Title VII of the Dodd-Frank Act,^[1] titled the “Wall Street Transparency and Accountability Act of 2010” (the “Act”), was enacted on July 21, 2010. Under the Act, which is generally intended to bring the $600 trillion over-the-counter derivatives market under greater regulation, the Commodity Futures Trading Commission (“CFTC”) will have primary responsibility for the regulation of “swaps” and the Securities Exchange Commission (“SEC” and, together with the CFTC, the “Commissions”) will have primary responsibility for the regulation of “security-based swaps.” Since our last update, the Commissions have continued to propose rules and consider comments in connection with the implementation of the Act. A summary of certain noteworthy developments since our last update follows.^[2]

CFTC Re-Opens Comment Periods for Numerous Proposed Rules

Amid an outpouring of concern expressed by market participants regarding the torrid pace of the promulgation of proposed regulations implementing the Act, the CFTC re­opened (or extended) the comment period for 32 proposed rules it had issued.^[3] In re­opening (or extending) these comment periods, the CFTC noted that it had consulted and coordinated with other regulators, held hundreds of meetings with market participants and other members of the public, and received thousands of comments on its proposed rules, which together enabled it to “present a complete mosaic of [its] proposed regulatory framework for swaps.”^[4] Nevertheless, the CFTC reopened (or extended) the comment periods until June 3, 2011 to allow the public an additional opportunity to comment on the new regulatory framework, including regarding the costs and benefits of the proposed rules. In its notice re-opening and extending the relevant comment periods, the CFTC also requested comments on the order in which it should issue final rulemakings in connection with the Act.

CFTC Inspector General Suggests More Robust Cost-Benefit Analyses

The Office of the Inspector General of the CFTC (“OIG”) issued a report (the “OIG Report”) on April 15th regarding the cost-benefit analyses formulated by the CFTC in connection with four rulemakings under the Act:

(i) the definitions of key terms; (ii) confirmation, portfolio reconciliation and compression requirements for swap dealers (“SDs”) and major swap participants (“MSPs” and, together with SDs, “Regulated Entities”), (iii) core principles and other requirements for designated contract markets; and (iv) the duties of Regulated Entities.^[5] The OIG Report acknowledged that the CFTC was in the midst of a daunting task in implementing the Act within the contemplated timeframe, and that it had already published some 50 rulemakings in connection with the Act since its enactment. However, it found that the Office of General Counsel (“OGC”) appeared to take a more dominant role than the Office of the Chief Economist (“OCE”) in formulating the analyses at issue and noted that “similar economic analyses in the context of federal rulemaking have proved perilous for financial market regulators.”

The dominance of the OGC in the process struck the OIG as odd, especially since the CFTC was an agency that regularly engaged in economic analysis. Moreover, the cost-benefit analyses did not always appear to the OIG to acknowledge the cost issues addressed by the technical side of the rulemaking team. The OIG further noted that the cost-benefit analyses lacked any data whatsoever regarding the CFTC’s internal costs to implement the Act. The OIG Report concluded that a more robust process for formulating the cost-benefit analyses for these rulemakings was clearly permitted and desirable, and recommended that greater input from the OCE should be included in any revised methodology.

CFTC Proposes Margin Rules for Uncleared Swaps

On April 28th, the CFTC, after consulting with the SEC and “prudential regulators,” published proposed rules (the “Proposed Margin Rules”)^[6] regarding initial and variation margin for uncleared swaps entered into by Regulated Entities that are not subject to regulation by a prudential regulator.^[7] The proposed rules would not impose margin requirements on non-financial entities (commonly referred to as “commercial end-users”).^[8]

Under the Proposed Margin Rules, Regulated Entities would be required to have two-way collateral arrangements, collecting both initial and variation margin from one another in connection with each swap, with no threshold of uncollateralized exposure (although a $100,000 “minimum transfer amount,” or nuisance amount, would apply to transfers). Also, Regulated Entities would be required to collect, but not deliver, initial and variation margin in connection with each swap with a financial entity, with a threshold of uncollateralized exposure, if any, linked to the risk level of the financial entity to the financial system.^[9] However, a Regulated Entity would not be required to collect initial or variation margin for a swap with a non-financial entity; rather, a Regulated Entity simply would be required to enter into a privately-negotiated credit support arrangement with such an entity.

Regulated Entities and financial entities would be generally permitted to deliver the following forms of collateral to satisfy initial margin requirements: (i) cash; (ii) obligations of (or guaranteed by) the United States or any agency thereof; (iii) senior debt obligations of the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation, a Federal Home Loan Bank, or the Federal Agricultural Mortgage Corporation; and (iv) insured obligations of Farm Credit Services banks. However, only cash and U.S. Treasury securities would be permitted to satisfy variation margin requirements. Unlike other counterparties, non-financial entities would be permitted to deliver non-traditional forms of collateral, as specified in their credit support arrangements with Regulated Entities, as long as the value of such collateral is “reasonably ascertainable” on a periodic basis. Specified haircuts would apply to all non-cash collateral.

