 Debt Index Rules.

    ---------------------------------------------------------------------------

    The Commissions are further defining the term ``security-based

    swap,'' and the use of the term ``narrow-based security index'' within

    that definition, to modify the criteria applied in the context of index

    CDS in assessing whether the index is a narrow-based security index.

    The third prong of the security-based swap definition includes a Title

    VII instrument based on the occurrence of an event relating to the

    ``issuers of securities in a narrow-based security index,'' provided

    that such event directly affects the ``financial statements, financial

    condition, or financial obligations of the issuer.'' \754\ The first

    prong of the security-based swap definition includes a Title VII

    instrument that is based on a narrow-based security-index.\755\ Because

    the third prong of the security-based swap definition relates to

    issuers of securities, while the first prong of such definition relates

    to securities, the Commissions are further defining both the term

    ``narrow-based security index'' and the term ``issuers of securities in

    a narrow-based security index'' in the context of the security-based

    swap definition as applied to index CDS. The Commissions believe it is

    important to further define both terms in order to assure consistent

    analysis of index CDS.\756\ While the wording of the two definitions as

    adopted differs slightly, the Commissions expect that they will yield

    the same substantive results in distinguishing narrow-based and broad-

    based index CDS.\757\

    ---------------------------------------------------------------------------

    \754\ Section 3(a)(68)(A)(ii)(III) of the Exchange Act, 15

    U.S.C. 78c(a)(68)(A)(ii)(III).

    \755\ Section 3(a)(68)(A)(ii)(I) of the Exchange Act, 15 U.S.C.

    78c(a)(68)(A)(ii)(I).

    \756\ Because they apply only with respect to index CDS, the

    definitions of ``issuers of securities in a narrow-based security

    index'' and ``narrow-based security index'' as adopted do not apply

    with respect to other types of event contracts, whether analyzed

    under the first or third prong.

    \757\ For example, if the reference entities included in one

    index are the same as the issuers of securities included in another

    index, application of the two definitions should result in both

    indexes being either broad-based or narrow-based.

    ---------------------------------------------------------------------------

    (b) Rules Regarding the Definitions of ``Issuers of Securities in a

    Narrow-Based Security Index'' and ``Narrow-Based Security Index'' for

    Index Credit Default Swaps

    The Commissions proposed rules to further define the terms

    ``issuers of securities in a narrow-based security index'' and

    ``narrow-based security index'' in order to provide appropriate

    criteria for determining whether an index composed of issuers of

    securities referenced by an index CDS and an index composed of

    securities referenced by an index CDS are narrow-based security

    indexes.\758\ The Commissions are adopting rules 1.3(zzz) and 1.3(aaaa)

    under the CEA and rules 3a68-1a and 3a68-1b under the Exchange Act as

    proposed with certain modifications.\759\

    ---------------------------------------------------------------------------

    \758\ See Proposing Release at 29848.

    \759\ The discussion throughout this section refers to

    ``reference entities'' and ``issuers'' in discussing the final

    rules. The term ``reference entity'' is defined in paragraph (c)(3)

    of rule 1.3(zzz) under the CEA and rule 3a68-1a under the Exchange

    Act and the term ``issuer'' is defined in paragraph (c)(3) of rule

    1.3(aaaa) under the CEA and rule 3a68-1b under the Exchange Act. The

    final rules provide that the term ``reference entity'' includes: (i)

    An issuer of securities; (ii) an issuer of securities that is an

    issuing entity of asset-backed securities is a reference entity or

    issuer, as applicable; and (iii) an issuer of securities that is a

    borrower with respect to any loan identified in an index of

    borrowers or loans is a reference entity. The final rules provide

    that the term ``issuer'' includes: (i) An issuer of securities; and

    (ii) an issuer of securities that is an issuing entity of asset-

    backed securities is a reference entity or issuer, as applicable.

    See paragraph (c)(3) of rules 1.3(zzz) and 1.3(aaaa) under the CEA

    and rule 3a68-1a and 3a68-1b under the Exchange Act.

    ---------------------------------------------------------------------------

    In formulating the criteria in the final rules, and consistent with

    the guidance and rules the Commissions have

    [[Page 48274]]

    previously issued and adopted regarding narrow-based security indexes

    in the context of security futures, the Commissions believe that there

    should be public information available about a predominant percentage

    of the reference entities included in the index, or, in the case of an

    index CDS on an index of securities, about the issuers of the

    securities or the securities underlying the index, in order to reduce

    the likelihood that non-narrow-based indexes referenced in index CDS or

    the component securities or issuers of securities in that index would

    be readily susceptible to manipulation, as well as to help prevent the

    misuse of material non-public information through the use of CDS based

    on such indexes.

    To satisfy these objectives, the Commissions are adopting rules

    that are based on the criteria developed for debt indexes discussed

    above \760\ but that tailor these criteria to address index CDS.\761\

    These criteria are included solely for the purpose of defining the

    terms ``narrow-based security index'' and ``issuers of securities in a

    narrow-based security index'' in the first and third prongs of the

    security-based swap definition with respect to index CDS and will not

    affect any other interpretation or use of the term ``narrow-based

    security index'' or any other provision of the Dodd-Frank Act, the CEA,

    or the Exchange Act.

    ---------------------------------------------------------------------------

    \760\ See discussion of July 2006 Debt Index Rules.

    \761\ The Commissions note that the language of the rules is

    intended, in general, to be consistent with the criteria developed

    for debt indexes discussed above. Certain changes from the criteria

    developed for debt indexes are necessary to address differences

    between futures on debt indexes and index CDS. Certain other changes

    are necessary because the rules for debt indexes define under what

    conditions an index is not a narrow-based security index, whereas

    the rules for index CDS define what is a narrow-based security

    index. For example, an index is not a narrow-based security index

    under the rule for debt indexes if it is not a narrow-based security

    index under either subparagraph (a)(1) or paragraph (a)(2) of the

    rule. See July 2006 Debt Index Rules. Under the rules for index CDS,

    however, an index is a narrow-based security index if it meets the

    requirements of both of the counterpart paragraphs in the rules

    regarding index CDS (paragraphs (1)(i) and (1)(ii) of rules 1.3(zzz)

    and 1.3(aaaa) under the CEA and paragraph (a)(1) and paragraph

    (a)(2) of rules 3a68-1a and 3a68-1b under the Exchange Act), even

    though the criteria in the debt index rules and the rules for index

    CDS include generally the same criteria and structure.

    ---------------------------------------------------------------------------

    Further, in response to commenters,\762\ the Commissions are

    clarifying that if an index CDS is based on an index of loans that are

    not securities,\763\ an event relating to a loan in the index, such as

    a default on a loan, is an event ``relating to'' the borrower.\764\ To

    the extent that the borrower is an issuer of securities, the index CDS

    based on such index of loans will be analyzed under the third prong of

    the security-based swap definition in the same manner as any other

    index CDS.

    ---------------------------------------------------------------------------

    \762\ See infra note 768 and accompanying text.

    \763\ If the loans underlying the index of loans are securities,

    the index CDS would be analyzed in the same manner as any other

    index CDS based on an index of securities.

    \764\ An index CDS referencing loans also may be based on events

    relating to the borrower, such as bankruptcy, and to defaults on any

    obligation of the borrower.

    ---------------------------------------------------------------------------

    Comments

    The Commissions received two general comments requesting that the

    proposed rules further defining the terms ``issuers of securities in a

    narrow-based security index'' and ``narrow-based security index'' be

    simplified.\765\ One commenter believed that the rules were exceedingly

    complicated.\766\ Another commenter thought that the criteria should

    allow transactions to be readily and transparently classifiable as a

    swap or security-based swap.\767\ The commenters did not provide

    analysis supporting their comments or recommend language changes.

    ---------------------------------------------------------------------------

    \765\ See ISDA Letter and MarketAxess Letter.

    \766\ See MarketAxess Letter. This commenter stated that ``The

    Proposed Rules layout an exceedingly complex process for determining

    whether an index CDS is broad-based or narrow-based.'' Id.

    \767\ See ISDA Letter.

    ---------------------------------------------------------------------------

    The Commissions are adopting the rules regarding index CDS

    essentially as proposed with certain modifications to address

    commenters' concerns. While the final rules contain a number of

    elements that are similar or identical to elements contained in the

    statutory narrow-based security index definition, in order to enable

    the narrow-based security index definition to apply appropriately to

    index CDS, the final rules contain some alternative tests to those set

    forth in the statutory definition.

    The Commissions also recognize the diversity of Title VII

    instruments. While the final rules for index CDS are based on the July

    2006 Debt Index Rules, the substantive differences between the final

    rules in the index CDS and the equity or debt security contexts are

    intended to reflect the particular characteristics of the CDS

    marketplace, in which, for example, index components may be entities

    (issuers of securities) as well as specific equity and debt securities.

    The Commissions also received three comments requesting

    clarification regarding the applicability of the index CDS rules to CDS

    based on indexes of loans.\768\ One commenter noted that the

    Commissions did not address in the Proposing Release the question of

    whether an index composed exclusively of loans should be treated as a

    narrow-based security index.\769\ This commenter noted that because the

    first and third prongs of the statutory security-based swap definition

    do not explicitly reference loans, the statutory definition does not

    expressly categorize Title VII instruments based on more than one loan,

    or contingent on events that occur with respect to more than one loan

    borrower, unless such borrowers are also ``issuers of securities.''

    \770\ Based on this commenter's view of the statutory definition, this

    commenter requested that the Commissions clarify the treatment of

    indexes composed exclusively of loans.\771\ Another commenter provided

    similar comments and also requested clarification regarding the

    treatment of CDS based on indexes of loans.\772\ A third commenter

    stated its view that the third prong of the statutory security-based

    swap definition implies that Title VII instruments on a basket of loans

    are security-based swaps if the lenders would satisfy the criteria for

    issuers of a ``narrow-based security index'' and encouraged the

    Commissions to clarify this issue.\773\ The Commissions agree with

    commenters that an index CDS based on an index of loans that are not

    securities is analyzed under the third prong of the statutory security-

    based swap definition and, therefore, are clarifying the treatment of

    these Title VII instruments above.\774\

    ---------------------------------------------------------------------------

    \768\ See Allen & Overy Letter; July LSTA Letter; and SIFMA

    Letter.

    \769\ See Allen & Overy Letter.

    \770\ Id.

    \771\ Id.

    \772\ See July LSTA Letter. This commenter noted that prong

    (III) of the statutory security-based swap definition does not

    clearly reference borrowers of loans or indexes of borrowers.

    However, this commenter noted that because most borrowers that are

    named as reference entities in loan CDS transactions are corporate

    entities that issue equity interests to one or more shareholders

    (although they may not issue public securities or become subject to

    public reporting requirements), this commenter believes that prong

    (III) can be interpreted to include swaps that reference a single

    borrower or borrowers of loans in an index. Id.

    \773\ See SIFMA Letter.

    \774\ The Commissions also are providing guidance with respect

    to TRS based on two or more loans that are not securities. See supra

    part III.C.

    ---------------------------------------------------------------------------

    (i) Number and Concentration Percentages of Reference Entities or

    Securities

    The Commissions believe that the first three criteria of the debt

    security index test (which are based on the statutory narrow-based

    security index definition) discussed above (i.e., the number and

    concentration weighting requirements) are appropriate to apply to index

    CDS,

    [[Page 48275]]

    whether CDS on indexes of securities or indexes of issuers of

    securities.\775\ Accordingly, the Commissions are adopting the first

    three criteria of rule 1.3(zzz) under the CEA and rule 3a68-1a under

    the Exchange Act as proposed with certain modifications in response to

    commenters' concerns.\776\ These rules contain the same number and

    concentration criteria as proposed, but modify the method of

    calculating affiliation among issuers and reference entities in

    response to commenters.\777\ Further, in response to commenters,\778\

    the Commissions are providing an additional interpretation with respect

    to the application of these criteria to two particular types of CDS,

    commonly known as ``nth-to-default CDS'' and ``tranched CDS.''

    ---------------------------------------------------------------------------

    \775\ See infra notes 792 and 793 and accompanying text.

    \776\ See paragraphs (a)(1)(i)-(iii) of rules 1.3(zzz) and

    1.3(aaaa) under the CEA and rules 3a68-1a and 3a68-1b under the

    Exchange Act.

    \777\ See infra note 804 and accompanying text.

    \778\ See infra notes 795 and 796 and accompanying text.

    ---------------------------------------------------------------------------

    The first three criteria provide that, for purposes of determining

    whether an index CDS is a security-based swap under section

    3(a)(68)(A)(ii)(III) of the Exchange Act,\779\ the term ``issuers of

    securities in a narrow-based security index'' includes issuers of

    securities identified in an index (including an index referencing loan

    borrowers) in which:

    ---------------------------------------------------------------------------

    \779\ 15 U.S.C. 78c(a)(68)(A)(ii)(III).

    ---------------------------------------------------------------------------

    Number: There are nine or fewer non-affiliated issuers of

    securities that are reference entities included in the index, provided

    that an issuer of securities shall not be deemed a reference entity

    included in the index unless (i) a credit event with respect to such

    reference entity would result in a payment by the credit protection

    seller to the credit protection buyer under the index CDS based on the

    related notional amount allocated to such reference entity; or (ii) the

    fact of such credit event or the calculation in accordance with clause

    (i) above of the amount owed with respect to such credit event is taken

    into account in determining whether to make any future payments under

    the index CDS with respect to any future credit events;

    Single Component Concentration: The effective notional

    amount allocated to any reference entity included in the index

    comprises more than 30 percent of the index's weighting; or

    Largest Five Component Concentration: The effective

    notional amount allocated to any five non-affiliated reference entities

    included in the index comprises more than 60 percent of the index's

    weighting.\780\

    ---------------------------------------------------------------------------

    \780\ These rules refer to the ``effective notional amount''

    allocated to reference entities or securities in order to address

    potential situations in which the means of calculating payout across

    the reference entities or securities is not uniform. Thus, if one or

    more payouts is leveraged or enhanced by the structure of the

    transaction (i.e., 2x recovery rate), that amount would be the

    ``effective notional amount'' for purposes of the 30 percent and 60

    percent tests in paragraphs (1)(i)(B) and (1)(i)(C) of rules

    1.3(zzz) and 1.3(aaaa) and paragraphs (a)(1)(ii) and (a)(1)(iii) of

    rules 3a68-1a and 3a68-1b. Similarly, if the aggregate notional

    amount under a CDS is not uniformly allocated to each reference

    entity or security, then the portion of the notional amount

    allocated to each reference entity or security (which may be by

    reference to the product of the aggregate notional amount and an

    applicable percentage) would be the ``effective notional amount.''

    ---------------------------------------------------------------------------

    Similarly, the Commissions are adopting as proposed the first three

    criteria of rule 1.3(aaaa) under the CEA and rule 3a68-1b under the

    Exchange Act. These three criteria provide that, for purposes of

    determining whether an index CDS is a security-based swap under section

    3(a)(68)(A)(ii)(I) of the Exchange Act,\781\ the term ``narrow-based

    security index'' includes an index in which essentially the same

    criteria apply, substituting securities for issuers. Under these

    criteria, the term ``narrow-based security index'' would mean an index

    in which:

    ---------------------------------------------------------------------------

    \781\ 15 U.S.C. 78c(a)(68)(A)(ii)(I).

    ---------------------------------------------------------------------------

    Number: There are nine or fewer securities, or securities

    that are issued by nine or fewer non-affiliated issuers, included in

    the index, provided that a security shall not be deemed a component of

    the index unless (i) a credit event with respect to the issuer of such

    security or a credit event with respect to such security would result

    in a payment by the credit protection seller to the credit protection

    buyer under the index CDS based on the related notional amount

    allocated to such security, or (ii) the fact of such credit event or

    the calculation in accordance with clause (i) above of the amount owed

    with respect to such credit event is taken into account in determining

    whether to make any future payments under the index CDS with respect to

    any future credit events;

    Single Component Concentration: The effective notional

    amount allocated to the securities of any issuer included in the index

    comprises more than 30 percent of the index's weighting; or

    Largest Five Component Concentration: The effective

    notional amount allocated to the securities of any five non-affiliated

    issuers included in the index comprises more than 60 percent of the

    index's weighting.

    Thus, the applicability of the final rules depends on conditions

    relating to the number of non-affiliated reference entities or issuers

    of securities, or securities issued by non-affiliated issuers, as

    applicable, included in an index and the weighting of notional amounts

    allocated to the reference entities or securities included in the

    index, as applicable. These first three criteria of the final rules

    evaluate the number and concentration of the reference entities or

    securities included in the index, as applicable, and ensure that an

    index with a small number of reference entities, issuers, or securities

    or concentrated in only a few reference entities, issuers, or

    securities is narrow-based, and thus where such index is the underlying

    reference of an index CDS, the index CDS is a security-based swap.

    Further, as more fully described below,\782\ the final rules provide

    that a reference entity or issuer of securities included in an index

    and any of that reference entity's or issuer's affiliated entities (as

    defined in the final rules) that also are included in the index are

    aggregated for purposes of determining whether the number and

    concentration criteria are met.

    ---------------------------------------------------------------------------

    \782\ See infra part III.G.3(b)(ii), for a discussion of the

    affiliation definition applicable to calculating the number and

    concentration criteria. As noted above, the Commissions are

    modifying the method of calculating affiliation for purposes of

    these criteria.

    ---------------------------------------------------------------------------

    Specifically, the final rules provide that an index meeting any one

    of certain identified conditions would be a narrow-based security

    index. The first condition in paragraph (1)(i)(A) of rule 1.3(zzz)

    under the CEA and paragraph (a)(1)(i) of rule 3a68-1a under the

    Exchange Act is that there are nine or fewer non-affiliated issuers of

    securities that are reference entities in the index. An issuer of

    securities counts toward this total only if a credit event with respect

    to such entity would result in a payment by the credit protection

    seller to the credit protection buyer under the index CDS based on the

    notional amount allocated to such entity, or if the fact of such a

    credit event or the calculation of the payment with respect to such

    credit event is taken into account when determining whether to make any

    future payments under the index CDS with respect to any future credit

    events.

    Similarly, the first condition in paragraph (1)(i)(A) of rule

    1.3(aaaa) under the CEA and paragraph (a)(1)(i) of rule 3a68-1b under

    the Exchange Act provides that a security counts toward the total

    number of securities in the index only if a credit event with respect

    to such security, or the issuer of such security, would result in a

    payment by the credit protection seller to the credit

    [[Page 48276]]

    protection buyer under the index CDS based on the notional amount

    allocated to such security, or if the fact of such a credit event or

    the calculation of the payment with respect to such credit event is

    taken into account when determining whether to make any future payments

    under the index CDS with respect to any future credit events.

    These provisions are intended to ensure that an index concentrated

    in a few reference entities or securities, or a few reference entities

    that are affiliated (as defined in the final rules) or a few securities

    issued by issuers that are affiliated, are within the narrow-based

    security index definition.\783\ These provisions also are intended to

    ensure that an entity is not counted as a reference entity included in

    the index, and a security is not counted as a security included in the

    index, unless a credit event with respect to the entity, issuer, or

    security affects payout under a CDS on the index.\784\

    ---------------------------------------------------------------------------

    \783\ This requirement is generally consistent with the

    definition of ``narrow-based security index'' in section 1a(35)(A)

    of the CEA, 7 U.S.C. 1a(35)(A), and section 3(a)(55)(B) of the

    Exchange Act, 15 U.S.C. 78c(a)(55)(B), and the July 2006 Debt Index

    Rules.

    \784\ Id.

    ---------------------------------------------------------------------------

    Further, as this condition is in the alternative (i.e., either

    there must be a credit event resulting in a payment under the index CDS

    or a credit event is considered in determining future CDS payments),

    the tests encompass all index CDS. For example, and in response to a

    commenter,\785\ the test would cover an nth-to-default CDS,\786\ in

    which default with respect to a specified component of an index (such

    as the first default or fifth default) triggers the CDS payment, even

    if the CDS payment is not made with respect to such particular credit

    event. As another example, and in response to another commenter,\787\

    the test applies to a tranched CDS \788\ if the payments are made on

    only a tranche, or portion, of the potential aggregate notional amount

    of the CDS (often expressed as a percentage range of the total notional

    amount of the CDS) because the CDS payment takes into account a credit

    event with respect to an index component, even if the credit event

    itself does not result in such a payment.

    ---------------------------------------------------------------------------

    \785\ See infra note 795 and accompanying text.

    \786\ An ``nth-to-default CDS'' is a CDS in which the payout is

    linked to one in a series of defaults (such as first-, second- or

    third-to-default), with the contract terminating at that point. See

    SIFMA Letter.

    \787\ See infra note 796 and accompanying text.

    \788\ A ``tranched CDS'' is a CDS in which the counterparties

    agree to buy and sell credit protection on only a portion of the

    potential losses that could occur on an underlying portfolio of

    reference entities. The portion is typically denoted as a specified

    percentage range of aggregate losses (e.g., 2 percent to 5 percent,

    meaning the credit protection seller would not make payments until

    aggregate losses exceed 2 percent of the notional of the

    transaction, and would no longer be obligated to make payments after

    aggregate losses reach 5 percent). See SIFMA Letter.

    ---------------------------------------------------------------------------

    The second condition, in paragraphs (1)(i)(B) of rules 1.3(zzz) and

    1.3(aaaa) under the CEA and paragraphs (a)(1)(ii) of rules 3a68-1a and

    3a68-1b under the Exchange Act, is that the effective notional amount

    allocated to any reference entity or security of any issuer included in

    the index comprises more than 30 percent of the index's weighting.

    The third condition, in paragraphs (1)(i)(C) of rules 1.3(zzz) and

    1.3(aaaa) under the CEA and paragraphs (a)(1)(iii) of rules 3a68-1a and

    3a68-1b under the Exchange Act, is that the effective notional amount

    allocated to any five non-affiliated reference entities, or to the

    securities of any five non-affiliated issuers, included in the index

    comprises more than 60 percent of the index's weighting.

    Given that Congress determined that these concentration percentages

    are appropriate to characterize an index as a narrow-based security

    index, and the Commissions have determined they are appropriate for

    debt security indexes in the security futures context,\789\ the

    Commissions believe that these concentration percentages are

    appropriate to apply to the notional amount allocated to reference

    entities and securities in order to apply similar standards to indexes

    that are the underlying references of index CDS. Moreover, with respect

    to both the number and concentration criteria, the markets have had

    experience with these criteria with respect to futures on equity

    indexes, volatility indexes, and debt security indexes.\790\

    ---------------------------------------------------------------------------

    \789\ See July 2006 Debt Index Rules.

    \790\ As noted above, the Commissions are modifying the method

    of calculating affiliation for purposes of the number and

    concentration criteria. See infra part III.G.3(b)(ii).

    ---------------------------------------------------------------------------

    Comments

    One commenter expressed its view that the Commissions should

    increase the percentage test in the largest five component

    concentration.\791\ The Commissions are adopting the number and

    concentration criteria as proposed. The statutory definition of the

    term ``security-based swap'' references the definition of the term

    ``narrow-based security index'' contained in the Exchange Act and the

    CEA,\792\ which includes the same number and concentration percentages

    as the Commissions are adopting in this release. The Commissions are

    not modifying the statutory definition to change the percentages. The

    statutory definition included the concentration percentages, which the

    Commissions understand are intended to assure that a security index

    could not be used as a surrogate for the underlying securities in order

    to avoid application of the Federal securities laws. The Commissions

    also previously determined to retain these statutory percentages in

    connection with rules relating to debt security indexes in the security

    futures context.\793\ The Commissions believe that these percentages

    are similarly appropriate to apply to indexes on which index CDS are

    based. Moreover, with respect to the number and concentration criteria,

    as these are in the statutory definition of the term ``narrow-based

    security index'' applicable to security futures, market participants

    have experience in analyzing indexes, including equity, volatility and

    debt security indexes, to determine compliance with these criteria. As

    discussed below,\794\ though, the Commissions are modifying the

    affiliation definition used in analyzing the number and concentration

    criteria for an index.

    ---------------------------------------------------------------------------

    \791\ See ISDA Letter. According to this commenter, the

    ``operational complexity'' of the number and concentration criteria

    will increase costs and compliance risks. Id.

    \792\ See 15 U.S.C. 78c(a)(55)(B) and 7 U.S.C. 1a(35).

    \793\ See July 2006 Debt Index Rules.

    \794\ See infra part III.G.3(b)(ii).

    ---------------------------------------------------------------------------

    Two commenters requested clarification regarding nth-to-default

    CDS, stating their view that such CDS should be treated as security-

    based swaps to reflect their single-entity triggers.\795\ Two

    commenters requested clarification regarding tranched index CDS,

    including whether the CDS would be classified based on the underlying

    index.\796\ As discussed above, the Commissions are providing an

    interpretation on the applicability of the first three criteria of the

    rules to nth-to-default CDS and tranched CDS. As noted above, the

    Commissions believe the rules encompass all index CDS, regardless of

    the type or payment

    [[Page 48277]]

    structure, such as whether there is a single-entity payment based on

    credit events of other index components or whether the payment is based

    on a specific entity.

