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, [email protected], Lee Ann Duffy,

Assistant General Counsel, at 202-418-6763, [email protected]; Mark

Fajfar, Assistant General Counsel, at 202-418-6636, [email protected],

or David E. Aron, Counsel, at 202-418-6621, [email protected], 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

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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.

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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.

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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.

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\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.

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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.

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\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).

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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\

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\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.

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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.

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\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).

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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).

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\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'');

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\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.

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(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:

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\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.

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(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

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\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.

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

who:

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\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'').

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\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).

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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\

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\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.

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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\

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\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.

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[[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.

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

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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.

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(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.

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\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.

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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\

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\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.

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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.

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\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).

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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\

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\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\

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\61\ See infra note 105 and accompanying text.

\62\ See supra note 41 and accompany text.

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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.

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

\64\ See supra note 41 and accompanying text.

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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\

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\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'').

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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\

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\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.

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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\

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\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.

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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.

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\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.

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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.

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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).

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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.

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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.

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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.

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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.

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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'').

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\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.

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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\

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\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.

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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.

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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).

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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.

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\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.

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(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:

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\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.

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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.

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\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.

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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.

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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.

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\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.

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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).

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(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.

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\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.

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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.

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\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\

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\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.

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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\

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\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.

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(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.

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\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'').

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(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.

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\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.

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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\

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\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).

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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\

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\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.

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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.

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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.

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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)).

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[[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\

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\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.

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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\

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\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.

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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\

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\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.

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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.

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\301\ See Letter from Lauren Newberry, Jeffrey C. Fort, Jeremy

D. Weinstein, and Christopher B. Berendt, Environmental Markets

Association, dated July 21, 2011.

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(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\

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\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.

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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\

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\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.

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(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\

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\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.

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(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.

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\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.

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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.

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\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).

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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\

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\316\ 7 U.S.C. 6c(b).

\317\ See Commodity Options, 77 FR 25320 (Apr. 27, 2012).

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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\

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\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).

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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\

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\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.

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(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\

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\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.

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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):

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\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.

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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;

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\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.

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\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 *

* *.'').

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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:

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\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.

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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\

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\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.

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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

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\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\

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\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.

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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\

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\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.

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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\

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\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.

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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.

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\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).

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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.

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\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)).

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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\

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\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).

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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\

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\350\ See California Utilities Letter.

\351\ See NEMA Letter.

\352\ See California Utilities Letter.

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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.

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\353\ Id.

\354\ See infra part II.B.2.(b)(iii).

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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\

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\355\ See AGA Letter.

\356\ See Atmos Letter.

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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\

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\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.

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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.

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\362\ See COPE Letter.

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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\

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\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.

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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\

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\366\ See COPE Letter, Appendix.

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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\

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\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).

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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.

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\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\

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\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.

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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\

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\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).

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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:

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\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.

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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\

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\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.

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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.''

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\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.

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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.

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\378\ See BGA Letter and California Utilities Letter.

\379\ See BGA Letter.

\380\ See California Utilities Letter.

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(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\

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\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.

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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\

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\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.

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(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\

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\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.

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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.

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[[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.

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[[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\

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\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.

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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\

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\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.

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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\

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\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.

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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:

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\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).

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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.

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\444\ See infra notes 456 and 461 and accompanying text.

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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.

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\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.

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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.

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\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.

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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.

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\451\ See ISDA Letter.

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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.

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\452\ Id.

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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.

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\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.

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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.

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\455\ See PMAA/NEFI Letter.

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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).

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\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.

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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.

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\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.

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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\

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\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.

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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.

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\466\ See FCC Letter.

\467\ See ETA Letter and ISDA Letter.

\468\ Id.

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[[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.

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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.

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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.

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\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'').

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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.

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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\

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\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.

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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\

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\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).

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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.

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\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.

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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\

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\493\ Proposing Release at 29834.

\494\ See infra note 503 and accompanying text.

\495\ Id.

\496\ Id.

\497\ Id.

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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).

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\498\ See supra note 482. See infra note 501.

\499\ See infra note 506 and accompanying text.

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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.

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\500\ See January LSTA Letter.

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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.

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\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.

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\505\ See July LMA Letter.

\506\ Id.

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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.

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\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\

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\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).

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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\

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\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).

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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\

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\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.

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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.

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\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.

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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.

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\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).

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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\

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\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.

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(i) Foreign Currency Options \525\

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\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).

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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\

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\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).

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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\

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\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.

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(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.

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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\

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\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).

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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\

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\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.

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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.

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\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'').

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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\

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\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.

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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\

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\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.

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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).

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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\

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\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.

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(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.

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\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.

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\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.

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(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\

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\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.

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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.

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\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.

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\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\

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\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.

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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.

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\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.

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(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).

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\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).

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\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'').

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[[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.

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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.

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[[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.

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\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).

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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\

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\624\ In some cases, the Title VII instrument may be a mixed

swap. Mixed swaps are discussed further in section IV below.

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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\

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\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.

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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\

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\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''.

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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:

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\629\ See infra part III.F, regarding the use of certain terms

and conditions.

