United States: What Is A Swap? Maybe (Almost) Everything? You Gotta Problem With That?

Last Updated: April 24 2012

I. Introduction.

It has now been almost two years since Dodd-Frank was enacted in order to provide comprehensive regulation of those transactions the legislation calls "swaps." In a world regulated by common sense, "what is a swap?" would have been the first question answered by the regulators—indeed, the term should have been clearly defined by the statute. After all, how can the regulators adopt rules that govern a group of transactions where the regulators themselves do not know the transactions to which the rules will apply? How can businesses comment as to whether the proposed rules are sensible, or even feasible, as applied to a set of transactions that is boundless?

In a world regulated by common sense, the next term to be defined would have been "dealer," so that those entities most affected by the Dodd-Frank swaps regime would know who they were (and so that the regulators might know whom they were regulating and thus anticipate the consequences of regulation). The third "definition" would have been as to the geographic scope of Dodd-Frank: so that non-US persons could determine whether they would be subject to the statute, or so that they might limit their business to avoid the statute.

None of this is done. Instead, the regulators have proposed, and in some cases even adopted, rules dealing with recordkeeping (but concerning what transactions and by whom and where located?) and documentation (but concerning what transactions and by whom and where located?) and margin (but concerning what transactions and by whom and where located?). Meanwhile, the rules defining the term "swap" and "dealer" are postponed; and no date has been set for resolution of the geographic jurisdictional questions. The end result is that Dodd-Frank rules are proposed and adopted in a vacuum: they are to be applied to an undefined set of transactions, entered into by an undefined group of persons, located in undefined settings.

There are a few reasons for the regulatory delay of the definition of the term "swap":

  • The definition of "swap" in Dodd-Frank is impossibly, and I would guess unintentionally, overbroad. While it does not include the kitchen sink, it does include the contract to purchase and install the kitchen sink--if that contract has a price contingency relating to the timing of delivery and installation, the quality of work, or allowing the buyer to back-out of the deal for a fee, then the contract may be a "swap" within the meaning of Dodd-Frank.
  • Congress amended the Commodity Exchange Act and the Securities Exchange Act to withdraw from the regulators the authority to provide exemptions from, or otherwise limit, the statutory definition of the term "swap." This means that the regulators don't actually have the legal authority to exclude the kitchen sink contingency contract, or insurance contracts for that matter, from the statutory definition of swap.
  • The regulators themselves seem unsure of what they think should be, or what they want to regulate as, a swap. In the original proposal to define a regulated "swap," as opposed to an unregulated "forward," the CFTC, within the space of a few pages, (a) endorses cases that reach opposite results; (b) describes "intent to deliver" as (i) a "part of the analysis" for distinguishing swaps from forwards (but what are the other parts?) and (ii) an "essential part" of that analysis (are there any other parts?); and (c) then goes on to inquire as to the "primary purpose" of a swap or forward transaction (but does not explain what purposes are permissible or not). Ultimately, the regulators seem to give up on attempting an explanation of the swap/forward distinction, and the CFTC announces that it will determine what is a swap "in light of the totality of the circumstances" (but what circumstances? and what totality?) This "definition," or absence of definition, does no good for the certainty of contract on which businesses depend, and are entitled to expect. It likewise does no good for the ability of commercial entities, financial entities, insurance companies and their state regulators, and consumers attempting to comply with the law, and to plan their business and consumer activities, if no one can define a swap except by its gestalt (and even that to be judged in retrospect).

II. What is a "Swap" As Actually "Defined" in Dodd-Frank?

Dodd-Frank provides a nine-pronged definition of the term "swap," along with ten prongs of exclusion (and the regulators have created an eleventh "interpretative" prong). The nine inclusive prongs are, to be blunt, loosely drafted, ambiguous, and overlapping, with some of them entirely duplicative of others. That said, the key (over-inclusive) prongs are, in plain English, as follows:

  • An agreement that provides for a payment based on the value of any commodity but that does not transfer ownership of the commodity, or an agreement that provides for payment based on an index or measure.
  • An option on any property or an option that is tied to any quantitative measurement or a financial or economic measure.
  • Any contract as to which any payment or delivery term is associated with any event or contingency associated with a potential financial, economic, or commercial consequence.
  • Any contract that has been structured to evade being a swap.

There are also various exclusions from the scope of these prongs. Among the significant ones are debt securities, floating rate bank loans and bank deposits.