Initial margin, generally, would be calculated using a qualifying model approved by the CFTC and would have to cover 99% of price changes, by product and by portfolio, over at least a 10-day liquidation horizon. Variation margin would be calculated, among other things, pursuant to a method agreed by the parties in their credit support arrangement, consistent with certain requirements specified in the Proposed Margin Rules and set forth with sufficient specificity to allow the counterparty, the CFTC and any applicable prudential regulator to calculate margin requirements independently.

Under the Proposed Margin Rules, initial margin for swaps between Regulated Entities could not be held directly but, rather, would have to be held at a third-party custodian and not be rehypothecated. Regulated Entities must offer non-Regulated Entities the opportunity to have initial (but not variation) margin segregated. Significantly, the Proposed Margin Rules would not apply retroactively to swaps entered into before the effectiveness of the related final rules. On May 12th, the CFTC extended the comment deadline for the Proposed Margin Rules until July 11th, so that it would coincide with the deadline for its proposed rules on capital requirements (discussed below).

On May 17th, New York federal legislators, led by Senators Charles Schumer and Kirsten Gillibrand, sent a letter to the heads of the Federal Reserve Board, the CFTC, the FDIC and the OCC warning that margin rules proposed by various regulators would inevitably result in a competitive disadvantage for U.S. firms operating globally. In particular, the legislators expressed concern about the extraterritorial application of these margin rules, which would require non-U.S. subsidiaries and affiliates of U.S. banks to demand collateral in connection with derivatives transactions from non-U.S. customers. Absent a harmonization of rules with non-U.S. regulators, the relevant margin requirements would result in regulatory arbitrage, as they would incentivize non­U.S. customers to move business to European (or other) counterparts which did not have similar requirements. The legislators asked the regulators to reconsider the extraterritorial application of the regulators’ proposed margin rules and urged them to work closely with international regulators to ensure that they adopted as rigorous a regulatory regime for over-the-counter (“OTC”) derivatives as the U.S. was adopting.

CFTC Proposes Capital Rules for Swaps

Section 731 of the Act required the CFTC to adopt capital requirements for Regulated Entities that are not subject to regulation by prudential regulators. In preparing the capital requirements it proposed on May 12th (the “Proposed Capital Rules”),^[10] the CFTC consulted with the SEC and the prudential regulators. The Proposed Capital Rules essentially provide rules for Regulated Entity qualifying capital, as well as minimum levels of such qualified capital that must be maintained. The Proposed Capital Rules encompass both amendments to existing CFTC rules for futures commision merchants (“FCMs”), as well as new rules applicable to Regulated Entities that are not FCMs.

Regulated Entities that are also FCMs would be required to meet existing requirements for FCMs to hold minimum levels of adjusted net capital, and would also be required to calculate the required minimum level as the greatest of: (i) a fixed dollar amount (currently $20,000,000); (ii) the amount required for FCMs also acting as retail foreign exchange dealers; (iii) 8% of the risk margin required for customer and non-customer exchange-traded futures positions and OTC swap positions cleared by a derivatives clearing organization (“DCO”); (iv) the amount of adjusted net capital required by a registered futures association of which such FCM is a member; and

(v) if the FCM is also registered as a securities broker or dealer, the amount of net capital required by SEC rules.

Regulated Entities that are not also FCMs but that are non-bank subsidiaries of U.S. bank holding companies would be required to meet the same capital requirements applicable to bank holding companies, which generally means a minimum ratio of qualifying total capital to risk-weighted assets of 8%, half of which (and at least $20,000,000) would be required to be in the form of Tier 1 capital.

Regulated Entities that are neither FCMs nor bank holding company subsidiaries would be required to maintain a minimum tangible net equity (generally, based on net equity, as determined under U.S. generally accepted accounting principles, minus intangibles such as goodwill) equal to $20,000,000, plus additional amounts for market risk and OTC derivatives credit risk.

Under the Proposed Capital Rules, a Regulated Entity may apply for CFTC approval to use internal models to determine its capital requirements. The Proposed Capital Rules also include certain financial condition reporting and recordkeeping requirements for Regulated Entities, similar to those currently applicable to FCMs.

CFTC Proposes Recordkeeping and Reporting Rules for Legacy Swaps

On April 25th (the “Proposed Reporting Rule Date”), the CFTC issued proposed rules (the “Proposed Reporting Rules”)^[11] establishing recordkeeping and reporting requirements for pre-enactment swaps (i.e., swaps entered into before the July 21, 2010 enactment of the Act that remain outstanding) and transition swaps (i.e., swaps entered into on or after the enactment date of the Act, but prior to the compliance date specified in the CFTC’s final swap data reporting rules) that are not accepted for clearing by a DCO, which constitute “uncleared swaps.” Under Section 729 of the Act, at least one party to an uncleared swap must be responsible for reporting data concerning that swap to a swap data repository (“SDR”). The reporting party is generally the party in the best position to perform the reporting obligation. Specifically, if only one party to a swap is an SD, then the SD is responsible for reporting; if one party is an MSP and the other party is neither an SD nor an MSP, then the MSP is responsible for reporting; where parties have the same status, then the parties are to decide between them which party is responsible for reporting. Section 729 also provides for reporting directly to the CFTC of uncleared swaps that are not accepted by an SDR and, in connection therewith, requires that books and records be kept in a manner and for the time required by the CFTC to facilitate such reporting.