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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\

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\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;

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\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.

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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.

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\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.

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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.

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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\

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\638\ See, e.g., Securities Confirmations, 47 FR 37920 (Aug. 27,

1982).

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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.

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\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.

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\641\ Public Law 97-444, 96 Stat. 2294 (1983).

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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.''

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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\

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\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.

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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\

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\651\ See Mixed Swaps, infra part IV.

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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:

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\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\

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\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.

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\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.

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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\

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\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.

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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.

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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\

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\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.

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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\

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\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.

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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\

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\668\ See SIFMA Letter.

\669\ Id.

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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\

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\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.

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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\

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\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.

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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.

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\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.

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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.

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\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.

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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.

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\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.''

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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\

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\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.

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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).

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\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.

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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\

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\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\

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\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\

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\684\ See Proposing Release at 29843.

\685\ See infra note 689 and accompanying text.

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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''.

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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\

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\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\

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\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\

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\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.

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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\

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\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.

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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.

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\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.

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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).

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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.

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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.

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\705\ See Proposing Release at 29844.

\706\ See infra note 718 and accompanying text.

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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.

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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\

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\709\ See supra note 700.

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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\

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\710\ Id.

\711\ See infra part III.H.

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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\

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\712\ See Proposing Release at 29844.

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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.

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\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.

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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.

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\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.

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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.

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\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.

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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\

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\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.

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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.

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\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.

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[[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\

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\723\ See ISDA Letter.

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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\

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\724\ See infra part III.G.5(a).

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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\

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\725\ See Proposing Release at 29845-58.

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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.

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\726\ See Proposing Release at 29845-48.

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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:

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\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).

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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\

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\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).

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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\

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\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).

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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.

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\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'').

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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

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\734\ 15 U.S.C. 78f(a).

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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\

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\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).

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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:

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\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.

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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\

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\737\ 15 U.S.C. 78m or 78o(d).

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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

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\738\ 15 U.S.C. 78c(a)(12).

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The issuer of the security is a government of a foreign

country or a political subdivision of a foreign country.\739\

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\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).

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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\

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\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.

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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.

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\745\ 7 U.S.C. 1a(35) and 15 U.S.C. 78c(a)(55).

\746\ See infra part III.G.3.

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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.

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\747\ Id.

\748\ See infra part III.G.4.

\749\ See infra part III.G.5.

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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\

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\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.

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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.

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\753\ See July 2006 Debt Index Rules.

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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\

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\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.

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(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\

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\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.

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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.

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\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.

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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.

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\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.

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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.

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\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.

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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\

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\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.

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(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.''

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\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.

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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:

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\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\

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\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.

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\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.

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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\

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\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.

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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.

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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\

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\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).

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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.

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\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).

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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.

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(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.

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\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\

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\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.

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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.

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(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\

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\809\ See Proposing Release at 29850.

\810\ See infra notes 845, 847, 849 and 867 and accompanying

text.

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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\

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\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\

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\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.

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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).

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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\

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\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.

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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.

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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.

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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.

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\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).

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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.

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\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.

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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.

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\846\ See infra part III.G.3(b)(iv).

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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.

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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\

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\848\ See Markit Letter.

\849\ Id.

\850\ Id.

\851\ Id.

\852\ Id.

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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.

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\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.

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(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\

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\854\ See infra note 867 and accompanying text.

\855\ See supra part III.G.3(b)(ii).

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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\

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\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.

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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\

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\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).

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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.

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\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\

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\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.

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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.

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\875\ See Proposing Release at 29851-52.

\876\ See ISDA Letter and SIFMA Letter.

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(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.

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\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'').

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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\

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\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''.

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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\

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\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.

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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.

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\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.

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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\

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\889\ See supra note 886, regarding the aggregation of separate

trades.

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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).

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\890\ See infra note 891 and accompanying text.

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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\

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\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.

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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.

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\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.

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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.

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\893\ See supra note 625 and accompanying text.

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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.

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\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.

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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\

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\895\ See infra note 898 and accompanying text.

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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.

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\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.

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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.

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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.

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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.

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\903\ See Proposing Release at 29856.

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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\

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\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.

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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.

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\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.

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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\

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\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.

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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.

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\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).

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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.

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\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).

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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.

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\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).

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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.

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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\

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\921\ See MarketAxess Letter.

\922\ Id.

\923\ Id.

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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.

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\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.

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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\

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\925\ See supra part I, under ``Overall Economic

Considerations''.

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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.

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\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.

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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.

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\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.

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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.

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\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.

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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\

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\935\ See ISDA Letter.

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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.

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\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).

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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\

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\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.''

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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\

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\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).

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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.

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\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.

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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.

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\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).

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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.

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\946\ See Better Markets Letter.

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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.

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\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.

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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):

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\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.

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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\

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\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.

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Reporting to an SDR: CEA section 4r; \953\

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

\953\ 7 U.S.C. 6r.

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

Real-time reporting: CEA section 2(a)(13); \954\

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\954\ 7 U.S.C. 2(a)(13).

