United States: Regulators Issue Final Rules And Interpretations Further Defining Swap-Related Terms - Part II

IV. MIXED SWAPS AND SECURITY-BASED SWAP AGREEMENTS

A. Mixed Swaps

A mixed swap is both a security-based swap and a swap. It is defined as a security-based swap that is also based (i) on a reference that is not a single security or narrow-based security index or (ii) on the occurrence, non-occurrence, or extent of occurrence of an event or contingency associated with a potential financial, economic, or commercial consequence (other than an event relating to a single issuer of a security or the issuers of securities in a narrow-based index, provided that the event directly affects the financial condition, obligations, or statements of the issuer).

1. Reference to Standard Agreements

A Title VII Instrument will not be both a swap and a security-based swap merely because it incorporates by reference a standard agreement, including default and termination events that relate to the counterparties to the Title VII Instrument.

2. Certain TRS

Interest rate payments that act merely as a financing component in a security-based TRS (or in any other security-based swap) will not generally turn a security-based swap into a mixed swap. However, it will become a mixed swap if the payments incorporate additional elements that create additional rate or currency exposures unrelated to the financing or that shift or limit financing-related risks, such as where the counterparties embed a cap, collar, call, or put into the terms of the security-based swap in a way that is designed to shift or limit the interest rate exposure. Similarly, if the TRS is also based on a non-security-based component such as the price of oil, it would be a mixed swap.

3. Rules and Procedures Relating to Mixed Swaps

The Commissions are required to prescribe joint rules for mixed swaps to ensure that there will be no gaps in the regulation of Title VII Instruments. The mixed swap category is intended to be narrow in scope and thus covers only a small subset of Title VII Instruments. The Commissions recognize that dual regulation of mixed swaps may be duplicative and even potentially conflicting and may not be appropriate in all instances, and have attempted in the final rules and interpretations appropriately to narrow the reach of their respective regulatory regimes.

Under this approach, swap dealers and MSPs that are dually-registered with both Commissions will be permitted to comply with an alternative regulatory regime in connection with bilateral uncleared mixed swaps (regardless of whether the counterparty is a registered entity) under certain conditions. They will be subject to all applicable federal securities laws and regulations but only to a limited number of CEA provisions and CFTC rules thereunder. These include examinations and information sharing, enforcement (including prohibitions on fraud, manipulation, and abusive practices, as well as the whistleblower rules and the requirements relating to confidential treatment of counterparty information), reporting to an SDR, real time reporting, capital, and position limits.

With respect to all other mixed swaps (i.e., mixed swaps that are intended to be listed, traded, or cleared, or uncleared mixed swaps that are not entered into bilaterally by at least one duallyregistered entity), any person may ask the Commissions for a joint order (to be made public) permitting that person to comply with only one set of provisions where the provisions in both regimes are parallel and where the requesting party specifies the provisions and provides reasons and analysis as to why they are parallel, comparable, and, if applicable, conflicting or different.

The requesting party must also provide the Commissions with all material information regarding the terms and economic characteristics of the mixed swap (or class of mixed swap).

Parties will be allowed to withdraw a request at any time before the Commissions issue a joint order, which is required within 120 days of receipt of a complete request. The 120-day period may be tolled if the Commissions request public comment. If the Commissions do not issue an order within the 120-day period, they must publicly provide their reasons for not having done so.

B. Security-Based Swap Agreements

An SBSA is defined as a "swap agreement" 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.31 SBSAs are swaps. However, while the CFTC has regulatory and enforcement authority over these swaps, the SEC also has antifraud and in some cases recordkeeping and examination authority over them. The Adopting Release makes clear that the SEC will not impose any additional books and records requirements related to SBSAs other than those required for swaps.

The Commissions recognize the difficulty in providing a clear definition of SBSAs and instead have determined to clarify that certain swaps clearly fall within that definition. These include, for example, a swap based on a broad-based security-index, a broad-based index CDS, and a swap based on US Treasury or certain other exempted securities.

V. ANTI-EVASION AUTHORITY AND ADDITIONAL DEFINITIONAL ISSUES

A. Anti-Evasion

The DFA requires the CFTC and authorizes the SEC to issue Product Definitions designed to address evasion of Title VII's provisions. The SEC, whose authority in this area is permissive, has declined to adopt anti-evasion rules because security-based swaps, as securities, are already subject to all of the SEC's existing regulatory authority. The CFTC, on the other hand, has adopted anti-evasion rules and issued an interpretation that essentially defines as swaps transactions that are willfully structured to evade the provisions of Title VII. In enforcing the new rules, the CFTC will look beyond the form, label, or documentation of a transaction and will also look to activities conducted outside of the US It also will consider transactions designed to evade a determination of whether an entity is a swap dealer or MSP. The rules will not apply to an Instrument structured as a security.

B. Additional Definitional Issues

1. Stable Value Contracts

Section 719(d)(1)(A) of the DFA requires the Commissions to conduct a study on stable value contracts to determine whether they are swaps, and, if they are, whether it is in the public interest that they be exempted from the definition. The joint study is still underway. In the meantime, the requirements of Title VII do not apply to stable value contracts. In addition, stable value contracts in effect before the effective date of any regulations the Commissions may adopt are not considered swaps.

2. Inter-Affiliate Swaps

In response to requests from numerous commenters, the Commissions anticipate addressing in a separate rulemaking whether inter-affiliate swaps or security-based swaps should be treated differently from other swaps and security-based swaps.

VI. CONCLUSION

Notwithstanding the Commissions' assertion that classification of most Title VII Instruments as swaps, security-based swaps, or mixed swaps will be relatively easy, the 600-page Adopting Release is fraught with complexity and it is likely that market participants will regularly use the process for seeking a joint order to help them assess their compliance obligations with Title VII.

Footnotes

^{31 Exchange Act Section 3(a)(78). See Section 206A of the Gramm-Leach-Bliley Act, 15 U.S.C. 78c note.}

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