III. Provide Some Examples.

Essentially, unless there is an exemption, every contract that has an uncertain payment amount, or that has an "out" for the obligation to make or take delivery, is potentially a swap. Here are a few simple, but important, examples.

  • A home buyer obtains a floating rate mortgage from a credit union on which the mortgage payments are linked to LIBOR. Since the payments are tied to an interest index, the mortgage may be a "swap." This has significant legal consequences, including that the mortgage is illegal unless, among other things, the buyer qualifies as an eligible contract participant.
  • A developer is interested in building an apartment building and purchases an option on a potential development property. The option allows the developer to walk away from the purchase. The option may be a "swap."
  • A car owner purchases accident insurance for the vehicle. As car insurance is a contract that will pay off if the owner's vehicle smashes into another vehicle (an event of economic consequence to the car owner), the insurance policy may be a swap.

IV. Is it Really That Bad?

Some Examples of Uncertainty Cited By the Regulators. Below is a list of the types of contracts that the regulators concede are subject to uncertain treatment under Dodd-Frank. (It is not a full list; it includes only those specifically cited by the regulators themselves.)

  • Guarantees of loans;
  • Letters of credit;
  • Guarantees of swaps;
  • Insurance contracts of the following types: variable universal life insurance and annuity contracts, private passenger or commercial automobile, homeowners, mortgage, commercial multiperil, general liability, professional liability, workers compensation, fire and allied lines, farm owners multiperil, aircraft, fidelity, surety, medical malpractice, ocean marine, inland marine, and boiler and machinery insurance;
  • Contracts, consumer and commercial, of the following types: installment sales contracts, business financing arrangements such as receivables financings, pensions and other postretirement benefits, contracts relating to the performance of a service, standby liquidity agreements, reimbursement agreements, affiliate guarantees;
  • Purchases, sales, leases or transfers of equipment and inventory;
  • Mortgage securitizations, buying and selling mortgages, and forward trading of government agency mortgage-backed securities, TBA contracts;
  • Capacity contracts, reserve sharing agreements, tolling agreements, energy managements agreements;
  • Forward sales of emissions allowances, carbon offsets/credits and renewable energy certificates;
  • Debt with a variable rate of interest;
  • Commercial contracts containing acceleration, escalation or indexation clauses;
  • Agreements to acquire personal property, real property, mortgages, employment, leave and service agreements; all contracts that contain contingent payment arrangements;
  • All contracts with caps (such as consumer mortgages and utility rates);
  • Loan participations;
  • Options that, by their terms and when exercised, call for delivery of a physical commodity;
  • Options that allow the buyer not to exercise if the option is out of the money.

V. How Did We Get Such a Big, Bad Definition?

This definitional problem is not a new one. In fact, the definitional problem existed, albeit on a much much smaller scale, as to the definition of "futures" in the Commodity Exchange Act, prior to the adoption of the Commodity Futures Modernization Act in 2000.

When Congress adopted the Commodity Futures Modernization Act in 2000, for the purpose of exempting swaps from regulation, it created a very broad definition of a "swap agreement" (and "over-the-counter derivatives instrument") for the purposes of providing exemptions from the CEA in light of the problems created by the uncertain definition of the term futures. This broad definition of swap made sense, in that context, because Congress was making it clear that a particular type of transaction was not intended to be regulated. Unfortunately, when a definition that is intended to provide an exemption from regulation is used instead as a basis for regulation, there are unintended consequences. An illustrative hypothetical follows:

Suppose that Congress had passed an exemptive statute providing that "restaurants in the United States are exempted from any requirement of local law to tell diners the calorie count of the foods that the restaurants serve" – and, just to be clear, Congress defined the term "restaurant" to include a "private citizen who invites a non-family member to dine in her house." No harm is done by the broad definition of restaurant, even though no sensible person would believe that a private citizen could be thought a "restaurant."

Congress later decides that restaurants should disclose their calorie counts. Therefore, Congress requires that "each restaurant tell its diners how many calories are in the restaurant's food, and, for the avoidance of doubt, the term "restaurant" includes a private citizen who invites a family member to dine in her house."

Now that broad definition of restaurant has become a problem. And it gets worse.