Following enactment of the Act, the CFTC issued certain interim final rules regarding pre-enactment and transition swaps. As contemplated in those interim final rules, the Proposed Reporting Rules were issued to address the following matters: (i) records, information and data that must be retained for historical swaps; (ii) the timeframe for reporting data to an SDR or the CFTC; and (iii) the specific data required to be reported. Among other things, the Proposed Reporting Rules would require that parties retain records of an asset class-specific set of minimum, primary economic terms for swaps in existence on or after the Proposed Reporting Rule Date (for swaps that expired or terminated before such date, less rigorous requirements would apply). The Proposed Reporting Rules include a detailed appendix in which the minimum primary economic terms data for historical swaps are specified by asset class.

SEC Proposes Beneficial Ownership Rule for Security-Based Swaps

The Act amended the Securities Exchange Act of 1934, as amended (the “Exchange Act”), in several important respects in connection with “security-based swaps,”^[12] including amending the definition of “security” in Section 3(a)(10) of the Exchange Act to include security-based swaps. The Act also amended Sections 13(d) and 13(g) of the Exchange Act (regarding beneficial ownership reporting requirements) to include any person who “becomes or is deemed to become a beneficial owner of any [listed security] upon the purchase or sale of a security-based swap that the [SEC] may define by rule.” Finally, the Act added Section 13(o) to the Exchange Act, which provides that a person is deemed to acquire beneficial ownership of an equity security in connection with the purchase or sale of a security-based swap only to the extent that the SEC determines (after consultation with the prudential regulators and the Secretary of the Treasury), that the purchase or sale provides incidents of ownership comparable to direct ownership of the equity security.

These amendments created uncertainty regarding the treatment of security-based swaps under the existing beneficial ownership reporting rules of the Exchange Act. In order to address this concern, the SEC issued a proposed rule^[13] (the “Proposed Beneficial Owner Rule”). The Proposed Beneficial Owner Rule would clarify that the existing rules concerning beneficial ownership will continue to apply to security-based swaps after the provisions of the Act become effective. The SEC is effectively proposing to “readopt without change” the relevant beneficial ownership rules and clarify that, even after the effectiveness of Section 13(o), persons who purchase or sell security-based swaps will remain within the scope of the existing Exchange Act rules to the same extent as they are now. The SEC highlights that the proposed readoption of the relevant portions of the beneficial ownership rules “is neither intended nor expected to change any existing administrative or judicial application or interpretation of the rules.”^[14]

Although the Proposed Beneficial Owner Rule is intended to preserve the status quo, the SEC made several statements in the release that may be important for market participants. First, the SEC noted that it is engaged in a separate effort to modernize reporting under Sections 13(d) and 13(g) of the Exchange Act. Further, the SEC cautioned that a person who does not hold voting or investment power over securities that are subject to a security-based swap may still be deemed to have beneficial ownership of those securities if the security-based swap is part of a plan or scheme to evade the relevant reporting requirements.^[15] Finally, the SEC pointed out that if a person enters into a security-based swap for the purpose or effect of changing or influencing the control of the issuer of the securities subject to the security-based-swap, that person will be deemed to be a beneficial owner under Rule 13d-3(d)(1).^[16]

Commissions Issue Joint Proposed Definitions

On April 27th, the Commissions issued joint proposed rules and interpretive guidance (the “Joint Rules and Guidance”) addressing the scope of the terms “swap” and “security-based swap” under the Act, the two critical definitions in determining whether a financial instrument comes under regulation.^[17] The Commissions also issued proposed rules and interpretive guidance on the relationship between the definitions of swap and security-based swap and clarified which instruments would be subject to regulation by the CFTC, SEC, or both, in the case of “mixed swaps” (discussed below). In issuing these rules and guidance, the Commissions highlighted that the name or label parties use to identify a product is not dispositive in determining that instrument’s status under the Act; rather, a product’s terms and characteristics will be evaluated in making such a determination.

The Act itself included comprehensive lists of financial instruments that would qualify as “swaps” and “security-based swaps.” The Joint Rules and Guidance provide additional guidance as to whether certain transaction types should be included in those definitions. Generally, the Commissions determined that foreign currency options, non-deliverable (foreign exchange) forwards, currency swaps, cross-currency swaps and forward rate agreements^[18] will constitute swaps. The Commissions also determined that insurance products, forward contracts, consumer and commercial agreements, contracts, and transactions, and loan participations will fall outside the scope of the Act.

