SEC Proposes Product Definitions for Swaps
FOR IMMEDIATE RELEASE
Washington, D.C., April 27, 2011 — The Securities and Exchange Commission today voted unanimously to propose rules further defining the terms “swap,” “security-based swap,” and “security-based swap agreement.”
The Commission also proposed rules regarding “mixed swaps” and books and records for “security-based swap agreements.”
The rules were proposed jointly with the Commodity Futures Trading Commission (CFTC) and stem from the Dodd-Frank Wall Street Reform and Consumer Protection Act.
“The proposed definitions balance several policy and legal issues in a way I believe is practical, takes into account the specific nature of derivatives contracts, and is consistent with existing securities regulations,” said SEC Chairman Mary L. Schapiro. “The proposal seeks to provide guidance in rules and interpretations by using clear and objective criteria that should clarify whether a particular instrument is a swap regulated by the CFTC, a security-based swap regulated by the SEC, or a mixed swap regulated by both agencies.”
Public comments on the rule proposal should be received within 60 days after it is published in the Federal Register.
The SEC still has several more rules it must propose under Title VII of the Dodd-Frank Act and continues to welcome comments on those rulemakings that have already been proposed. When all of those rulemaking proposals have been completed, the SEC will consider what additional opportunity for public comment would be appropriate for its Dodd-Frank Act Title VII rules.
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Proposals to Further Define Terms in Title VII of the Dodd-Frank Act
The Dodd-Frank Act established a comprehensive framework for regulating the over-the-counter swaps markets. In particular, the Act provides that the SEC will regulate “security-based swaps,” the CFTC will regulate other “swaps,” and the CFTC and the SEC will jointly regulate “mixed swaps.”
Title VII of the Dodd-Frank Act requires that both the SEC and CFTC, in consultation with the Board of Governors of the Federal Reserve System, shall jointly further define the terms “swap,” “security-based swap,” and “security-based swap agreement.” Title VII further provides that the SEC and CFTC shall jointly establish such regulations regarding “mixed swaps” as may be necessary to carry out the purposes of swap and security-based swap regulation under Title VII.
In addition, Title VII requires the SEC and CFTC to jointly adopt rules governing the way in which books and records must be kept for security-based swap agreements. These rules would apply to those entities registered as swap data repositories under the Commodity Exchange Act or registered as swap dealers, major swap participants, security-based swap dealers, and major security-based swap participants.
The joint proposal of the SEC and the CFTC would add rules under the Securities Exchange Act of 1934 and provide interpretive guidance regarding which products would – and would not – be considered a “swap” or a “security-based swap” (referred to collectively in the proposing release as “Title VII instruments”).
Products That Are Not “Swaps” or “Security-Based Swaps”
Insurance: Under the proposed rule and interpretive guidance, insurance products would not be considered swaps or security-based swaps. To be considered insurance, the rules would require that both the product as well as the person or entity providing the product must meet certain criteria. The interpretive guidance would provide that certain types of products must be provided by a person or entity that meets certain criteria in order to be considered insurance.
Among other things, the beneficiary of the insurance product must have an insurable interest and thereby bear the risk of loss with respect to that interest continuously throughout the duration of the agreement, contract, or transaction.
- The loss must occur and be proved.
- Any payment or indemnification for loss must be limited to the value of the insurable interest.
- The agreement, contract or transaction must not be traded, separately from the insured interest, on an organized market or over-the-counter.
- With respect to financial guaranty insurance only, in the event of a payment default or insolvency of the obligor, any acceleration of payments under the policy must be at the sole discretion of the insurer.
A person or entity providing the insurance product must be one of the following:
- An insurance company whose primary and predominant business activity is insuring or reinsuring risks underwritten by insurance companies, subject to supervision by a state or federal insurance commissioner.
- The United States or any of its agencies or instrumentalities.
- In the case of reinsurance, a person located outside the United States providing the agreement, contract or transaction to an insurance company eligible under the proposed rules, provided that:
- Such person is not otherwise prohibited by law from offering the agreement, contract, or transaction to such an insurance company.
- The product to be reinsured meets the requirements under the proposed rules to be an insurance product.
- The total amount reimbursable by all reinsurers for such insurance product cannot exceed the claims or losses paid by the cedant.
In some cases, under the proposed interpretive guidance, certain types of products that may not meet the proposed criteria would still be considered insurance, and not swaps or security-based swaps, if those products are offered by a regulated insurance company. These products include surety bonds, life insurance, health insurance, long-term care insurance, title insurance, property and casualty insurance, and annuity products the income on which is subject to tax treatment under Section 72 of the Internal Revenue Code.
Security forwards: The SEC proposed interpretive guidance clarifying that security forwards fall outside the definitions of swap and security-based swap. This includes the treatment of mortgage backed securities that are eligible to be sold in the “to-be-announced” or “TBA” market.
Consumer and Commercial Transactions: The SEC also proposed interpretive guidance describing the way in which certain consumer and commercial transactions fall outside the definitions of swap and security-based swap.
Under the proposed interpretive guidance, certain agreements, contracts or transactions entered into by consumers primarily for personal, family or household purposes should not be considered swaps or security-based swaps.
They include 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).
- 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 by the consumer only if the loan or mortgage is made thereto.
They also include consumer loans or mortgages with variable rates of interest, 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.