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

Capital: CEA section 4s(e); \955\ and

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\955\ 7 U.S.C. 6s(e).

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

Position Limits: CEA section 4a.\956\

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\956\ 7 U.S.C. 6a.

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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\

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\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.

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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.

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\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.

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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\

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\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)).

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[[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\

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\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.

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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\

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\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.

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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.

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\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.

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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\

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\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.

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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.

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\973\ See Proposing Release at 29864-65.

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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\

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\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.

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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\

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\975\ See paragraph (a) of rule 1.8 under the CEA and rule 3a68-

2 under the Exchange Act.

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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:

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\976\ See paragraph (b) of rule 1.8 under the CEA and rule 3a68-

2 under the Exchange Act.

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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.

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\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.

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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.

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\978\ See paragraph (c) of rule 1.8 under the CEA and rule 3a68-

2 under the Exchange Act.

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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.

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\979\ See paragraph (d) of rule 1.8 under the CEA and rule 3a68-

2 under the Exchange Act.

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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.

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\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.

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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.

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\982\ See paragraph (f) of rule 1.8 under the CEA and rule 3a68-

2 under the Exchange Act.

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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\

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\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.

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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.

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\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.

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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.

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\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.

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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.

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\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.

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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\

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\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.

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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.

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\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:

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\996\ Proposing Release at 29866.

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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\

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\997\ CEA section 1a(47)(E), 7 U.S.C. 1a(47)(E).

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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

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\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.''

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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\

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\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).

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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.

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\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).

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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\

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\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.

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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.

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

\1012\ See supra part II.D.1.

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

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.

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

\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\

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

\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.

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

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.

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

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.

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

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.

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\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.

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

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

``evading'' party would become a party to a swap, but the ``non-

evading'' party would not.\1036\ The other comments believed that a

transaction that is determined to have violated the CFTC's anti-evasion

rules should be considered a swap only if it meets all other aspects of

the statutory definition of the term ``swap.'' \1037\ The CFTC agrees

that the anti-evasion rules are not meant to ``punish the innocent,''

but rather to appropriately address the evading counterparty's or

counterparties' failure to meet the requirements of the Dodd-Frank Act.

Therefore, the CFTC has provided an interpretation described above

about how a transaction, discovered to have evaded the CEA or the Dodd-

Frank Act (and therefore, a swap under rule 1.3(xxx)(6) or subject to

the provisions of Subtitle A under rule 1.6) will be treated after the

evasion is discovered.

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

\1034\ See IECA Letter and WGCEF Letter.

\1035\ See IECA Letter.

\1036\ Id.

\1037\ See WGCEF Letter.

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

Furthermore, the CFTC agrees that a transaction that is determined

to have violated the CFTC's anti-evasion rules will be considered a

swap only if it meets the definition of the term ``swap,'' and has

provided an interpretation to address this comment. In response to both

comments, the CFTC also has provided an example to illustrate the

concepts in the interpretation.

The CFTC received one comment regarding rules 1.3(xxx)(6)(iv) and

1.6(b). This commenter believed that a difference exists between

``documentation,'' which contains terms, conditions, etc. of an

agreement, and the ``form or label.'' \1038\ Thus, because a form or

label may be duplicitously assigned to a transaction, this commenter

agreed that neither the form nor the label should be dispositive.\1039\

However, because documentation contains the substance of an agreement,

this commenter believed that documentation should be dispositive in

determining whether a given contract has been entered to willfully

evade because the substance of a contract is derived from its

documentation.\1040\ Alternatively, this commenter requested that if

the CFTC does not amend its proposal, the CFTC clarify what evidence or

subject matter would be dispositive of willful evasion.\1041\ The CFTC

disagrees with these comments and has provided an interpretation

discussed above that the documentation of an instrument, transaction,

or entity is a relevant, but not dispositive, factor. This view not

only is consistent with CFTC case law, and the CFTC's interpretations

herein, but reduces the possibility of providing a potential roadmap

for evasion.

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

\1038\ See CME Letter.

\1039\ Id.

\1040\ Id.

\1041\ Id.

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

Two commenters raised issues applicable to proposed rule 1.6 alone.

One commenter believed that proposed rule 1.6 should not be adopted

until the cross-border application of the swap provisions of Title VII

is addressed.\1042\ The CFTC disagrees and believes that the rule

provides sufficient clarity to market participants even though the CFTC

has not yet finalized guidance

[[Page 48301]]

regarding the cross-border application of the swap provisions of the

Dodd-Frank Act. The other commenters believed that the proposed rule

text and interpretation does not fully explain how the CFTC would apply

proposed rule 1.6 in determining whether a swap subject to foreign

jurisdiction and regulated by a foreign regulator is evasive.\1043\ As

stated above, an agreement, contract, instrument or transaction that is

found to have been willfully structured to evade will be subject to CEA

provisions and the regulations thereunder pursuant to rule 1.6(c).

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

\1042\ See ISDA Letter.

\1043\ See CME Letter.