With respect to insurance products, the Joint Rules and Guidance would generally exclude State- or federally-regulated insurance products that are provided by State- or federally-regulated insurance companies. Specifically, an instrument would be excluded from the relevant definitions if it has the following characteristics: (i) the instrument beneficiary has an insurable interest and thereby carries the risk of loss with respect to that interest continuously throughout the duration of the instrument; (ii) the loss must occur and be proved, with indemnification or payment therefor limited to the value of the insurable interest; (iii) the instrument is not traded on an organized market or OTC; and (iv) with respect to financial guaranty insurance only, acceleration of payments under the policy is at the sole discretion of the insurer. It is not clear whether the fourth characteristic of this test would be satisfied by a termination payment on a credit default swap (“CDS”) under which a monoline insurance company provides financial guaranty insurance. This ambiguity was compounded by a potential discrepancy in the relevant commentary provided by each of the Commissions with respect to “wraps” of swaps (with the CFTC apparently believing more strongly than the SEC that such wraps themselves should also constitute swaps). The Joint Rules and Guidance request comments as to whether a wrap is sufficiently different from the underlying swap being insured to justify excluding it from the relevant definitions. The Commission also provided guidance specifically excluding from the relevant definitions products such as surety bonds, life insurance, health insurance, property and casualty insurance and certain annuity products, so long as such products were offered by an appropriate company and were regulated as insurance under the laws of any State or by the United States.

With respect to forward contracts, the Commissions noted that such contracts on nonfinancial commodities and security forwards (so long as they are “intended to be physically settled,” as required by the Act) would not be considered swaps or security-based swaps, although a forward contract with an embedded commodity option would be subject to a three-part analysis in establishing its regulatory status under the Act.^[19]

Moreover, the Joint Rules and Guidance indicated that the Commissions do not believe that Congress intended to regulate customary consumer and commercial transactions under the Act. For example, transactions to acquire or lease real or personal property, mortgage rate locks and variable interest rate loans would not constitute swaps or security-based swaps. The Commissions further noted that two characteristics generally distinguish consumer and commercial agreements, contracts, and transactions from swaps or security-based swaps. Specifically, unlike swaps and security-based swaps: (i) the payment obligations under the arrangements are not severable; and (ii) the agreement, contract, or transaction is not traded on an organized market or OTC and does not involve risk-shifting arrangements with a financial entity.

The Commissions further clarified in the Joint Rules and Guidance that they would not interpret the definitions of swap and security-based swap to include loan participations in which the purchaser acquires: (i) a current or future direct or indirect ownership interest in the underlying loan; or (ii) a beneficial ownership interest in the economics of the underlying loan.

The Joint Rules and Guidance also address the relationship between swaps and security-based swaps, reasoning that the facts and circumstances (i.e., the specific terms and conditions of the instrument and the nature of the underliers on which it is based) existing at its time of the instrument’s execution should determine its status. If the instrument is based on interest or monetary rates (e.g., interbank offered rates, money market rates, government target rates, general lending rates, certain indexes), then that suggests it will constitute a “swap” and be subject to regulation by the CFTC under the CEA, but if it is based on the yield (i.e., price or value) of a single security, single loan, or narrow-based security index, then that suggests it will constitute a “security-based swap” and be subject to regulation by the SEC under the Exchange Act.

In addition, the Joint Rules and Guidance addressed the narrow category of instruments known as “mixed swaps,” which are generally defined under the Act as security-based swaps that are also based on one or more interest or other rates, currencies, commodities, etc. An example of a mixed swap is an instrument under which the underlying references are the value of an oil corporation stock and the price of oil. In order to avoid dual registration, persons intending to list, trade or clear mixed swaps may request that the Commissions issue a joint order permitting compliance with specified parallel provisions of the CEA and Exchange Act. In making such a request, a party would be required to provide the Commissions with all material information regarding the terms of the mixed swap, including its economic characteristics and purpose. Within 120 days of receipt of a complete request, the Commissions would be required to either issue a joint order or publicly detail the reasons for failing to do so.

One area of continuing focus relating to the scope of the definition of “swap” is the treatment of foreign exchange swaps and forwards (“FX Trades”). FX Trades represent about 5% of the OTC derivatives market. As we have addressed in previous editions of this publication, certain legislative proposals considered prior to passage of the Act suggested that FX Trades would not be regulated, as they are typically entered into by end-users for hedging purposes, they are typically short-dated and, unlike CDS, they were not at the root cause of any market turmoil. However, under the Act, such transactions were not given a full exemption but, rather, discretion was granted to the Secretary of the Treasury (the “Treasury”) to determine whether they should be exempt from regulation, after considering several factors.^[20] These factors include whether the required trading and clearing of FX Trades would create systemic risk, lower transparency, or threaten the financial stability of the United States. Any such determination made by the Treasury was required to be submitted to the appropriate committees of Congress and was to explain the “qualitative difference” between FX Trades and other classes of swaps that would make them “ill-suited” for regulation as swaps and identify “objective differences” between FX Trades, on the one hand, and other swaps, on the other hand, that warrant an exempted status.

