CFTC/SEC Update

As part of implementing new statutory provisions enacted by Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"), which establishes a comprehensive framework for the regulation of the swap market, the Commodity Futures Trading Commission (the "CFTC") and the Securities and Exchange Commission (the "SEC" and collectively with the CFTC, the "Commissions") have been jointly tasked, in consultation with the Board of Governors of the Federal Reserve System, with further defining various terms added by the Dodd-Frank Act to the Commodity Exchange Act, as amended (the "CEA") and the Securities Exchange Act of 1934, as amended (the "Exchange Act"), including "major swap participant" ("MSP"), "major security-based swap participant" ("MSBSP"), "swap dealer" ("SD") and "security-based swap dealer" ("SBSD"). The Commissions have also been given authority to further define the term "eligible contract participant" ("ECP"), as defined under the CEA.

Under Title VII of the Dodd-Frank Act, SDs and MSPs are entities with substantial activities in swaps and are subject to registration and comprehensive regulation by the CFTC. Similarly, SBSDs and MSBSPs are entities with substantial activities in security-based swaps and are subject to registration and comprehensive regulation by the SEC. We note that the Commissions have not yet provided guidance on the meanings of the terms "swap" or "securities-based swap," thereby rendering it difficult to determine the precise scope of the terms MSP, MSBSP, SD and SBSD.

The Commissions have published in the Federal Register a joint release (the "Release")¹ proposing definitions of the terms MSP, MSBSP, SD and SBSD, amendments to the ECP definition and certain related interpretative guidance. We have set forth below a brief summary of the Commissions‟ proposed definitions, including practical considerations for applying these definitions and potential exclusions and exemptions from the defined terms. The Commissions are seeking comments on the proposed rules by February 22, 2011.

PROPOSED RULES DEFINING "MAJOR SWAP PARTICIPANT" AND "MAJOR SECURITY-BASED SWAP PARTICIPANT"

Pursuant to Sections 712(d)(1), 721(c) and 761(b) of the Dodd-Frank Act, the Commissions are proposing definitions of MSP and MSBSP. These definitions would establish the criteria by which entities whose swap or security-based swap activities do not subject them to regulation as an SD or an SBSD, but who are major market participants, might nonetheless be brought within the ambit of regulation under the Dodd-Frank Act. In the view of the Commissions, the underlying purpose of these definitions is to address the market impact and risks associated with certain entities‟ swap and security-based swap positions because such positions and related activities may pose a high degree of risk to the U.S. financial system. Accordingly, once an entity is deemed to be an MSP or an MSBSP, it must comply with statutory and regulatory requirements similar to those applicable to SDs and SBSDs, including, but not limited to, registration, capital, margin and business conduct requirements.² Note that an entity that is an SD or an SBSD will not be subject to regulation as an MSP or an MSBSP, respectively.

Three Alternative Tests for Classification as an MSP or an MSBSP

As proposed by the Commissions, an entity that meets any one of the following three alternative tests would be classified as an MSP or an MSBSP.

A. Entities who maintain a "substantial position" in any of the "major" categories of swaps or security-based swaps (as those categories are determined by the Commissions) (hereafter referred to as "Test #1" or the "Substantial Position Test")

Substantial Position

The Dodd-Frank Act directs the Commissions to define "substantial position" at the threshold which each Commission determines "to be prudent for the effective monitoring, management, and oversight of entities that are systemically important or can significantly impact the financial system of the United States."³ Accordingly, the Commissions are proposing two alternative Substantial Position Tests.

The first Substantial Position Test is designed to measure the theoretical amount of current potential risk that an entity would pose to its counterparties (each, a "CP") if it were to default. Under this test, the Commissions would calculate an entity‟s current uncollateralized exposure by analyzing such entity‟s exposure with each CP in each "major" category (as discussed below), determining the value of its aggregate current negative (i.e., out of the money for the entity) exposure (subject to netting between such entity and each CP, but not across multiple CPs) by marking-to-market under standard industry practices and deducting the amount of posted collateral. These amounts would then be summed across all CPs within that major category of swaps or security-based swaps to determine the entity‟s current uncollateralized exposure for such major category. Note that cleared positions would be excluded from this analysis.

An entity would be an MSP or an MSBSP, as applicable, if its uncollateralized exposure exceeds the prescribed threshold for a given major category of swaps or security-based swaps, unless an exemption applies. The Commissions are proposing thresholds for current uncollateralized exposure for MSPs and for MSBSPs, respectively, as a daily average of (a) $1 billion for each "major" category of swaps, except rate swaps, for which the threshold would be $3 billion and (b) $1 billion for each "major" category of security-based swaps.

The second Substantial Position Test calculates the sum of an entity‟s current uncollateralized exposure and its potential future exposure (including some collateralized and/or cleared exposure, as discussed below). This test seeks to address the uncertainty surrounding potential fluctuations in the value of positions over time. The Commissions are attempting to estimate the risk that an entity may pose to its CPs by measuring the total notional principal amount of its "major" swap positions, as modified by leverage created by the structure of the positions and as adjusted by certain risk factors reflecting the type of instrument and the duration of each position. The proposed measures would also employ downward adjustments for certain types of positions that pose relatively lower potential risks.