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3. Interpretation Contained in the Proposing Release

The CFTC is restating the interpretation contained in the Proposing

Release,\1044\ but is providing additional clarification regarding

certain types of circumstances that may (or may not) constitute an

evasion of the requirements of Title VII. However, the CFTC notes that

each activity will be evaluated on a case-by-case basis with

consideration given to all relevant facts and circumstances.

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

\1044\ See Proposing Release at 29865.

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

In developing its interpretation, the CFTC considered legislative,

administrative, and judicial precedent with respect to the anti-evasion

provisions in other Federal statutes. For example, the CFTC examined

the anti-evasion provisions in the Truth in Lending Act,\1045\ the Bank

Secrecy Act,\1046\ and the Internal Revenue Code.\1047\

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\1045\ 15 U.S.C. 1604(a) provides, in relevant part, that the

Federal Reserve Board: shall prescribe regulations to carry out the

purposes of this subchapter * * *. [T]hese regulations may contain

such classifications, differentiations, or other provisions, and may

provide for such adjustments and exceptions for any class of

transactions, as in the judgment of the Board are necessary or

proper to effectuate the purposes of this subchapter, to prevent

circumvention or evasion thereof, or to facilitate compliance

therewith.

In affirming the Board's promulgation of Regulation Z, the

Supreme Court noted that anti-evasion provisions such as section

1604(a) evince Congress's intent to ``stress[] the agency's power to

counteract attempts to evade the purposes of a statute.'' Mourning

v. Family Publ'ns Serv., Inc., 411 U.S. 356, 370 (1973) (citing

Gemsco v. Walling, 324 U.S. 244 (1945) (giving great deference to a

regulation promulgated under similar prevention-of-evasion

rulemaking authority in the Fair Labor Standards Act)).

\1046\ 31 U.S.C. 5324 (stating, in pertinent part, that ``[n]o

person shall, for the purpose of evading the reporting requirements

of [the Bank Secrecy Act (BSA) or any regulation prescribed

thereunder] * * * . structure or assist in structuring, or attempt

to structure or assist in structuring, any transaction with one or

more domestic financial institutions''). The Federal Deposit

Insurance Corporation regulations implementing the BSA require banks

to report transactions that ``the bank knows, suspects, or has

reason to suspect'' are ``designed to evade any regulations

promulgated under the Bank Secrecy Act.'' 12 CFR 353.3 (2010).

\1047\ The Internal Revenue Code makes it unlawful for any

person willfully to attempt ``in any manner to evade or defeat any

tax * * * .'' 26 U.S.C. 7201. While a considerable body of case law

has developed under the tax evasion provision, the statute itself

does not define the term, but generally prohibits willful attempts

to evade tax.

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The CFTC will not consider transactions, entities, or instruments

structured in a manner solely motivated by a legitimate business

purpose to constitute willful evasion (``Business Purpose Test'').

Additionally, relying on Internal Revenue Service (``IRS'') concepts,

when determining whether particular conduct is an evasion of the Dodd-

Frank Act, the CFTC will consider the extent to which the conduct

involves deceit, deception, or other unlawful or illegitimate activity.

(a) Business Purpose Test

Interpretation

Consistent with the Proposing Release,\1048\ the CFTC recognizes

that transactions may be structured, and entities may be formed, in

particular ways for legitimate business purposes, without any intention

of circumventing the requirements of the Dodd-Frank Act with respect to

swaps. Thus, in evaluating whether a person is evading or attempting to

evade the swap requirements with respect to a particular instrument,

entity, or transaction, the CFTC will consider the extent to which the

person has a legitimate business purpose for structuring the instrument

or entity or entering into the transaction in that particular manner.

Although different means of structuring a transaction or entity may

have differing regulatory implications and attendant requirements,

absent other indicia of evasion, the CFTC will not consider

transactions, entities, or instruments structured in a manner solely

motivated by a legitimate business purpose to constitute evasion.

However, to the extent a purpose in structuring an entity or instrument

or entering into a transaction is to evade the requirements of Title

VII with respect to swaps, the structuring of such instrument, entity,

or transaction may be found to constitute willful evasion.\1049\

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\1048\ Proposing Release at 29867.

\1049\ As the CFTC observed in the Proposing Release, a similar

concept applies with respect to tax evasion. See Proposing Release

at 29867 n. 324. A transaction that is structured to avoid the

payment of taxes but that lacks a valid business purpose may be

found to constitute tax evasion. See, e.g., Gregory v. Helvering,

293 U.S. 465, 469 (1935) (favorable tax treatment disallowed because

transaction lacked any business or corporate purpose). Under the

``sham-transaction'' doctrine, ``a transaction is not entitled to

tax respect if it lacks economic effects or substance other than the

generation of tax benefits, or if the transaction serves no business

purpose.'' Winn-Dixie Stores, Inc. v. Comm'r, 254 F.3d 1313, 1316

(11th Cir. 2001) (citing Knetsch v. United States, 364 U.S. 361

(1960)). ``The doctrine has few bright lines, but `it is clear that

transactions whose sole function is to produce tax deductions are

substantive shams.' '' Id. (quoting United Parcel Serv. of Am., Inc.

v. Comm'r, 254 F.3d 1014, 1018 (11th Cir. 2001)). To be clear,

though, while the Proposing Release references the use of the

business purpose test in tax law, the CFTC is not using the

legitimate business purpose consideration in the same manner as the

IRS.