In the absence of any Treasury determination, the Joint Rules and Guidance treated FX Trades as swaps. However, on April 29th, two days following the publication of the Joint Rules and Guidance, the Treasury issued its decision proposing that FX Trades be excluded from the definition of “swap” under the CEA. In making its determination, the Treasury noted that forcing FX Trades onto exchanges and requiring that they be centrally cleared was not necessary because existing procedures already mitigate the risk posed by such trades and ensure stability.^[21] In particular, the Treasury pointed out that these trades already have high levels of price transparency, effective risk management and electronic trading. Another significant consideration may have been the possibility that, as highlighted by the comments of certain market participants, the margin requirements that would be imposed on customers for cleared trades could push FX Trades offshore. It has been reported that U.S. commercial banks recorded $9.1 billion in revenue from foreign exchange derivatives trades in 2010, the largest source of revenue for bank derivatives and cash positions that year, according to the OCC.

Significantly, the Treasury proposal does not exempt FX Trades from the reporting requirements and business conduct standards of the Act. Moreover, if trades are structured as FX Trades to benefit from the Treasury exemption, anti-evasion rules under the Act would give regulators authority to regulate such trades as swaps.^[22]

^[1] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. 111-203, 124 Stat. 1376 (2010). The text of the full Dodd-Frank reform is available at https://www.cftc.gov/LawRegulation/DoddFrankAct/index.htm.

^[2] Implementation of derivatives reform has also continued in Europe. On May 24th, the Economic Affairs Committee of the European Parliament (the “EP”) voted overwhelmingly in favor of a draft regulation requiring most OTC derivatives to be centrally cleared and imposing reporting requirements on all derivatives, including those traded on exchanges. Among other things, the draft regulation envisages a key supervisory role for the European Securities and Markets Authority. The draft regulation will be voted on by the full EP in July 2011. Unlike the Act, the draft regulation would not regulate how derivatives are traded, which is being addressed through amendments to the Markets in Financial Instruments Directive (commonly referred to as “MiFID”). Note that repeated concerns have been raised about the possibility of disconnected implementation of global derivatives reforms, as non-U.S. reforms appear to be lagging begin implementation of the Act.

^[3] Reopening and Extension of Comment Periods for Rulemakings Implementing the Dodd-Frank Wall Street Reform and Consumer Protection Act, 76 Fed. Reg. 25274 (May 4, 2011).

^[4] Id. at 25275.

^[5] U.S. Commodity Futures Trading Commission, Office of the Inspector General, An Investigation Regarding Cost-Benefit Analyses Performed by the Commodity Futures Trading Commission in Connection with Rulemakings Undertaken Pursuant to the Dodd­FrankAct (April 15, 2011).

^[6] As used in the Act, “prudential regulators” means the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”), the Office of the Comptroller of the Currency (the “OCC”), the Federal Deposit Insurance Corporation (“FDIC”), the Farm Credit Administration and the Federal Housing Finance Agency (“FHFA”). The CFTC noted in the Proposed Margin Rules that, in designing the rules, it worked closely with the SEC and prudential regulators in an effort to make them as consistent as possible with margin rules being designed by the prudential regulators.

^[7] Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 76 Fed. Reg. 23732 (Apr. 28, 2011).

^[8] Whether an entity constitutes a “financial entity” for purposes of the Proposed Margin Rules will be determined in accordance with a definition set forth in the rules. This definition largely tracks, but differs in certain respects from, the definition of the same term in Section 2(h)(7)(C) of the Commodity Exchange Act, as amended (“CEA”), which is relevant for purposes of the exception to the clearing mandate of the Act.

^[9] Specifically, Regulated Entities would be permitted to have some uncollateralized exposure to financial entities that qualify as “low risk,” if such financial entities: (i) are subject to capital requirements established by a prudential regulator or a State insurance regulator; (ii) predominantly use swaps to hedge; and (iii) do not have “significant swaps exposure” (determined in accordance with previously-proposed CFTC rulemakings).

^[10] Capital Requirements of Swap Dealers and Major Swap Participants, 76 Fed. Reg. 27802 (May 12, 2011).

^[11] Swap Data Recordkeeping and Reporting Requirements: Pre-Enactment and Transition Swaps, 76 Fed. Reg. 22833 (Apr. 25, 2011).

^[12] “Security-based swaps” are defined under the Act to include, inter alia, swaps based on either: (i) a narrow-based security index, including any interest therein or on the value thereof; (ii) a single security or loan, including any interest therein or on the value thereof; or (iii) the occurrence, nonoccurrence, or extent of the occurrence of an event relating to a single issuer of a security or the issuers of securities in a narrow-based security index, provided that such event directly affects the financial statements, financial condition, or financial obligations of the issuer.

^[13] Beneficial Ownership Reporting Requirements and Security-Based Swaps, 55 Fed. Reg. 15874 (Mar. 22, 2011).

^[14] Id. at 15875.