To determine potential future exposure, the second Substantial Position Test employs multipliers to adjust for the risk and duration of various positions (e.g., 0.60 for equity swaps with a maturity of less than one year; 0.10 for a maturity of more than five years). The test generally excludes swap positions that are purchases of options and includes a formulation to take into account the risk-reducing impact of master netting agreements. Moreover, if positions are cleared or are subject to daily mark-to-market margining, their potential future exposures would be discounted to 20% of the amount that would otherwise apply, provided that the parties exchange collateral on a daily basis to reflect changes in exposure (after taking into account the impact of any netting agreements on the parties‟ positions). If the parties are permitted to maintain an uncollateralized "threshold" amount under the relevant agreements, such threshold amount would be considered uncollateralized exposure for purposes of the test. Further, if the relevant agreements specify a minimum transfer amount for collateral higher than $1 million, the entirety of that amount would be considered uncollateralized exposure.

Under the second Substantial Position Test, an entity would be deemed an MSP or an MSBSP, respectively, if the sum of its daily average current uncollateralized exposure and its aggregate potential future exposure exceeds any of the following prescribed thresholds: (a) $2 billion for each "major" category of swaps, except rate swaps, for which the threshold would be $6 billion and (b) $2 billion for each "major" category of security-based swaps.

The Commissions believe that most entities will not need to calculate their potential future exposure, because their notional positions generally will fall well below the thresholds, particularly when taking into account the discounting multipliers described above.

The Commissions are interested in receiving comments on a variety of issues relating to these calculations, including whether the tests are practical in application, whether there should be a more definitive formula for determining uncollateralized exposure or alternative multipliers for future exposure, how valuation uncertainty or disputes can be addressed, whether the thresholds are set at appropriate levels, how the tests would impact liquidity and risk-taking activities in the relevant markets, whether there are additional important netting considerations and how overcollateralization should be analyzed under the proposed framework.

"Major" Categories of Swaps and Security-Based Swaps

According to the Commissions, the "major" categories of swaps definitions described below relate solely to the definitions of MSPs and MSBSPs and are not applicable for other purposes.

The Commissions are proposing to establish four "major" categories of swaps for purposes of the MSP definition: (a) rate swaps, defined as "any swap which is primarily based on one or more reference rates, such as swaps of payments determined by fixed or floating interest rates, currency exchange rates, inflation rates or other monetary rates;"⁴ (b) credit swaps, defined as "any swap that is primarily based on instruments of indebtedness, including but not limited to any swap primarily based on one or more indices related to debt instruments, or any swap that is an index credit default swap or total return swap on one or more indices of debt instruments;"⁵ (c) equity swaps, defined as "any swap that is primarily based on equity securities, such as any swap primarily based on one or more indices of equity securities, or any total return swap on one of more equity indices;"⁶ and (d) other commodity swaps, a category which seeks to capture all swaps not qualifying as swaps under the other three categories, including swaps on physical commodities. These categories are derived from market statistics that distinguish between these types of swaps and from existing market infrastructures previously established for such swaps. Swaps would be grouped into whichever category most closely resembles the item underlying the swap; if the swap is based on multiple items, the swap would be grouped into the applicable category that is most likely to impact the economic return of the swap.

For purposes of the MSBSP definition, the Commissions are proposing two "major" categories: (a) any security-based swap based on instruments of indebtedness (including loans) or a credit event relating to one or more issuers of securities (CDS, TRS, debt swaps, debt index swaps, credit spreads) and (b) everything else not in the first category (including equity swaps). These categories seek to reflect "the fact that entities that transact in security-based swaps for non-speculative purposes would be expected to use the respective instruments for different purposes. For example, swaps based on instruments of indebtedness, such as credit derivatives, can be used to hedge the risks associated with the default of a counterparty or debt obligation. Equity swaps can be used...to hedge the risks associated with equity ownership or gain synthetic exposure to equities."⁷ Again, the Commissions believe that these major categories are consistent with market statistics and existing infrastructures.

The Commissions are seeking comments on whether any swaps would not be clearly categorized under the aforementioned framework and whether the proposed categorization of swaps is appropriate or whether better alternatives exist.

Exemptions

The Substantial Position Test provides an exemption for any swap or security-based swap positions that are held for "hedging or mitigating commercial risk" (interpreted in the same manner as the similar concept included in the end-user exemption from the mandatory clearing requirement under the Dodd-Frank Act) and for positions maintained by or contracts held by any employee benefit plan (as defined in paragraphs (3) and (32) of section 3 of the Employee Retirement Income Security Act of 1974, as amended ("ERISA")), for the purpose of hedging risks directly associated with such employee benefit plan. The Commissions preliminarily have taken the view that the nature of the entity is not pertinent to the applicability of this exemption. Moreover, a swap or security-based swap would not be required to qualify as a hedge for accounting purposes to qualify for the exemption. The Commissions are proposing different rules for applying this exemption to MSPs and MSBSPs.