    ---------------------------------------------------------------------------

    \795\ See ISDA Letter and SIFMA Letter. One of these commenters

    noted that such an approach also made sense for nth-to-default CDS

    because they are typically based on baskets of less than 10

    securities. See ISDA Letter.

    \796\ See Markit Letter and SIFMA Letter. One of these

    commenters stated that classifying tranches underlying index CDS

    according to attachment or detachment points is not appropriate

    because it is impossible to know for certain at inception of the CDS

    the number of credit events that will ultimately affect actual

    payments, which typically depend on the severity of loss associated

    with each credit event. See SIFMA Letter.

    ---------------------------------------------------------------------------

    (ii) Affiliation of Reference Entities and Issuers of Securities With

    Respect to Number and Concentration Criteria

    The Commissions are adopting the affiliation definition that

    applies when calculating the number and concentration criteria with

    certain modifications from the proposal to address commenters'

    concerns.\797\ The final rules provide that the terms ``reference

    entity included in the index'' and ``issuer of the security included in

    the index'' include a single reference entity or issuer of securities

    included in an index, respectively, or a group of affiliated reference

    entities or issuers included in an index, respectively.\798\ For

    purposes of the rules, affiliated reference entities or issuers of

    securities included in an index or securities included in an index

    issued by affiliated issuers will be counted together for determining

    whether the number and concentration criteria are met. However, with

    respect to asset-backed securities, the final rules provide that each

    reference entity or issuer of securities included in an index that is

    an issuing entity of an asset-backed security is considered a separate

    reference entity or issuer, as applicable, and will not be considered

    affiliated with other reference entities or issuers of securities

    included in the index.

    ---------------------------------------------------------------------------

    \797\ See infra note 804 and accompanying text.

    \798\ See paragraph (c)(4) of rules 1.3(zzz) and 1.3(aaaa) under

    the CEA and rule 3a68-1a and 3a68-1b under the Exchange Act.

    ---------------------------------------------------------------------------

    The final rules provide that a reference entity or issuer of

    securities included in an index is affiliated with another reference

    entity or issuer of securities included in the index if it controls, is

    controlled by, or is under common control with, that other reference

    entity or issuer.\799\ The final rules define control, solely for

    purposes of this affiliation definition, to mean ownership of more than

    50 percent of a reference entity's or issuer's equity or the ability to

    direct the voting of more than 50 percent of a reference entity's or

    issuer's voting equity.\800\ The affiliation definition in the final

    rules differs from the definition included in the proposal, which

    provided for a control threshold of 20 percent ownership.\801\ This

    change is based on the Commissions' consideration of comments

    received.\802\ By using a more than 50 percent (i.e., majority

    ownership) test rather than a 20 percent ownership test for the control

    threshold, there is a greater likelihood that there will be an

    alignment of economic interests of the affiliated entities that is

    sufficient to aggregate reference entities or issuers of securities

    included in an index for purposes of the number and concentration

    criteria.\803\

    ---------------------------------------------------------------------------

    \799\ See paragraph (c)(1) of rules 1.3(zzz) and 1.3(aaaa) under

    the CEA and rules 3a68-1a and 3a68-1b under the Exchange Act.

    \800\ See paragraph (c)(2) of rules 1.3(zzz) and 1.3(aaaa) under

    the CEA and rules 3a68-1a and 3a68-1b under the Exchange Act.

    \801\ See Proposing Release at 29849.

    \802\ See infra note 804 and accompanying text. The Commissions

    note that another alternative would have been to include a

    requirement that the entities satisfy the 20 percent control

    threshold and also be consolidated with each other in financial

    statements. The Commissions did not include a requirement that the

    entities be consolidated with each other in financial statements

    because they do not believe that the scope of the affiliation

    definition should be exposed to the risk of future changes in

    accounting standards. Further, the use of a majority ownership

    control threshold (more than 50 percent) is generally consistent

    with consolidation under generally accepted accounting principles.

    See FASB ASC section 810-10-25, Consolidation--Overall--Recognition

    (stating that consolidation is appropriate if a reporting entity has

    a controlling financial interest in another entity and a specific

    scope exception does not apply).

    \803\ In such a case, as noted by commenters, the affiliated

    entities are viewed as part of group for which aggregation of these

    entities is appropriate. See infra note 806 and accompanying text.

    ---------------------------------------------------------------------------

    As the affiliation definition is applied to the number criterion,

    affiliated reference entities or issuers of securities included in an

    index will be viewed as a single reference entity or issuer of

    securities to determine whether there are nine or fewer non-affiliated

    reference entities included in the index or securities that are issued

    by nine or fewer non-affiliated issuers. Similarly, as the affiliation

    definition is applied to the concentration criteria, the notional

    amounts allocated to affiliated reference entities included in an index

    or the securities issued by a group of affiliated issuers of securities

    included in an index must be aggregated to determine the level of

    concentration of the components of the index for purposes of the 30-

    percent and 60-percent concentration criteria.

    Comments

    Three commenters requested that the Commissions revise the

    affiliation definition that applies when calculating the number and

    concentration criteria to increase the control threshold from 20

    percent ownership to majority ownership.\804\ These commenters noted

    that majority ownership is consistent with current market practice,

    including the definition of affiliate included in the 2003 ISDA Credit

    Derivatives Definitions.\805\ One commenter also stated its belief that

    affiliated entities should only be aggregated where the reference

    entities' credit risks are substantially similar and credit decisions

    are made by the same group of individuals.\806\ This commenter stated

    its view that 20 percent ownership is too low and that majority

    ownership is necessary for credit risk and credit decisions to be

    aligned enough as to warrant collapsing two issuers into one for

    purposes of the number and concentration criteria.\807\

    ---------------------------------------------------------------------------

    \804\ See ISDA Letter (requesting a threshold of at least 50

    percent); Markit Letter (requesting a threshold of at least 50

    percent); and SIFMA Letter (requesting a threshold of majority

    ownership, or 51 percent). One commenter also requested that the

    Commissions clarify the application of the affiliation definition.

    See Markit Letter. The Commissions have provided above and in infra

    part III.G.3(b)(ii), several examples illustrating the application

    of the affiliation definition in response to this commenter.

    \805\ Id.

    \806\ See SIFMA Letter. The ISDA Letter provides a similar

    rationale that ``the control threshold was too low and potentially

    disruptive when viewed against entities that the swap markets now

    trade as separate entities. In the CDS market, for example, entities

    that share ownership ties of substantially more than 20 percent

    trade quite independently. These entities may have completely

    disparate characteristics for the purpose of an index grouping of

    one sort or another.'' See ISDA Letter.

    \807\ See SIFMA Letter.

    ---------------------------------------------------------------------------

    As stated above, the Commissions are modifying the affiliation

    definition that applies when calculating the number and concentration

    criteria in response to commenters to use an affiliation test based on

    majority ownership. Based on commenters' letters, the Commissions

    understand that the current standard CDS documentation and the current

    approach used by certain index providers for index CDS with respect to

    the inclusion of affiliated entities in the same index use majority

    ownership rather than 20 percent ownership to determine affiliation.

    The Commissions are persuaded by commenters that, in the case of index

    CDS only it is more appropriate to use majority ownership because

    majority-owned entities are more likely to have their economic

    interests aligned and be viewed by the market as part of a group. The

    Commissions believe that revising the affiliation definition in this

    manner for purposes of calculating the number and concentration

    criteria responds to commenters' concerns that the percentage control

    threshold may inadvertently include entities that are not viewed as

    part of a group. Thus, as revised, the affiliation definition will

    include only those reference entities or issuers included in an index

    that satisfy the more than 50 percent (i.e., majority ownership)

    control threshold. The

    [[Page 48278]]

    Commissions believe that determining affiliation in this manner for

    purposes of calculating the number and concentration criteria responds

    to the commenters' concerns.

    The Commissions also believe that the modified affiliation

    definition addresses commenters' concerns noted above \808\ that the

    rules further defining the terms ``issuers of securities in a narrow-

    based security index'' and ``narrow-based security index'' should be

    simplified. The modified affiliation definition enables market

    participants to make an affiliation determination for purposes of

    calculating the number and concentration criteria by measuring the more

    than 50 percent (i.e., majority ownership) control threshold.

    ---------------------------------------------------------------------------

    \808\ See supra note 765 and accompanying text.

    ---------------------------------------------------------------------------

    (iii) Public Information Availability Regarding Reference Entities and

    Securities

    In addition to the number and concentration criteria, the debt

    security index test also includes, as discussed above, a public

    information availability test. The public information availability test

    is intended as the substitute for the average daily trading volume

    (``ADTV'') provision in the statutory narrow-based security index

    definition. An ADTV test is designed to take into account the trading

    of individual stocks and, because Exchange Act registration of the

    security being traded is a listing standard for equity securities, the

    issuer of the security being traded must be subject to the reporting

    requirements under the Exchange Act. Based on the provisions of the

    statutory ADTV test, the Commissions have determined that the ADTV test

    is not useful for purposes of determining the status of the index on

    which the index CDS is based because index CDS most commonly reference

    entities, which do not ``trade,'' or debt instruments, which commonly

    are not listed, and, therefore, do not have a significant trading

    volume. However, the underlying rationale of such provision, that there

    is sufficient trading in the securities and therefore public

    information and market following of the issuer of the securities,

    applies to index CDS.

    In general, if an index is not narrow-based under the number and

    concentration criteria, it will be narrow-based if one of the reference

    entities or securities included in the index fails to meet at least one

    of the criteria in the public information availability test. This test

    was designed to reduce the likelihood that broad-based debt security

    indexes or the component securities or issuers of securities in that

    index would be readily susceptible to manipulation. The fourth

    condition in the index CDS rules sets out a similar public information

    availability test that is intended solely for purposes of determining

    whether an index underlying a CDS is narrow-based.\809\ The Commissions

    are adopting the public information availability test essentially as

    proposed with certain modifications to address commenters' concerns,

    including modifications to the definition of affiliation for purposes

    of satisfying certain criteria of the public information availability

    test.\810\

    ---------------------------------------------------------------------------

    \809\ See Proposing Release at 29850.

    \810\ See infra notes 845, 847, 849 and 867 and accompanying

    text.

    ---------------------------------------------------------------------------

    The Commissions are adopting final rules under which an index CDS

    will be considered narrow-based (except as discussed below) if a

    reference entity or security included in the index does not meet any of

    the following criteria: \811\

    ---------------------------------------------------------------------------

    \811\ See paragraphs (a)(1)(iv)(A)-(G) of rules 1.3(zzz) and

    1.3(aaaa) under the CEA and rule 3a68-1a and 3a68-1b under the

    Exchange Act.

    ---------------------------------------------------------------------------

    The reference entity or the issuer of the security

    included in the index is required to file reports pursuant to the

    Exchange Act or the regulations thereunder;

    The reference entity or the issuer of the security

    included in the index is eligible to rely on the exemption provided in

    rule 12g3-2(b) under the Exchange Act; \812\

    ---------------------------------------------------------------------------

    \812\ 17 CFR 240.12g3-2(b).

    ---------------------------------------------------------------------------

    The reference entity or the issuer of the security

    included in the index has a worldwide market value of its outstanding

    common equity held by non-affiliates of $700 million or more; \813\

    ---------------------------------------------------------------------------

    \813\ See July 2006 Debt Index Rules (noting that issuers having

    worldwide equity market capitalization of $700 million or more are

    likely to have public information available about them).

    ---------------------------------------------------------------------------

    The reference entity or the issuer of the security

    included in the index (other than a reference entity or an issuer of

    the security included in the index that is an issuing entity of an

    asset-backed security as defined in section 3(a)(77) of the Exchange

    Act \814\) has outstanding notes, bonds, debentures, loans, or

    evidences of indebtedness (other than revolving credit facilities)

    having a total remaining principal amount of at least $1 billion; \815\

    ---------------------------------------------------------------------------

    \814\ 15 U.S.C. 78c(a)(77).

    \815\ See July 2006 Debt Index Rules (noting that issuers having

    at least $1 billion in outstanding debt are likely to have public

    information available about them).

    ---------------------------------------------------------------------------

    The reference entity included in the index is an issuer of

    an exempted security, or the security included in the index is an

    exempted security, each as defined in section 3(a)(12) of the Exchange

    Act \816\ and the rules promulgated thereunder (except a municipal

    security);

    ---------------------------------------------------------------------------

    \816\ 15 U.S.C. 78c(a)12.

    ---------------------------------------------------------------------------

    The reference entity or the issuer of the security

    included in the index is a government of a foreign country or a

    political subdivision of a foreign country; or

    If the reference entity or the issuer of the security

    included in the index is an issuing entity of asset-backed securities

    as defined in section 3(a)(77) of the Exchange Act,\817\ such asset-

    backed security was issued in a transaction registered under the

    Securities Act and has publicly available distribution reports.

    ---------------------------------------------------------------------------

    \817\ 15 U.S.C. 78c(a)(77).

    ---------------------------------------------------------------------------

    However, so long as the effective notional amounts allocated to

    reference entities or securities included in the index that satisfy the

    public information availability test comprise at least 80 percent of

    the index's weighting, failure by a reference entity or security

    included in the index to satisfy the public information availability

    test will be disregarded if the effective notional amounts allocated to

    that reference entity or security comprise less than five percent of

    the index's weighting.\818\ In this situation, the public information

    availability test for purposes of the index would be satisfied.

    ---------------------------------------------------------------------------

    \818\ See paragraph (b) of rules 1.3(zzz) and 1.3(aaaa) under

    the CEA and rule 3a68-1a and 3a68-1b under the Exchange Act.

    ---------------------------------------------------------------------------

    The determination as to whether an index CDS is narrow-based is

    conditioned on the likelihood that information about a predominant

    percentage of the reference entities or securities included in the

    index is publicly available.\819\ For example, a reference entity or an

    issuer of securities

    [[Page 48279]]

    included in the index that is required to file reports pursuant to the

    Exchange Act or the regulations thereunder makes regular and public

    disclosure through those filings. Moreover, a reference entity or an

    issuer of securities included in the index that does not file reports

    with the SEC but that is eligible to rely on the exemption in rule

    12g3-2(b) under the Exchange Act (i.e., foreign private issuers) is

    required to make certain types of financial information publicly

    available in English on its Web site or through an electronic

    information delivery system generally available to the public in its

    primary trading markets.\820\

    ---------------------------------------------------------------------------

    \819\ Most of the thresholds in the public information

    availability test are similar to those the Commissions adopted in

    their joint rules regarding the application of the definition of the

    term ``narrow-based security index'' to debt security indexes and

    security futures on debt securities. See July 2006 Debt Index Rules.

    The July 2006 Debt Index Rules also included an additional

    requirement regarding the minimum principal amount outstanding for

    each security in the index. The Commissions have not included this

    requirement in rule 1.3(zzz) under the CEA and rule 3a68-1a under

    the Exchange Act. That requirement was intended as a substitute

    criterion for trading volume because the trading volume of debt

    securities with a principal amount outstanding above that minimum

    amount was found to be generally larger than debt securities with a

    principal amount outstanding below that minimum amount. See July

    2006 Debt Index Release. There is no similar criterion that would be

    applicable in the context of index CDS. The numerical thresholds

    also are similar to those the SEC adopted in other contexts,

    including in the existing definitions of ``well-known seasoned

    issuer'' and ``large accelerated filer.'' See rule 405 under the

    Securities Act, 17 CFR 230.405, and rule 12b-2 under the Exchange

    Act, 17 CFR 240.12b-2.

    \820\ 17 CFR 240.12g3-2(b).

    ---------------------------------------------------------------------------

    The Commissions believe that other reference entities or issuers of

    securities included in the index that do not file reports with the SEC,

    but that have worldwide equity market capitalization of $700 million or

    more, have at least $1 billion in outstanding debt obligations (other

    than in the case of issuing entities of asset-backed securities), issue

    exempted securities (other than municipal securities), or are foreign

    sovereign entities either are required to or are otherwise sufficiently

    likely, solely for purposes of the ``narrow-based security-index'' and

    ``issuers of securities in a narrow-based security index'' definitions,

    to have public information available about them.\821\

    ---------------------------------------------------------------------------

    \821\ It is important to note that the public information

    availability test is designed solely for purposes of distinguishing

    between index CDS that are swaps and index CDS that are security-

    based swaps. The proposed criteria are not intended to provide any

    assurance that there is any particular level of information actually

    available regarding a particular reference entity or issuer of

    securities. Meeting one or more of the criteria for the limited

    purpose here--defining the terms ``narrow-based security index'' and

    ``issuers of securities in a narrow-based security index'' in the

    first and third prongs of the security-based swap definition with

    respect to index CDS--would not substitute for or satisfy any other

    requirement for public disclosure of information or public

    availability of information for purposes of the Federal securities

    laws.

    ---------------------------------------------------------------------------

    In response to commenters,\822\ the Commissions are modifying the

    outstanding debt threshold criterion in the public information

    availability test to include any indebtedness, including loans, so long

    as such indebtedness is not a revolving credit facility. The

    Commissions believe that expanding the definition of indebtedness to

    include loans (other than revolving credit) for purposes of the debt

    threshold determination is consistent with the view that entities that

    have significant outstanding indebtedness likely will have public

    information available about them.\823\

    ---------------------------------------------------------------------------

    \822\ See infra note 845 and accompanying text.

    \823\ See July 2006 Debt Index Release.

    ---------------------------------------------------------------------------

    As more fully described below,\824\ for purposes of satisfying one

    of these issuer eligibility criteria, the final rules provide that a

    reference entity or an issuer of securities included in an index may

    rely upon the status of an affiliated entity as an Exchange Act

    reporting company or foreign private issuer or may aggregate the

    worldwide equity market capitalization or outstanding indebtedness of

    an affiliated entity, regardless of whether such affiliated entity

    itself or its securities are included in the index.

    ---------------------------------------------------------------------------

    \824\ See infra part III.G.3(b)(iv), for a discussion regarding

    the affiliation definition applicable to the public information

    availability test. As noted above, the Commissions are modifying the

    method of calculating affiliation for purposes of this test.

    ---------------------------------------------------------------------------

    In the case of indexes including asset-backed securities, or

    reference entities that are issuing entities of asset-backed

    securities, information about the reference entity or issuing entity of

    the asset-backed security will not alone be sufficient and,

    consequently, the rules provide that the public information

    availability test will be satisfied only if certain information also is

    available about the asset-backed securities. An issuing entity (whether

    or not a reference entity) of asset-backed securities will meet the

    public information availability test if such asset-backed securities

    were issued in a transaction for which the asset-backed securities

    issued (which includes all tranches) \825\ were registered under the

    Securities Act and distribution reports about such asset-backed

    securities are publicly available. In response to commenters,\826\ the

    Commissions note that distribution reports, which sometimes are

    referred to as servicer reports, delivered to the trustee or security

    holders, as the case may be, are filed with the SEC on Form 10-D. In

    addition, because of the lack of public information regarding many

    asset-backed securities, despite the size of the outstanding amount of

    securities,\827\ the rules do not permit such reference entities and

    issuers to satisfy the public information availability test by having

    at least $1 billion in outstanding indebtedness. Characterizing an

    index with reference entities or securities for which public

    information is not likely to be available as narrow-based, and thus

    index CDS where the underlying references or securities are such

    indexes as security-based swaps, should help to ensure that the index

    cannot be used to circumvent the Federal securities laws, including

    those relating to Securities Act compliance and the antifraud,

    antimanipulation and insider trading prohibitions with respect to the

    index components or the securities of the reference entities.

    ---------------------------------------------------------------------------

    \825\ Under this part of the public information availability

    test, all offerings of the asset-backed securities will have to be

    covered by a registration statement under the Securities Act,

    including all tranches, so that public information would exist for

    any tranche included in an index. However, as noted below, CDS that

    are offered to ECPs only may rely on alternatives to satisfy the

    public information test for asset-backed securities.

    \826\ See infra note 849 and accompanying text.

    \827\ See generally Asset-Backed Securities, 75 FR 23328 (May 3,

    2010).

    ---------------------------------------------------------------------------

    As noted above, if an index is not narrow-based under the number

    and concentration criteria, it will be narrow-based if one of the

    reference entities or securities included in the index fails to meet at

    least one of the criteria in the public information availability test.

    However, even if one or more of the reference entities or securities

    included in the index fail the public information availability test,

    the final rules provide that the index will not be considered ``issuers

    of securities in a narrow-based security index'' or a ``narrow-based

    security index,'' so long as the applicable reference entity or

    security that fails the test represents less than five percent of the

    index's weighting, and so long as reference entities or securities

    comprising at least 80 percent of the index's weighting satisfy the

    public information availability test.

    An index that includes a very small proportion of reference

    entities or securities that do not satisfy the public information

    availability test will be treated as a broad-based security index if

    the other elements of the definition, including the five percent and 80

    percent thresholds, are satisfied prior to execution, but no later than

    when the parties offer to enter into the index CDS.\828\ The five-

    percent weighting threshold is designed to provide that reference

    entities or securities not satisfying the public information

    availability test comprise only a very small portion of the index, and

    the 80-percent weighting threshold is designed to provide that a

    predominant percentage of the reference entities or securities in the

    index satisfy the public information availability test. As a result,

    these thresholds provide market participants with flexibility in

    constructing an index. The Commissions believe that these thresholds

    are appropriate and that providing such flexibility is not likely to

    increase the likelihood that an index that satisfies these provisions

    or the component securities or issuers of securities in that index

    would be readily susceptible to manipulation or that there would be

    misuse of material non-public information about the component

    [[Page 48280]]

    securities or issuers of securities in that index through the use of

    CDS based on such indexes.

    ---------------------------------------------------------------------------

    \828\ See supra note 625 and accompanying text.

    ---------------------------------------------------------------------------

    The final rules also provide that, for index CDS entered into

    solely between ECPs, there are alternative means to satisfy the public

    information availability test. Under the final rules, solely for index

    CDS entered into between ECPs, an index will be considered narrow-based

    if a reference entity or security included in the index does not meet

    (i) any of the criteria enumerated above or (ii) any of the following

    criteria: \829\

    ---------------------------------------------------------------------------

    \829\ See paragraph (a)(1)(iv)(H) of rules 1.3(zzz) and

    1.3(aaaa) under the CEA and rule 3a68-1a and 3a68-1b under the

    Exchange Act.

    ---------------------------------------------------------------------------

    The reference entity or the issuer of the security

    included in the index (other than a reference entity or issuer included

    in the index that is an issuing entity of an asset-backed security)

    makes available to the public or otherwise makes available to such ECP

    information about such reference entity or issuer pursuant to rule

    144A(d)(4) under the Securities Act; \830\

    ---------------------------------------------------------------------------

    \830\ 17 CFR 230.144A(d)(4).

    ---------------------------------------------------------------------------

    Financial information about the reference entity or the

    issuer of the security included in the index (other than a reference

    entity or issuer included in the index that is an issuing entity of an

    asset-backed security) is otherwise publicly available; or

    In the case of an asset-backed security included in the

    index, or a reference entity included in the index that is an issuing

    entity of an asset-backed security, information of the type and level

    included in public distribution reports for similar asset-backed

    securities is publicly available about both the reference entity or

    issuing entity and the asset-backed security.

    As more fully described below, for purposes of satisfying either

    the rule 144A information criterion or the financial information

    otherwise publicly available criterion, the final rules provide that a

    reference entity or an issuer of securities included in an index may

    look to an affiliated entity to determine whether it satisfies one of

    these criterion, regardless of whether such affiliated entity itself or

    its securities are included in the index.\831\

    ---------------------------------------------------------------------------

    \831\ See infra part III.G.3(b)(iv), for a discussion regarding

    the affiliation definition applicable to the public information

    availability test applicable to index CDS entered into solely

    between ECPs. As noted above, the Commissions are modifying the

    method of calculating affiliation for purposes of this test.

    ---------------------------------------------------------------------------

    In response to commenters,\832\ the Commissions are revising the

    rule 144A information criterion of the public information availability

    test applicable to index CDS entered into solely between ECPs to

    clarify that the rule 144A information must either be made publicly

    available or otherwise made available to the ECP. In addition, the

    Commissions are clarifying that financial information about the

    reference entity or the issuer of the security may otherwise be

    publicly available through an issuer's Web site, through public filings

    with other regulators or exchanges, or through other electronic means.

    This method of satisfying the public information availability test does

    not specify the precise method by which financial information must be

    available.

    ---------------------------------------------------------------------------

    \832\ See infra note 847 and accompanying text.

    ---------------------------------------------------------------------------

    As with other index CDS, with respect to index CDS entered into

    solely with ECPs, if the percentage of the effective notional amounts

    allocated to reference entities or securities satisfying this expanded

    public information availability test comprise at least 80 percent of

    the index's weighting, then a reference entity or security included in

    the index that fails to satisfy the alternative public information test

    criteria will be disregarded so long as the effective notional amount

    allocated to that reference entity or security comprises less than five

    percent of the index's weighting.