^[15] Id. at 15876 (“application of Rule 13d-3(b) may result in a beneficial ownership determination even if a person does not hold voting and/or investment power”) and 15877 (“To the extent a security-based swap is used with the purpose or effect of divesting a person of beneficial ownership or preventing the vesting of beneficial ownership as part of a plan or scheme to evade Sections 13(d) or 13(g), the security-based swap may be viewed as a contract, arrangement or device within the meaning of those terms as used in Rule 13d-3(b). A person using a security-based swap, therefore, may be deemed a beneficial owner under Rule 13d-3(b) in this context”).

^[16] Id. at 15877 (“under existing Rule 13d-3(d)(1), a person is deemed a beneficial owner of an equity security if the person has a right to acquire the equity security within 60 days or holds the right with the purpose or effect of changing or influencing control of the issuer of the security for which the right is exercisable, regardless of whether the right to acquire originates in a security-based swap or an understanding in connection with a security-based swap”).

^[17] Further Definition of “Swap”, “Security-Based Swap”, and “Security-Based Swap Agreement”; Mixed Swaps; Security-Based Swap Agreement Recordkeeping, 76 Fed. Reg. 29818 (May 23, 2011).

^[18] A forward rate agreement is a contract for a single cash payment on a settlement date, based on a spot rate and forward rate determined on the trade date.

^[19] Such forward contracts would be excluded from the definition of swap and security-based swap if the embedded options: (i) may be used to adjust the forward contract price, but do not undermine the overall nature of the contract as a forward contract; (ii) do not target the delivery term; and (iii) cannot be severed and marketed separately from the forward contract in which they are embedded.

^[20] Note, however, that, as discussed above, OTC foreign currency options, non-deliverable forward contracts involving foreign exchange, and currency and cross-currency swaps are considered “swaps” under the Act and may not be exempted by the Treasury.

^[21] The exemption of FX Trades has not been universally embraced. For example, a comment letter submitted by Professor Darrell Duffie of Stanford University reasons that the arguments supporting the exemption of FX Trades from the clearing, margin and other requirements of the Act would benefit from additional analysis. Among other things, Professor Duffie highlighted that FX Trades may not be as short-dated as some market participants have suggested, with data indicating that more than half of the monthly volume of new foreign exchange forward contracts have maturities exceeding one month. Darrell Duffie, On the Clearing of Foreign Exchange Derivatives, Graduate School of Business, Stanford University.

^[22] In determining whether a swap was willfully structured to evade its regulatory authority, the CFTC would consider the extent to which an entity has a legitimate business purpose for structuring the instrument or entering into the transaction in such a manner. The CFTC would also use the Internal Revenue Service’s criteria for tax evasion in determining which activities constitute an evasion of the Act.

On April 22nd, the Office of the Comptroller of the Currency (the “OCC”) proposed a rule (the “Proposed OCC FX Rule”)^[1] authorizing national banks^[2] to engage in off-exchange transactions in foreign currency with retail customers, subject to certain specified conditions. In the interest of promoting consistent treatment of retail foreign exchange transactions, the Proposed OCC FX Rule is modeled on the recent rule issued by the CFTC with respect to such transactions (the “CFTC FX Rule”).^[3]

The Proposed OCC FX Rule defines “retail foreign exchange transactions” to include certain specified transactions in foreign currency between national banks and a person that is not an “eligible contract participant,” as defined in the CEA.^[4] The specified foreign currency transactions are, generally: (i) futures (or options on futures); (ii) options not traded on registered national securities exchanges; and (iii) certain leveraged or margined transactions. Significantly, transactions executed on exchanges, forward transactions under which a commercial entity is obligated to make or take delivery of a currency (and has the ability to do so in connection with its line of business) and traditional “spot” foreign exchange transactions (i.e., where settlement occurs within two days of trade) would not constitute retail foreign exchange transactions. However, rolling spot transactions (i.e., also known as “Zelener contracts” under which, in practice, the contract is indefinitely renewed and no currency is actually delivered until a party affirmatively closes out its position) may constitute retail foreign exchange transactions.^[5]

Under the Proposed OCC FX Rule, among other things, a national bank would not be permitted to act as a counterparty to retail foreign exchange transactions if the bank (or any of its affiliates) exercises discretion over a customer’s retail foreign exchange account, as such conduct would constitute self-dealing. Prior to engaging in retail foreign exchange transactions, a national bank would be required to obtain a written supervisory non-objection from the OCC, which would require the bank to provide information regarding its customer due diligence (including its credit and customer appropriateness evaluations), new product approvals and haircuts for non-cash margin, and to establish that it has adequate written policies, procedures and risk measurement and management systems and controls relating to this business. National banks also would be required to provide customers with risk disclosure statements which, among other things, would make clear that a national bank is prohibited from applying customer losses arising out of retail foreign exchange transactions against any other property of a customer other than that specifically given as margin for retail foreign exchange transactions. The OCC has requested comment on whether such disclosure statements should, similar to the CFTC FX Rule, disclose the percentage of retail foreign exchange accounts that earned a profit or the percentage of retail foreign exchange accounts that experienced a loss over the most recent four calendar quarters.^[6]