Application of "Hedging or Mitigating Commercial Risk" Exemption to MSPs

The Commissions are proposing a rule that specifies eight (8) categories of commercial risk which, if hedged or otherwise mitigated through a swap position, would enable an MSP to qualify for the "hedging or mitigating commercial risk" exemption. Any such swap position must be "economically appropriate" (as such concept already is used in the rules exempting bona fide hedging from position limits under the CEA) to the reduction of risks in the conduct or management of a commercial enterprise that arise from:

• the potential change in the value of assets that a person owns, produces, manufactures, processes, or merchandises or reasonably anticipates owning, producing, manufacturing, processing, or merchandising in the ordinary course of business;
• the potential change in the value of liabilities that a person has incurred or reasonably anticipates incurring in the ordinary course of business;
• the potential change in the value of services that a person provides, purchases, or reasonably anticipates providing or purchasing in the ordinary course of business;
• the potential change in the value of assets, services, inputs, products, or commodities that a person owns, produces, manufactures, processes, merchandises, leases, or sells, or reasonably anticipates owning, producing, manufacturing, processing, merchandising, leasing, or selling in the ordinary course of business;
• any potential change in value related to any of the foregoing arising from foreign exchange rate movements associated with such assets, liabilities, services, inputs, products, or commodities;
• any fluctuation in interest, currency, or foreign exchange rate exposures arising from a person‟s current or anticipated assets or liabilities;
• activity which qualifies as bona fide hedging for purposes of an exemption from position limits under the CEA; or
• activity which qualifies for hedging treatment under Financial Accounting Standards Board Accounting Standards Codification Topic 815, Derivatives and Hedging (formerly known as Statement No. 133).

Additionally, to qualify for this exemption, the Commissions are proposing to require that the swap position not be held (i) for purposes of speculation, investing or trading or (ii) to hedge or mitigate the risk of another swap or security-based swap position, unless such position itself is held for purposes of hedging or mitigating commercial risk. In this regard, the Commissions "preliminarily believe that swap positions that are held for the purpose of speculation or trading are, for example, those positions that are held primarily to take an outright view on the direction of the market, including positions held for short term resale, or to obtain arbitrage profits."⁸ The Commissions further "preliminarily believe that swap positions that are held for the purpose of investing are, for example, those positions that are held primarily to obtain an appreciation in value of the swap position itself, without regard to using the swap to hedge an underlying risk."⁹

From a timing perspective, a determination of whether a position hedges or mitigates commercial risk would be made at the time an MSP enters into a swap.

The Commissions are interested in receiving comments on this exemption, including whether the exemption should apply solely to swaps in which the underlying hedged item is a non-financial commodity, and whether potentially exempt swaps should be required to mitigate risk on a single risk basis or on an aggregate risk basis.

Application of "Hedging or Mitigating Commercial Risk" Exemption to MSBSPs

For an MSBSP‟s security-based swap positions to qualify under the exemption for hedging or mitigating commercial risk, the Commissions are proposing a rule which would require that such positions be "economically appropriate" (here, preliminarily interpreted by the SEC under a "reasonably prudent person" standard) to the reduction of risks in the conduct and management of a commercial enterprise, where such risks arise from:

• the potential change in the value of assets that the entity owns, produces, manufactures, processes or merchandises or reasonably anticipates owning, producing, manufacturing, processing or merchandising in the ordinary course of business;
• the potential change in the value of liabilities that the entity has incurred or reasonably anticipates incurring in the ordinary course of business; or
• the potential change in the value of services that the entity provides, purchases, or reasonably anticipates providing or purchasing in the ordinary course of business.

In addition, these security-based swap positions may not introduce additional basis risk or other new types of risk more than are reasonably necessary to manage the identified commercial risk, and these positions cannot be held for purposes of speculation or trading, or to hedge other swap or security-based swap positions that do not qualify for the exemption. Moreover, to claim this exemption, the Commissions are proposing that an entity would be required to (i) identify and document the risks that are being reduced by the security-based swap position; (ii) establish and document a method of assessing the effectiveness of such position as a hedge; and (iii) regularly assess the effectiveness of such hedging.

The Commissions are interested in receiving comments regarding, among other things, whether this exemption achieves the goal of reducing risk to CPs and to the market, whether the "economically appropriate" standard is appropriate, whether the line between mitigating risk/hedging and speculation/investment is sufficiently clear and whether financial entities should be able to rely upon this exemption or whether they should be subject to alternative criteria.