    Comments

    The Commissions received a number of general and specific comments

    regarding the public information availability test.

    A number of commenters believed that the public information

    availability test should not be included in the final rules for various

    reasons, including the potential disparate treatment between products

    based on indexes due to changes in index components,\833\ the impact of

    the migration of indexes from narrow-based to broad-based and vice-

    versa,\834\ and assertions that the test was not needed due to the

    types of participants engaged in swap and security-based swap

    transactions.\835\ One commenter suggested replacing the public

    information availability test with a volume trading test.\836\

    ---------------------------------------------------------------------------

    \833\ See SIFMA Letter. This commenter expressed its concern

    that transactions on the same or similar indexes may result in

    differing regulatory treatment due to changes in index components as

    a result of component adjustments or as the availability of

    information relating to a component issuer changes over time. Id.

    \834\ See Markit Letter. According to this commenter,

    determining whether an index of loans or borrowers meets the public

    information availability test would be more difficult and more

    costly than making the same determination for an index of

    securities, which ``are generally subject to national or exchange-

    based reporting and disclosure regimes'' and could create regulatory

    uncertainty. Id. This commenter also expressed its belief that the

    public information availability test would cause indexes to switch

    between a narrow-based and broad-based classification, which could

    result in unnecessary cost, confusion, and market disruption. Id.

    \835\ See ISDA Letter. This commenter expressed its belief that

    the public information availability test is not needed given the

    largely institutional nature of the existing over-the-counter

    market. Id. See also July LSTA Letter.

    \836\ See Markit Letter. This commenter expressed its belief

    that a volume-based classification process would be preferable to

    the public information availability test for several reasons. First,

    the statutory definition of ``narrow-based security index'' includes

    a volume-based factor. Second, a volume-based factor could be

    applied easily and transparently because the outstanding notional

    volume of CDS referencing each index constituent is captured by the

    Trade Information Warehouse. Third, an index classification based on

    outstanding notional amount as opposed to the public information

    availability test would result in less indices migrating from broad-

    to narrow-based classifications, and vice versa. This commenter also

    expressed its belief that a volume-based test would ensure that

    broad-based indices are not readily susceptible to manipulation

    because indexes based on constituents with high volumes are likely

    to have significant public information available. Id.

    ---------------------------------------------------------------------------

    The Commissions are adopting the public information availability

    test as proposed with certain modifications described above. As

    discussed above, the public information availability test is intended

    as the substitute for the ADTV provision in the statutory narrow-based

    security index definition, which the Dodd-Frank Act included as the

    method for determining whether index CDS are swaps or security-based

    swaps. Based on the reasons discussed above, the Commissions have

    retained the public information availability test as the underlying

    rationale of such provision, that there is sufficient trading in the

    securities and therefore public information and market following of the

    issuer of the securities, applies to index CDS. Accordingly, the

    Commissions believe that there should be public information available

    about a predominant percentage of the reference entities or issuers of

    securities underlying the index in order to prevent circumvention of

    other provisions of the Federal securities laws through the use of CDS

    based on such indexes, to reduce the likelihood that the index, the

    component securities, or the named issuers of securities in the index

    could be readily susceptible to manipulation, and to prevent the misuse

    of material non-public information about such an index, the component

    securities, or the reference entities.

    The Commissions understand that the characterization of an index

    underlying a CDS as broad-based or narrow-based may change because of

    changes to the index, such as addition or removal of components, or

    changes regarding the

    [[Page 48281]]

    specific components of the index, such as a decrease in the amount of

    outstanding common equity for a component. However, these types of

    changes are contemplated by the statutory narrow-based security index

    definition, which the Dodd-Frank Act used to establish whether index

    CDS are swaps or security-based swaps.\837\ Moreover, the Commissions

    have provided that the determination of whether a Title VII instrument

    is a swap, security-based swap or mixed swap is made prior to

    execution, but no later than when the parties offer to enter into the

    Title VII instrument,\838\ and does not change if a security index

    underlying such instrument subsequently migrates from broad to narrow

    (or vice versa) during its life. Accordingly, even if the public

    information availability test would cause indexes underlying index CDS

    to migrate as suggested by a commenter, that will not affect the

    classification of outstanding index CDS entered into prior to such

    migration. However, if an amendment or change is made to such

    outstanding index CDS that would cause it to be a new purchase or sale

    of such index CDS, that could affect the classification of such

    outstanding index CDS. Further, as is true for other products using the

    narrow-based security index definition, the Commissions also believe

    that the effects of changes to an index underlying a CDS traded on an

    organized platform are addressed through the tolerance period and grace

    period rules the Commissions are adopting, which rules are based on

    tolerance period and grace period rules for security futures to which

    the statutory narrow-based security index definition applies.\839\

    ---------------------------------------------------------------------------

    \837\ The index migration issue exists for all products in which

    the ``narrow-based security index'' definition is used. Thus, as is

    true for security futures, the migration issue exists for debt

    security indexes and the statutory definition of the term ``narrow-

    based security index,'' under which an index's characterization may

    be affected by a change to the index itself or to the components of

    the index.

    \838\ See supra note 625 and accompanying text.

    \839\ See infra part III.G.6.

    ---------------------------------------------------------------------------

    The Commissions are not adopting a volume-based test based on the

    trading of the CDS or the trading of the index, either as a replacement

    for the public information availability test or as an alternative means

    of satisfying it, as one commenter suggested.\840\ The Commissions

    believe that using a volume-based test based on the trading of the CDS

    or the trading of the index would not work in the index CDS context

    because the character of the index CDS would have to be determined

    before any trading volume could exist and, therefore, the index CDS

    would fail a volume-based test. The Commissions also believe that a

    volume-based test based either on the CDS components of the index or

    the index itself would not be an appropriate substitute for or an

    alternative to a public information availability test with respect to

    the referenced entity, issuer of securities, or underlying security

    because such a volume-based test would not provide transparency on such

    underlying entities, issuers of securities or securities.\841\

    ---------------------------------------------------------------------------

    \840\ See supra note 836 and accompanying text.

    \841\ In the context of equity securities indexes to which the

    ADTV test applies, there likely is information regarding the

    underlying entities, issuers of securities or securities because, as

    noted above, Exchange Act registration of the security being traded

    is a listing standard for equity securities and, therefore, the

    issuer of the security being traded must be subject to the reporting

    requirements under the Exchange Act. However, in the context of

    index CDS, there are no comparable listing standards that would be

    applicable to provide transparency on the underlying entities,

    issuers of securities or securities.

    ---------------------------------------------------------------------------

    The Commissions believe that the public information availability

    test in the index CDS rules allows more flexibility with respect to the

    types of components included in indexes underlying index CDS. For many

    indexes, such as bespoke indexes, trading volume for CDS on individual

    components may not be significant even though the index component would

    otherwise have no trouble satisfying one of the criteria of the public

    information availability test. The public information availability test

    in the index CDS rules also is very similar to the test in the rules

    for debt security indexes, which, as noted above, apply in the context

    of Title VII instruments, thus providing a consistent set of rules

    under which index compilers and market participants can analyze the

    characterization of CDS.

    One commenter also had concerns regarding specific types of indexes

    and specific types of index components, including the applicability of

    the public information availability test to indexes of loans or

    borrowers.\842\ As discussed above, however, the Commissions believe

    that index CDS based on indexes of loans or borrowers should be

    analyzed under the third prong of the statutory security-based swap

    definition in the same manner as any other index CDS. Although this

    commenter noted such indexes may include a higher proportion of

    ``private'' borrowers (those borrowers who are not public reporting

    companies or that do not register offerings of their securities) and

    thus may themselves not satisfy any of the criteria for the public

    information availability test,\843\ the Commissions believe that the

    information tests of the rule as modified will address these concerns.

    The modified rule will add loans to the categories of instruments to be

    aggregated for purposes of the outstanding indebtedness criterion and,

    as discussed below, will aggregate outstanding indebtedness of

    affiliates.\844\ As a result of these modifications, the Commissions

    believe that the indexes the commenter was concerned about may be more

    likely to satisfy the public information availability test.

    ---------------------------------------------------------------------------

    \842\ See July LSTA Letter.

    \843\ Id.

    \844\ As noted above, the Commissions are modifying the method

    of calculating affiliation for purposes of certain criteria of the

    public information availability test. See infra part III.G.3(b)(iv).

    ---------------------------------------------------------------------------

    One commenter agreed with including an outstanding debt threshold

    as a criterion in the public information availability test, but

    requested that the Commissions change this criterion to include loans

    that are not within the definition of security, as well as affiliate

    debt guaranteed by the issuer of securities or reference entity, and to

    reduce the required outstanding debt threshold from $1 billion to $100

    million.\845\ As discussed above, the Commissions are revising the

    rules to expand the types of debt that are counted toward the $1

    billion debt threshold to include any indebtedness, including loans, so

    long as such indebtedness is not a revolving credit facility. The

    Commissions have made no other changes to the $1 billion debt

    threshold.

    ---------------------------------------------------------------------------

    \845\ See Markit Letter. This commenter suggested that the debt

    threshold should be reduced to $100 million because debt issuances

    in some debt markets, such as the high yield markets, tend to be

    relatively small. This commenter also suggested that the debt

    threshold should include debt guaranteed by the issuer of the

    securities or reference entity because in many cases the issuer of

    the securities or reference entity is merely guaranteeing debt of

    its affiliates and not issuing the debt. Finally, this commenter

    requested clarification as to whether the debt threshold included

    loans and leveraged loans.

    ---------------------------------------------------------------------------

    The Commissions believe that the fact that an entity has guaranteed

    the obligations of another entity will not affect the likelihood that

    public information is available about either the borrower on the

    guaranteed obligation or on the guarantor entity. However, the

    Commissions note that they are providing an additional interpretation

    on the affiliation definition of the index CDS rules, including

    modifying the method of calculating affiliation, that should address

    this commenter's concerns regarding guaranteed affiliate

    [[Page 48282]]

    debt.\846\ The Commissions also believe that the $1 billion debt

    threshold, which is the same amount as the outstanding debt threshold

    in the rules for debt security indexes, is set at the appropriate level

    to achieve the objective that such entities are likely to have public

    information available about them.

    ---------------------------------------------------------------------------

    \846\ See infra part III.G.3(b)(iv).

    ---------------------------------------------------------------------------

    One commenter suggested that the proposed rule 144A information

    criterion of the public information availability test applicable to

    index CDS entered into solely between ECPs should be satisfied if the

    issuer made the rule 144A information available upon request to the

    public or to the ECP in question, rather than being required to provide

    the information.\847\ In response to this commenter, the Commissions

    are revising the rule 144A information criterion of the public

    information availability test applicable to index CDS entered into

    solely between ECPs to clarify that the rule 144A information must be

    made publicly available or otherwise made available to the ECP.

    ---------------------------------------------------------------------------

    \847\ See SIFMA Letter.

    ---------------------------------------------------------------------------

    The Commissions received one comment regarding the criteria of the

    public information availability test that relate specifically to asset-

    backed securities.\848\ The commenter was concerned that the test for

    asset-backed securities underlying an index may be difficult to apply

    because all asset-backed securities underlying an index are not always

    registered under the Securities Act.\849\ This commenter also was

    concerned that the term ``distribution reports'' may not be the same as

    monthly service reports, which this commenter indicated are available

    through the deal trustee and/or the SEC Web site.\850\ This commenter

    also believed that it was unclear whether these monthly service reports

    would qualify as ``distribution reports'' for purposes of the public

    information availability test and whether information regarding Agency

    MBS pools, which are available on Agency Web sites, would be sufficient

    to satisfy the public information availability test.\851\ In addition,

    this commenter requested that the Commissions clarify that not all

    tranches of a transaction need to be registered under the Securities

    Act to satisfy the publicly available distribution report

    requirement.\852\

    ---------------------------------------------------------------------------

    \848\ See Markit Letter.

    \849\ Id.

    \850\ Id.

    \851\ Id.

    \852\ Id.

    ---------------------------------------------------------------------------

    The Commissions are adopting as proposed the provisions of the

    public information availability test applicable to indexes based on

    asset-backed securities. The Commissions note that there are two

    possible ways to satisfy the public information availability test for

    index CDS based on asset-backed securities or asset-backed issuers. For

    index CDS available to non-ECPs, all asset-backed securities in the

    index or of the issuer in the index must have been sold in registered

    offerings under the Securities Act and have publicly available

    distribution reports. The Commissions are clarifying that monthly

    service reports filed with the SEC will satisfy the requirement for

    publicly available distribution reports.\853\ However, for index CDS

    being sold only to ECPs, the public information availability test with

    respect to the index components is satisfied, regardless of whether the

    asset-backed securities have been sold in registered offerings under

    the Securities Act, if information of the type and level included in

    public distribution reports for similar asset-backed securities is

    publicly available about both the issuing entity and such asset-backed

    securities. The Commissions believe that requiring such information

    about the asset-backed securities and the assets in the pools

    underlying such asset-backed securities is consistent with existing

    disclosure requirements for asset-backed securities and existing

    practices of ABS issuers.

    ---------------------------------------------------------------------------

    \853\ Distribution reports, which sometimes are referred to as

    servicer reports, delivered to the trustee or security holders, as

    the case may be, are filed with the SEC on Form 10-D.

    ---------------------------------------------------------------------------

    (iv) Affiliation of Reference Entities and Issuers of Securities With

    Respect to Certain Criteria of the Public Information Availability Test

    The Commissions are adopting the affiliation definition that

    applies to certain criteria of the public information availability test

    with certain modifications from the proposals to address commenters'

    concerns.\854\ The Commissions are making modifications to this

    affiliation definition that are the same as the modifications the

    Commissions are making to the affiliation definition that applies when

    calculating the number and concentration criteria.\855\

    ---------------------------------------------------------------------------

    \854\ See infra note 867 and accompanying text.

    \855\ See supra part III.G.3(b)(ii).

    ---------------------------------------------------------------------------

    This affiliation definition applies for purposes of determining

    whether a reference entity or issuer of securities included in an index

    satisfies one of the following four criteria of the public information

    availability test: (i) The reference entity or issuer of the security

    included in the index is required to file reports pursuant to the

    Exchange Act or the regulations thereunder; \856\ (ii) the reference

    entity or issuer of the security included in the index is eligible to

    rely on the exemption provided in rule 12g3-2(b) under the Exchange Act

    for foreign private issuers; \857\ (iii) the reference entity or issuer

    of the security included in the index has a worldwide market value of

    its outstanding common equity held by non-affiliates of $700 million or

    more; \858\ and (iv) the reference entity or issuer of the security

    included in the index has outstanding notes, bonds, debentures, loans,

    or evidences of indebtedness (other than revolving credit facilities)

    having a total remaining principal amount of at least $1 billion.\859\

    This affiliation definition also applies for purposes of determining

    whether a reference entity or issuer of securities included in an index

    satisfies one of the following two criteria of the alternative public

    information availability test applicable to index CDS entered into

    solely between ECPs: (i) The reference entity or issuer of the security

    included in the index makes available rule 144A information; \860\ and

    (ii) financial information about the reference entity or issuer of the

    security included in the index is otherwise publicly available.\861\

    ---------------------------------------------------------------------------

    \856\ See paragraph (a)(1)(iv)(A) of rules 1.3(zzz) and

    1.3(aaaa) under the CEA and rule 3a68-1a and 3a68-1b under the

    Exchange Act.

    \857\ See paragraph (a)(1)(iv)(B) of rules 1.3(zzz) and

    1.3(aaaa) under the CEA and rule 3a68-1a and 3a68-1b under the

    Exchange Act.

    \858\ See paragraph (a)(1)(iv)(C) of rules 1.3(zzz) and

    1.3(aaaa) under the CEA and rule 3a68-1a and 3a68-1b under the

    Exchange Act.

    \859\ See paragraph (a)(1)(iv)(D) of rules 1.3(zzz) and

    1.3(aaaa) under the CEA and rule 3a68-1a and 3a68-1b under the

    Exchange Act.

    \860\ See paragraph (a)(1)(iv)(H)(1) of rules 1.3(zzz) and

    1.3(aaaa) under the CEA and rule 3a68-1a and 3a68-1b under the

    Exchange Act.

    \861\ See paragraph (a)(1)(iv)(H)(2) of rules 1.3(zzz) and

    1.3(aaaa) under the CEA and rule 3a68-1a and 3a68-1b under the

    Exchange Act.

    ---------------------------------------------------------------------------

    The final rules provide that the terms ``reference entity included

    in the index'' and ``issuer of the security included in the index''

    include a single reference entity or issuer of securities included in

    an index, respectively, or a group of affiliated entities.\862\ For

    purposes of the rules, a reference entity or issuer of securities

    included in an index may rely upon an affiliated entity to satisfy

    certain criteria of the public information availability test. However,

    with respect to asset-backed securities, the final rules provide that

    each reference entity or issuer of securities included in an index

    [[Page 48283]]

    that is an issuing entity of an asset-backed security is considered a

    separate reference entity or issuer, as applicable, and will not be

    considered affiliated with any other entities.

    ---------------------------------------------------------------------------

    \862\ See paragraph (c)(4) of rules 1.3(zzz) and 1.3(aaaa) under

    the CEA and rule 3a68-1a and 3a68-1b under the Exchange Act.

    ---------------------------------------------------------------------------

    The final rules provide that a reference entity or issuer of

    securities included in an index is affiliated with another entity if it

    controls, is controlled by, or is under common control with, that other

    entity.\863\ The final rules define control, solely for purposes of

    this affiliation definition, to mean ownership of more than 50 percent

    of a reference entity's or issuer's equity or the ability to direct the

    voting of more than 50 percent of a reference entity's or issuer's

    voting equity.\864\ This revision is the same as the modification the

    Commissions are making to the affiliation definition that applies when

    calculating the number and concentration criteria, which is discussed

    above.\865\

    ---------------------------------------------------------------------------

    \863\ See paragraph (c)(1) of rules 1.3(zzz) and 1.3(aaaa) under

    the CEA and rule 3a68-1a and 3a68-1b under the Exchange Act.

    \864\ See paragraph (c)(2) of rules 1.3(zzz) and 1.3(aaaa) under

    the CEA and rule 3a68-1a and 3a68-1b under the Exchange Act.

    \865\ See supra part III.G.3(b)(ii).

    ---------------------------------------------------------------------------

    As the Commissions noted above, this change is based on the

    Commissions' consideration of comments received. By using a more than

    50 percent (i.e., majority ownership) test rather than a 20 percent

    ownership test for the control threshold, there is a greater likelihood

    that there will be information available about the reference entity or

    issuer of securities included in the index because the market likely

    will view the affiliated entity and the reference entity or issuer of

    securities included in the index as a single company or economic

    entity.\866\ Accordingly, to the extent information regarding the

    affiliated entity is publicly available, there may be information

    regarding the reference entity or issuer of securities included in the

    index that also is publicly available. This modified control threshold

    will permit such reference entity or issuer of securities to rely upon

    an affiliated entity to satisfy one of the criteria of the public

    information availability test. Further, unlike the affiliation

    definition that applies when calculating the number and concentration

    criteria, the affiliation definition that applies to certain criteria

    of the public information availability test does not require that the

    affiliated entity or its securities be included in the index.

    ---------------------------------------------------------------------------

    \866\ The more than 50 percent (i.e., majority ownership) test

    is generally consistent with consolidation under U.S. generally

    accepted accounting principles. See FASB ASC section 810-10-25,

    Consolidation--Overall--Recognition (stating that consolidation is

    appropriate if a reporting entity has a controlling financial

    interest in another entity and a specific scope exception does not

    apply). Accordingly, using a more than 50 percent (i.e., majority

    ownership) test will make it more likely that the reference entity

    or issuer of securities included in the index and the affiliated

    entity will be consolidated with each other in financial statements.

    Consolidated financial statements present the financial position and

    results of operations for a parent (controlling entity) and one or

    more subsidiaries (controlled entities) as if the individual

    entities actually were a single company or economic entity.

    ---------------------------------------------------------------------------

    As the affiliation definition applies to the Exchange Act reporting

    company and foreign private issuer criteria of the public information

    availability test, a reference entity or an issuer of securities

    included in an index that itself is not required to file reports

    pursuant to the Exchange Act or the regulations thereunder or is not

    eligible to rely on the exemption provided in rule 12g3-2(b) under the

    Exchange Act for foreign private issuers may rely upon the status of an

    affiliated entity as an Exchange Act reporting company or foreign

    private issuer, regardless of whether that affiliated entity itself or

    its securities are included in the index, to satisfy one of these

    criteria. For example, a majority-owned subsidiary included in an index

    may rely upon the status of its parent, which may or may not be

    included in the index, to satisfy the issuer eligibility criteria if

    the parent is required to file reports under the Exchange Act or is a

    foreign private issuer.

    Similarly, as the affiliation definition applies to the worldwide

    equity market capitalization and outstanding indebtedness criteria of

    the public information availability test, a reference entity or an

    issuer of securities included in an index that itself does not have a

    worldwide market value of its outstanding common equity held by non-

    affiliates of $700 million or more or outstanding notes, bonds,

    debentures, loans, or evidences of indebtedness (other than revolving

    credit facilities) having a total remaining principal amount of at

    least $1 billion, may aggregate the worldwide equity market

    capitalization or outstanding indebtedness of an affiliated entity,

    regardless of whether that affiliated entity itself or its securities

    are included in the index, to satisfy one of these criteria. For

    example, a majority-owned subsidiary included in an index may aggregate

    the worldwide equity market capitalization or outstanding indebtedness

    of its parent and/or other affiliated entities, such as other majority-

    owned subsidiaries of the parent, to satisfy one of these criteria.

    Finally, as the affiliation definition applies to the rule 144A

    information and financial information otherwise publicly available

    criteria of the alternative public information availability test

    applicable to index CDS entered into solely between ECPs, a reference

    entity or an issuer of securities included in an index that itself does

    not make available rule 144A information or does not have financial

    information otherwise publicly available may rely upon an affiliated

    entity, regardless of whether that affiliated entity itself or its

    securities are included in the index, to satisfy one of these criteria.

    Comments

    One commenter requested that the Commissions revise the affiliation

    definition that applies for purposes of the public information

    availability test to increase the threshold from 20 percent ownership

    to majority ownership.\867\ This commenter noted that majority

    ownership is consistent with current market practice, including the

    definition of affiliate included in the 2003 ISDA Credit Derivatives

    Definitions.\868\ This commenter also noted that the current approach

    with respect to the inclusion of affiliated entities in the same index

    uses majority ownership rather than 20 percent ownership to determine

    affiliation.\869\ This commenter also requested that the Commissions

    clarify the application of the affiliation definition to the public

    information availability test.\870\ Further, this commenter requested

    that the worldwide equity market capitalization criterion should

    include all affiliated entities because the reference entity included

    in the index may not be the member of a corporate group that issues

    public equity.\871\ Finally, this commenter was concerned that the

    outstanding indebtedness criterion would not include affiliate debt

    guaranteed by the reference entity or issuer of securities included in

    the index.\872\ Further, as noted above,\873\ another commenter was

    concerned that index CDS may include a higher proportion of ``private''

    borrowers (those borrowers that are not public reporting companies or

    that do not register offerings of their securities) and thus may

    themselves not satisfy each of the

    [[Page 48284]]

    criteria for the public information availability test.\874\

    ---------------------------------------------------------------------------

    \867\ See Markit Letter (requesting a threshold of at least 50

    percent).

    \868\ Id.

    \869\ Id.

    \870\ Id.

    \871\ Id. This commenter provided Kinder Morgan Kansas Inc.

    (CDS) and Kinder Morgan Inc. (equity) as an example of where the

    reference entity and issuer of equity among a corporate group are

    not the same. Id.

    \872\ Id.

    \873\ See supra note 842 and accompanying text.

    \874\ See July LSTA Letter.

    ---------------------------------------------------------------------------

    The Commissions note the commenters' concerns. The Commissions are

    modifying the method of determining affiliation that applies for

    purposes of satisfying certain criteria of the public information

    availability test. The final rules provide that a reference entity or

    issuer of securities included in an index may rely upon an affiliated

    entity (meeting the more than 50 percent control threshold) to satisfy

    one of the criterion of the public information availability test. This

    modification is similar to the one the Commissions are making to the

    affiliation definition that applies for purposes of calculating the

    number and concentration criteria. As noted above, based on commenters'

    letters, the Commissions understand that the current standard CDS

    documentation and the current approach with respect to the inclusion of

    affiliated entities in the same index use majority ownership rather

    than 20 percent ownership to determine affiliation. The Commissions

    agree with commenters that in the case of index CDS only it is more

    appropriate to use a more than 50 percent (i.e., majority ownership)

    test rather than a 20 percent ownership test. The Commissions believe

    that because reference entities or issuers of securities included in an

    index may rely on an affiliated entity to help satisfy the public

    information availability test a threshold of majority ownership rather

    than 20 percent ownership will increase the likelihood that there is

    information available about the reference entity or issuer of

    securities included in the index. The Commissions believe that

    determining affiliation in this manner for purposes of the public

    availability of information test responds to the commenter's concerns.