  • In adopting Dodd-Frank, Congress actually further expanded the existing definition of what had been a "swap" for exemptive purposes— (e.g., the definition now applies not only to transactions in "commodities," but also to transactions in all "property" or "events") (to stick with my "restaurant" analogy, not just to private citizens, but also to social clubs, colleges and street vendors).
  • Congress denied the regulators the power to provide exemptions from the definition of "swap" (no carve-outs for private citizens, social clubs, colleges and street vendors).
  • Congress provided that any attempt to evade the Dodd-Frank's regulation of a "swap" was a crime (if the private citizen packs a picnic lunch to be eaten with third-parties outside her home, is that an "evasion"?).

VI. Can This Definitional Problem Be Solved?

Bluntly, the swap definition problem cannot really be fixed without corrective legislation. At a minimum, Congress should (i) deliberate as to how to define, by statute, the term "swap" and (ii) provide the regulators with exemptive authority to be used "in the public interest" (to use the common phraseology).

Failing corrective legislation, the regulators should (i) make a far more aggressive effort to limit the scope of the term "swap," and (ii) hope that no one challenges their exemptive authority (or lack thereof). To some extent, the regulators have moved in this direction, although somewhat halfheartedly, by, for example, asserting that "insurance" is carved out from the definition of swap.

Nonetheless, I think it incumbent upon the regulators to be far more aggressive. After all, if the regulators can "interpret" some insurance contracts out of regulation as a swap, there is no reason why this power of interpretation should not be used more broadly. At a minimum, the regulators should interpret out of the definition of swap transactions the following:

  • any loan on which the interest amounts are linked on a direct 1-1 basis to a common interest rate measure, such as LIBOR or Fed Funds;
  • any option on a specific, non-fungible physical asset, such as a particular parcel of real estate;
  • any instrument commonly known as insurance that is sold by a regulated insurance company in the United States;
  • any loan participation sold between banking institutions; and
  • any merger or purchase agreement that provides for termination based on a "material adverse change" in the business or condition of the merged or acquired asset.

However the regulators elect to define a swap, I do believe it is their responsibility to the commercial, financial, insurance and consumer markets to define the word in a way that we can all understand what is intended. An economy can only thrive where it operates subject to rules that provide a high degree of legal certainty.1 For the regulators to say that they will judge whether a trade is a "swap" in light of the "totality of the circumstances" seems unsatisfactory to me as a guide to participants in the economy. If the regulators do not believe that they can provide more definitive advice in light of the expansiveness of Dodd-Frank, then it is incumbent on the regulators to go back to Congress and ask for a narrower definition and for exemptive authority.

(As I noted above, the full legal-academic version of this memorandum, What is a Swap and Other Jurisdictional Questions, is available through the month on the Cadwalader Cabinet.)

Article by Steven Lofchie2

Footnotes

1 See, e.g., "The Rule of Law Influences Sovereign Yields" on the Center for Financial Stability webpage. The report demonstrates a very close correlation between a high degree of legal certainty in a jurisdiction and low borrowing rates by the government. (The Center for Financial Stability is an independent, nonpartisan, and nonprofit think tank dedicated to financial markets for the benefit of investors, officials, and the public. Steven Lofchie also serves as a Legal Studies Senior Fellow at the Center.)

2 I recognize that some readers of this article believe that I will have pointed out these problems with the statutory definition of the term "swap," because I do not like Dodd-Frank. It is absolutely true that I do not like Dodd-Frank, and that I do not believe that the statute is good legal policy and that I have written previously (and intend to write more) as to what I perceive as its flaws. (In fact, I wrote my first piece criticizing "Dodd-Frank" more than a year before the statute was even proposed. See Meet the New Regulators; Same as the Old Regulators".) I hope that admission is not disqualifying. In fact, I would even hope that those who are better able to perceive the good in Dodd-Frank than I would seek to correct what I think are some fairly serious problems that create genuine uncertainty of a type that cannot be good for commerce in the United States.

www.cadwalader.com

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

 
In association with
Related Video
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert
Email Address
Company Name
Password
Confirm Password
Mondaq Topics -- Select your Interests
Accounting and Audit
Anti-trust/Competition Law
Consumer Protection
Corporate/Commercial Law
Criminal Law
Employment and HR
Energy and Natural Resources
Environment
Family and Matrimonial
Finance and Banking
Food, Drugs, Healthcare, Life Sciences
Government, Public Sector
Immigration
Insolvency/Bankruptcy, Re-structuring
Insurance
Intellectual Property
International Law
Law Practice Management
Litigation, Mediation & Arbitration
Media, Telecoms, IT, Entertainment
Privacy
Real Estate and Construction
Strategy
Tax
Transport
Wealth Management
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.