B. Entities whose outstanding swaps or security-based swaps create "substantial counterparty exposure that could have serious adverse effects on the financial stability of the U.S. banking system or financial markets" (hereafter, "Test #2")

Unlike the Substantial Position Test, this proposed test is not premised on "major" categories of swaps, nor would it provide an exemption for hedging positions or employee benefit plan positions. Otherwise, however, this test essentially replicates the components of the Substantial Position Test, and its threshold calculations are made using similar methods. Under this test, the proposed thresholds for current uncollateralized negative exposure (across all swap or security-based swap positions) are (a) $5 billion for MSPs and (b) $2 billion for MSBSPs. The proposed thresholds for current uncollateralized exposure plus potential future exposure (across all swap or security-based swap positions) are (a) $8 billion for MSPs and (b) $4 billion for MSBSPs. The Release notes that these higher thresholds reflect that this test consolidates multiple swap categories and encompasses certain hedging positions that the Commissions expect are likely to pose fewer risks to CPs and to the markets than those positions which are not used for hedging purposes.

The Commissions are seeking comments regarding whether these thresholds are appropriate, whether the tests should exclude positions hedging commercial risk and positions held by employee benefit plans for the purpose of hedging risks directly associated with such plans and whether an entity‟s swap and security-based swap positions should be combined when calculating the applicability of the proposed thresholds.

C. Any "financial entity" that is "highly leveraged relative to the amount of capital such entity holds and that is not subject to capital requirements established by an appropriate Federal banking agency" and that maintains a "substantial position" in swaps or security-based swaps for any of the "major" categories of swaps or security-based swaps (hereafter, "Test #3")

Like Test #2, Test #3 contains no exemption for positions hedging commercial risk. However, this test does contain an exemption for financial institutions that are subject to capital requirements set by the Federal banking agencies. The Commissions are proposing definitions of "financial entity" and of "highly leveraged" for purposes of this test.

"Financial Entity"

The Commissions are proposing to define the term "financial entity" in the same manner as the term is used in the Dodd-Frank Act in the context of the end-user exemption from mandatory clearing. Specifically, the term "financial entity" would include any: commodity pool (as defined in section 1a(10) of the CEA); private fund (as defined in section 202(a) of the Investment Advisers Act of 1940); employee benefit plan; and person predominantly engaged in the activities that are in the business of banking or of a financial nature (as defined in section 4(k) of the Bank Holding Company Act of 1956). For MSPs, the definition would also include SBSDs and MSBSPs; for MSBSPs, the definition would also include SDs and MSPs. The Commissions believe that this approach is consistent with the statutory intent to treat non-financial end-users differently than financial entities.

"Highly Leveraged"

The Commissions are proposing two alternative definitions for "highly leveraged": either the ratio of an entity‟s total liabilities to equity is in excess of 8 to 1 or the ratio is in excess of 15 to 1 (both measured as of close of business in the applicable fiscal quarter). These ratios are derived from (i) the requirements for bank holding companies and non-bank financial companies set forth in Title I of the Dodd-Frank Act (the 15:1 ratio) and (ii) an estimation of the leverage of financial institutions that fall outside of the scope of Test #3‟s exemption, but that are nonetheless similar to such exempt institutions (the 8:1 ratio).

The Commissions are requesting comments regarding which ratio is a better assessment of the risks that an entity may pose to its CPs and to the markets generally, how the ratio should be calculated (i.e., which valuations/instruments should be excluded or included), and whether potential future exposures should be considered in this calculation.

Financing-Related Exemption for MSPs

Notably, only the definition of MSP includes an exemption for any "entity whose primary business is providing financing, and [which] uses derivatives for the purpose of hedging underlying commercial risks related to interest rates and foreign currency exposures, 90 percent or more of which arise from financing that facilitates the purchase or lease of products, 90 percent or more of which are manufactured by the parent company or another subsidiary of the parent company."¹⁰ However, the Release does not further elaborate upon this point.

Practical Considerations of Applying the Proposed MSP and MSBSP Definitions

The Release also addresses several areas regarding the practical application of the proposed definitions. For instance, an entity would be deemed an MSP or an MSBSP once it registers as such, or two months after the end of the fiscal quarter within which it satisfies the definition, whichever is earlier. If an entity exceeds one of the applicable thresholds for status as an MSP or an MSBSP in a fiscal quarter by twenty percent (20%) or less, that entity would not need to register immediately. Instead, the entity would be required to register only if it again exceeded any of the applicable daily average thresholds in the next fiscal quarter. However, once an entity is deemed to be an MSP or an MSBSP, the entity would be required to maintain that status until it did not exceed any of the applicable thresholds for at least four consecutive quarters after becoming registered as an MSP or an MSBSP. Moreover, an entity presumably would be required to register as both an MSP and as an MSBSP if its swap and security-based swap positions meet the criteria for each corresponding major participant test, although the Release is not explicit on this point. However, a person may be designated as a major participant for one or more categories of swaps or security-based swaps without being classified as a major participant for all categories.

The Commissions are requesting comments regarding whether two months is adequate time for registration, whether twenty percent is an appropriate threshold for reevaluation and whether the four consecutive quarter waiting period prior to expiration of major participant status is appropriate.