    Further, the Commissions are providing several illustrative

    examples of the way in which the affiliation definition works in the

    context of the public availability of information criteria to address

    the commenter's concerns regarding the application of the affiliation

    definition in that context. The Commissions also note that the final

    rules respond to the commenter's concerns regarding the applicability

    of the affiliation definition to the worldwide equity market

    capitalization criterion by providing that the worldwide market

    capitalization of an affiliate can be counted in determining whether

    the reference entity or issuer of securities included in the index

    meets the worldwide equity market capitalization criterion. Moreover,

    the Commissions note that the final rules respond to the commenter's

    concerns regarding affiliate debt by providing that indebtedness of an

    affiliate can be counted in determining whether the reference entity or

    issuer of securities included in the index meets the outstanding

    indebtedness criterion. Finally, the Commissions note that the

    affiliation definition as modified responds to the commenter's concerns

    regarding ``private'' borrowers because the modified affiliation

    definition will allow a reference entity or issuer of securities

    included in an index to consider the indebtedness, the outstanding

    equity, and the reporting status of an affiliate in determining whether

    the public information availability test is satisfied.

    As noted above, the Commissions also believe that the modified

    affiliation definition responds to commenters' concerns noted above

    that the rules further defining the terms ``issuers of securities in a

    narrow-based security index'' and ``narrow-based security index''

    should be simplified. The modified affiliation definition enables

    market participants to make an affiliation determination for purposes

    of the public information availability test criteria by measuring the

    more than 50 percent (i.e., majority ownership) control threshold.

    (v) Application of the Public Information Availability Requirements to

    Indexes Compiled by a Third-Party Index Provider

    The Commissions requested comment in the Proposing Release as to

    whether the public information availability test should apply to an

    index compiled by an index provider that is not a party to an index CDS

    (``third-party index provider'') that makes publicly available general

    information about the construction of the index, index rules, identity

    of components, and predetermined adjustments, and which index is

    referenced by an index CDS that is offered on or subject to the rules

    of a DCM or SEF, or by direct access in the U.S. from an FBOT that is

    registered with the CFTC.\875\ Two commenters stated that the presence

    of a third-party index provider would assure that sufficient

    information is available regarding the index CDS itself.\876\ Neither

    commenter provided any analysis to explain how or whether a third-party

    index provider would be able to provide information about the

    underlying securities or issuers of securities in the index. The

    Commissions are not revising the rules to exclude from the public

    information availability test any index compiled by a third-party index

    provider.

    ---------------------------------------------------------------------------

    \875\ See Proposing Release at 29851-52.

    \876\ See ISDA Letter and SIFMA Letter.

    ---------------------------------------------------------------------------

    (vi) Treatment of Indexes Including Reference Entities That Are Issuers

    of Exempted Securities or Including Exempted Securities

    The Commissions are adopting the rules regarding the treatment of

    indexes that include exempted securities or reference entities that are

    issuers of exempted securities as proposed without modification.\877\

    The Commissions believe such treatment is consistent with the objective

    and intent of the statutory definition of the term ``security-based

    swap,'' as well as the approach taken in the context of security

    futures.\878\ Accordingly, paragraph (1)(ii) of rules 1.3(zzz) and

    1.3(aaaa) under the CEA and paragraph (a)(2) of rules 3a68-1a and 3a68-

    1b under the Exchange Act provide that, in the case of an index that

    includes exempted securities, or reference entities that are issuers of

    exempted securities, in each case as defined as of the date of

    enactment of the Futures Trading Act of 1982 (other than municipal

    securities), such securities or reference entities are excluded from

    the index when determining whether the securities or reference entities

    in the index constitute a ``narrow-based security index'' or ``issuers

    of securities in a narrow-based security index'' under the rules.

    ---------------------------------------------------------------------------

    \877\ See rules 1.3(zzz)(1)(i) and 1.3(aaaa)(1)(i) under the CEA

    and rules 3a68-1a(a)(2) and 3a68-1b(a)(2) under the Exchange Act;

    and July 2006 Debt Index Rules. The Commissions did not receive any

    comments on the proposed rules regarding the treatment of indexes

    that include exempted securities or reference entities that are

    issuers of exempted securities.

    \878\ See section 3(a)(68)(C) of the Exchange Act, 15 U.S.C.

    78c(a)(68)(C) (providing that ``[t]he term `security-based swap'

    does not include any agreement, contract, or transaction that meets

    the definition of a security-based swap only because such agreement,

    contract, or transaction references, is based upon, or settles

    through the transfer, delivery, or receipt of an exempted security

    under paragraph (12) [of the Exchange Act], as in effect on the date

    of enactment of the Futures Trading Act of 1982 (other than any

    municipal security as defined in paragraph (29) [of the Exchange

    Act] as in effect on the date of enactment of the Futures Trading

    Act of 1982), unless such agreement, contract, or transaction is of

    the character of, or is commonly known in the trade as, a put, call,

    or other option'').

    ---------------------------------------------------------------------------

    Under paragraph (1)(ii) of rules 1.3(zzz) and 1.3(aaaa) under the

    CEA and paragraph (a)(2) of rules 3a68-1a and 3a68-1b) under the

    Exchange Act, an index composed solely of securities that are, or

    reference entities that are issuers of, exempted securities (other than

    municipal securities) will not be a

    [[Page 48285]]

    ``narrow-based security index'' or an index composed of ``issuers of

    securities in a narrow-based security index.'' In the case of an index

    where some, but not all, of the securities or reference entities are

    exempted securities (other than municipal securities) or issuers of

    exempted securities (other than municipal securities), the index will

    be a ``narrow-based security index'' or an index composed of ``issuers

    of securities in a narrow-based security index'' only if the index is

    narrow-based when the securities that are, or reference entities that

    are issuers of, exempted securities (other than municipal securities)

    are disregarded. The Commissions believe this approach should result in

    consistent treatment for indexes regardless of whether they include

    securities that are, or issuers of securities that are, exempted

    securities (other than municipal securities) while helping to ensure

    that exempted securities (other than municipal securities) and issuers

    of exempted securities (other than municipal securities) are not

    included in an index merely to make the index either broad-based or

    narrow-based under the rules.

    4. Security Indexes

    The Dodd-Frank Act defines the term ``index'' as ``an index or

    group of securities, including any interest therein or based on the

    value thereof.'' \879\ The Commissions provided an interpretation in

    the Proposing Release regarding how to determine when a portfolio of

    securities is a narrow-based or broad-based security index, and the

    circumstances in which changes to the composition of a security index

    (including a portfolio of securities) \880\ underlying a Title VII

    instrument would affect the characterization of such Title VII

    instrument.\881\ The Commissions are restating the interpretation set

    forth in the Proposing Release with one clarification in response to a

    commenter.\882\ Specifically, the Commissions are clarifying what is

    meant by ``predetermined'' for purposes of whether criteria or a self-

    executing formula for adjusting the security index underlying a Title

    VII instrument qualify under the interpretation. The Commissions find

    that this interpretation is an appropriate way to address how to

    determine when a portfolio of securities is a narrow-based or broad-

    based security index, and the circumstances in which changes to the

    composition of a security index (including a portfolio of securities)

    underlying a Title VII instrument would affect the characterization of

    such Title VII instrument, and is designed to reduce costs associated

    with making such a determination.\883\

    ---------------------------------------------------------------------------

    \879\ See section 3(a)(68)(E) of the Exchange Act, 15 U.S.C.

    78c(a)(68)(E).

    \880\ The Commissions noted in the Proposing Release that a

    ``portfolio'' of securities could be a group of securities and

    therefore an ``index'' for purposes of the Dodd-Frank Act. See

    Proposing Release at 29854. To the extent that changes are made to

    the securities underlying the Title VII instrument and each such

    change is individually confirmed, then those substituted securities

    are not part of a security index as defined in the Dodd-Frank Act,

    and therefore a Title VII instrument on each of those substituted

    securities is a security-based swap.

    \881\ Solely for purposes of the discussion in this section, the

    terms ``security index'' and ``security portfolio'' are intended to

    include either securities or the issuers of securities.

    \882\ See infra note 891 and accompanying text.

    \883\ See supra part I, under ``Overall Economic

    Considerations''.

    ---------------------------------------------------------------------------

    A security index in most cases is designed to reflect the

    performance of a market or sector by reference to representative

    securities or interests in securities. There are several well-known

    security indexes established and maintained by recognized index

    providers currently in the market.\884\ However, instead of using these

    established indexes, market participants may enter into a Title VII

    instrument where the underlying reference of the Title VII instrument

    is a portfolio of securities selected by the counterparties or created

    by a third-party index provider at the behest of one or both

    counterparties. In some cases, the Title VII instrument may give one or

    both of the counterparties, either directly or indirectly (e.g.,

    through an investment adviser or through the third-party index

    provider), discretionary authority to change the composition of the

    security portfolio, including, for example, by adding or removing

    securities in the security portfolio on an ``at-will'' basis during the

    term of the Title VII instrument.\885\ Where the counterparties, either

    directly or indirectly (e.g., through an investment adviser or through

    the third-party index provider), have this discretionary authority to

    change the composition or weighting of securities in a security

    portfolio, that security portfolio will be treated as a narrow-based

    security index, and therefore a Title VII instrument on that security

    portfolio is a security-based swap.\886\

    ---------------------------------------------------------------------------

    \884\ One example is the S&P 500[supreg] Index, an index that

    gauges the large cap U.S. equities market.

    \885\ Alternatively, counterparties may enter into Title VII

    instruments where a third-party investment manager selects an

    initial portfolio of securities and has discretionary authority to

    change the composition of the security portfolio in accordance with

    guidelines agreed upon with the counterparties. Under the final

    guidance the Commissions are issuing today, such security portfolios

    are treated as narrow-based security indexes, and Title VII

    instruments on those security portfolios are security-based swaps.

    \886\ The Commissions understand that a security portfolio could

    be labeled as such or could just be an aggregate of individual Title

    VII instruments documented, for example, under a master agreement or

    by amending an annex of securities attached to a master trade

    confirmation. If the security portfolio were created by aggregating

    individual Title VII instruments, each Title VII instrument must be

    evaluated in accordance with the guidance to determine whether it is

    a swap or a security-based swap. For the avoidance of doubt, if the

    counterparties to a Title VII instrument exchanged payments under

    that Title VII instrument based on a security index that was itself

    created by aggregating individual security-based swaps, such Title

    VII instrument would be a security-based swap. See supra part III.D.

    ---------------------------------------------------------------------------

    However, not all changes that occur to the composition or weighting

    of a security index underlying a Title VII instrument will always

    result in that security index being treated as a narrow-based security

    index. Many security indexes are constructed and maintained by an index

    provider pursuant to a published methodology.\887\ For instance, the

    various Standard & Poor's security indexes are reconstituted and

    rebalanced as needed and on a periodic basis pursuant to published

    index criteria.\888\ Such indexes underlying a Title VII instrument

    would be broad-based or narrow-based depending on the composition and

    weighting of the underlying security index.

    ---------------------------------------------------------------------------

    \887\ See, e.g., NASDAQ, ``NASDAQ-100 Index'' (``The NASDAQ-100

    Index is calculated under a modified capitalization-weighted

    methodology. The methodology generally is expected to retain the

    economic attributes of capitalization-weighting while providing

    enhanced diversification. To accomplish this, NASDAQ will review the

    composition of the NASDAQ-100 Index on a quarterly basis and adjust

    the weightings of Index components using a proprietary algorithm, if

    certain pre-established weight distribution requirements are not

    met.''), available at http://dynamic.nasdaq.com/dynamic/nasdaq100_activity.stm.

    \888\ Information regarding security indexes and their related

    methodologies may be widely available to the general public or

    restricted to licensees in the case of proprietary or ``private

    label'' security indexes. Both public and private label security

    indexes frequently are subject to intellectual property protection.

    ---------------------------------------------------------------------------

    In addition, counterparties to a Title VII instrument frequently

    agree to use as the underlying reference of a Title VII instrument a

    security index based on predetermined criteria where the security index

    composition or weighting may change as a result of the occurrence of

    certain events specified in the Title VII instrument at execution, such

    as ``succession events.'' Counterparties to a Title VII instrument also

    may use a predetermined self-executing formula to make other changes to

    the composition or weighting of a security index underlying a Title VII

    instrument. In either of these situations, the composition of a

    security index may

    [[Page 48286]]

    change pursuant to predetermined criteria or predetermined self-

    executing formulas without the Title VII instrument counterparties,

    their agents, or third-party index providers having any direct or

    indirect discretionary authority to change the security index.

    In general, and by contrast to Title VII instruments in which the

    counterparties, either directly or indirectly (e.g., through an

    investment adviser or through the third-party index provider), have the

    discretion to change the composition or weighting of the referenced

    security index, where there is an underlying security index for which

    there are predetermined criteria or a predetermined self-executing

    formula for adjusting the security index that are not subject to change

    or modification through the life of the Title VII instrument and that

    are set forth in the Title VII instrument at execution (regardless of

    who establishes the criteria or formula), a Title VII instrument on

    such underlying security index is based on a broad-based or narrow-

    based security index, depending on the composition and weighting of the

    underlying security index. Subject to the interpretation discussed

    below regarding security indexes that may shift from being a narrow-

    based security index or broad-based security index during the life of

    an existing Title VII instrument, the characterization of a Title VII

    instrument based on a security index as either a swap or a security-

    based swap will depend on the characterization of the security index

    using the above interpretation.\889\

    ---------------------------------------------------------------------------

    \889\ See supra note 886, regarding the aggregation of separate

    trades.

    ---------------------------------------------------------------------------

    The Commissions are clarifying in response to a commenter that, for

    purposes of this interpretation, criteria or a self-executing formula

    regarding composition of a security index underlying a Title VII

    instrument shall be considered ``predetermined'' if it is bilaterally

    agreed upon pre-trade by the parties to a transaction.\890\ In order to

    qualify under this interpretation, however, the Commissions reiterate

    that the ``predetermined'' criteria or self-executing formula, as

    described above, must not be subject to change or modification through

    the life of the Title VII instrument and must be set forth in the Title

    VII instrument at execution (regardless of who establishes the criteria

    or formula).

    ---------------------------------------------------------------------------

    \890\ See infra note 891 and accompanying text.

    ---------------------------------------------------------------------------

    Comments

    The Commissions requested comment on a number of issues regarding

    the interpretation contained in this section as it was proposed,

    including whether the terms ``predetermined criteria'' and

    ``predetermined self-executing formula'' are clear, and whether

    additional interpretations should be provided with respect to these

    terms. The Commissions received one comment on the interpretation

    provided in the Proposing Release, in which the commenter requested

    clarification that criteria affecting the composition of an index, when

    such criteria are agreed bilaterally, pre-trade, by the counterparties

    to a bespoke index trade, are ``predetermined'' for purposes of

    determining whether the index is treated as narrow-based or broad-

    based.\891\

    ---------------------------------------------------------------------------

    \891\ See ISDA Letter. While this commenter agrees with the

    guidance that the predetermined changes described in this section

    should not alter the character of an index (or the classification of

    a Title VII instrument based thereon), this commenter disagrees that

    the ability to make discretionary changes should cause an otherwise

    broad-based security index to be a narrow-based security index. This

    commenter requested that the Commissions classify transactions ``at

    inception and upon actual change in respect of any classification-

    related characteristic, be that change the product of a

    renegotiation or a unilateral exercise of discretion.'' Id. The

    Commissions note that if material terms of a Title VII instrument

    are amended or modified during its life based on an exercise of

    discretion and not through predetermined criteria or a predetermined

    self-executing formula, the Commissions view the amended or modified

    Title VII instrument as a new Title VII instrument. See infra part

    III.G.5.

    ---------------------------------------------------------------------------

    The Commissions are restating the interpretation set forth in the

    Proposing Release with one clarification in response to the commenter's

    concerns. As discussed above, the Commissions are providing that not

    all changes that occur to the composition or weighting of a security

    index underlying a Title VII instrument will result in that security

    index being treated as a narrow-based security index. Foremost among

    these examples is a security index that is constructed and maintained

    by an index provider pursuant to a published methodology.\892\ Changes

    to such an index pursuant to such a methodology are not the type of

    discretionary changes that will render an otherwise broad-based

    security index a narrow-based security index. The Commissions believe

    this clarification addresses the commenter's concerns.

    ---------------------------------------------------------------------------

    \892\ Indeed, the Commissions specifically mentioned in this

    regard, and have included in the final guidance above, the various

    Standard & Poor's security indexes--some of which may be described

    as ``common equity indices'' as alluded to in ISDA's comment--that

    are reconstituted and rebalanced as needed and on a periodic basis

    pursuant to published index criteria.

    ---------------------------------------------------------------------------

    5. Evaluation of Title VII Instruments on Security Indexes That Move

    from Broad-Based to Narrow-Based or Narrow-Based to Broad-Based

    (a) In General

    The determination of whether a Title VII instrument is a swap, a

    security-based swap, or both (i.e., a mixed swap), is made prior to

    execution, but no later than when the parties offer to enter into the

    Title VII instrument.\893\ If the security index underlying a Title VII

    instrument migrates from being broad-based to being narrow-based, or

    vice versa, during the life of a Title VII instrument, the

    characterization of that Title VII instrument will not change from its

    initial characterization regardless of whether the Title VII instrument

    was entered into bilaterally or was executed through a trade on or

    subject to the rules of a DCM, SEF, FBOT, security-based SEF, or NSE.

    For example, if two counterparties enter into a swap based on a broad-

    based security index, and three months into the life of the swap the

    security index underlying that Title VII instrument migrates from being

    broad-based to being narrow-based, the Title VII instrument will remain

    a swap for the duration of its life and will not be recharacterized as

    a security-based swap.

    ---------------------------------------------------------------------------

    \893\ See supra note 625 and accompanying text.

    ---------------------------------------------------------------------------

    If the material terms of a Title VII instrument are amended or

    modified during its life based on an exercise of discretion and not

    through predetermined criteria or a predetermined self-executing

    formula, the Commissions view the amended or modified Title VII

    instrument as a new Title VII instrument.\894\ As a result, the

    characteristics of the underlying security index must be reassessed at

    the time of such an amendment or modification to determine whether the

    security index has migrated from broad-based to narrow-based, or vice

    versa. If the security index has migrated, then the characterization of

    the amended or

    [[Page 48287]]

    modified Title VII instrument will be determined by evaluating the

    underlying security index at the time the Title VII instrument is

    amended or modified. Similarly, if a security index has migrated from

    broad-based to narrow-based, or vice versa, any new Title VII

    instrument based on that security index will be characterized pursuant

    to an evaluation of the underlying security index at the execution of

    that new Title VII instrument.

    ---------------------------------------------------------------------------

    \894\ For example, if, on its effective date, a Title VII

    instrument tracks the performance of an index of 12 securities but

    is amended during its term to track the performance of only 8 of

    those 12 securities, the Commissions would view the amended or

    modified Title VII instrument as a new Title VII instrument. Because

    it is a new Title VII instrument, any regulatory requirements

    regarding new Title VII instruments apply. Conversely, if, on its

    effective date, a Title VII instrument tracks the performance of an

    index of 12 securities but is amended during its term to reflect the

    replacement of a departing ``key person'' of a hedge fund that is a

    counterparty to the Title VII instrument with a new ``key person,''

    the Commissions would not view the amended or modified Title VII

    instrument as a new Title VII instrument because the amendment or

    modification is not to a material term of the Title VII instrument.

    ---------------------------------------------------------------------------

    The Commissions provided an interpretation in the Proposing Release

    regarding circumstances in which the character of a security index on

    which a Title VII instrument is based changes according to

    predetermined criteria or a predetermined self-executing formula set

    forth in the Title VII instrument (or in a related or other agreement

    entered into by the counterparties or a third-party index provider to

    the Title VII instrument) at execution. The Commissions are restating

    this interpretation with one clarification in response to a

    commenter.\895\

    ---------------------------------------------------------------------------

    \895\ See infra note 898 and accompanying text.

    ---------------------------------------------------------------------------

    Where at the time of execution such criteria or such formula would

    cause the underlying broad-based security index to become or assume the

    characteristics of a narrow-based security index or vice versa during

    the duration of the instrument,\896\ then the Title VII instrument

    based on such security index is a mixed swap during the entire life of

    the Title VII instrument.\897\ Although at certain points during the

    life of the Title VII instrument, the underlying security index would

    be broad-based and at other points the underlying security index would

    be narrow-based, regulating such a Title VII instrument as a mixed swap

    from the execution of the Title VII instrument and throughout its life

    reflects the appropriate characterization of a Title VII instrument

    based on a security index that migrates pursuant to predetermined

    criteria or a predetermined self-executing formula.

    ---------------------------------------------------------------------------

    \896\ Thus, for example, if a predetermined self-executing

    formula agreed to by the counterparties of a Title VII instrument at

    or prior to the execution of the Title VII instrument provided that

    the security index underlying the Title VII instrument would

    decrease from 20 to 5 securities after six months, such that the

    security index would become narrow-based as a result of the reduced

    number of securities, then the Title VII instrument is a mixed swap

    at its execution. The characterization of the Title VII instrument

    as a mixed swap will not change during the life of the Title VII

    instrument.

    \897\ As discussed in section III.G.4., supra, to the extent a

    Title VII instrument permits ``at-will'' substitution of an

    underlying security index, however, as opposed to the use of

    predetermined criteria or a predetermined self-executing formula,

    the Title VII instrument is a security-based swap at its execution

    and throughout its life regardless of whether the underlying

    security index was narrow-based at the execution of the Title VII

    instrument.

    ---------------------------------------------------------------------------

    The Commissions are clarifying what is meant by whether the pre-

    determined criteria or pre-determined self-executing formula ``would

    cause'' the underlying broad-based security index to become or assume

    the characteristics of a narrow-based security index, or vice versa, as

    noted above in the interpretation. The Commissions believe that, unless

    the criteria or formula were intentionally designed to change the index

    from narrow to broad, or vice versa, Title VII instruments based on

    indexes that may, but will not necessarily, change from broad to narrow

    (or vice versa) under such criteria or formula should be considered

    swaps or security-based swaps, as appropriate, at execution and for the

    term thereof, and not mixed swaps. In such circumstances, it is not the

    case that the criteria or formula ``would cause'' the change within the

    meaning of the Commission's interpretation.

    The Commissions believe that this interpretation regarding the use

    of predetermined criteria or a predetermined self-executing formula

    will prevent potential gaming of the Commissions' interpretation

    regarding security indexes, and prevent potential regulatory arbitrage

    based on the migration of a security index from broad-based to narrow-

    based, or vice versa. In particular, predetermined criteria and

    predetermined self-executing formulas can be constructed in ways that

    take into account the characteristics of a narrow-based security index

    and prevent a narrow-based security index from becoming broad-based,

    and vice versa.

    Comments

    The Commissions received two comments on the proposed

    interpretation in this section regarding the classification of Title

    VII Instruments based on security indexes that change from narrow-based

    to broad-based, or vice versa, under predetermined criteria or a

    predetermined self-executing formula, as mixed swaps. One commenter

    requested that the Commissions clarify that a Title VII instrument

    based on a security index that may, but will not necessarily, change

    from narrow-based to broad-based, or vice versa, under predetermined

    criteria or a predetermined self-executing formula should be

    characterized at execution as a swap or security-based swap, as

    applicable, and not as a mixed swap.\898\ This commenter believed that

    the Commissions' interpretation should capture as mixed swaps only

    those Title VII instruments on indexes that will change with certainty,

    and not those that might change given specific market

    circumstances.\899\ Moreover, this commenter believed that the

    Commissions' statement that a Title VII instrument on a security index

    governed by a pre-determined self-executing formula that ``would

    cause'' a change from broad to narrow, or narrow to broad, means that

    the change in character must be a certainty for the instrument to be

    classified as a mixed swap.\900\ The Commissions have clarified their

    interpretation in response to this commenter's concerns as discussed

    above.

    ---------------------------------------------------------------------------

    \898\ See SIFMA Letter.

    \899\ Id.

    \900\ Id.

    ---------------------------------------------------------------------------

    Another commenter disagreed with the Commissions' proposed

    interpretation that transactions on indexes under predetermined

    criteria or a predetermined self-executing formula that would change

    from broad to narrow, or narrow to broad, should be classified as mixed

    swaps at inception.\901\ This commenter does not believe that

    regulatory arbitrage is such a significant concern in this context that

    would justify the challenges to market participants if these

    transactions were treated as mixed swaps subject to the dual regulatory

    authority of the Commissions.\902\

    ---------------------------------------------------------------------------

    \901\ See ISDA Letter.

    \902\ Id.