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Although some commenters suggest that the determination that there

is a legitimate business purpose, and the use of that concept as a

relevant fact in the determination of the possibility of evasion, will

not provide appropriate clarity, it is a recognized analytical method

and would be useful in the overall analysis of potentially willful

evasive conduct.

The CFTC fully expects that a person acting for legitimate business

purposes within its respective industry will naturally weigh a

multitude of costs and benefits associated with different types of

financial transactions, entities, or instruments, including the

applicable regulatory obligations. In that regard, and in response to

commenters, the CFTC is clarifying that a person's specific

consideration of regulatory burdens, including the avoidance thereof,

is not dispositive that the person is acting without a legitimate

business purpose in a particular case. The CFTC will view legitimate

business purpose considerations on a case-by-case basis in conjunction

with all other relevant facts and circumstances.

Moreover, the CFTC recognizes that it is possible that a person

intending to willfully evade Dodd-Frank may attempt to justify its

actions by claiming that they are legitimate business practices in its

industry; therefore, the CFTC will retain the flexibility, via an

analysis of all relevant facts and circumstances, to confirm not only

the legitimacy of the business purpose of those actions but whether the

actions could still be determined to be willfully evasive. For example,

a person may attempt to disguise a product that may be a swap by

employing accounting practices that are not appropriate for swaps.

Whether or not the method of

[[Page 48302]]

accounting or employed accounting practices are determined to be for

legitimate business purposes, that alone will not be dispositive in

determining whether it is willfully evasive according to either rule

1.3(xxx)(6) or 1.6.

Because transactions and instruments are regularly structured, and

entities regularly formed, in a particular way for various, and often

times multiple, reasons, it is essential that all relevant facts and

circumstances be considered. Where a transaction, instrument, or entity

is structured solely for legitimate business purposes, it is not

willfully evasive. By contrast, where a consideration of all relevant

facts and circumstances reveals the presence of a purpose that is not a

legitimate business purpose, evasion may exist.

Comments

Two commenters believed the proposed business purpose test is

inappropriate for determining if a transaction is structured to evade

Title VII.\1050\ One of these commenters stated that the CFTC

misunderstood how the ``business purpose'' test is applied by the IRS

in the tax evasion context resulting in misguided proposed interpretive

guidance.\1051\ As stated above, the CFTC believes that it is

appropriate to consider legitimate business purposes in determining if

a transaction is structured to evade Title VII. In response to this

comment, although the interpretation references the use of legitimate

business purpose in tax law, the CFTC is not bound to use the

legitimate business purpose consideration in the same manner as the IRS

and, accordingly, is not adopting the IRS's interpretation.

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\1050\ See CME Letter and WGCEF Letter.

\1051\ See CME Letter.

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Two commenters urged the CFTC to clarify that considering the costs

of regulation is a legitimate business purpose when structuring a

transaction. Accordingly, they request that the CFTC clarify that

entering into a transaction to avoid costly regulations, even though

that transaction could otherwise be structured as a swap, will not be

considered per se evasion/evasive.\1052\ Finally, one commenter took

issue with the statement that ``absent other indicia of evasion, [the

CFTC] would not consider transactions, entities, or instruments in a

manner solely motivated by a legitimate business purpose to constitute

evasion.'' \1053\ Because ``transactions, entities, or instruments''

are rarely structured a certain way solely for one purpose, this

commenter believed such a statement does not give market participants

any relief or guidance.\1054\ The CFTC has addressed these comments

received on the business purpose test through the clarifications to its

interpretation discussed above and reiterates that the CFTC will

consider all relevant facts and circumstances in determining whether an

action is willfully evasive.

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\1052\ See ISDA Letter and WGCEF Letter.

\1053\ See SIFMA Letter.

\1054\ Id.

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(b) Fraud, Deceit or Unlawful Activity

Interpretation

When determining whether a particular activity constitutes willful

evasion of the CEA or the Dodd-Frank Act, the CFTC will consider the

extent to which the activity involves deceit, deception, or other

unlawful or illegitimate activity. This concept was derived from the

IRS's delineation of what constitutes tax evasion, as elaborated upon

by the courts. The IRS distinguishes between tax evasion and legitimate

means for citizens to minimize, reduce, avoid or alleviate the tax that

they pay under the Internal Revenue Code.\1055\ Similarly, persons that

craft derivatives transactions, structure entities, or conduct

themselves in a deceptive or other illegitimate manner in order to

avoid regulatory requirements should not be permitted to enjoy the

fruits of their deceptive or illegitimate conduct.