It appears as a practical matter that few entities would fall within the proposed definitions of an MSP or an MSBSP. Entities that would fall within the scope of the proposed definitions would necessarily have large asset bases with significant amounts of uncollateralized negative swap exposure. Indeed, the Commissions anticipate that "very few" entities would meet any of the thresholds for qualification as MSPs, and that only approximately ten currently existing entities would qualify as MSBSPs.

Application of Proposed Definitions to Managed Accounts, Asset Managers and Investment Advisers

The Release discusses the applicability of the proposed definitions to managed accounts, asset managers and investment advisers. Commenters suggested that asset managers and investment advisers should not be subject to designation as MSPs or MSBSPs because they are separate legal entities from the accounts that they manage; the Commissions agree with this analysis. Thus, preliminarily, the Commissions do not believe that accounts managed by asset managers or investment advisers should be aggregated to determine whether an asset manager is a major participant. However, the Commissions note that all of the managed positions of which a person is a beneficial owner should be aggregated for purposes of determining whether the owner is a major participant.

Additional Issues

The Release raises a number of additional issues relating to the proposed definitions of MSPs and MSBSPs.

For example, the Commissions inquire whether certain types of entities should be excluded from the definitions and, if so, to what extent. The Commissions also note that the Substantial Position Test allows for the exclusion of all hedging by employee benefit plans (not limited to hedging of "commercial risk"), and inquire whether this broad exclusion should be extended to other types of entities.

Additionally, the Release addresses the applicability of the tests to affiliated entities and preliminarily concludes that, in cases where a parent is the majority owner of a subsidiary, the subsidiary‟s swaps would be aggregated at the parent level. However, the Commissions are seeking comments regarding which entity should then be responsible for the capital, margin and business conduct requirements related to registration, and whether attribution of a subsidiary‟s positions to its parent should be limited to scenarios in which the parent guarantees the obligations of the subsidiary.

The Commissions also briefly consider the application of the tests to inter-affiliate swaps and security-based swaps. The Release posits that the economic reality of any inter-affiliate swaps or securities-based swaps should be considered. In this regard, if such transactions merely represent an allocation of risk within a corporate group, they probably would not contribute to the entity being classified as a major participant.

Finally, the Commissions are interested in comments regarding potential additional exclusions to the major participant definitions for, for instance, investment companies, employee benefit plans, registered broker-dealers, registered futures commission merchants and sovereign wealth funds. The Commissions are requesting comments regarding whether banks and registered investment companies should be excluded from these definitions because they are already subject to detailed regulation and whether registered investment companies would be capable of complying with the capital and margin requirements for major participants if they are not subject to an exclusion in the final rules.

PROPOSED RULES DEFINING "SWAP DEALER" AND "SECURITY-BASED SWAP DEALER"

Under the Dodd-Frank Act, the definitions of the terms SD and SBSD are based upon whether an entity engages in certain types of activities in the swap and/or security-based swap markets. Pursuant to Sections 712(d)(1), 721(c) and 761(b) of the Dodd-Frank Act, the Commissions are proposing rules to further define the terms SD and SBSD and proposing some guidance for the interpretation of these definitions. The rules proposed by the Commissions are substantially similar to the statutory definitions under the Dodd-Frank Act. In the view of the Commissions, the Dodd-Frank Act "defines the terms SD and SBSD in a functional manner, encompassing how a person holds itself out in the market, the nature of the conduct engaged in by the person, and how the market perceives the person‟s activities."¹¹ Therefore, these definitions focus on the type of activity in which an entity is engaged and, except for the de minimis exception (as described below), generally do not consider the size or economic impact of the activity.

Activities Leading to Status as an SD or an SBSD

Under the Dodd-Frank Act, an entity generally would be classified an SD or an SBSD, respectively, if, absent an exemption:

• it holds itself out as a dealer in swaps or security-based swaps;
• it makes a market in swaps or security-based swaps;
• it regularly enters into swaps or security-based swaps as an ordinary course of business for its own account; or
• it engages in any activity causing it to be commonly known in the trade as a dealer or market maker in swaps or security-based swaps.

Satisfying any of the foregoing criteria would result in an entity being classified an SD or an SBSD, even if only one of them is met, if it enters into swaps or security-based swaps as part of its "regular business," as further discussed below.

Distinguishing Characteristics of SDs and SBSDs

The Commissions recognize that the swap and security-based swap markets are diverse and, while there does not appear to be a single set of criteria that can be used in all markets to identify SDs and SBSDs, there may be certain distinguishing characteristics of swap dealers and security-based swap dealers, including that dealers:

• generally tend to accommodate demand for swap or security-based swap transactions from other parties;
• generally are available to enter into swaps or security-based swaps to facilitate other parties‟ interest in entering into those instruments;
• tend to use their own standard terms for such transactions or are able to arrange for customized terms to be used instead of relying on a CP to propose such terms; and
• generally tend to be able to arrange customized terms for swaps or security-based swaps upon request or create new types of swaps or security-based swaps upon their own initiative.