    ---------------------------------------------------------------------------

    The Commissions believe that regulatory arbitrage is a sufficient

    concern to justify mixed swap status and dual regulatory oversight for

    Title VII instruments where the index would change from broad to

    narrow, or narrow to broad, under the pre-determined criteria or

    predetermined self-executing formula. Counterparties that are concerned

    about regulatory burdens associated with mixed swap status can redesign

    their formula to avoid the result, or enter into another swap or

    security-based swap that is structured to achieve the same economic

    result without mixed swap status.

    (b) 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

    As was recognized in the Proposing Release, security indexes

    underlying Title VII instruments that are traded on DCMs, SEFs, FBOTs,

    security-based SEFs, or NSEs raise particular issues if an underlying

    security index migrates

    [[Page 48288]]

    from broad-based to narrow-based, or vice versa.\903\ The Commissions

    are adopting as proposed their interpretation clarifying that the

    characterization of an exchange-traded Title VII instrument based on a

    security index at its execution will not change through the life of the

    Title VII instrument, regardless of whether the underlying security

    index migrates from broad-based to narrow-based, or vice versa.

    Accordingly, a market participant who enters into a swap on a broad-

    based security index traded on or subject to the rules of a DCM, SEF or

    FBOT that migrates from broad-based to narrow-based may hold that

    position until the swap's expiration without any change in regulatory

    responsibilities, requirements, or obligations; similarly, a market

    participant who enters into a security-based swap on a narrow-based

    security index traded on a security-based SEF or NSE that migrates from

    narrow-based to broad-based may hold that position until the security-

    based swap's expiration without any change in regulatory

    responsibilities, requirements, or obligations.

    ---------------------------------------------------------------------------

    \903\ See Proposing Release at 29856.

    ---------------------------------------------------------------------------

    In addition, the Commissions are adopting, as proposed, final rules

    providing for tolerance and grace periods for Title VII instruments on

    security indexes that are traded on DCMs, SEFs, FBOTs, security-based

    SEFs and NSEs.\904\ As was noted in the Proposing Release,\905\ in the

    absence of any action by the Commissions, if a market participant wants

    to offset a swap or enter into a new swap on a DCM, SEF or FBOT where

    the underlying security index has migrated from broad-based to narrow-

    based, or to offset a security-based swap or enter into a new security-

    based swap on a security-based SEF or NSE where the underlying security

    index has migrated from narrow-based to broad-based, the participant

    would be prohibited from doing so. That is because swaps may trade only

    on DCMs, SEFs, and FBOTs, and security-based swaps may trade only on

    registered NSEs and security-based SEFs.\906\ The rules being adopted

    by the Commissions address how to treat Title VII instruments traded on

    trading platforms where the underlying security index migrates from

    broad-based to narrow-based or narrow-based to broad-based, so that

    market participants will know where such Title VII instruments may be

    traded and can avoid potential disruption of their ability to offset or

    enter into new Title VII instruments on trading platforms when such

    migration occurs.\907\

    ---------------------------------------------------------------------------

    \904\ See paragraphs (2), (3) and (4) of rule 1.3(yyy) under the

    CEA and paragraphs (b), (c) and (d) of rule 3a68-3 under the

    Exchange Act.

    \905\ See Proposing Release at 29857.

    \906\ If a swap were based on a security index that migrated

    from broad-based to narrow-based, a DCM, SEF, or FBOT could no

    longer offer the Title VII instrument because it is now a security-

    based swap. Similarly, if a security-based swap were based on a

    security index that migrated from narrow-based to broad-based, a

    security-based SEF or NSE could no longer offer the Title VII

    instrument because it is now a swap.

    \907\ The rules apply only to the particular Title VII

    instrument that is traded on or subject to the rules of a DCM, SEF,

    FBOT, security-based SEF, or NSE. As the Commissions noted in the

    Proposing Release, to the extent that a particular Title VII

    instrument is not traded on such a trading platform (even if another

    Title VII instrument of the same class or type is traded on such a

    trading platform), the rules do not apply to that particular Title

    VII instrument. See Proposing Release at 29857 n. 259.

    ---------------------------------------------------------------------------

    As was noted in the Proposing Release,\908\ Congress and the

    Commissions addressed a similar issue in the context of security

    futures, where the security index on which a future is based may

    migrate from broad-based to narrow-based or vice versa. Congress

    provided in the definition of the term ``narrow-based security index''

    in both the CEA and the Exchange Act \909\ for a tolerance period

    ensuring that, under certain conditions, a futures contract on a broad-

    based security index traded on a DCM may continue to trade, even when

    the index temporarily assumes characteristics that would render it a

    narrow-based security index under the statutory definition.\910\ In

    general, an index is subject to this tolerance period, and therefore is

    not a narrow-based security index, if: (i) A futures contract on the

    index traded on a DCM for at least 30 days as a futures contract on a

    broad-based security index before the index assumed the characteristics

    of a narrow-based security index; and (ii) the index does not retain

    the characteristics of a narrow-based security index for more than 45

    business days over 3 consecutive calendar months. Pursuant to these

    statutory provisions, if the index becomes narrow-based for more than

    45 business days over 3 consecutive calendar months, the index is

    excluded from the definition of the term ``narrow-based security

    index'' for the following 3 calendar months as a grace period.

    ---------------------------------------------------------------------------

    \908\ See Proposing Release at 29857.

    \909\ CEA section 1a(35)(B)(iii), 7 U.S.C. 1a(35)(B)(iii);

    section 3(a)(55)(C)(iii) of the Exchange Act, 15 U.S.C.

    78c(a)(55)(C)(iii).

    \910\ By joint rules, the Commissions have provided that

    ``[w]hen a contract of sale for future delivery on a security index

    is traded on or subject to the rules of a foreign board of trade,

    such index shall not be a narrow-based security index if it would

    not be a narrow-based security index if a futures contract on such

    index were traded on a designated contract market * * * .'' See rule

    41.13 under the CEA, 17 CFR 41.13, and rule 3a55-3 under the

    Exchange Act, 17 CFR 240.3a55-3. Accordingly, the statutory

    tolerance period applicable to futures on security indexes traded on

    DCMs applies to futures traded on FBOTs as well.

    ---------------------------------------------------------------------------

    The Commissions believe that a similar tolerance period should

    apply to swaps traded on DCMs, SEFs, and FBOTs and security-based swaps

    traded on security-based SEFs and NSEs. Accordingly, the Commissions

    are adopting the rules, as proposed, providing for tolerance periods

    for swaps that are traded on DCMs, SEFs, or FBOTs \911\ and for

    security-based swaps traded on security-based SEFs and NSEs.\912\

    ---------------------------------------------------------------------------

    \911\ See paragraph (2) of rule 1.3(yyy) under the CEA and

    paragraph (b) of rule 3a68-3 under the Exchange Act.

    \912\ See paragraph (3) of rule 1.3(yyy) under the CEA and

    paragraph (c) of rule 3a68-3 under the Exchange Act.

    ---------------------------------------------------------------------------

    The final rules provide that to be subject to the tolerance period,

    a security index underlying a swap executed on or subject to the rules

    of a DCM, SEF, or FBOT must not have been a narrow-based security index

    \913\ during the first 30 days of trading.\914\ If the index becomes

    narrow-based during the first 30 days of trading, the index must not

    have been a narrow-based security index during every trading day of the

    6 full calendar months preceding a date no earlier than 30 days prior

    to the commencement of trading of a swap on such index.\915\ If either

    of these alternatives is met, the index will not be a narrow-based

    security index if it has been a narrow-based security index for no more

    than 45 business days over 3 consecutive calendar months.\916\ These

    provisions apply solely for purposes of swaps traded on or subject to

    the rules of a DCM, SEF, or FBOT.

    ---------------------------------------------------------------------------

    \913\ For purposes of these rules, the term ``narrow-based

    security index'' shall also mean ``issuers of securities in a

    narrow-based security index.'' See supra part III.G.3(b),

    (discussing the rules defining ``issuers of securities in a narrow-

    based security index'').

    \914\ This provision is consistent with the provisions of the

    CEA and the Exchange Act applicable to futures contracts on security

    indexes. CEA section 1a(35)(B)(iii)(I), 7 U.S.C. 1a(35)(B)(iii)(I);

    section 3(a)(55)(C)(iii)(I) of the Exchange Act, 15 U.S.C.

    78c(a)(55)(C)(iii)(I).

    \915\ This alternative test is the same as the alternative test

    applicable to futures contracts in CEA rule 41.12, 17 CFR 41.12, and

    rule 3a55-2 under the Exchange Act, 17 CFR 240.3a55-2.

    \916\ These provisions are consistent with the parallel

    provisions in the CEA and Exchange Act applicable to futures

    contracts on security indexes traded on DCMs. See CEA section

    1a(35)(B)(iii)(II), 7 U.S.C. 1a(35)(B)(iii)(II), and section

    3(a)(55)(C)(iii)(II) of the Exchange Act, 15 U.S.C.

    78c(a)(55)(C)(iii)(II).

    ---------------------------------------------------------------------------

    Similarly, the rules provide a tolerance period for security-based

    swaps traded on security-based SEFs or NSEs. To be subject to the

    tolerance period, a security index underlying a security-based swap

    executed on a security-based SEF or NSE must have

    [[Page 48289]]

    been a narrow-based security index during the first 30 days of trading.

    If the index becomes broad-based during the first 30 days of trading,

    paragraph (3)(i)(B) of rule 1.3(yyy) under the CEA and paragraph

    (c)(1)(ii) of rule 3a68-3 under the Exchange Act provide that the index

    must have been a non-narrow-based (i.e., a broad-based) security index

    during every trading day of the 6 full calendar months preceding a date

    no earlier than 30 days prior to the commencement of trading of a

    security-based swap on such index. If either of these alternatives is

    met, the index will be a narrow-based security index if it has been a

    security index that is not narrow-based for no more than 45 business

    days over 3 consecutive calendar months.\917\ These provisions apply

    solely for purposes of security-based swaps traded on security-based

    SEFs or NSEs.

    ---------------------------------------------------------------------------

    \917\ These provisions are consistent with the parallel

    provisions in the CEA and the Exchange Act applicable to futures

    contracts on security indexes traded on DCMs. See CEA section

    1a(35)(B)(iii), 7 U.S.C. 1a(35)(B)(iii); section 3(a)(55)(C)(iii) of

    the Exchange Act, 15 U.S.C. 78c(a)(55)(C)(iii).

    ---------------------------------------------------------------------------

    In addition, the Commissions are adopting rules as proposed that,

    once the tolerance period under the rules has ended, there will be a

    grace period during which a Title VII instrument based on a security

    index that has migrated from broad-based to narrow-based, or vice

    versa, will be able to trade on the platform on which Title VII

    instruments based on such security index were trading before the

    security index migrated and can also, during such period, be

    cleared.\918\ The final rules provide for an additional three-month

    grace period applicable to a security index that becomes narrow-based

    for more than 45 business days over three consecutive calendar months,

    solely with respect to swaps that are traded on or subject to the rules

    of DCMs, SEFs, or FBOTs. During the grace period, such an index will

    not be considered a narrow-based security index. The rules apply the

    same grace period to a security-based swap on a security index that

    becomes broad-based for more than 45 business days over 3 consecutive

    calendar months, solely with respect to security-based swaps that are

    traded on a security-based SEF or NSE. During the grace period, such an

    index will not be considered a broad-based security index.\919\ As a

    result, this rule provides sufficient time for a Title VII instrument

    based on a migrated security index to satisfy listing and clearing

    requirements applicable to swaps or security-based swaps, as

    appropriate.

    ---------------------------------------------------------------------------

    \918\ See paragraph (4) of rule 1.3(yyy) under the CEA and

    paragraph (d) of rule 3a68-3 under the Exchange Act.

    \919\ These provisions are consistent with the parallel

    provisions in the CEA and the Exchange Act applicable to futures

    contracts on security indexes traded on DCMs. See CEA section

    1a(35)(D), 7 U.S.C. 1a(35)(D); section 3(a)(55)(E) of the Exchange

    Act, 15 U.S.C. 78c(a)(55)(E).

    ---------------------------------------------------------------------------

    As was noted in the Proposing Release,\920\ there will be no

    overlap between the tolerance and the grace periods under the rules and

    no ``re-triggering'' of the tolerance period. For example, if a

    security index becomes narrow-based for more than 45 business days over

    3 consecutive calendar months, solely with respect to swaps that are

    traded on or subject to the rules of DCMs, SEFs, or FBOTs, but as a

    result of the rules is not considered a narrow-based security index

    during the grace period, the tolerance period provisions will not

    apply, even if the security-index migrated temporarily during the grace

    period. After the grace period has ended, a security index will need to

    satisfy anew the requirements under the rules regarding the tolerance

    period in order to trigger a new tolerance period.

    ---------------------------------------------------------------------------

    \920\ See Proposing Release at 29858.

    ---------------------------------------------------------------------------

    The rules will not result in the re-characterization of any

    outstanding Title VII instruments. In addition, the tolerance and grace

    periods as adopted will apply only to Title VII instruments that are

    traded on or subject to the rules of DCMs, SEFs, FBOTs, security-based

    SEFs, and NSEs.

    Comments

    The Commissions received one comment on the proposed rules

    described in this section.\921\ This commenter stated its view that

    extending the ``grace period'' from three months to six months would

    ease any disruption or dislocation associated with the delisting

    process with respect to an index that has migrated from broad to

    narrow, or narrow to broad, and that has failed the tolerance

    period.\922\ This commenter also stated its view that where an index

    CDS migrates, for entities operating both a SEF and a security-based

    SEF, such entities should be permitted to move the index from one

    platform to the other simply by providing a notice to the SEC and

    CFTC.\923\

    ---------------------------------------------------------------------------

    \921\ See MarketAxess Letter.

    \922\ Id.

    \923\ Id.

    ---------------------------------------------------------------------------

    As discussed above, the Commissions are adopting the proposed rules

    without modification. The Commissions note that the three-month grace

    period applicable to security futures was mandated by Congress in that

    context,\924\ and the commenter has provided no data or evidence for

    its request that the Commissions diverge from that grace period and

    provide for a longer grace period with respect to swaps and security-

    based swaps. The Commissions believe that the three-month grace period

    is similarly appropriate to apply in the context of a Title VII

    instrument based on an index that has migrated to provide sufficient

    time to execute off-setting positions. With respect to the commenter's

    other suggestion that entities operating both a SEF and a security-

    based SEF should be able to move the index from one platform to another

    where an index CDS migrates simply by filing a notice with the SEC and

    CFTC, the Commissions do not believe that this proposal is within the

    scope of this rulemaking.

    ---------------------------------------------------------------------------

    \924\ See July 2006 Debt Index Rules. The Commissions are not

    aware of any disruptions caused by the three-month grace period in

    the context of security futures.

    ---------------------------------------------------------------------------

    H. Method of Settlement of Index CDS

    The method that the parties have chosen or use to settle an index

    CDS following the occurrence of a credit event under such index CDS

    also can affect whether such index CDS would be a swap, a security-

    based swap, or both (i.e., a mixed swap). The Commissions provided an

    interpretation in the Proposing Release regarding the method of

    settlement of index CDS and are restating the interpretation without

    modification. The Commissions find that this interpretation is an

    appropriate way to address index CDS with different settlement methods

    and is designed to reduce the cost associated with determining whether

    such an index CDS is a swap or a security-based swap.\925\

    ---------------------------------------------------------------------------

    \925\ See supra part I, under ``Overall Economic

    Considerations''.

    ---------------------------------------------------------------------------

    If an index CDS that is not based on a narrow-based security index

    under the Commissions' rules includes a mandatory physical settlement

    provision that would require the delivery of, and therefore the

    purchase and sale of, a non-exempted security \926\

    [[Page 48290]]

    or a loan in the event of a credit event, such an index CDS is a mixed

    swap.\927\ Conversely, if an index CDS that is not based on a narrow-

    based security index under the Commissions' rules includes a mandatory

    cash settlement \928\ provision, such index CDS is a swap, and not a

    security-based swap or a mixed swap, even if the cash settlement were

    based on the value of a non-exempted security or a loan.

    ---------------------------------------------------------------------------

    \926\ The Commissions note that section 3(a)(68)(C) of the

    Exchange Act, 15 U.S.C. 78c(a)(68)(C), provides that ``[t]he term

    ``security-based swap'' does not include any agreement, contract, or

    transaction that meets the definition of a security-based swap only

    because such agreement, contract, or transaction references, is

    based upon, or settles through the transfer, delivery, or receipt of

    an exempted security under paragraph (12) [of the Exchange Act], as

    in effect on the date of enactment of the Futures Trading Act of

    1982 (other than any municipal security as defined in paragraph (29)

    [of the Exchange Act] as in effect on the date of enactment of the

    Futures Trading Act of 1982), unless such agreement, contract, or

    transaction is of the character of, or is commonly known in the

    trade as, a put, call, or other option.''

    \927\ The SEC also notes that there must either be an effective

    registration statement covering the transaction or an exemption

    under the Securities Act would need to be available for such

    physical delivery of securities and compliance issues under the

    Exchange Act would also need to be considered.

    \928\ The Commissions are aware that the 2003 Definitions

    include ``Cash Settlement'' as a defined term and that such

    ``Settlement Method'' (also a defined term in the 2003 Definitions)

    works differently than auction settlement pursuant to the ``Big Bang

    Protocol'' or ``Auction Supplement'' (each as defined below). The

    Commissions' use of the term ``cash settlement'' in this section

    includes ``Cash Settlement,'' as defined in the 2003 Definitions,

    and auction settlement, as described in the ``Big Bang Protocol'' or

    ``Auction Supplement.'' See infra note 929 and accompanying text.

    ---------------------------------------------------------------------------

    An index CDS that is not based on a narrow-based security index

    under the Commissions' rules and that provides for cash settlement in

    accordance with the 2009 ISDA Credit Derivatives Determinations

    Committees and Auction Settlement Supplement to the 2003 Definitions

    (the ``Auction Supplement'') or with the 2009 ISDA Credit Derivatives

    Determinations Committees and Auction Settlement CDS Protocol (``Big

    Bang Protocol'') \929\ is a swap, and will not be considered a

    security-based swap or a mixed swap solely because the determination of

    the cash price to be paid is established through a securities or loan

    auction.\930\ In 2009, auction settlement, rather than physical

    settlement, became the default method of settlement for, among other

    types of CDS, index CDS on corporate issuers of securities.\931\ The

    amount of the cash settlement is determined through an auction

    triggered by the occurrence of a credit event.\932\ The Auction

    Supplement ``hard wired'' the mechanics of credit event auctions into

    the 2003 Definitions.\933\ The Commissions understand that the credit

    event auction process that is part of the ISDA terms works as follows.

    ---------------------------------------------------------------------------

    \929\ See ISDA, ``2009 ISDA Credit Derivatives Determinations

    Committees and Auction Settlement CDS Protocol,'' available at

    http://www.isda.org/bigbangprot/docs/Big-Bang-Protocol.pdf.

    \930\ The possibility that such index CDS may, in fact, be

    physically settled if an auction is not held or if the auction fails

    would not affect the characterization of the index CDS.

    \931\ The Commissions understand that the Big Bang Protocol is

    followed for index CDS involving corporate debt obligations but is

    not followed for index CDS based on asset-backed securities, loan-

    only CDS, and certain other types of CDS contracts. To the extent

    that such other index CDS contain auction procedures similar to the

    auction procedures for corporate debt to establish the cash price to

    be paid, the Commissions also would not consider such other index

    CDS that are not based on narrow-based security indexes under the

    Commissions' rules to be mixed swaps.

    \932\ The Commissions understand that other conditions may need

    to be satisfied as well for an auction to be held.

    \933\ See supra note 48.

    ---------------------------------------------------------------------------

    Following the occurrence of a credit event under a CDS, a

    determinations committee (``DC'') established by ISDA, following a

    request by any party to a credit derivatives transaction that is

    subject to the Big Bang Protocol or Auction Supplement, will determine,

    among other matters: (i) Whether and when a credit event occurred; (ii)

    whether or not to hold an auction to enable market participants to

    settle those of their credit derivatives transactions covered by the

    auction; (iii) the list of deliverable obligations of the relevant

    reference entity; and (iv) the necessary auction specific terms. The

    credit event auction takes place in two parts. In the first part of the

    auction, dealers submit physical settlement requests, which are

    requests to buy or sell any of the deliverable obligations (based on

    the dealer's needs and those of its counterparties), and an initial

    market midpoint price is created based on dealers' initial bids and

    offers. Following the establishment of the initial market midpoint, the

    physical settlement requests are then calculated to determine the

    amount of open interest.

    The aggregate amount of open interest is the basis for the second

    part of the auction. In the second part of the auction, dealers and

    investors can determine whether to submit limit orders and the levels

    of such limit orders. The limit orders, which are irrevocable, have a

    firm price in addition to size and whether it is a buy or sell order.

    The auction is conducted as a ``dutch'' auction, in which the open buy

    interests and open sell interests are matched.\934\ The final price of

    the auction is the last limit order used to match against the open

    interest. The final price in the auction is the cash price used for

    purposes of calculating the settlement payments in respect of the

    orders to buy and sell the deliverable obligations and it is also used

    to determine the cash settlement payment under the CDS.

    ---------------------------------------------------------------------------

    \934\ The second part of the credit event auction process

    involves offers and sales of securities that must be made in

    compliance with the provisions of the Securities Act and the

    Exchange Act. First, the submission of a physical settlement request

    constitutes an offer by the counterparty to either buy or sell any

    one of the deliverable obligations in the auction. Second, the

    submission of the irrevocable limit orders by dealers or investors

    are sales or purchases by such persons at the time of submission of

    the irrevocable limit order. Through the auction mechanism, where

    the open interest (which represents physical settlement requests) is

    matched with limit orders, buyers and sellers are matched. Finally,

    following the auction and determination of the final price, the

    counterparty who has submitted the physical delivery request decides

    which of the deliverable obligations will be delivered to satisfy

    the limit order in exchange for the final price. The sale of the

    securities in the auction occurs at the time the limit order is

    submitted, even though the identification of the specific

    deliverable obligation does not occur until the auction is

    completed.

    ---------------------------------------------------------------------------

    Comments

    One commenter believed that a mandatory physical settlement

    provision in an index CDS based on a broad-based security index should

    not transform a swap into a mixed swap because (i) the SEC would retain

    jurisdiction over a transfer of securities as part of such settlement

    and (ii) application of the interpretation would be difficult since

    many instruments contemplate physical settlement but have a cash

    settlement option, or vice versa.\935\

    ---------------------------------------------------------------------------

    \935\ See ISDA Letter.

    ---------------------------------------------------------------------------

    As discussed above, the Commissions are restating the

    interpretation regarding mandatory physical settlement as provided in

    the Proposing Release. The Commissions' interpretation assures that the

    Federal securities laws apply to the offer and sale of the underlying

    securities at the time the index CDS is sold.\936\ The Commissions note

    the commenter's concerns but believe that as a result of the

    Commissions' understanding of the auction settlement process for index

    CDS, which is the primary method by which index CDS are settled and

    which addresses circumstances in which securities may be tendered in

    the auction process separate from the CDS settlement payment, it is not

    clear that there is in fact any significant number of circumstances in

    which such index CDS may be optionally physically settled. The

    Commissions note that this commenter did not elaborate on the

    [[Page 48291]]

    circumstances in which the auction process would not apply.

    ---------------------------------------------------------------------------

    \936\ With respect to the applicability of the Federal

    securities laws, the Commissions are concerned about the use of

    index CDS to effect distributions of securities without compliance

    with the requirements of the Securities Act. The Commissions

    recognize that with respect to transactions in security-based swaps

    by an issuer of an underlying security, an affiliate of the issuer,

    or an underwriter the offer and sale of the underlying security (in

    this case the security to be delivered) occur at the time that the

    security-based swap is offered and sold, not at the time of

    settlement. Further, the Commissions note the restrictions on offers

    and sales of security-based swaps to non-ECPs without compliance

    with the registration requirements of the Securities Act. See

    section 5(e) of the Securities Act, 15 U.S.C. 77e(d).

    ---------------------------------------------------------------------------

    I. Security-Based Swaps as Securities Under the Exchange Act and

    Securities Act

    Pursuant to the Dodd-Frank Act, a security-based swap is defined as

    a ``security'' under the Exchange Act\937\ and Securities Act.\938\ As

    a result, security-based swaps are subject to the Exchange Act and the

    Securities Act and the rules and regulations promulgated

    thereunder.\939\

    ---------------------------------------------------------------------------

    \937\ See section 761(a)(2) of the Dodd-Frank Act (inserting the

    term ``security-based swap'' into the definition of ``security'' in

    section 3a(10) of the Exchange Act, 15 U.S.C. 78c(a)(10)).

    \938\ See section 768(a)(1) of the Dodd-Frank Act (inserting the

    term ``security-based swap'' into the definition of ``security'' in

    section 2(a)(1) of the Securities Act, 15 U.S.C. 77b(a)(1)).