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\1055\ Whereas permissible means of reducing tax (or ``tax

avoidance,'' as the IRS refers to the practice) is associated with

full disclosure and explanation of why the tax should be reduced

under law, tax evasion consists of the willful attempt to evade tax

liability, and generally involves ``deceit, subterfuge, camouflage,

concealment, or some attempt to color or obscure events or to make

things seem other than they are.'' The IRS explains:

Avoidance of taxes is not a criminal offense. Any attempt to

reduce, avoid, minimize, or alleviate taxes by legitimate means is

permissible. The distinction between avoidance and evasion is fine,

yet definite. One who avoids tax does not conceal or misrepresent.

He/she shapes events to reduce or eliminate tax liability and, upon

the happening of the events, makes a complete disclosure. Evasion,

on the other hand, involves deceit, subterfuge, camouflage,

concealment, some attempt to color or obscure events or to make

things seem other than they are. For example, the creation of a bona

fide partnership to reduce the tax liability of a business by

dividing the income among several individual partners is tax

avoidance. However, the facts of a particular investigation may show

that an alleged partnership was not, in fact, established and that

one or more of the alleged partners secretly returned his/her share

of the profits to the real owner of the business, who, in turn, did

not report this income. This would be an instance of attempted

evasion. IRS, Internal Revenue Manual, part 9.1.3.3.2.1, available

at http://www.irs.gov/irm/part9/irm_09-001-003.html#d0e169.

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Although it is likely that fraud, deceit, or unlawful activity will

be present where willful evasion has occurred, the CFTC does not

believe that these factors are prerequisites to an evasion finding. As

stated throughout this release, the presence or absence of fraud,

deceit, or unlawful activity is one fact (or circumstance) the CFTC

will consider when evaluating a person's activity. That said, the anti-

evasion rules do require willfulness, i.e. ``scienter.'' In response to

the commenter who requests the CFTC define ``willful conduct,'' the

CFTC will interpret ``willful'' consistent with how the CFTC has in the

past, that a person acts ``willfully'' when they act either

intentionally or with reckless disregard.\1056\

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\1056\ See In re Squadrito, [1990-1992 Transfer Binder] Comm.

Fut. L. Rep. (CCH) ] 25,262 (CFTC Mar. 27, 1992) (adopting

definition of ``willful'' in McLaughlin v. Richland Shoe Co., 486

U.S. 128 (1987)).

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

Comments

One commenter, although generally supportive of the use of the IRS

``tax evasion'' concept as a guidepost for this criterion, requested

the CFTC provide examples of legitimate versus evasive conduct in a

manner similar to what is contained in the Internal Revenue

Manual.\1057\ The CFTC does not believe it is appropriate to provide an

example because such an example may provide a guidepost for evasion.

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

\1057\ See CME Letter.

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Two commenters suggested that a finding of fraud, deceit, or

unlawful activity should be a prerequisite to any finding of

evasion.\1058\ As noted above, the CFTC disagrees that such activity

should be a prerequisite to a finding of evasion, but its presence or

absence is one relevant fact and circumstance the CFTC will consider.

Finally, one commenter requested further guidance defining willful

conduct in the context of deliberate and knowing wrongdoing.\1059\ As

noted above, the CFTC has considered the suggestion that the CFTC

provide guidance on what defines ``willful behavior,'' with some

commenters submitting that some definitional guidance should be offered

or that the standard should be whether or not a transaction is

``lawful.'' \1060\ The CFTC agrees with the need for legal clarity and

believes that the concept of willfulness is a well-recognized legal

concept of which there is substantial case law and legal commentary

familiar to the financial industry.\1061\

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\1058\ See ISDA Letter and SIFMA Letter.

\1059\ See ISDA Letter (citing U.S. v. Tarallo, 380 F.3d 1174,

1187 (9th Cir. 2004), and Merck & Co. v. Reynolds, 130 S. Ct. 1784,

1796 (2010)).

\1060\ See CME Letter; ISDA Letter; and WGCEF Letter.

\1061\ See supra note 1056.

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[[Page 48303]]

B. SEC Position Regarding Anti-Evasion Rules

Section 761(b)(3) of the Dodd-Frank Act grants discretionary

authority to the SEC to define the terms ``security-based swap,''

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

participant,'' and ``eligible contract participant,'' with regard to

security-based swaps, ``for the purpose of including transactions and

entities that have been structured to evade'' subtitle B of Title VII

(or amendments made by subtitle B).

The SEC did not propose rules under section 761(b)(3) regarding

anti-evasion but requested comment on whether SEC rules or interpretive

guidance addressing anti-evasion with respect to security-based swaps,

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

ECPs were necessary. Two commenters responded to the request for

comment and recommended that the SEC adopt anti-evasion rules and

interpretive guidance.\1062\ One commenter suggested that the SEC model

its anti-evasion rules and interpretive guidance on the CFTC's anti-

evasion rules.\1063\

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

\1062\ See Barnard Letter and Better Markets Letter.

\1063\ See Barnard Letter.