A national bank offering or entering into retail foreign exchange transactions would be required to: (i) be “well capitalized” (as defined in the relevant OCC regulations) or would otherwise be required to obtain an exemption from the OCC; and (ii) hold capital against such transactions in accordance with OCC regulations. It also would be required to collect initial margin from retail customers of at least 2% of the notional amount for each transaction in a major currency pair (e.g., USD/EUR, EUR/GBP, USD/CAD) and at least 5% of the notional amount for each transaction not involving a major currency pair. These percentages of notional amount are consistent with those set forth in the CFTC FX rule, although the OCC has requested comment on whether they should be adjusted. A national bank also would have to mark each customer’s foreign exchange positions daily to determine whether additional margin is required from the customer. Margin could be in the form of either cash or specified financial instruments, the latter of which would be subject to haircuts (evaluated at least annually) established by written policies and procedures of the national bank. Moreover, all margin would have to be held by a national bank in a separate account that contains only such customer’s margin.

The Proposed OCC FX Rule would require national banks to provide monthly statements clearly indicating: (i) each open foreign exchange transaction and the price at which it was acquired; (ii) the net unrealized profits or losses on all open transactions, as marked to market; (iii) all property held in the customer’s separate margin account; and (iv) all financial charges and credits over the monthly reporting period (including fees, commissions, etc.). National banks also would be required to provide confirmation statements to customers no later than the next business day following the execution of a retail foreign exchange transaction. Such confirmation statements would include specified information, including any premium, strike price and exercise dates (for options). However, the OCC has requested comment on whether other information would be more appropriate in light of the distinctive characteristics of retail foreign exchange transactions.

^[1] Retail Foreign Exchange Transactions, 76 Fed. Reg. 22633 (Apr. 22, 2011).

^[2] The Proposed OCC FX Rule defines “national banks” to include national banks, federal branches or agencies of foreign banks, and the operating subsidiaries of the foregoing.

^[3] Regulation of Off-Exchange Retail Foreign Exchange Transactions and Intermediaries, 75 Fed. Reg. 3282 (Sep. 10, 2011).

^[4] The term “eligible contract participant” is defined under 7 U.S.C. §1a(18) to include various entities, including corporations, partnerships, trust and governmental entities, subject to specified total asset, net worth and/or discretionary investment thresholds. Note, however, that the OCC has requested comment on whether this definition adequately captures retail customers for the relevant products, or whether it should expand the scope of the rule to capture certain eligible contract participants as well.

^[5] Note, however, that the OCC has requested comment on whether leveraged or margined foreign exchange transactions, including rolling spot transactions, should, in fact, be regulated under the OCC Proposed FX Rule.

^[6] In proposing its own rule, the CFTC had expressed concern about the retail foreign exchange market, noting that the “vast majority” of retail customers engage in such trading solely to speculate and that very few of them do so profitably. 75 Fed. Reg. at 3289.

Under Title VII of the Dodd-Frank financial reform, titled the “Wall Street Transparency and Accountability Act of 2010” (the “Act”), which is generally intended to bring the $600 trillion over-the-counter derivatives market under greater regulation, the Commodity Futures Trading Commission (“CFTC”) will have primary responsibility for the regulation of “swaps” and the Securities Exchange Commission (“SEC” and, together with the CFTC, the “Commissions”) will have primary responsibility for the regulation of “security-based swaps.”

The Commissions continue to meet with market participants and industry groups and to publish proposed rules and requests for comment related to the implementation of the Act. The implementation timeline mandated by Congress is extremely compressed for such an expansive undertaking and, as a result, the pace of the publication of notices and marketplace responses has been simply torrid. In fact, as of February 10^th, the CFTC had held nine roundtables and over 500 meetings with market participants and had approved 39 notices of proposed rulemaking, two interim final rules, four advanced notices of proposed rulemaking and one final rule. As of the same date, the CFTC had received over 2,800 submissions from the public and over 1,100 official comments in response to its proposed rulemakings under the Act. This pace has led to concern over whether the appropriate deliberation was taking place before the finalization of rules that could result in unintended consequences.^[1]

Each market participant is necessarily concerned with the impact proposed regulations (and their interpretation) will have on that participant’s use of swaps in connection with its specific business. Of course, market participants and their use of swaps are necessarily diverse, and include everything from a governmental agency hedging interest rate risk on its variable rate bonds to an airline hedging the future cost of jet fuel to a hedge fund speculating on the value of equity securities. Consequently, the areas of concern in the derivatives market relating to implementation of the Act are similarly diverse. A few of these areas of concern— primarily relating to regulations proposed by the CFTC—are discussed the news items in this edition.

Special Entities

Significant market concerns exist over the business conduct standards proposed by the CFTC that would govern the relationship between swap dealers and major swap participants and their “special entity” counterparties, such as employee benefit plans subject to the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), endowments and state and local governmental entities. In accordance with the Act, each swap dealer or major swap participant that enters into or offers to enter into a swap with a special entity must comply with certain specified requirements.^[2] However, in the drafting stages of the Act, Congress considered—but ultimately rejected—imposing a fiduciary standard on swap dealers transacting with special entities.