    \939\ Sections 761(a)(3) and (4) of the Dodd-Frank Act amend

    sections 3(a)(13) and (14) of the Exchange Act, 15 U.S.C. 78c(a)(13)

    and (14), and section 768(a)(3) of the Dodd-Frank Act adds section

    2(a)(18) to the Securities Act, 15 U.S.C. 77b(a)(18), to provide

    that the terms ``purchase'' and ``sale'' of a security-based swap

    shall mean the ``the execution, termination (prior to its scheduled

    maturity date), assignment, exchange, or similar transfer or

    conveyance of, or extinguishing of rights or obligations under, a

    security-based swap, as the context may require.''

    ---------------------------------------------------------------------------

    The SEC did not provide interpretations in the Proposing Release on

    the application of the Exchange Act and the Securities Act, and the

    rules and regulations thereunder, to security-based swaps. However, the

    SEC solicited comment on whether additional interpretations may be

    necessary regarding the application of certain provisions of the

    Exchange Act and the Securities Act, and the rules and regulations

    promulgated thereunder, to security-based swaps. The SEC did not

    receive any comments with respect to this issue in the context of this

    rulemaking and is not providing any interpretations in this release.

    IV. Mixed Swaps

    A. Scope of the Category of Mixed Swap

    The category of mixed swap is described, in both the definition of

    the term ``security-based swap'' in the Exchange Act and the definition

    of the term ``swap'' in the CEA, as a security-based swap that is also

    based on the value of 1 or more interest or other rates, currencies,

    commodities, instruments of indebtedness, indices, quantitative

    measures, other financial or economic interest or property of any kind

    (other than a single security or a narrow-based security index), or the

    occurrence, non-occurrence, or the extent of the occurrence of an event

    or contingency associated with a potential financial, economic, or

    commercial consequence (other than an event described in subparagraph

    (A)(ii)(III) [of section 3(a)(68) of the Exchange Act]).\940\

    ---------------------------------------------------------------------------

    \940\ Section 3(a)(68)(D) of the Exchange Act, 15 U.S.C.

    78c(a)(68)(D); section 1a(47)(D) of the CEA, 7 U.S.C. 1a(47)(D).

    ---------------------------------------------------------------------------

    A mixed swap, therefore, is both a security-based swap and a

    swap.\941\ As stated in the Proposing Release, the Commissions believe

    that the scope of mixed swaps is, and is intended to be, narrow.\942\

    Title VII establishes robust and largely parallel regulatory regimes

    for both swaps and security-based swaps and directs the Commissions to

    jointly prescribe such regulations regarding mixed swaps as may be

    necessary to carry out the purposes of the Dodd-Frank Act.\943\ More

    generally, the Commissions believe the category of mixed swap was

    designed so that there would be no gaps in the regulation of swaps and

    security-based swaps. Therefore, in light of the statutory scheme

    created by the Dodd-Frank Act for swaps and security-based swaps, the

    Commissions believe the category of mixed swap covers only a small

    subset of Title VII instruments.

    ---------------------------------------------------------------------------

    \941\ Id. The exclusion from the definition of the term ``swap''

    for security-based swaps does not include security-based swaps that

    are mixed swaps. See section 1a(47)(B)(x) of the CEA, 7 U.S.C.

    1a(47)(B)(x).

    \942\ See Proposing Release at 29860.

    \943\ See section 712(a)(8) of the Dodd-Frank Act.

    ---------------------------------------------------------------------------

    For example, a Title VII instrument in which the underlying

    references are the value of an oil corporation stock and the price of

    oil would be a mixed swap. Similarly, a Title VII instrument in which

    the underlying reference is a portfolio of both securities (assuming

    the portfolio is not an index or, if it is an index, that the index is

    narrow-based) and commodities would be a mixed swap. Mixed swaps also

    would include certain Title VII instruments called ``best of'' or ``out

    performance'' swaps that require a payment based on the higher of the

    performance of a security and a commodity (other than a security). As

    discussed elsewhere in this release, the Commissions also believe that

    certain Title VII instruments may be mixed swaps if they meet specified

    conditions.

    The Commissions also believe that the use of certain market

    standard agreements in the documentation of Title VII instruments

    should not in and of itself transform a Title VII instrument into a

    mixed swap. For example, many instruments are documented by

    incorporating by reference market standard agreements. Such agreements

    typically set out the basis of establishing a trading relationship with

    another party but are not, taken separately, a swap or security-based

    swap. These agreements also include termination and default events

    relating to one or both of the counterparties; such counterparties may

    or may not be entities that issue securities.\944\ The Commissions

    believe that the term ``any agreement * * * based on * * * the

    occurrence of an event relating to a single issuer of a security,'' as

    provided in the definition of the term ``security-based swap,'' was not

    intended to include such termination and default events relating to

    counterparties included in standard agreements that are incorporated by

    reference into a Title VII instrument.\945\ Therefore, an instrument

    would not be simultaneously a swap and a security-based swap (and thus

    not a mixed swap) simply by virtue of having incorporated by reference

    a standard agreement, including default and termination events relating

    to counterparties to the Title VII instrument.

    ---------------------------------------------------------------------------

    \944\ Those standard events include inter alia bankruptcy,

    breach of agreement, cross default to other indebtedness, and

    misrepresentations.

    \945\ See section 3(a)(68)(A)(ii)(III) of the Exchange Act, 15

    U.S.C. 78c(a)(68)(A)(ii)(III).

    ---------------------------------------------------------------------------

    Comments

    While the Commissions did not receive any comments on the

    interpretation regarding the scope of the category of mixed swaps, one

    commenter recommended that the Commissions require that market

    participants disaggregate mixed swaps and enter into separate

    simultaneous transactions so that they cannot employ mixed swaps to

    obscure the underlying substance of transactions.\946\ The Commissions

    are not adopting any rules or interpretations to require disaggregation

    of mixed swaps into their separate components, as the Dodd-Frank Act

    specifically contemplated that there would be mixed swaps comprised of

    both swaps and security-based swaps.

    ---------------------------------------------------------------------------

    \946\ See Better Markets Letter.

    ---------------------------------------------------------------------------

    B. Regulation of Mixed Swaps

    1. Introduction

    The Commissions are adopting as proposed paragraph (a) of rule 1.9

    under the CEA and rule 3a68-4 under the Exchange Act to define a

    ``mixed swap'' in the same manner as the term is defined in both the

    CEA and the Exchange Act. The Commissions also are adopting as proposed

    two rules to address the regulation of mixed swaps. First, paragraph

    (b) of rule 1.9 under the CEA and rule 3a68-4 under the Exchange Act

    will provide a regulatory framework with which parties to bilateral

    uncleared mixed swaps (i.e.,

    [[Page 48292]]

    mixed swaps that are neither executed on or subject to the rules of a

    DCM, NSE, SEF, security-based SEF, or FBOT nor cleared through a DCO or

    clearing agency), as to which at least one of the parties is dually

    registered with both Commissions, will need to comply. Second,

    paragraph (c) of rule 1.9 under the CEA and rule 3a68-4 under the

    Exchange Act establishes a process for persons to request that the

    Commissions issue a joint order permitting such persons (and any other

    person or persons that subsequently lists, trades, or clears that class

    of mixed swap)\947\ to comply, as to parallel provisions\948\ only,

    with specified parallel provisions of either the CEA or the Exchange

    Act, and related rules and regulations (collectively ``specified

    parallel provisions''), instead of being required to comply with

    parallel provisions of both the CEA and the Exchange Act.

    ---------------------------------------------------------------------------

    \947\ All references to Title VII instruments in parts IV and VI

    shall include a class of such Title VII instruments as well. For

    example, a ``class'' of Title VII instrument would include

    instruments that are of similar character and provide substantially

    similar rights and privileges.

    \948\ As stated in paragraph (c) of proposed rule 1.9 under the

    CEA and rule 3a68-4 under the Exchange Act, ``parallel provisions''

    means comparable provisions of the CEA and the Exchange Act that

    were added or amended by Title VII with respect to security-based

    swaps and swaps, and the rules and regulations thereunder.

    ---------------------------------------------------------------------------

    2. Bilateral Uncleared Mixed Swaps Entered Into by Dually-Registered

    Dealers or Major Participants

    Swap dealers and major swap participants will be comprehensively

    regulated by the CFTC, and security-based swap dealers and major

    security-based swap participants will be comprehensively regulated by

    the SEC.\949\ The Commissions recognize that there may be differences

    in the requirements applicable to swap dealers and security-based swap

    dealers, or major swap participants and major security-based swap

    participants, such that dually-registered market participants may be

    subject to potentially conflicting or duplicative regulatory

    requirements when they engage in mixed swap transactions. In order to

    assist market participants in addressing such potentially conflicting

    or duplicative requirements, the Commissions are adopting, as proposed

    with one modification explained below, rules that will permit dually-

    registered swap dealers and security-based swap dealers and dually-

    registered major swap participants and major security-based swap

    participants to comply with an alternative regulatory regime when they

    enter into certain mixed swaps under specified circumstances. The

    Commissions received no comments on the proposed rules.

    ---------------------------------------------------------------------------

    \949\ Section 712(a)(7)(A) of the Dodd-Frank Act requires the

    Commissions to treat functionally or economically similar entities

    in a similar manner.

    ---------------------------------------------------------------------------

    Accordingly, as adopted, paragraph (b) of rule 1.9 under the CEA

    and rule 3a68-4 under the Exchange Act provide that a bilateral

    uncleared mixed swap,\950\ where at least one party is dually-

    registered with the CFTC as a swap dealer or major swap participant and

    with the SEC as a security-based swap dealer or major security-based

    swap participant, will be subject to all applicable provisions of the

    Federal securities laws (and SEC rules and regulations promulgated

    thereunder). The rules as adopted also provide that such mixed swaps

    will be subject to only the following provisions of the CEA (and CFTC

    rules and regulations promulgated thereunder):

    ---------------------------------------------------------------------------

    \950\ Under paragraph (b) of rule 1.9 under the CEA and rule

    3a68-4 under the Exchange Act, a ``bilateral uncleared mixed swap''

    will be a mixed swap that: (i) Is neither executed on nor subject to

    the rules of a DCM, NSE, SEF, security-based SEF, or FBOT; and (ii)

    will not be submitted to a DCO or registered or exempt clearing

    agency to be cleared. To the extent that a mixed swap is subject to

    the mandatory clearing requirement (see section 2(h)(1)(A) of the

    CEA, 7 U.S.C. 2(h)(1)(A), and section 3C(a)(1) of the Exchange Act)

    (and where a counterparty is not eligible to rely on the end-user

    exclusion from the mandatory clearing requirement (see section

    2(h)(7) of the CEA, 7 U.S.C. 2(h)(7), and section 3C(g) of the

    Exchange Act)), this alternative regulatory treatment will not be

    available.

    ---------------------------------------------------------------------------

    Examinations and information sharing: CEA sections 4s(f)

    and 8; \951\

    ---------------------------------------------------------------------------

    \951\ 7 U.S.C. 6s(f) and 12, respectively.

    ---------------------------------------------------------------------------

    Enforcement: CEA sections 2(a)(1)(B), 4(b), 4b, 4c,

    4s(h)(1)(A), 4s(h)(4)(A), 6(c), 6(d), 6c, 6d, 9, 13(a), 13(b) and 23;

    \952\

    ---------------------------------------------------------------------------

    \952\ 7 U.S.C. 2(a)(1)(B), 6(b), 6b, 6c, 6s(h)(1)(A),

    6s(h)(4)(A), 9 and 15, 13b, 13a-1, 13a-2, 13, 13c(a), 13c(b), and

    26, respectively.

    ---------------------------------------------------------------------------

    Reporting to an SDR: CEA section 4r; \953\

    ---------------------------------------------------------------------------

    \953\ 7 U.S.C. 6r.

    ---------------------------------------------------------------------------

    Real-time reporting: CEA section 2(a)(13); \954\

    ---------------------------------------------------------------------------

    \954\ 7 U.S.C. 2(a)(13).

    ---------------------------------------------------------------------------

    Capital: CEA section 4s(e); \955\ and

    ---------------------------------------------------------------------------

    \955\ 7 U.S.C. 6s(e).

    ---------------------------------------------------------------------------

    Position Limits: CEA section 4a.\956\

    ---------------------------------------------------------------------------

    \956\ 7 U.S.C. 6a.

    ---------------------------------------------------------------------------

    The Commissions are modifying proposed rule 1.9(b)(3)(i) under the

    CEA and Rule 3a68-4(b)(3)(i) to include additional ``enforcement''

    authority. Specifically, as adopted, the rules provide that such swaps

    will be subject to the anti-fraud, anti-manipulation, and other

    provisions of the business conduct standards in CEA sections

    4s(h)(1)(A) and 4s(h)(4)(A) and the rules promulgated thereunder for

    mixed swaps.\957\ Rule 23.410 under the CEA,\958\ adopted under CEA

    section 4s(h)(1)(A), applies to swap dealers and major swap

    participants and prohibits fraud, manipulation, and other abusive

    practices and also imposes requirements regarding the confidential

    treatment of counterparty information, which will apply to mixed

    swaps.\959\

    ---------------------------------------------------------------------------

    \957\ 7 U.S.C. 6s(h)(1)(A) and 6s(h)(4)(A).

    \958\ 17 CFR 23.410.

    \959\ Business Conduct Standards for Swap Dealers and Major Swap

    Participants With Counterparties, 77 FR 9734, 9751-9755 (Feb. 17,

    2012). The Commissions note that, while the introductory text of

    rule 1.9(b)(3)(i)(A) through (F) under the CEA and rule 3a68-

    4(b)(3)(i)(A) through (F) under the Exchange Act characterizes the

    cited CEA sections (e.g., ``enforcement,'' ``capital,'' etc.), such

    characterization is meant as guidance only. For example, final rule

    1.9(b)(3)(i)(B) uses the word ``enforcement'' to characterize

    certain of the cited CEA sections and the rules and regulations

    promulgated thereunder that prohibit fraud, manipulation, or abusive

    practices. Other cited provisions, such as the Whistleblower

    protections under CEA section 23, or the related rules and

    regulations, such as requirements to keep counterparty information

    confidential under rule 23.410(c) under the CEA, 17 CFR 23.410(c),

    are similarly enforcement provisions in that they protect market

    participants from fraudulent or other abusive practices.

    ---------------------------------------------------------------------------

    As discussed in the Proposing Release, the Commissions believe that

    paragraph (b) of rule 1.9 under the CEA and rule 3a68-4 under the

    Exchange Act will address potentially conflicting or duplicative

    regulatory requirements for dually-registered dealers and major

    participants that are subject to regulation by both the CFTC and the

    SEC, while requiring dual registrants to comply with the regulatory

    requirements the Commissions believe are necessary to provide

    sufficient regulatory oversight for mixed swap transactions entered

    into by such dual registrants. The CFTC also believe that paragraph (b)

    of rule 1.9 under the CEA and rule 3a68-4 under the Exchange Act will

    provide clarity to dually-registered dealers and major participants,

    who are subject to regulation by both the CFTC and the SEC, as to the

    requirements of each Commission that will apply to their bilateral

    uncleared mixed swaps.

    3. Regulatory Treatment for Other Mixed Swaps

    Because mixed swaps are both security-based swaps and swaps,\960\

    absent a joint rule or order by the Commissions permitting an

    alternative regulatory approach, persons who desire or intend to list,

    trade, or clear a mixed swap (or class thereof) will be required to

    comply with all the statutory provisions in the CEA and the Exchange

    Act (including all the rules and regulations thereunder) that were

    added or amended by Title VII with respect to swaps or security-based

    swaps.\961\ Such

    [[Page 48293]]

    dual regulation may not be appropriate in every instance and may result

    in potentially conflicting or duplicative regulatory requirements.

    However, before the Commissions can determine the appropriate

    regulatory treatment for mixed swaps (other than the treatment

    discussed above), the Commissions will need to understand better the

    nature of the mixed swaps that parties want to trade. As a result, the

    Commissions proposed paragraph (c) of rule 1.9 under the CEA and rule

    3a68-4 under the Exchange Act to establish a process pursuant to which

    any person who desires or intends to list, trade, or clear a mixed swap

    (or class thereof) that is not subject to the provisions of paragraph

    (b) of the rules (i.e., bilateral uncleared mixed swaps entered into by

    at least one dual registrant) may request the Commissions to publicly

    issue a joint order permitting such person (and any other person or

    persons that subsequently lists, trades, or clears that class of mixed

    swap) to comply, as to parallel provisions only, with the specified

    parallel provisions, instead of being required to comply with parallel

    provisions of both the CEA and the Exchange Act.\962\ The Commissions

    received no comments on the proposed rules and are adopting the rules

    as proposed.

    ---------------------------------------------------------------------------

    \960\ See supra note 10.

    \961\ Because security-based swaps are also securities,

    compliance with the Federal securities laws and rules and

    regulations thereunder (in addition to the provisions of the Dodd-

    Frank Act and the rules and regulations thereunder) will also be

    required. To the extent one of the Commissions has exemptive

    authority with respect to other provisions of the CEA or the Federal

    securities laws and the rules and regulations thereunder, persons

    may submit separate exemptive requests or rulemaking petitions

    regarding those provisions to the relevant Commission.

    \962\ Other than with respect to the specified parallel

    provisions with which such persons may be permitted to comply

    instead of complying with parallel provisions of both the CEA and

    the Exchange Act, any other provision of either the CEA or the

    Federal securities laws that applies to swaps or security-based

    swaps will continue to apply.

    ---------------------------------------------------------------------------

    As adopted, paragraph (c) of rule 1.9 under the CEA and rule 3a68-4

    under the Exchange Act further provide that a person submitting such a

    request to the Commissions must provide the Commissions with:

    (i) All material information regarding the terms of the specified,

    or specified class of, mixed swap;

    (ii) the economic characteristics and purpose of the specified, or

    specified class of, mixed swap;

    (iii) the specified parallel provisions, and the reasons the person

    believes such specified parallel provisions would be appropriate for

    the mixed swap (or class thereof);

    (iv) an analysis of (1) the nature and purposes of the parallel

    provisions that are the subject of the request; (2) the comparability

    of such parallel provisions; and (3) the extent of any conflicts or

    differences between such parallel provisions; and

    (v) such other information as may be requested by either of the

    Commissions.

    This provision is intended to provide the Commissions with

    sufficient information regarding the mixed swap (or class thereof) and

    the proposed regulatory approach to make an informed determination

    regarding the appropriate regulatory treatment of the mixed swap (or

    class thereof).

    As adopted, paragraph (c) of rule 1.9 under the CEA and rule 3a68-4

    under the Exchange Act also will allow a person to withdraw a request

    regarding the regulation of a mixed swap at any time prior to the

    issuance of a joint order by the Commissions. This provision is

    intended to permit persons to withdraw requests that they no longer

    need. This, in turn, will save the Commissions time and staff

    resources.

    As adopted, paragraph (c) of rule 1.9 under the CEA and rule 3a68-4

    under the Exchange Act further provide that in response to a request

    pursuant to the rules, the Commissions may jointly issue an order,

    after public notice and opportunity for comment, permitting the

    requesting person (and any other person or persons that subsequently

    lists, trades, or clears that class of mixed swap) to comply, as to

    parallel provisions only, with the specified parallel provisions (or

    another subset of the parallel provisions that are the subject of the

    request, as the Commissions determine is appropriate), instead of being

    required to comply with parallel provisions of both the CEA and the

    Exchange Act. In determining the contents of such a joint order, the

    Commissions can consider, among other things:

    (i) The nature and purposes of the parallel provisions that are the

    subject of the request;

    (ii) the comparability of such parallel provisions; and

    (iii) the extent of any conflicts or differences between such

    parallel provisions.

    Finally, as adopted, paragraph (c) of rule 1.9 under the CEA and

    rule 3a68-4 under the Exchange Act require the Commissions, if they

    determine to issue a joint order pursuant to these rules, to do so

    within 120 days of receipt of a complete request (with such 120-day

    period being tolled during the pendency of a request for public comment

    on the proposed interpretation). If the Commissions do not issue a

    joint order within the prescribed time period, the rules require that

    each Commission publicly provide the reasons for not having done so.

    Paragraph (c) of rule 1.9 under the CEA and rule 3a68-4 under the

    Exchange Act makes clear that nothing in the rules requires either

    Commission to issue a requested joint order regarding the regulation of

    a particular mixed swap (or class thereof).

    These provisions are intended to provide market participants with a

    prompt review of requests for a joint order regarding the regulation of

    a particular mixed swap (or class thereof). The rules also will provide

    transparency and accountability by requiring that at the end of the

    review period, the Commissions issue the requested order or publicly

    state the reasons for not doing so.

    V. Security-Based Swap Agreements

    A. Introduction

    SBSAs are swaps over which the CFTC has regulatory and enforcement

    authority but for which the SEC also has antifraud and certain other

    authority.\963\ The term ``security-based swap agreement'' is defined

    as a ``swap agreement'' (as defined in section 206A of the GLBA \964\)

    of which ``a material term is based on the price, yield, value, or

    volatility of any security or any group or index of securities,

    including any interest therein'' but does not include a security-based

    swap.\965\

    ---------------------------------------------------------------------------

    \963\ See section 3(a)(78) of the Exchange Act, 15 U.S.C.

    78c(a)(78); CEA section 1a(47)(A)(v), 7 U.S.C. 1a(47)(A)(v). The

    Dodd-Frank Act provides that certain CFTC registrants, such as DCOs

    and SEFs, will keep records regarding SBSAs open to inspection and

    examination by the SEC upon request. See, e.g., sections 725(e) and

    733 of the Dodd-Frank Act. The Commissions are committed to working

    cooperatively together regarding their dual enforcement authority

    over SBSAs.

    \964\ 15 U.S.C. 78c note. The Dodd-Frank Act amended the

    definition of ``swap agreement'' in section 206A of the GLBA to

    eliminate the requirements that a swap agreement be between ECPs, as

    defined in section 1a(18)(C) of the CEA, 7 U.S.C. 1a(18)(C), and

    subject to individual negotiation. See section 762(b) of the Dodd-

    Frank Act. Sections 762(c) and (d) of the Dodd-Frank Act also made

    conforming amendments to the Exchange Act and the Securities Act to

    reflect the changes to the regulation of ``swap agreements'' that

    are either ``security-based swaps'' or ``security-based swap

    agreements'' under the Dodd-Frank Act.

    \965\ See section 3(a)(78) of the Exchange Act, 15 U.S.C.

    78c(a)(78). The CFMA amended the Exchange Act and the Securities Act

    to exclude swap agreements from the definitions of security in those

    statutes but subjected ``security-based swap agreements,'' as

    defined in section 206B of the GLBA, 15 U.S.C. 78c note, to the

    antifraud, anti-manipulation, and anti-insider trading provisions of

    the Exchange Act and Securities Act. See CFMA, supra note 697, title

    III.

    The CEA does not contain a stand-alone definition of

    ``security-based swap agreement,'' but includes the definition

    instead in subparagraph (A)(v) of the swap definition in CEA section

    1a(47), 7 U.S.C. 1a(47). The only difference between these

    definitions is that the definition of SBSA in the Exchange Act

    specifically excludes security-based swaps (see section 3(a)(78)(B)

    of the Exchange Act, 15 U.S.C. 78c(a)(78)(B)), while the definition

    of SBSA in the CEA does not contain a similar exclusion. Instead,

    the exclusion for security-based swaps is placed in the general

    exclusions from the swap definition in the CEA (see CEA section

    1a(47)(B)(x), 7 U.S.C. 1a(47)(B)(x)).

    ---------------------------------------------------------------------------

    [[Page 48294]]

    B. Swaps That are Security-Based Swap Agreements

    Although the Commissions believe it is not possible to provide a

    bright line test to define an SBSA, the Commissions believe that it is

    possible to clarify that certain types of swaps clearly fall within the

    definition of SBSA. For example, as the Commissions noted in the

    Proposing Release, a swap based on an index of securities that is not a

    narrow-based security index (i.e., a broad-based security index) would

    fall within the definition of an SBSA under the Dodd-Frank Act.\966\

    Similarly, an index CDS that is not based on a narrow-based security

    index or on the ``issuers of securities in a narrow-based security

    index,'' as defined in rule 1.3(zzz) under the CEA and rule 3a68-1a

    under the Exchange Act, would be an SBSA. In addition, a swap based on

    a U.S. Treasury security or on certain other exempted securities other

    than municipal securities would fall within the definition of an SBSA

    under the Dodd-Frank Act.\967\

    ---------------------------------------------------------------------------

    \966\ See Proposing Release at 29863. Swaps based on indexes

    that are not narrow-based security indexes are not included within

    the definition of the term security-based swap under the Dodd-Frank

    Act. See section 3(a)(68)(A)(ii)(I) of the Exchange Act, 15 U.S.C.