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

The SEC is not adopting anti-evasion rules under section 761(b)(3)

at this time. The SEC notes that since security-based swaps are

``securities'' for purposes of the Federal securities laws, unless the

SEC grants a specific exemption,\1064\ all of the SEC's existing

regulatory authority will apply to security-based swaps. Since existing

regulations, including antifraud and anti-manipulation provisions, will

apply to security-based swaps, the SEC believes that it is unnecessary

to adopt additional anti-evasion rules for security-based swaps under

section 761(b)(3) at this time.

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

\1064\ See Effective Date and Implementation infra part IX.

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

VIII. Miscellaneous Issues

A. Distinguishing Futures and Options From Swaps

The Commissions did not propose rules or interpretations in the

Proposing Release regarding distinguishing futures from swaps. One

commenter requested that the CFTC clarify that nothing in the release

was intended to limit a DCM's ability to list for trading a futures

contract regardless of whether it could be viewed as a swap if traded

over-the-counter or on a SEF, since futures and swaps are

indistinguishable in material economic effects.\1065\ This commenter

further recommended that the CFTC adopt a final rule that further

interprets the statutory ``swap'' definition.\1066\

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\1065\ See CME Letter.

\1066\ Id. CME suggested that the CFTC modify the futures

contract exclusion in CEA Section 1a(47)(B)(i) so that the modified

language would read as follows: (B) EXCLUSIONS.--The term `swap'

does not include-- (i) any contract for the sale of a commodity for

future delivery listed for trading by a designated contract market

(or option on such contract) * * * CME believes that such a rule

would clarify the scope of Section 4(a) of the CEA, which makes it

illegal to trade a futures contract except on or subject to the

rules of a DCM.

CME believed that such a modification would clarify the scope of

Section 4(a) of the CEA, 7 U.S.C. 6(a), which makes it unlawful to

trade a futures contract except on or subject to the rules of a DCM.

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The CFTC declines to provide the requested clarification or adopt a

rule. Prior distinctions that the CFTC relied upon (such as the

presence or absence of clearing) to distinguish between futures and

swaps may no longer be relevant.\1067\ As a result, it is difficult to

distinguish between futures and swaps on a blanket basis as the

commenter suggested. However, a case-by-case approach for

distinguishing these products may lead to more informed decision-making

by the CFTC. Moreover, the CFTC notes that a DCM may self-certify its

contracts pursuant to Part 40 of the CFTC's rules,\1068\ subject to the

CFTC's oversight authority. If a DCM has a view that a particular

product is a futures contract, it may self-certify the contract

consistent with that view. The DCM also has a number of other options,

including seeking prior approval from the CFTC, requesting an

interpretation, or requesting a rulemaking if it is in doubt about

whether a particular agreement, contract or transaction should be

classified as a futures contract or a swap.

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\1067\ See, e.g., Swap Policy Statement, supra note 214.

\1068\ 17 CFR Part 40.

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B. Transactions Entered Into by Foreign Central Banks, Foreign

Sovereigns, International Financial Institutions, and Similar Entities

The swap definition excludes ``any agreement, contract, or

transaction a counterparty of which is a Federal Reserve bank, the

Federal Government, or a Federal agency that is expressly backed by the

full faith and credit of the United States.'' \1069\ Some commenters to

the ANPR suggested that the Commissions should exercise their authority

to further define the terms ``swap'' to similarly exclude transactions

in which a counterparty is a foreign central bank, a foreign sovereign,

an international financial institution (``IFI''),\1070\ or similar

organization. ANPR commenters advanced international comity, national

treatment, limited regulatory resources, limits on the Commissions'

respective extraterritorial jurisdiction, and international

harmonization as rationales for such an approach. The Proposing Release

was silent on this issue.\1071\

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\1069\ CEA section 1a(47)(B)(ix), 7 U.S.C. 1a(47)(B)(ix).

\1070\ For this purpose, we consider the ``international

financial institutions'' to be those institutions defined as such in

22 U.S.C. 262r(c)(2) and the institutions defined as ``multilateral

development banks'' in the Proposal for the Regulation of the

European Parliament and of the Council on OTC Derivative

Transactions, Central Counterparties and Trade Repositories, Council

of the European Union Final Compromise Text, Article 1(4a(a)) (March

19, 2012). There is overlap between the two definitions, but

together they include the following institutions: the International

Monetary Fund, International Bank for Reconstruction and

Development, European Bank for Reconstruction and Development,

International Development Association, International Finance

Corporation, Multilateral Investment Guarantee Agency, African

Development Bank, African Development Fund, Asian Development Bank,

Inter-American Development Bank, Bank for Economic Cooperation and

Development in the Middle East and North Africa, Inter-American

Investment Corporation, Council of Europe Development Bank, Nordic

Investment Bank, Caribbean Development Bank, European Investment

Bank and European Investment Fund. (The term international financial

institution includes entities referred to as multilateral

development banks. The International Bank for Reconstruction and

Development, the International Finance Corporation and the

Multilateral Investment Guarantee Agency are parts of the World Bank

Group.) The Bank for International Settlements, which also submitted

a comment, is a bank in which the Federal Reserve and foreign

central banks are members. Another commenter, KfW, is a corporation

owned by the government of the Federal Republic of Germany and the

German State governments and backed by the ``full faith and credit''

of the Federal Republic of Germany.

