United States: Update: SEC And CFTC Adopt Final Swap Definitional Rules, Triggering Compliance Dates For Multiple Dodd-Frank Act Rules

Today final rules recently adopted by the Securities and Exchange Commission (the "SEC") and the Commodity Futures Trading Commission (the "CFTC" and, together with the SEC, the "Commissions") defining the terms "swap" and "security-based swap" (the "swap definitional rules") were published in the Federal Register. The final rules can be found here. This marks a critical milestone in the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act") regulatory timeline, as the compliance dates for many other rules under the Dodd-Frank Act (some of which already have been finalized by the Commissions) are dependent on the effective date of these swap definitional rules, which is 60 days following the date of such publication, i.e., October 12, 2012.

Under Title VII of the Dodd-Frank Act, regulation of the over-the-counter swaps market is divided between the SEC and the CFTC; the SEC has regulatory authority over security-based swaps, while the CFTC has regulatory authority over swaps. The swap definitional rules will enable market participants to determine whether transactions or instruments are swaps, and therefore subject to the rules regulating derivatives adopted by the CFTC under the Dodd-Frank Act, security-based swaps, and therefore subject to the rules regulating derivatives adopted by the SEC under the Dodd-Frank Act, or neither, and therefore not covered by either the SEC's or the CFTC's regulatory regime.

The swap definitional rules will become effective on Friday, October 12. Under the CFTC's regulatory framework, the compliance date for a number of other rules will occur automatically in connection with (or following) the effective date of the swap definitional rules. A summary of certain of these rules which will have the greatest impact on buy-side users of derivatives, and their respective compliance dates, is included below.

Swap Definition

The final definition of "swap" generally tracks the definition set forth in Section 721(a)(21) of the Dodd-Frank Act and remains largely unchanged from the CFTC's proposed swap definitional rules. Very generally, the definition includes interest rate swaps, commodity swaps, currency swaps, credit default swaps on broad-based security indices, forwards, foreign currency options, commodity options, non-deliverable forwards in foreign exchange, cross currency swaps, forward rate agreements, options to enter into swaps, forward swaps, total return swaps on broad-based security indices, and total return swaps on two or more loans. The final definition of swap also includes deliverable currency forwards and foreign exchange swaps, although the United States Department of the Treasury has proposed excluding such transactions from the definition of swap for most purposes under the Dodd-Frank Act (except reporting requirements and business conduct standards). Forwards on a nonfinancial commodity that are intended to be physically settled and securities forwards (including TBAs) are not swaps.

Security-Based Swap Definition

The final definition of "security-based swap" generally includes swaps based on a single security or loan or a narrow-based group or index of securities (including any interest therein or the value thereof), or events relating to a single issuer or issuers of securities in a narrow-based security index. Examples of security-based swaps are swaps on "yields" (where yield is a proxy for the price or value of a debt security, loan, or narrow-based security index), a total return swap on a single security, loan, or narrow-based security index, swaps on security futures, credit default swaps on narrow-based security indices, and credit default swaps where the underlying reference is a single entity or a single obligation of a single entity (such as a specific bond, loan, or asset-backed security, or any tranche of any of the foregoing).

As noted above, swaps on a narrow-based securities index are security-based swaps, while swaps on a broad-based securities index are swaps. The Commissions adopted rules and guidance for determining whether an index is a narrow-based security index for this purpose. An index (other than in the context of an index credit default swap) is a narrow-based security index if it meets any of the following four criteria:

• 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 million (or in the case of an index with more than 15 component securities, $30 million), except that in the case of an index in respect of debt securities, a test measuring public availability of information regarding debt securities or issuers of debt securities in the index is used in lieu of the trading volume test.

In addition, the Commissions adopted separate criteria for determining whether an index is a narrow-based security index in the context of an index credit default swap. A credit default swap index that meets any of the following characteristics will be a narrow-based security index:

• it has nine or fewer component securities or non-affiliated issuers as reference entities;
• the effective notional amount allocated to the securities of any one issuer comprises more than 30 percent of the index's weighting;
• the effective notional amount allocated to the securities of any five non-affiliated issuers in the index comprises more than 60 percent of the index's weighting; or
• less than 80 percent of the index's weighting is comprised of reference entities that satisfy a public information availability test, or any reference entity that does not satisfy such test comprises 5 percent or more of such index's weighting. An entity satisfies the public information availability test if, for example, the entity is required to file reports pursuant to the Securities Exchange Act of 1934, the entity has a worldwide market value of outstanding common equity held by non-affiliates of $700 million or more, or the entity (other than an entity issuing an asset-backed security) has outstanding debt with a remaining principal amount of at least $1 billion.

Commodity Pool Operator and Commodity Trading Advisor Registration

The swap definitional rules will also be significant to fund sponsors and advisors as they analyze their commodity pool operator and commodity trading advisor registration status in the wake of the repeal of the registration exemption under CFTC Rule 4.13(a)(4) and modifications to the exclusion and exemption under CFTC Rules 4.5 and 4.13(a)(3), respectively. The final rule regarding these changes can be found here. As a result of these changes, fund sponsors and advisors will need to determine whether an alternative exemption is available or whether registration is required, and now will need to include swaps in calculating whether the Rule 4.5 exclusion or the Rule 4.13(a)(3) exemption is available.

Under the revised rules, the Rule 4.5 exclusion or the Rule 4.13(a)(3) exemption will be available for funds which trade only a de minimis level of commodity interests and which are not marketed as vehicles for trading in commodity interests; however, the analysis of whether a fund can rely on these provisions has been modified to take into account swaps trading in the de minimis threshold calculations. Under the Rule 4.13(a)(3) exemption, a fund generally must keep the aggregate initial margin or premium necessary to establish a commodity interest position at or below five percent of the liquidation value of the fund's portfolio, or keep the aggregate net notional value of its commodity interest trading from exceeding 100 percent of the liquidation value of the fund's portfolio. The same de minimis thresholds apply in the Rule 4.5 exclusion, but bona fide hedging transactions are excluded from the calculations. Private fund operators that have typically relied on Rule 4.13(a)(4) may be able to rely instead on the exemption in Rule 4.13(a)(3). However, doing so may be more difficult than in the past since swaps will now be taken into account. Please see Ropes & Gray's Alerts here and here for more information.

CFTC Rules: Compliance Timeline

Implementation of the Dodd-Frank Act regulatory scheme depends on the adoption of swap definitions, as several key CFTC rules hinge on their meaning and cannot be implemented until the swap definitional rules have become effective. As noted above, the swap definitional rules will become effective on October 12, 2012. Several CFTC rules will become effective on that date, with compliance dates for a number of other rules to follow. These compliance dates are set forth in the following table, which outlines some of the key CFTC regulations whose effective date has now been established as a result of the adoption of the swap definitional rules and summarizes in very general terms how these regulations will impact buy-side users of derivatives.

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