    78c(a)(68)(A)(ii)(I), and discussion supra part III.G. However, such

    swaps have a material term that is ``based on the price, yield,

    value, or volatility of any security or any group or index of

    securities, or any interest therein,'' and therefore such swaps fall

    within the SBSA definition.

    \967\ Swaps on U.S. Treasury securities that do not have any

    other underlying references involving securities are expressly

    excluded from the definition of the term ``security-based swap''

    under the Dodd-Frank Act. See section 3(a)(68)(C) of the Exchange

    Act, 15 U.S.C. 78c(a)(68)(C) (providing that an agreement, contract,

    or transaction that would be a security-based swap solely because it

    references, is based on, or settles through the delivery of one or

    more U.S. Treasury securities (or certain other exempted securities)

    is excluded from the security-based swap definition). However, swaps

    on U.S. Treasury securities or on other exempted securities covered

    by subparagraph (C) of the security-based swap definition have a

    material term that is ``based on the price, yield, value, or

    volatility of any security or any group or index of securities, or

    any interest therein,'' and therefore fall within the SBSA

    definition.

    ---------------------------------------------------------------------------

    The Commissions received no comments on the examples provided in

    the Proposing Release regarding SBSAs. Accordingly, the Commissions are

    not further defining SBSA beyond restating the examples above.\968\

    ---------------------------------------------------------------------------

    \968\ The Commissions noted that certain transactions that were

    not ``security-based swap agreements'' under the CFMA are

    nevertheless included in the definition of security-based swap under

    the Dodd-Frank Act--including, for example, a CDS on a single loan.

    Accordingly, although such transactions were not subject to insider

    trading restrictions under the CFMA, under the Dodd-Frank Act they

    are subject to the Federal securities laws, including insider

    trading restrictions.

    ---------------------------------------------------------------------------

    C. Books and Records Requirements for Security-Based Swap Agreements

    The Commissions are adopting rule 1.7 under the CEA and rule 3a68-3

    under the Exchange Act, as proposed, to clarify that there will not be

    additional books and records requirements regarding SBSAs other than

    those that are required for swaps. The Dodd-Frank Act provides that the

    Commissions shall adopt rules regarding the books and records required

    to be kept for SBSAs.\969\ As discussed above, SBSAs are swaps over

    which the CFTC has regulatory authority, but for which the SEC has

    antifraud, anti-manipulation, and certain other authority. In the

    Proposing Release, the Commissions noted that the CFTC had proposed

    rules governing books and records for swaps, which would apply to swaps

    that also are SBSAs.\970\ The Commissions further stated their belief

    that those proposed rules would provide sufficient books and records

    regarding SBSAs, and that additional books and records requirements

    were not necessary for SBSAs.\971\ The Commissions received no comments

    on the proposed rules.

    ---------------------------------------------------------------------------

    \969\ Specifically, section 712(d)(2)(B) of the Dodd-Frank Act

    requires the Commissions, in consultation with the Board, to jointly

    adopt rules governing books and records requirements for SBSAs by

    persons registered as SDRs under the CEA, including uniform rules

    that specify the data elements that shall be collected and

    maintained by each SDR. Similarly, section 712(d)(2)(C) of the Dodd-

    Frank Act requires the Commissions, in consultation with the Board,

    to jointly adopt rules governing books and records for SBSAs,

    including daily trading records, for swap dealers, major swap

    participants, security-based swap dealers, and major security-based

    swap participants.

    \970\ See Swap Data Recordkeeping and Reporting Requirements, 75

    FR 76573 (Dec. 8, 2010) (proposed rules regarding swap data

    recordkeeping and reporting requirements for SDRs, DCOs, DCMs, SEFs,

    swap dealers, major swap participants, and swap counterparties who

    are neither swap dealers nor major swap participants); See

    Reporting, Recordkeeping, and Daily Trading Records Requirements for

    Swap Dealers and Major Swap Participants, 75 FR 76666 (Dec. 9, 2010)

    (proposed rules regarding reporting and recordkeeping requirements

    and daily trading records requirements for swap dealers and major

    swap participants). These rules have been adopted by the CFTC. See

    Swap Data Recordkeeping and Reporting Requirements, 77 FR 2136 (Jan.

    13, 2012) (final rules regarding swap data recordkeeping and

    reporting requirements for SDRs, DCOs, DCMs, SEFs, swap dealers,

    major swap participants, and swap counterparties who are neither

    swap dealers or major swap participants); See Swap Dealer and Major

    Swap Participant Recordkeeping, Reporting, and Duties Rules; Futures

    Commission Merchant and Introducing Broker Conflicts of Interest

    Rules; and Chief Compliance Officer Rules for Swap Dealers, Major

    Swap Participants, and Futures Commission Merchants, 77 FR 20128

    (Apr. 3, 2012) (final rules regarding reporting and recordkeeping

    requirements and daily trading records requirements for swap dealers

    and major swap participants).

    \971\ See Proposing Release at 29863.

    ---------------------------------------------------------------------------

    Accordingly, rule 1.7 under the CEA and rule 3a68-3 under the

    Exchange Act provide that persons registered as SDRs under the CEA and

    the rules and regulations thereunder are not required to (i) keep and

    maintain additional books and records regarding SBSAs other than the

    books and records regarding swaps that SDRs would be required to keep

    and maintain pursuant to the CEA and rules and regulations thereunder;

    and (ii) collect and maintain additional data regarding SBSAs other

    than the data regarding swaps that SDRs are required to collect and

    maintain pursuant to the CEA and rules and regulations thereunder. In

    addition, rule 1.7 under the CEA and rule 3a68-3 under the Exchange Act

    provide that persons registered as swap dealers or major swap

    participants under the CEA and the rules and regulations thereunder, or

    registered as security-based swap dealers or major security-based swap

    participants under the Exchange Act and the rules and regulations

    thereunder, are not required to keep and maintain additional books and

    records, including daily trading records, regarding SBSAs other than

    the books and records regarding swaps that those persons are required

    to keep and maintain pursuant to the CEA and the rules and regulations

    thereunder.\972\

    ---------------------------------------------------------------------------

    \972\ Rule 1.7 under the CEA and Rule 3a69-3 under the Exchange

    Act provide that the term ``security-based swap agreement'' has the

    meaning set forth in CEA section 1a(47)(A)(v), 7 U.S.C.

    1a(47)(A)(v), and section 3(a)(78) of the Exchange Act, 15 U.S.C.

    78c(a)(78), respectively.

    ---------------------------------------------------------------------------

    VI. Process for Requesting Interpretations of the Characterization of a

    Title VII Instrument

    The Commissions recognize that there may be Title VII instruments

    (or classes of Title VII instruments) that may be difficult to

    categorize definitively as swaps or security-based swaps. Further,

    because mixed swaps are both swaps and security-based swaps,

    identifying a mixed swap may not always be straightforward.

    Section 712(d)(4) of the Dodd-Frank Act provides that any

    interpretation of, or guidance by, either the CFTC or SEC regarding a

    provision of Title VII shall be effective only if issued jointly by the

    Commissions (after consultation with the Board) on issues where Title

    VII requires the CFTC and SEC to issue joint regulations to implement

    the provision. The Commissions believe that any interpretation or

    guidance regarding whether a Title VII instrument is a

    [[Page 48295]]

    swap, a security-based swap, or both (i.e., a mixed swap), must be

    issued jointly pursuant to this requirement.

    The Commissions proposed rules in the Proposing Release to

    establish a process for interested persons to request a joint

    interpretation by the Commissions regarding whether a particular Title

    VII instrument (or class of Title VII instruments) is a swap, a

    security-based swap, or both (i.e., a mixed swap).\973\ The Commissions

    are adopting the rules as proposed.

    ---------------------------------------------------------------------------

    \973\ See Proposing Release at 29864-65.

    ---------------------------------------------------------------------------

    Section 718 of the Dodd-Frank Act establishes a process for

    determining the status of ``novel derivative products'' that may have

    elements of both securities and futures contracts. Section 718 of the

    Dodd-Frank Act provides a useful model for a joint Commission review

    process to appropriately categorize Title VII instruments. As a result,

    the final rules include various attributes of the process established

    in section 718 of the Dodd-Frank Act. In particular, to permit an

    appropriate review period that provides sufficient time to ensure

    Federal regulatory interests are satisfied that also does not unduly

    delay the introduction of new financial products, the adopted process,

    like the process established in section 718, includes a deadline for

    responding to a request for a joint interpretation.\974\

    ---------------------------------------------------------------------------

    \974\ The Commissions note that section 718 of the Dodd-Frank

    Act is a separate process from the process the Commissions are

    adopting, and that any future interpretation involving the process

    under section 718 would not affect the process being adopted here,

    nor will any future interpretation involving the process adopted

    here affect the process under section 718.

    ---------------------------------------------------------------------------

    The Commissions are adopting rule 1.8 under the CEA and rule 3a68-2

    under the Exchange Act that establish a process for parties to request

    a joint interpretation regarding the characterization of a particular

    Title VII instrument (or class thereof). Specifically, the final rules

    provide that any person may submit a request to the Commissions to

    provide a public joint interpretation of whether a particular Title VII

    instrument is a swap, a security-based swap, or both (i.e., a mixed

    swap).\975\

    ---------------------------------------------------------------------------

    \975\ See paragraph (a) of rule 1.8 under the CEA and rule 3a68-

    2 under the Exchange Act.

    ---------------------------------------------------------------------------

    The final rules afford market participants with the opportunity to

    obtain greater certainty from the Commissions regarding the regulatory

    status of particular Title VII instruments under the Dodd-Frank Act.

    This provision should decrease the possibility that market participants

    inadvertently might fail to meet the regulatory requirements applicable

    to a particular Title VII instrument.

    The final rules provide that a person requesting an interpretation

    as to the characterization of a Title VII instrument as a swap, a

    security-based swap, or both (i.e., a mixed swap), must provide the

    Commissions with the person's determination of the characterization of

    the instrument and supporting analysis, along with certain other

    documentation.\976\ Specifically, the person must provide the

    Commissions with the following information:

    ---------------------------------------------------------------------------

    \976\ See paragraph (b) of rule 1.8 under the CEA and rule 3a68-

    2 under the Exchange Act.

    ---------------------------------------------------------------------------

    All material information regarding the terms of the Title

    VII instrument;

    A statement of the economic characteristics and purpose of

    the Title VII instrument;

    The requesting person's determination as to whether the

    Title VII instrument should be characterized as a swap, a security-

    based swap, or both (i.e., a mixed swap), including the basis for such

    determination; and

    Such other information as may be requested by either

    Commission.

    This provision should provide the Commissions with sufficient

    information regarding the Title VII instrument at issue so that the

    Commissions can appropriately evaluate whether it is a swap, a

    security-based swap, or both (i.e., a mixed swap).\977\ By requiring

    that requesting persons furnish a determination regarding whether they

    believe the Title VII instrument is a swap, a security-based swap, or

    both (i.e., a mixed swap), including the basis for such determination,

    this provision also will assist the Commissions in more quickly

    identifying and addressing the relevant issues involved in arriving at

    a joint interpretation of the characterization of the instrument.

    ---------------------------------------------------------------------------

    \977\ The Commissions also may use this information to issue

    (within the timeframe for issuing a joint interpretation) a joint

    notice of proposed rulemaking to further define one or more of the

    terms ``swap,'' ``security-based swap,'' or ``mixed swap.'' See

    paragraph (f) of rule 1.8 under the CEA and rule 3a68-2 under the

    Exchange Act, which are discussed below.

    ---------------------------------------------------------------------------

    The final rules provide that a person may withdraw a request at any

    time prior to the issuance of a joint interpretation or joint notice of

    proposed rulemaking by the Commissions.\978\ Notwithstanding any such

    withdrawal, the Commissions may provide an interpretation regarding the

    characterization of the Title VII instrument that was the subject of a

    withdrawn request.

    ---------------------------------------------------------------------------

    \978\ See paragraph (c) of rule 1.8 under the CEA and rule 3a68-

    2 under the Exchange Act.

    ---------------------------------------------------------------------------

    This provision will permit parties to withdraw requests for which

    the party no longer needs an interpretation. This, in turn, should save

    the Commissions time and staff resources. If the Commissions believe

    such an interpretation is necessary regardless of a particular request

    for interpretation, however, the Commissions may provide such a joint

    interpretation of their own accord.

    The final rules provide that if either Commission receives a

    proposal to list, trade, or clear an agreement, contract, or

    transaction (or class thereof) that raises questions as to the

    appropriate characterization of such agreement, contract, or

    transaction (or class thereof) as a swap, security-based swap, or both

    (i.e., a mixed swap), the receiving Commission promptly shall notify

    the other.\979\ This provision of the final rules further provides that

    either Commission, or their Chairmen jointly, may submit a request for

    a joint interpretation to the Commissions as to the characterization of

    the Title VII instrument where no external request has been received.

    ---------------------------------------------------------------------------

    \979\ See paragraph (d) of rule 1.8 under the CEA and rule 3a68-

    2 under the Exchange Act.

    ---------------------------------------------------------------------------

    This provision is intended to ensure that Title VII instruments do

    not fall into regulatory gaps and will help the Commissions to fulfill

    their responsibility to oversee the regulatory regime established by

    Title VII of the Dodd-Frank Act by making sure that Title VII

    instruments are appropriately characterized, and thus appropriately

    regulated. An agency, or their Chairmen jointly, submitting a request

    for an interpretation as to the characterization of a Title VII

    instrument under this paragraph will be required to submit the same

    information as, and could withdraw a request in the same manner as, a

    person submitting a request to the Commissions. The bases for these

    provisions are set forth above with respect to paragraphs (b) and (c)

    of the final rules.

    The final rules require that the Commissions, if they determine to

    issue a joint interpretation as to the characterization of a Title VII

    instrument, do so within 120 days of receipt of the complete external

    or agency submission (unless such 120-day period is tolled during the

    pendency of a request for public comment on the proposed

    interpretation).\980\ If the Commissions do not issue a joint

    interpretation within the prescribed time period, the final rules

    require that each Commission publicly provide the reasons for not

    having done so within

    [[Page 48296]]

    such prescribed time period. This provision of the final rules also

    incorporates the mandate of the Dodd-Frank Act that any joint

    interpretation by the Commissions be issued only after consultation

    with the Board of Governors of the Federal Reserve System.\981\

    Finally, the rules make clear that nothing requires either Commission

    to issue a requested joint interpretation regarding the

    characterization of a particular instrument.

    ---------------------------------------------------------------------------

    \980\ See paragraph (e) of rule 1.8 under the CEA and rule 3a68-

    2 under the Exchange Act. This 120-day period is based on the

    timeframe set forth in section 718(a)(3) of the Dodd-Frank Act.

    \981\ See section 712(d)(4) of the Dodd-Frank Act.

    ---------------------------------------------------------------------------

    These provisions are intended to assure market participants a

    prompt review of submissions requesting a joint interpretation of

    whether a Title VII instrument is a swap, a security-based swap, or

    both (i.e., a mixed swap). The final rules also provide transparency

    and accountability by requiring that at the end of the review period,

    the Commissions issue the requested interpretation or publicly state

    the reasons for not doing so.

    The final rules permit the Commissions, in lieu of issuing a

    requested interpretation, to issue (within the timeframe for issuing a

    joint interpretation) a joint notice of proposed rulemaking to further

    define one or more of the terms ``swap,'' ``security-based swap,'' or

    ``mixed swap.'' \982\ Under the final rules, the 120-day period to

    provide a response will be tolled during the pendency of a request for

    public comment on any such proposed interpretation. Such a rulemaking,

    as required by Title VII, would be required to be done in consultation

    with the Board of Governors of the Federal Reserve System. This

    provision is intended to provide the Commissions with needed

    flexibility to address issues that may be of broader applicability than

    the particular Title VII instrument that is the subject of a request

    for a joint interpretation.

    ---------------------------------------------------------------------------

    \982\ See paragraph (f) of rule 1.8 under the CEA and rule 3a68-

    2 under the Exchange Act.

    ---------------------------------------------------------------------------

    Comments

    Three commenters discussed the proposed process for requesting

    interpretations of the characterization of a Title VII instrument,\983\

    and while supporting such joint interpretive process, suggested certain

    changes, including extending it to SBSAs,\984\ mandating that the

    Commissions issue a response to a request,\985\ and suggesting that the

    Commissions should seek expedited judicial review in the event the

    Commissions do not agree on the interpretation.\986\

    ---------------------------------------------------------------------------

    \983\ See Better Markets Letter; CME Letter; and SIFMA Letter.

    \984\ See Better Markets Letter.

    \985\ See CME Letter and SIFMA Letter. These commenters

    suggested that the Commissions should be required to issue a joint

    interpretation for all joint interpretive requests that are not

    withdrawn. Id.

    \986\ See CME Letter. This commenter suggested that the

    Commissions should seek expedited judicial review to determine the

    characterization of a Title VII instrument if the Commissions cannot

    agree on a joint interpretation. Id.

    ---------------------------------------------------------------------------

    The Commissions are adopting the final rules as proposed and are

    not including SBSAs in the process. The joint interpretive process is

    intended to decrease the possibility that market participants

    inadvertently might fail to meet regulatory requirements that are

    applicable to swaps, security-based swaps, or mixed swaps and, as such,

    provides a mechanism for market participants to request whether an

    instrument will be regulated by the CFTC, the SEC, or both. However,

    the Commissions do not believe it is appropriate to predetermine

    whether particular swaps also are SBSAs as SBSAs are already swaps over

    which the CFTC has regulatory and enforcement authority and as to which

    the SEC has antifraud and certain other related authorities.\987\

    Predetermining whether particular swaps may be SBSAs under this process

    is not needed to provide certainty as to the applicable regulatory

    treatment of these instruments.

    ---------------------------------------------------------------------------

    \987\ See section 3(a)(78) of the Exchange Act, 15 U.S.C.

    78c(a)(78), and section 1a(47)(A)(v) of the CEA, 7 U.S.C.

    1a(47)(A)(v). The Dodd-Frank Act provides that certain CFTC

    registrants, such as DCOs and SEFs, will keep records regarding

    security-based swap agreements open to inspection and examination by

    the SEC upon request. See, e.g., sections 725(e) and 733 of the

    Dodd-Frank Act.

    ---------------------------------------------------------------------------

    The Commissions also are retaining in the final rules the framework

    for providing or not providing joint interpretations. As noted above,

    section 718 of the Dodd-Frank Act contains a framework for evaluating

    novel derivative products that may have elements of both securities and

    futures contracts (other than swaps, security-based swaps or mixed

    swaps). The Commissions believe that establishing a joint interpretive

    process for swaps, security-based swaps and mixed swaps that is modeled

    in part on this statutory framework should facilitate providing

    interpretations to market participants in a timely manner, if the

    Commissions determine to do so. Establishing a process by rule will

    provide market participants with an understandable method by which they

    can request an interpretation from the Commissions. As the Commissions

    have the authority, but not the obligation, under the Dodd-Frank Act to

    further define the terms ``swap,'' ``security-based swap,'' and ``mixed

    swap,'' the Commissions are retaining the flexibility in the

    interpretive process rules to decide whether or not to issue joint

    interpretations. The Commissions believe, however, that it is

    appropriate to advise market participants of the reasons why such

    interpretation is not being issued and the final rules retain the

    requirement that the Commissions publicly explain the reasons for not

    issuing a joint interpretation.

    Further, the Commissions are not revising the final rules to

    provide for expedited judicial review. The Dodd-Frank Act does not

    contain any provision that provides for expedited judicial review if

    the Commissions do not issue a joint interpretation with respect to a

    Title VII instrument. Although the Commissions note that section 718 of

    the Dodd-Frank Act contains a statutorily mandated expedited judicial

    review of one of the Commission's actions (if sought by the other

    Commission) regarding novel derivative products that may have elements

    of both securities and futures contracts, such statutory provision does

    not apply to Title VII instruments.\988\ Further, Title VII provides

    flexibility to the Commissions to determine the methods by which joint

    interpretations are provided. Title VII does not contain any required

    expedited judicial review of Commission actions, and the Commissions do

    not have the authority to require expedited judicial review under Title

    VII, with respect to a Title VII instrument. Accordingly, the

    Commissions do not believe that including such a provision is

    appropriate in the context of providing interpretations to market

    participants regarding the definitions of swap, security-based swap, or

    mixed swap.

    ---------------------------------------------------------------------------

    \988\ The Commissions note that judicial review provisions in

    section 718 relating to the status of novel derivative products only

    provide that either Commission (either the SEC or the CFTC) has the

    right to petition for review of a final order of the other

    Commission with respect to novel derivative products that may have

    elements of both securities and futures that affects jurisdictional

    issues. Nothing in section 718 requires that the Commissions issue

    exemptions or interpretations pursuant to such section or provides

    any person other than the Commissions the right to petition for

    Court review of a Commission order issued pursuant to section 718.

    ---------------------------------------------------------------------------

    Two commenters were concerned about the length of the review period

    and believed that the Commissions should shorten such time period.\989\

    The

    [[Page 48297]]

    Commissions are not modifying the final rules from those proposed with

    respect to the length of the review period. The 120-day review period

    is based on a timeframe established by Congress with respect to

    determining the status of novel derivative products.\990\ The

    Commissions believe that this length of the review period also is

    appropriate for other derivative products such as swaps, security-based

    swaps, and mixed swaps. Further, the Commissions believe the 120-day

    review period is necessary to enable the Commissions to obtain the

    necessary information regarding a Title VII instrument, thoroughly

    analyze the instrument, and formulate any joint interpretation

    regarding the instrument. In a related comment, one commenter suggested

    that the Commissions allow a requesting party, while awaiting a joint

    interpretation, to make a good faith characterization of a particular

    Title VII instrument and engage in transactions based on such

    characterization.\991\ The Commissions believe that it is essential

    that the characterization of an instrument be established prior to any

    party engaging in the transactions so that the appropriate regulatory

    schemes apply. The Commissions do not believe that allowing market

    participants to make such a determination as to the status of a product

    is either appropriate or consistent with the statutory provisions

    providing for the Commissions to further define the terms ``swap,''

    ``security-based swap'' and ``mixed swap.'' Further, allowing market

    participants to determine the status of a product could give rise to

    regulatory arbitrage and inconsistent treatment of similar products.

    ---------------------------------------------------------------------------

    \989\ See CME Letter and Markit Letter. One of these commenters

    suggested that the Commissions should reduce the 120-day review

    period to 30 days because the value of receiving a joint

    interpretation would be negated if a market participant had to wait

    120 days. This commenter also suggested that foreign competitors

    will gain a competitive advantage to U.S. market participants

    because they will not need to wait for a joint interpretation before

    trading similar or identical products. See CME Letter. The

    Commissions note that to the extent foreign competitors are engaging

    in swap and security-based swap transactions subject to either

    Commission's jurisdiction, they will be subject to the same process

    for requesting interpretations of the characterization of Title VII

    instruments as U.S. market participants. The other commenter

    requested that the Commissions issue a joint interpretation for each

    ``widely-utilized index,'' at the time of the index series' launch,

    within a two-week period rather than the proposed 120-day period for

    novel derivative products under section 718 of the Dodd-Frank Act.

    This commenter did not recognize that the joint interpretive process

    would be available in this case, and that it may be initiated by an

    index provider. See paragraph (a) of rule 1.8 under the CEA and rule

    3a68-2 under the Exchange Act (providing that ``[a]ny person'' may

    submit a request for a joint interpretation). See Markit Letter.

    \990\ See section 718(a)(3) of the Dodd-Frank Act.

    \991\ See SIFMA Letter. This commenter also suggested that while

    the requesting party, and all other market participants, would be

    bound by the joint interpretation when issued, they should not face

    retroactive re-characterization of a transaction executed during the

    review period and prior to the issuance of the joint interpretation.

    Id.

    ---------------------------------------------------------------------------

    Finally, some commenters expressed concern about the public

    availability of information regarding the joint interpretive process

    and asked that the parties be able to seek confidential treatment of

    their submissions.\992\ The Commissions note that under existing rules

    of both Commissions, requesting parties may seek confidential treatment

    for joint interpretive requests from the SEC and the CFTC in accordance

    with the applicable existing rules relating to confidential treatment

    of information.\993\ The Commissions also note that even if

    confidential treatment has been requested, all joint interpretive

    requests, as well all joint interpretations and any decisions not to

    issue a joint interpretation (along with the explanation of the grounds

    for such decision), will be made publicly available at the conclusion

    of the review period.\994\

    ---------------------------------------------------------------------------

    \992\ One commenter suggested that the Commissions should permit

    the parties seeking a joint interpretation to request confidential

    treatment from the Commissions during the course of the review

    period in order to protect proprietary information and deal

    structures. See SIFMA Letter. Another commenter suggested that the

    Commissions should make public all requests for joint

    interpretations, any guidance actually provided in response to such

    requests, and any decisions not to provide guidance in response to

    such requests (along with an explanation of the grounds for any such

    decision). See Better Markets Letter.