While these characteristics are common among SDs and SBSDs, the Commissions also note certain additional factors that would be considered for identifying SDs and SBSDs, respectively. "In sum, to determine if a person is a swap dealer, [the Commissions] would consider that person‟s activities in relation to the other parties with which it interacts in the swap markets, [including its function, if any, as a point of connection in the markets]. If the person is available to accommodate demand for swaps from other parties, tends to propose terms, or tends to engage in the other activities discussed above, then the person is likely to be a swap dealer. Persons that rarely engage in such activities are less likely to be deemed swap dealers."¹² When identifying an SBSD, the Commissions utilize the definition of "dealer" in the Exchange Act as an important analytical tool. Relevant factors in determining whether an entity is a "dealer" include whether the entity generally provides liquidity services in connection with transactions with investors, whether the entity has a regular turnover of inventory (or participates in the sale or distribution of new issues, such as by acting as an underwriter), whether the entity has a regular clientele and whether or not the entity holds itself out as buying or selling securities at a regular place of business. While the concepts of "inventory" and a "regular place of business" may not be entirely relevant in the security-based swap market, the SEC believes that this facts-and-circumstances approach should be useful in evaluating whether an entity is an SBSD. The Commissions are requesting comments on this approach.

HOLDING ONESELF OUT AS A DEALER IN SWAPS OR SECURITY-BASED SWAPS AND ENGAGING IN ACTIVITIES CAUSING IT TO BE COMMONLY KNOWN IN THE TRADE AS A DEALER OR MARKET MAKER IN SWAPS OR SECURITY-BASED SWAPS

The Commissions highlight five non-exclusive factors which they believe may indicate that a person is holding itself out as an SD or an SBSD, or is commonly known in the trade as a dealer or market maker in swaps or security-based swaps:

• contacting potential CPs to solicit interest in swaps or security-based swaps;
• developing new types of swaps or security-based swaps (which may include financial products that contain swaps or security-based swaps) and informing potential CPs about the availability of such new types of swaps or security-based swaps and a willingness to enter into such swaps or security-based swaps with potential CPs;
• membership in a swap association in a category reserved for dealers;
• providing marketing materials (including a website) that describe the types of swaps or security-based swaps that it is willing to enter into; and
• generally expressing a willingness to provide or offer a range of financial products that include swaps or security-based swaps.

As noted above, the foregoing factors would be used to determine both whether an entity is holding itself out as an SD or an SBSD or whether an entity is commonly known in the trade as a dealer or market maker in swaps or security-based swaps. When determining whether an entity is commonly known in the trade as a dealer or market maker in swaps or security-based swaps, the Commissions note that the application of these factors will focus on the perspective of persons with substantial experience with and knowledge of the swap and security-based swap markets, regardless of whether such entity is known as a dealer by persons without such experience and knowledge.

The Commissions further clarify that a person may be viewed as holding itself out as a SBSD if it is a dealer in another type of security and it subsequently enters into a security-based swap transaction with a customer. For purposes of such security-based swap, the customer reasonably would be expected to view the person as a dealer. Additionally, a person may be classified as a SBSD if it expresses its availability to provide liquidity to CPs that seek to enter into security-based swaps, "regardless of the direction‟ of the transaction or across a broad spectrum of risks (e.g., credit default swaps related to a variety of issuers)."¹³

REGULARLY ENTERING INTO SWAPS OR SECURITY-BASED SWAPS WITH CPS AS AN ORDINARY COURSE OF BUSINESS FOR ITS OWN ACCOUNT

As noted above, a person must enter into swaps with a CP as part of its "regular business" to come within the definition of an SD or an SBSD. A person‟s swap activity would be deemed to be part of its regular business only if such activity is in response to interest shown by a CP or is at the CP‟s request. Specifically, the Commissions "believe that persons who enter into swaps as a part of a regular business‟ are those persons whose function is to accommodate demand for swaps from other parties and enter into swaps in response to interest expressed by other parties. Conversely, persons who do not fulfill this function should not be deemed to enter into swaps as part of a regular business‟ and are not likely to be swap dealers."¹⁴ The Release clarifies this point in response to concerns that the statutory definition could apply to those end-users who enter into swaps as part of their ordinary business (e.g., to mitigate commercial risk), but not in a dealing capacity.

The Commissions note that the reference to a person entering a swap transaction for "its own account" describes a person acting as a principal and not as an agent for customers. However, a person acting as an agent for customers could be required to register as a futures commission merchant, introducing broker, commodity pool operator or commodity trading advisor, each as defined in the CEA, as may be applicable.

MAKING A MARKET IN SWAPS OR SECURITY-BASED SWAPS

The Commissions do not clarify the meaning of the term "making a market" in the Release. However, the Commissions express the view that factors such as quoting a two-sided market consistently, or a willingness to buy or sell a swap or security-based swap at all times, may not be appropriate indicators of market making practices because many types of swaps and security-based swaps are not entered into on a continuous basis. In the view of the Commissions, the inclusion of a "continuous" requirement could result in non-continuous dealing activities avoiding regulation, which they believe would be inconsistent with Congressional intent.