\1071\ But see Dissent of Commissioner Sommers, Proposing

Release at 29899.

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Comments

Several commenters asserted that swaps transactions to which an IFI

is a counterparty should be excluded from the swap and security-based

swap definitions.\1072\ In addition to the arguments noted above,

commenters asserted that certain IFIs have been granted certain

statutory immunities by the United States, and that regulation under

the Dodd-Frank Act of their

[[Page 48304]]

activities would be inconsistent with the grant of these immunities.

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\1072\ See Letter from G[uuml]nter Pleines and Diego Devos, Bank

for International Settlements, dated July 20, 2011; Letter from

Jacques Mirante-P[eacute]r[eacute] and Jan De Bel, Council of Europe

Development Bank, dated July 22, 2011; Letter from Isabelle Laurant,

European Bank for Reconstruction and Development, dated July 22,

2011; Letter from A. Querejeta and B. de Mazi[egrave]res, European

Investment Bank, dated July 22, 2011; Letter from J. James Spinner

and S[oslash]ren Elbech, Inter-American Development Bank, dated July

22, 2011; Letter from Lutze-Christian Funke and Frank Czichowski,

KfW, dated August 12, 2011; Letter from Heikki Cantell and Lars

Eibeholm, Nordic Investment Bank, dated August 2, 2011; and Letter

from Vicenzo La Via, World Bank Group, dated July 22, 2011.

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The CFTC declines to provide an exclusion from the swap definition

along the lines suggested by these commenters.\1073\ An exclusion from

the swap definition for swap transactions entered into by foreign

sovereigns, foreign central banks, IFIs and similar entities, would

mean that swaps entered into by such entities would be completely

excluded from Dodd-Frank regulation. Their counterparties, who may be

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

or major security-based swap participants, would have no regulatory

obligations with respect to such swaps. These regulated counterparties

could develop significant exposures to the foreign sovereigns, foreign

central banks, IFIs and similar entities, without the knowledge of the

Commissions.

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

\1073\ The commenters' suggested exclusion from the swap

definition would also exclude their transactions from the security-

based swap definition, which is based on the definition of swap.

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

In addition, swaps entered into by foreign sovereigns, foreign

central banks, IFIs and similar entities undeniably are swaps. To be

sure, the Commissions have adopted rules and interpretations to further

define the term ``swap'' to exclude certain transactions, which prior

to the enactment of the Dodd-Frank Act generally would not have been

considered swaps. However, the CFTC is not using its authority to

further define the term ``swap'' to effectively exempt transactions

that are, in fact, swaps. While, as noted above, Congress included a

counterparty-specific exclusion for swaps entered into by the Federal

Reserve Board, the Federal government and certain government agencies,

Congress did not provide a similar exemption for foreign central banks,

foreign sovereigns, IFIs, or similar organizations.

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

in the Securities Act

The SEC is adopting a technical rule that provides that the terms

``swap'' and ``security-based swap'' as used in the Securities Act

\1074\ have the same meanings as in the Exchange Act \1075\ and the

rules and regulations thereunder.\1076\ The SEC is adopting such

technical rule to assure consistent definitions of these terms under

the Securities Act and the Exchange Act.

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\1074\ See section 2(a)(17) of the Securities Act, 15 U.S.C.

77b(a)(17).

\1075\ See sections 3(a)(69) of the Exchange Act, 15 U.S.C.

78c(a)(69), and 3(a)(68) of the Exchange Act, 15 U.S.C. 78c(a)(68).

The definitions of the terms ``swap'' and ``security-based swap'' in

the Exchange Act are the same as the definitions of these terms in

the CEA. See section 1a of the CEA, 7 U.S.C. 1a.

\1076\ See rule 194 under the Securities Act.

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IX. Effective Date and Implementation

Consistent with sections 754 and 774 of the Dodd-Frank Act, the

final rules and interpretations will be effective October 12, 2012. The

compliance date for the final rules and interpretations also will be

October 12, 2012; with the following exceptions:

The compliance date for the interpretation regarding

guarantees of swaps will be the effective date of the rules proposed in

the separate CFTC release when such rules are adopted by the CFTC.

Solely for the purposes of the Order Granting Temporary

Exemptions under the Securities Exchange Act of 1934 in Connection with

the Pending Revision of the Definition of ``Security'' to Encompass

Security-Based Swaps \1077\ and the Exemptions for Security-Based

Swaps,\1078\ the compliance date for the final rules further defining

the term ``security-based swap'' will be February 11, 2013.

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\1077\ 76 FR 39927 (Jul. 7, 2011) (``Exchange Act Exemptive

Order''). The Exchange Act Exemptive Order grants temporary relief

and provides interpretive guidance to make it clear that a

substantial number of the requirements of the Exchange Act do not

apply to security-based swaps as a result of the revised definition

of ``security'' going into effect on July 16, 2011. The Exchange Act

Exemptive Order also provided temporary relief from provisions of

the Exchange Act that allow the voiding of contracts made in

violation of those laws.