Under the proposed interpretive guidance, commercial agreements, contracts, or transactions that involve customary business or commercial arrangements (whether or not involving a for-profit entity) would not be considered swaps or security-based swaps.
- Employment contracts and retirement benefit arrangements.
- Sales, servicing, or distribution arrangements.
- Agreements, contracts, or transactions for the purpose of effecting a business combination transaction.
- 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).
- Mortgage or mortgage purchase commitments, or sales of installment loan agreements or contracts or receivables.
- Fixed or variable interest rate commercial loans entered into by non-banks.
- 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.
The consumer and commercial transactions listed in the proposed guidance are not an exhaustive list of transactions that should not be considered swaps or security-based swaps. The proposed guidance provides for certain factors the Commissions will consider in determining whether consumer and commercial transactions that are not listed are swaps or security-based swaps.
Transactions That Are “Swaps” or Security-Based Swaps”
The SEC proposed a rule and interpretive guidance that the following transactions fall within the definition of swap or security-based swap: foreign exchange forwards, foreign exchange swaps, foreign currency options (other than foreign currency options traded on a national securities exchange), non-deliverable forward contracts involving foreign exchange, currency and cross-currency swaps, forward rate agreements, contracts for differences, and certain combinations and permutations of (or options on) swaps and security-based swaps.
In its proposed interpretive guidance, the SEC would clarify whether particular agreements, contracts or transactions are swaps, security-based swaps, or mixed swaps. Among other things, the proposed guidance would provide that such a determination is to be made at the inception of the Title VII instrument and that such a characterization would remain throughout the life of the instrument unless the instrument is amended or modified.
Interest Rates, Other Monetary Rates and Yields: Under the proposed interpretive guidance, Title VII instruments on interest rates and other monetary rates would be swaps. And, Title VII instruments on “yields” – where “yield” is a proxy for the price or value of a debt security, loan, or narrow-based security index – would be security-based swaps, except in the case of certain exempted securities.
Meanwhile, Title VII instruments on rates or yields of U.S. Treasuries and certain other exempted securities (other than municipal securities) would be swaps and not security-based swaps.
Total Return Swaps: Under the proposed interpretive guidance, a Total Return Swap, or TRS, on a single security, loan, or narrow-based security index generally would be a security-based swap. Where counterparties embed interest-rate optionality or a non-securities component into the TRS (e.g., the price of oil, a currency hedge), it would be a mixed swap.
Title VII Instruments Based on Futures: Under the proposed interpretive guidance, Title VII instruments on futures (other than futures on foreign government debt securities) would generally be swaps and Title VII instruments on security futures would generally be security-based swaps.
Swaps and Security-Based Swaps Based on Security Indexes
The SEC proposed rules and interpretive guidance regarding the applicability of the “narrow-based security index” definition to certain products, including proposed rules regarding the definition of “narrow-based security index” and “issuers of securities in a narrow-based security index” for index credit default swaps (index CDS).
The SEC also proposed rules and interpretive guidance regarding the definition of a security index and the evaluation of Title VII instruments based on security indexes that migrate from broad-based to narrow-based and vice versa.
The SEC proposed rules and interpretive guidance regarding 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 SEC and CFTC regarding those criteria to Title VII instruments.
- New criteria for determining whether an index CDS where the underlying reference is a group or index of entities or obligations of entities is based on an index that is a narrow-based security index.
- The meaning of the term “index.”
- A rule governing the tolerance period for Title VII instruments on security indexes traded on designated contract markets (DCMs), swap execution facilities (SEFs), foreign boards of trade (FBOTs), security-based SEFs, or national securities exchanges (NSEs), where the security index temporarily moves from broad-based to narrow-based or from narrow-based to broad-based.
- A rule 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.
If a broad-based index CDS requires mandatory physical settlement, it would be a mixed swap.
If a broad-based index CDS requires cash settlement or auction settlement, it would be a swap, and would 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 security or loan auction.
The SEC proposed interpretive guidance regarding the scope of the mixed swap category, which both the SEC and CFTC believe to be narrow.
The SEC also proposed rules and interpretive guidance that mixed swaps would remain subject to the entirety of the SEC and CFTC regulatory regimes, but that for bilateral uncleared mixed swaps entered into by at least one dually-regulated swap and security-based swap dealer or major swap and security-based swap participant, certain regulatory requirements would apply.
In addition, the SEC proposed a rule establishing a process, for all other mixed swaps, by which persons may request modified regulatory treatment by joint order of the SEC and CFTC.
Security-Based Swap Agreements
The SEC proposed interpretative guidance regarding certain products that are security-based swap agreements (SBSA). It also proposed a rule requiring market participants to maintain the same books and records for security-based swap agreements as they would under the CFTC’s proposed books and records requirements for swaps.
Interpretation of the Characterization of a Product
The SEC proposed a rule establishing a process that would allow market participants or either the SEC or CFTC to request a determination from the SEC and CFTC of whether a product is a swap, security-based swap, or both (i.e., a mixed swap).
The proposal seeks public comment and data on a broad range of issues relating to the proposed rules and interpretive guidance, including the costs and benefits associated with the proposal. After careful review of comments, the SEC and the CFTC will consider whether to adopt the proposed rules and interpretive guidance or modify them. Comments should be received on or before 60 days after the date of publication in the Federal Register.