De Minimis Activity Exemption

A person who engages in a de minimis quantity of swap or security-based swap transactions with or on behalf of its customers generally would be exempt from designation as an SD or an SBSD. However, the Commissions believe that the de minimis quantity of swap and security-based swap dealing should not be measured against the person‟s other activities (or other swap or security-based swap activities). The Commissions believe that there is no such statutory "relative" test and note that such a relative test would lead to larger and more active companies being more likely to qualify for the exemption than smaller and less active companies who have less impact on the market. Further, there is no statutory "predominance" test that requires swap or security-based swap activity to be an entity‟s sole or predominant business to be considered an SD or an SBSD, inasmuch as the entity‟s dealing activities only need to be more than de minimis. Consequently, the following four conditions must be met for a person to rely upon the de minimis activity exemption:

• the aggregate effective notional amount entered into over the prior 12 months in connection with its dealing activities must not exceed $100 million. This amount is measured on a gross basis, without consideration of any long or short positions that the entity may have, or any collateral held or provided by the entity;
• the aggregate effective notional amount entered into over the prior 12 months with a CP that is a "special entity" (Federal agencies; states; state agencies and political subdivisions; "employee benefit plans" or "governmental plans," each as defined under ERISA; or endowments) must not exceed $25 million;
• the person must not have entered into swaps or security-based swaps as a dealer with more than 15 CPs, other than SBSDs, over the prior 12 months. CPs who are members of an affiliated group will generally count as one CP; and
• the person must not enter into more than 20 swaps or security-based swaps as a dealer during the prior 12 months. An amendment to an existing swap or security-based swap in which the CP and underlying items remain the same does not count as a new swap or security-based swap for purposes of this calculation.

The Commissions are particularly interested in comments regarding the $100 million limit on annual notional swap and security-based swap amounts and whether the limit should be lowered or raised and what, if any, implications there would be if entities were to adjust their activity to fall within the scope of the exemption. The Commissions are also requesting suggestions as to whether the exemption should be limited in availability to only certain types of CPs.

Exclusion for Swaps In Connection With Originating a Loan

The SD definition (but not the SBSD definition) provides an exclusion for an insured depository institution ("IDI") to the extent that it offers to enter into a swap with a customer in connection with originating a loan with that customer. The Commissions‟ preliminary interpretation of "offer" includes scenarios where the IDI requires the customer to enter into a swap or where the customer asks to enter into such swap, specifically in connection with a loan made by the IDI to the customer. The swap must be related to the financial terms of the loan in order for this exclusion to apply. For this purpose, the term "financial terms" includes the duration, interest rate, currency and principal amount of the loan. Additionally, the IDI must be a source of funds to the borrower directly, or by means of syndication, participation or a refinancing. However, the loan may not be a "sham" loan or a synthetic loan.

Thus, to qualify for this exclusion, a person must (i) be an IDI; (ii) be a source of funds to a borrower in connection with a loan (either directly or through syndication, participation, refinancing or otherwise); and (iii) enter into a swap with the borrower that is connected to the financial terms of the loan (so long as such loan is not a sham or synthetic loan).

Designation as a Dealer for Only Certain Types, Classes, or Categories of Swaps, Security-based Swaps or Activities

The Commissions generally are proposing that once a person satisfies the SD and/or SBSD definition, it would be considered a dealer for all types, classes or categories of swaps or security-based swaps in which it participates and would be subject to all regulatory requirements associated therewith. The Commissions are proposing to take this position because it may be difficult for an entity to separate its dealing activity from its other activities that involve swaps or security-based swaps. However, the Commissions are also proposing to permit a person to seek limited designation as a dealer for only certain types, classes or categories of swaps or security-based swaps, without being designated a dealer for all types, classes or categories. To be successful in such an application, a person would have to make an appropriate showing based on the facts and circumstances. The Commissions also note the potential for a division of an entity (that is not separately incorporated) to conduct swap dealing activities. In such circumstances, an entity may seek limited designation so that the regulations and requirements would apply solely to the swap dealing activities of the division, and not necessarily to the swap activities of the entire entity. The Commissions anticipate that an SD and/or an SBSD may seek such a limited designation when the person initially registers as such, or at a later time. The Commissions are seeking comments on this approach.

Practical Considerations of Applying the SD and SBSD Definitions

The Commissions believe that the word "person," when used in the definitions of SD and SBSD, should be interpreted as a separate legal person. For example, a particular trading desk would not be viewed as an SD or an SBSD; rather, the entity in which it is housed would be the SD or the SBSD.

Separate legal persons under common control may be separate SDs or SBSDs. The Commissions note that when affiliates enter into swaps or security-based swaps with each other, it is appropriate to consider the economic reality of such transactions, including whether such transactions merely represent a reallocation of risk within a corporate group. The Commissions recognize that it is problematic to view an affiliate as holding itself out as an SD or an SBSD to the other, and that such a relationship, by itself, may not involve the interaction with unaffiliated persons that is characteristic of the elements of the definitions that refer to holding oneself out as a dealer or being commonly known as a dealer.