    \993\ See 17 CFR 200.81 and 17 CFR 140.98. The Commissions note

    that the joint interpretive process is intended to provide, among

    other things, notification to all market participants as to the

    regulatory classification of a particular Title VII instrument. In

    this regard, the Commissions do not believe it is appropriate to

    provide a joint interpretation only to the market participants

    requesting the interpretation, while delaying publication of the

    same joint interpretation to market participants generally.

    Therefore, CFTC staff will not exercise its discretion under 17 CFR

    140.98(b) to delay publication of a joint interpretation. SEC staff

    does not have discretion under 17 CFR 200.81(b) to delay publication

    of a joint interpretation.

    \994\ The CFTC's publication of any joint interpretative request

    and the joint interpretation itself will be subject to the

    restrictions of section 8 of the CEA. See 7 U.S.C. 12. Subject to

    limited exceptions, CEA section 8 generally restricts the CFTC from

    publishing ``data and information that would separately disclose the

    business transactions or market positions of any person and trade

    secrets or names of customers[hellip]'' Id. The CFTC and its staff

    have a long history of providing interpretive guidance with respect

    to the regulatory status of specific proposed transactions in

    compliance with CEA section 8. However, market participants making a

    joint interpretive request should be aware that the SEC is not

    subject to CEA section 8 and, therefore, is not subject to the

    restrictions of CEA section 8. The CFTC anticipates that most joint

    interpretive requests will not contain CEA Section 8 information.

    However, given that the SEC is not subject to the restrictions of

    CEA section 8, the CFTC intends to work with requesting parties to

    assure that joint interpretive requests do not include CEA section 8

    information. Nevertheless, given the foregoing, market participants

    should not submit CEA section 8 information in their joint

    interpretive requests.

    ---------------------------------------------------------------------------

    VII. Anti-Evasion

    A. CFTC Anti-Evasion Rules

    1. CFTC's Anti-Evasion Authority

    (a) Statutory Basis for the Anti-Evasion Rules

    Pursuant to the authority in sections 721(c) and 725(g)(2) of the

    Dodd-Frank Act and CEA sections 1a(47)(E) and 2(i),\995\ the CFTC is

    promulgating the anti-evasion rules as they were proposed and restating

    the accompanying interpretation with modifications in response to

    commenters. The CFTC also is providing an additional interpretation

    regarding rules 1.3(xxx)(6) and 1.6 under the CEA.

    ---------------------------------------------------------------------------

    \995\ 7 U.S.C. 1a(47)(E) and 2(i).

    ---------------------------------------------------------------------------

    Section 721(c) of the Dodd-Frank Act requires the CFTC to further

    define the terms ``swap,'' ``swap dealer,'' ``major swap participant,''

    and ``eligible contract participant,'' in order ``[t]o include

    transactions and entities that have been structured to evade'' subtitle

    A of Title VII (or an amendment made by subtitle A of the CEA).

    Moreover, as the CFTC noted in the Proposing Release,\996\ several

    other provisions of Title VII reference the promulgation of anti-

    evasion rules, including:

    ---------------------------------------------------------------------------

    \996\ Proposing Release at 29866.

    ---------------------------------------------------------------------------

    Subparagraph (E) of the definition of ``swap'' provides

    that foreign exchange swaps and foreign exchange forwards shall be

    considered swaps unless the Secretary of the Treasury makes a written

    determination that either foreign exchange swaps or foreign exchange

    forwards, or both, among other things, ``are not structured to evade

    the [Dodd-Frank Act] in violation of any rule promulgated by the [CFTC]

    pursuant to section 721(c) of that Act;'' \997\

    ---------------------------------------------------------------------------

    \997\ CEA section 1a(47)(E), 7 U.S.C. 1a(47)(E).

    ---------------------------------------------------------------------------

    Section 722(d) of the Dodd-Frank Act provides that the

    provisions of the CEA relating to swaps shall not apply to activities

    outside the United States unless those activities, among other things,

    ``contravene such rules or regulations as the [CFTC] may prescribe or

    promulgate as are necessary or appropriate to prevent the evasion of

    any provision of [the CEA] that was enacted by the [Title VII];'' \998\

    and

    ---------------------------------------------------------------------------

    \998\ CEA section 2(i), 7 U.S.C. 2(i). New CEA section 2(i), as

    added by section 722(d) of the Dodd-Frank Act, also provides that

    the provisions of Title VII relating to swaps shall not apply to

    activities outside the United States unless those activities ``have

    a direct and significant connection with activities in, or effect

    on, commerce of the United States.''

    ---------------------------------------------------------------------------

    Section 725(g) of the Dodd-Frank Act amends the Legal

    Certainty for Bank Products Act of 2000 to provide that,

    [[Page 48298]]

    although identified banking products generally are excluded from the

    CEA, that exclusion shall not apply to an identified banking product

    that is a product of a bank that is not under the regulatory

    jurisdiction of an appropriate Federal banking agency,\999\ meets the

    definition of the terms ``swap'' or ``security-based swap,'' and ``has

    been structured as an identified banking product for the purpose of

    evading the provisions of the [CEA], the [Securities Act], or the

    [Exchange Act].'' \1000\

    ---------------------------------------------------------------------------

    \999\ The term ``identified banking product'' is defined in

    section 402 of the Legal Certainty for Bank Products Act of 2000, 7

    U.S.C. 27. The term ``appropriate Federal banking agency'' is

    defined in CEA section 1a(2), 7 U.S.C. 1a(2), and section 3(a)(72)

    of the Exchange Act, 15 U.S.C. 78c(a)(72), which were added by

    sections 721(a) and 761(a) of the Dodd-Frank Act, respectively.

    \1000\ Section 741(b) of the Dodd-Frank Act amends section 6(e)

    of the CEA, 7 U.S.C. 9a, to provide that any DCO, swap dealer, or

    major swap participant ``that knowingly or recklessly evades or

    participates in or facilitates an evasion of the requirements of

    section 2(h) [of the CEA] shall be liable for a civil monetary

    penalty in twice the amount otherwise available for a violation of

    section 2(h) [of the CEA].'' This anti-evasion provision is not

    dependent upon the promulgation of a rule under section 721(c) of

    the Dodd Frank Act, and hence the proposed rule and interpretive

    guidance is not meant to apply to CEA section 6(e).

    ---------------------------------------------------------------------------

    Comments

    One commenter asserted the CFTC has no statutory basis to

    promulgate the anti-evasion rules, as proposed.\1001\ Specifically,

    this commenter stated that neither CEA sections 2(h)(4)(A) nor 6(e)

    grant the CFTC authority to prescribe an anti-evasion rule and

    interpretation as described in the Proposing Release.\1002\ Moreover,

    this commenter argued that CEA section 2(i) limits the CFTC to

    prescribing anti-evasion rules related only to activities occurring

    outside of the United States.\1003\ The CFTC finds these comments

    misplaced because CEA sections 2(h)(4)(A) and 6(e) provide the CFTC

    with additional authority to prescribe anti-evasion rules for specific

    purposes above and beyond the authority provided by sections 721(c) and

    725(g) of the Dodd-Frank Act and CEA sections 1a(47)(E) and 2(i), upon

    which the CFTC is relying in this rulemaking.\1004\ In addition,

    section 2(i) of the CEA provides that activities conducted outside the

    United States, including entering into agreements, contracts and

    transactions or structuring entities, which willfully evade or attempt

    to evade any provision of the CEA, shall be subject to the provisions

    of Subtitle A of Title VII of the Dodd-Frank Act; it does not limit the

    CFTC's other authorities cited above. Accordingly, nothing in CEA

    sections 2(h)(4)(A), 2(i) or 6(e) prevent the CFTC from prescribing

    rules 1.3(xxx)(6) and 1.6.

    ---------------------------------------------------------------------------

    \1001\ See IECA Letter.

    \1002\ Id.; 7 U.S.C. 2(h)(4)(A) and 9a.

    \1003\ See IECA Letter; 7 U.S.C. 2(i).

    \1004\ CEA section 2(h)(4)(A), 7 U.S.C. 2(h)(4)(A), provides:

    The Commission shall prescribe rules under this subsection (and

    issue interpretations of rules prescribed under this subsection) as

    determined by the Commission to be necessary to prevent evasions of

    the mandatory clearing requirements under this Act.

    CEA section 6(e), 7 U.S.C. 9a, in relevant part, provides: (4)

    Any designated clearing organization that knowingly or recklessly

    evades or participates in or facilitates an evasion of the

    requirements of section 2(h) shall be liable for a civil money

    penalty in twice the amount otherwise available for a violation of

    section 2(h). (5) Any swap dealer or major swap participant that

    knowingly or recklessly evades or participates in or facilitates an

    evasion of the requirements of section 2(h) shall be liable for a

    civil money penalty in twice the amount otherwise available for a

    violation of section 2(h).

    ---------------------------------------------------------------------------

    Two commenters supported the proposal's ``principles-based''

    approach to anti-evasion,\1005\ while several others suggested

    modifications.\1006\ Two commenters believed that the Proposing Release

    is overly broad and that, if the CFTC does finalize anti-evasion rules,

    such rules should be narrower in scope.\1007\ Similarly, one other

    commenter asserted that the CFTC erred in the Proposing Release by

    placing too great an emphasis on the flexibility of the rules as

    opposed to providing clarity for market participants.\1008\ The CFTC

    continues to believe a ``principles-based'' approach to its anti-

    evasion rules is appropriate. The CFTC is not adopting an alternative

    approach, whereby it provides a bright-line test of non-evasive

    conduct, because such an approach may provide potential wrongdoers with

    a roadmap for structuring evasive transactions. Notwithstanding this

    concern, as described below, the CFTC is providing an additional

    interpretation and examples of evasion in order to provide clarity to

    market participants.\1009\

    ---------------------------------------------------------------------------

    \1005\ See Barnard Letter and Better Markets Letter.

    \1006\ See CME Letter; ISDA Letter; and SIFMA Letter.

    \1007\ See ISDA Letter and SIFMA Letter.

    \1008\ See CME Letter.

    \1009\ Examples described in the guidance are illustrative and

    not exhaustive of the transactions, instruments or entities that

    could be considered evasive. In considering whether a transaction,

    instrument or entity is evasive, the CFTC will consider the facts

    and circumstances of each situation.

    ---------------------------------------------------------------------------

    One commenter suggested an alternative standard for a finding of

    evasion should be ``whether the transaction is lawful or not'' under

    the CEA, CFTC rules and regulations, orders, or other applicable

    federal, state or other laws.\1010\ The CFTC is not adopting this

    suggested alternative standard for evasion because to adopt this

    standard would blur the distinction between whether a transaction (or

    entity) is lawful and whether it is structured in a way to evade the

    Dodd-Frank Act and the CEA. The anti-evasion rules provided herein are

    concerned with the latter conduct, not the former.\1011\ Thus, the CFTC

    does not believe it is appropriate to limit the enforcement of its

    anti-evasion authority to only unlawful transactions.

    ---------------------------------------------------------------------------

    \1010\ See WGCEF Letter.

    \1011\ If a transaction is unlawful, the CFTC (or another

    authority) may be able to bring an action alleging a violation of

    the applicable rule, regulation, order or law.

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    2. Final Rules

    (a) Rule 1.3(xxx)(6)

    The CFTC is adopting the Rule 1.3(xxx)(6) as proposed. As adopted,

    Rule 1.3(xxx)(6)(i) under the CEA generally defines as swaps those

    transactions that are willfully structured to evade the provisions of

    Title VII governing the regulation of swaps. Furthermore, rules

    1.3(xxx)(6)(ii) and (iii) effectuate CEA section 1a(47)(E)(i) and

    section 725(g) of the Dodd-Frank Act, respectively, and will be applied

    in a similar fashion as rule 1.3(xxx)(6)(i). Rule 1.3(xxx)(6)(ii)

    applies to currency and interest rate swaps that are willfully

    structured as foreign exchange forwards or foreign exchange swaps to

    evade the new regulatory regime for swaps enacted in Title VII. Rule

    1.3(xxx)(6)(iii) applies to transactions of a bank that are not under

    the regulatory jurisdiction of an appropriate Federal banking agency

    and where the transaction is willfully structured as an identified

    banking product to evade the new regulatory regime for swaps enacted in

    Title VII.

    Rule 1.3(xxx)(6)(iv) provides that in determining whether a

    transaction has been willfully structured to evade rules 1.3(xxx)(6)(i)

    through (iii), the CFTC will not consider the form, label, or written

    documentation dispositive.\1012\ This approach is intended to prevent

    evasion through clever draftsmanship of a form, label, or other written

    documentation.

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    \1012\ See supra part II.D.1.

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    Rule 1.3(xxx)(6)(v) further provides that transactions, other than

    transactions structured as securities, willfully structured to evade

    (as provided in rules 1.3(xxx)(6)(i) through (iii)) will be considered

    in determining whether a person is a swap dealer or major swap

    participant.

    Lastly, rule 1.3(xxx)(6)(vi) provides that rule 1.3(xxx)(6) will

    not apply to any agreement, contract or transaction structured as a

    security (including a security-based swap) under the

    [[Page 48299]]

    securities laws as defined in section 3(a)(47) of the Exchange

    Act.\1013\

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    \1013\ 15 U.S.C. 78c(a)(47).

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    (b) Rule 1.6

    The CFTC is adopting rule 1.6 as proposed. Section 2(i) of the CEA

    states that the provisions of the CEA relating to swaps that were

    enacted by Title VII (including any rule prescribed or regulation

    promulgated thereunder) shall not apply to activities outside the

    United States unless, among other things, those activities ``contravene

    such rules or regulations as the [CFTC] may prescribe or promulgate as

    are necessary or appropriate to prevent the evasion of any provision of

    [the CEA] that was enacted by [Title VII].''

    Pursuant to this authority, rule 1.6(a), as adopted, makes it

    unlawful to conduct activities outside the United States, including

    entering into transactions and structuring entities, to willfully evade

    or attempt to evade any provision of the CEA as enacted under Title VII

    or the rules and regulations promulgated thereunder.

    In addition, rule 1.6(b) provides that in determining whether a

    transaction or entity has been entered into or structured willfully to

    evade, as provided in rule 1.6(a), the CFTC will not consider the form,

    label, or written documentation as dispositive.

    Rule 1.6(c) provides that an activity conducted outside the United

    States to evade, as described in proposed rule 1.6(a), shall be subject

    to the provisions of Subtitle A of Title VII of the Dodd-Frank Act. As

    the CFTC explained in the Proposing Release,\1014\ such provisions are

    necessary to fully prevent those who seek to willfully evade the

    regulatory requirements established by Congress in Title VII relating

    to swaps from enjoying any benefits from their efforts to evade.

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    \1014\ Proposing Release at 29866.

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    Lastly, rule 1.6(d) provides that no agreement, contract or

    transaction structured as a security (including a security-based swap)

    under the securities laws shall be deemed a swap pursuant to rule 1.6.

    (c) Interpretation of the Final Rules

    The CFTC is providing an interpretation of the final rules in

    response to commenters, addressing (i) the applicability of the anti-

    evasion rules to transactions that qualify for the forward exclusion,

    (ii) the applicability of the anti-evasion rules to transactions

    executed on a SEF, (iii) the treatment of evasive transactions after

    they are discovered, and (iv) documentation considerations.\1015\

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    \1015\ The CFTC also is adopting the interpretive guidance from

    the Proposing Release, as proposed, but with certain clarifications.

    See infra part VII.A.3.

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    With regard to the forward exclusion, the CFTC is clarifying, in

    response to a commenter,\1016\ that entering into transactions that

    qualify for the forward exclusion from the swap definition shall not be

    considered evasive. However, in circumstances where a transaction does

    not, in fact, qualify for the forward exclusion, the transaction may or

    may not be evasive depending on an analysis of all relevant facts and

    circumstances.\1017\

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    \1016\ See COPE Letter (requesting clarification that

    transacting in the physical markets (e.g., entering into

    nonfinancial commodity forward contracts), as opposed to executing a

    swap, would not be considered evasion).

    \1017\ The CFTC is aware that there are circumstances where a

    forward contract can perform the same or a substantially similar

    economic function as a swap through alternative delivery procedures.

    Further, there are circumstances where a person who deals in both

    forwards and swaps may make decisions regarding financial risk

    assessment that will involve the consideration of regulatory

    obligations. The CFTC will carefully scrutinize the facts and

    circumstances associated with forward contracts.

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    Concerning the applicability of the anti-evasion rules to

    transactions executed on a SEF, the CFTC is clarifying, in response to

    comments,\1018\ that a transaction that has been self-certified by a

    SEF (or a DCM), or that has received prior approval from the CFTC, will

    not be considered evasive.\1019\

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    \1018\ See MarketAxess Letter (commenting that the anti-evasion

    rules should not apply to transactions executed on, or subject to

    the rules of, a SEF, because before a SEF may list a swap, it must

    self-certify or voluntarily obtain CFTC approval to list the

    product).

    \1019\ Pursuant to part 40 of the CFTC's regulations, 17 CFR

    Part 40, registered SEFs and DCMs must self-certify with the CFTC

    that any products that they list ``[comply] with the [CEA] and

    regulations thereunder'' and are liable for any false self-

    certifications. Therefore, market participants that have entered

    into such transactions will not be considered to be engaging in

    evasion, while a SEF or DCM could be found to have falsely self-

    certified.

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    With respect to the treatment of evasive transactions after they

    are discovered, the CFTC is clarifying, in response to comments,\1020\

    that in instances where one party willfully structures a transaction to

    evade but the counterparty does not, the transaction, which meets the

    swap definition under rule 1.3(xxx)(6), or is subject to the provisions

    of Subtitle A of Title VII pursuant to rule 1.6, will be subject to all

    CEA provisions and the regulations thereunder (as applied to the party

    who willfully structures a transaction to evade). In rare situations

    where there is a true ``innocent party,''\1021\ it will likely be due

    to fraud or misrepresentation by the evading party and the business

    consequences and remedies will be the same as for any such

    victim.\1022\ The CFTC will impose appropriate sanctions only on the

    willful evader for violations of the relevant provisions of the CEA and

    CFTC regulations since the individual agreement, contract or

    transaction was (and always should have been) subject to them.\1023\

    Further, on a prospective basis for future transactions or instruments

    similar to those of the particular evasive swap, the CFTC will consider

    these transactions or instruments to be swaps within the meaning of the

    Dodd-Frank Act (as applied to both the party who willfully structures a

    transaction to evade and the ``innocent party'').

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    \1020\ See WGCEF Letter (generally expressing concern that the

    penalty for anti-evasion is ``draconian'') and IECA Letter

    (commenting that the non-evading party should not become a party to

    an evasive ``swap'' transaction, and thus subject to the regulatory

    requirements of the Dodd-Frank Act.) .

    \1021\ The analysis of whether a party is ``innocent'' is based

    on the facts and circumstances of a particular transaction as well

    as a course of dealing by each of the parties.

    \1022\ This is not dissimilar to an enforcement action for

    trading illegal off-exchange futures contracts in violation of CEA

    section 4(a), 7 U.S.C. 6(a). The CFTC regularly seeks restitution

    for victims in enforcement actions where applicable. Additionally,

    victims retain their private rights of action for breach of contract

    and any related equitable remedies.

    \1023\ In considering which provisions of the CEA and CFTC

    regulations are relevant, the CFTC will evaluate which CEA

    provisions and CFTC regulations the evasive swap would have had to

    comply with had it not evaded the definition of swap (e.g.,

    reporting, recordkeeping, clearing, etc.). However, where both

    parties have willfully structured to evade or attempted to evade the

    requirements of the Dodd-Frank Act, the CFTC may subject the

    agreement, contract, instrument, or transaction itself to the full

    regulatory regime and the willful evaders to applicable sanctions.

    ---------------------------------------------------------------------------

    Moreover, evasive transactions will count toward determining

    whether each evading party with the requisite intent is a swap dealer

    or major swap participant.\1024\ In response to a commenter's

    suggestion that, as proposed, rule 1.3(xxx)(6)(v) should require a

    pattern of transactions,\1025\ the CFTC is not requiring a pattern of

    evasive transactions as a prerequisite to prove evasion, although such

    a pattern may be one factor in analyzing whether evasion has occurred

    under rules 1.3(xxx)(6) or 1.6. Further, in

    [[Page 48300]]

    determining whether such a transaction is a swap, the CFTC will

    consider whether the transaction meets the definition of the term

    ``swap'' as defined by statute and as it is further defined in this

    rulemaking.\1026\

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    \1024\ In other words, the evasive transaction would count

    toward the relevant thresholds (e.g., de minimis (with respect to

    determining swap dealer status, if the evasive transaction

    constituted dealing activity) and substantial position (with respect

    to determining major swap participant status)).

    \1025\ See IECA Letter. This same commenter suggested that rule

    1.3(xxx)(6)(v) should be applied only to the authorities regarding

    evasion provided by Congress and refer to the entity structuring the

    evading transaction have been addressed above.

    \1026\ Thus, for example, if a person, in seeking to evade Title

    VII, structures a product that is a privilege on a certificate of

    deposit, the CFTC's anti-evasion rules would not be implicated

    because CEA section 1a(47)(B)(iii), 7 U.S.C. 1a(47)(B)(iii),

    excludes such a product from the swap definition.

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    As an illustration of some of the foregoing concepts, if the market

    for foreign exchange forwards on a particular currency settles on a T+

    4 basis, but two counterparties agree to expedite the settlement of an

    foreign exchange forward on such currency to characterize the

    transaction falsely as a spot transaction in order to avoid reporting

    the transaction, rule 1.3(xxx)(6)(i) would define the transaction as a

    swap. In this example, both parties may be subject to sanctions if they

    both have the requisite intent (i.e., willfully evaded). However, had

    the counterparty with the reporting obligation in this example

    convinced the other counterparty, by using a false rationale unrelated

    to avoiding reporting, to expedite the foreign exchange forward

    settlement in order to avoid reporting, then the only party that would

    be at risk for sanctions (i.e., the only party with the requisite

    intent) would be the counterparty with the reporting obligation who

    deceived the other counterparty.

    With regard to documentation considerations, as discussed above,

    the CFTC is adopting rules 1.3(xxx)(6)(iv) and 1.6(b), as

    proposed,\1027\ but is providing the following interpretation. As

    stated in the Proposing Release,\1028\ the structuring of instruments,

    transactions, or entities to evade the requirements of the Dodd-Frank

    Act may be ``limited only by the ingenuity of man.''\1029\ Therefore,

    the CFTC will look beyond manner in which an instrument, transaction,

    or entity is documented to examine its actual substance and purpose to

    prevent any evasion through clever draftsmanship--an approach

    consistent with the CFTC's case law in the context of determining

    whether a contract is a futures contract and the CFTC's interpretations

    in this release regarding swaps.\1030\ The documentation of an

    instrument, transaction, or entity (like its form or label) is a

    relevant, but not dispositive, factor in determining whether evasion

    has occurred.

    ---------------------------------------------------------------------------

    \1027\ Rules 1.3(xxx)(6)(iv) and 1.6(b) provide that ``in

    determining whether a transaction has been willfully structured to

    evade, neither the form, label, nor written documentation of the

    transaction shall be dispositive.''

    \1028\ Proposing Release at 29866.

    \1029\ Cargill v. Hardin, 452 F.2d 1154, 1163 (8th Cir. 1971).

    \1030\ See supra part II.D.1.

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    Comments

    The CFTC received a number of comments on various aspects of

    proposed rules 1.3(xxx)(6) and 1.6.

    Several commenters requested clarity as to what types of

    transactions might be considered evasive under proposed rule

    1.3(xxx)(6) and 1.6.\1031\ One commenter requested that the CFTC

    clarify that transacting in the physical markets (e.g., entering into

    nonfinancial commodity forward contracts), as opposed to executing a

    swap, would not be considered evasion.\1032\ As discussed above, the

    CFTC has provided an interpretation regarding the applicability of the

    anti-evasion rules to transactions that qualify for the forward

    exclusion. Another commenter requested that the CFTC clarify that the

    anti-evasion rules would not apply to transactions executed on a SEF

    because, before a SEF may list a swap, it must self-certify or

    voluntarily obtain CFTC permission to list that product.\1033\ The CFTC

    has provided an interpretation discussed above to address this comment.

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    \1031\ See CME Letter; COPE Letter; IECA Letter; MarketAxess

    Letter; and WGCEF Letter.

    \1032\ See COPE Letter.

    \1033\ See MarketAxess Letter.

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    Two commenters expressed concern regarding the penalty to the

    counterparties to a transaction that is deemed to violate the CFTC's

    anti-evasion provisions.\1034\ Pursuant to the final rule, when a

    transaction violates the anti-evasion rules, the CFTC will consider the

    transaction a swap. One of these commenters said that the non-evading

    party should not unilaterally become a party to a swap, and thus be

    subject to the regulatory requirements of the Dodd-Frank Act.\1035\

    This commenter believed the rule should be clear that only the