PROPOSED RULES DEFINING "ELIGIBLE CONTRACT PARTICIPANT"

Under the Dodd-Frank Act, only ECPs are eligible to enter into swaps or security-based swaps bilaterally or on an off-exchange basis. For a non-ECP to enter into a swap or security-based swap, the transaction must take place on, or subject to the rules of, a designated contract market ("DCM") or a national securities exchange, respectively. Moreover, such security-based swap must also have an effective registration statement. The Dodd-Frank Act leaves the ECP definition in Section 1a(18) of the CEA¹⁵ largely intact, with the exception of certain changes that primarily affect governmental entities and individuals. The Commissions are proposing the following rules to define the term "ECP" further.

Inclusion of SDs, SBSDs, MSPs and MSBSPs in the Definition of ECP

The Commissions anticipate that SDs, SBSDs, MSPs and MSBSPs will be the largest users of swaps and securities-based swaps. To make it explicit that such entities may enter into these swaps bilaterally or on an off-exchange basis, the Commissions are proposing to add these parties to the ECP definition.

Proposed Rules Prohibiting Commodity Pools From Qualifying as ECPs Under the Business Entity Provision of the ECP Definition

The statutory definition of an ECP does not require each participant in a commodity pool to be an ECP for the commodity pool itself to be deemed an ECP. Instead, clause (A)(iv) of the ECP definition generally provides that a commodity pool with total assets exceeding $5,000,000 that is operated by a commodity pool operator that is regulated under the CEA or is subject to foreign regulation may be deemed an ECP.

Application of ECP Definition to Retail Forex Pools

Section 741(b)(10) of the Dodd-Frank Act amends clause (A)(iv) of the ECP definition by adding a proviso that effectively prohibits a commodity pool that engages in retail foreign currency transactions as described in Sections 2(c)(2)(B) or 2(c)(2)(C) of the CEA (a "Retail Forex Pool"), but that otherwise meets the requirements of clause (A)(iv), from being an ECP for this purpose, if at the investment level, any direct or indirect participant in the pool is not itself an ECP.¹⁶

In addition, a Retail Forex Pool that includes one or more non-ECP participants might still be able to qualify as an ECP for this purpose by relying on clause (A)(v) of the ECP definition. Clause (A)(v) of the ECP definition provides that a business entity (irrespective of its form of organization) may qualify as an ECP if (i) it has total assets exceeding $10,000,000 or (ii) it has a net worth exceeding $1,000,000 and such entity enters into an agreement, contract or transaction in connection with an asset or liability owned or incurred or reasonably likely to be owned or incurred by the entity in the conduct of its business.

To preclude that possibility, the Commissions are proposing a rule that would effectively prohibit any Retail Forex Pool that does not qualify under clause (A)(iv) of the ECP definition from relying on clause (A)(v) to be deemed an ECP.

Application of ECP Definition to All Commodity Pools

Similar to the Commissions‟ view that a Retail Forex Pool should not be able to circumvent Congress‟s intent regarding Section 741(b)(10) of the Dodd-Frank Act, the Commissions believe that any commodity pool that does not qualify as an ECP under clause (A)(iv) of the ECP definition should not be able to rely on clause (A)(v) of the ECP definition. In this regard, the Commissions are proposing a rule that would prohibit the use of clause (A)(v) by any commodity pool that is seeking to qualify as an ECP for the purpose of entering into swaps or security-based swaps bilaterally or on an off-exchange basis.

The Commissions are requesting comments regarding these proposed amendments, including whether any other entities that do not otherwise qualify as ECPs should be prohibited from relying on clause (A)(v), whether the Commissions should further narrow any of the provisions of the ECP definition and whether the Commissions should consider adding any new categories of ECPs.

We will continue to monitor and report on developments in this area as these issues are considered and resolved in the next few months.

Footnotes

1. See 75 Fed. Reg. 80174 (December 21, 2010).

2. See CEA Section 4s(h)(4), (5); Exchange Act, Section 15F(h)(4), (5).

3. See n.1 supra at 80186.

4. Id.

5. Id.

6. See n.1 supra at 80187.

7. Id.

8. See n.1 supra at 80195 n.128.

9. Id.

10. See n.2 supra at Section 1a(33)(D); Section 3(a)(67).

11. See n.1 supra at 80176.

12. See n.1 supra at 80177.

13. See n.1 supra at 80178.

14. See n.1 supra at 80177.

15. Section 1a(18) of the CEA was formerly Section 1a(12) of the Commodity Exchange Act prior to enactment of the Dodd-Frank Act.

16. Note that Section 741(b)(10) of the Dodd-Frank Act refers to amending Section 1a(19)(iv) of the ECP definition under the CEA. However, we believe that the correct reference is to Section 1a(18)(iv) of the CEA, which is the relevant provision of the ECP definition, as amended by Dodd-Frank Act.

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