The proposed rules nevertheless take an expansive approach, providing that swap dealers act as “advisers” to a special entity (and, as such, must act in the entity’s “best interests”) by recommending a swap or a trading strategy that involves the use of a swap. On February 17^th, the Securities Industry and Financial Markets Association and the International Swaps and Derivatives Association, Inc. jointly submitted a comment letter that, inter alia, argued that the proposed approach could effectively preclude the participation of special entities from the swap market. Among numerous other points, the groups noted that it is common for swap dealers to provide state and local governments and their advisors with valuable information identifying swap opportunities, proposing structures and products and presenting possibilities to restructure existing transactions. Preventing them from doing so would alter the face of this market and could ultimately involve additional costs for special entities. As a potential solution, the groups suggested that the CFTC instead treat swap dealers as advisors only where they provide advice to a special entity pursuant to a written agreement and the advice (i) will serve as the primary basis for the special entity’s investment decision and (ii) will be individualized based on the particular needs of the special entity.

With respect to ERISA plans, more specifically, the concerns fall into two main areas: (i) resurrection of the possibility that swap dealers engaging in typical business activities with special entities could be treated as ERISA fiduciaries (and, therefore, that the swaps entered into with such entities would be prohibited and, possibly, subject to rescission and excise taxes); and (ii) whether investment vehicles into which employee benefit plans invest (such as a fund in which 25% or more of its equity interests are held by “benefit plan investors,” a term that includes ERISA-subject plans and investment vehicles) constitute special entities in the same way as employee benefit plans themselves.^[3]

Position Limits

The Act requires that the CFTC establish position limits for certain commodity derivatives to prevent market manipulation and curb speculation in these critical markets, but at the same time ensure that sufficient market liquidity exists for bona fide hedgers and that the price discovery function of the underlying market is not disrupted.^[4] The CFTC was required to impose such limits within 180 days of enactment for “exempt” commodities (generally, metals and energy) and within 270 days of enactment for agricultural commodities.^[5] The Commission has been unable to strictly comply with this timing due to the lack of certain market data at its disposal. Nevertheless, it proposed rules that would establish position limits in two phases: (i) initially, “spot-month” (generally, the nearest delivery month on a futures contract) limits at the levels currently imposed by designated contract markets (“DCMs”) and (ii) once sufficient data is gathered, non-spot-month limits, as well as CFTC-determined spot-month limits.

DCMs currently set spot-month position limits based on their own estimates of deliverable supply. The CFTC will adopt these estimates of deliverable supply in the first phase. However, most non-spot-month position limits are based on “open interest” levels, for which the CFTC does not have sufficient information. As such, the Commission decided to defer establishing non­spot-month position limits until the implementation of a comprehensive system for gathering such information. Generally, for physically-delivered contracts, the proposed rules would impose a spot-month limit of 25% of estimated deliverable supply (to be adjusted annually) and, for cash-settled contracts, a conditional limit of five times the corresponding physical delivery limit where the relevant positions are all cash-settled and the trader holds physical commodity positions that are no more than 25% of the estimated deliverable supply. In the second phase, the proposed rules would impose a non-spot-month limit for each trader of 10% of open interest in a market up to the first 25,000 contracts and 2.5% for additional contracts. Positions of all accounts in which a trader holds an ownership interest of at least 10% would be aggregated for purposes of the rules. The proposed rules also provide for exemptions for bona fide hedging transactions and for positions established in good faith prior to the effective date of specific limits adopted.

Opponents of the proposed rules argue that, as written, they will constrain legitimate trading activity, harm liquidity and, potentially, drive markets overseas where regulation is lagging. Chairman Gensler has acknowledged that the CFTC would likely be revising its proposed position limit rules based on the comments it continues to receive from interested market participants.

End-Users

Another area of proposed regulation that has received substantial attention is the applicability of the Act to end-users of swaps, particularly corporate entities (such as airlines and manufacturers) which use derivatives to hedge market risks relating to volatility in interest rates, foreign exchange rates and commodity prices. Individual and groups of end-users have asked the CFTC for either an exemption or other accommodation from certain aspects of regulation. For example, at least one industry group has asked that end-users be exempt from the real-time reporting^[6] of uncleared swaps to a swap data repository (“SDR”) where one end-user faces another end-user, because (i) such swaps constitute an insignificant portion of the derivatives market and, therefore, do not present systemic risk and (ii) requiring such reporting would result in prohibitive costs for end-users to develop the necessary technologic and other infrastructure necessary for compliance^[7]. Alternatively, this industry group suggests that, in such a case, the reporting end-user be able to satisfy its reporting obligations by submitting a weekly report to an SDR.

Market participants have also expressed concerns about the implementation of the end-user clearing exemption in the Act. Among other things, this exemption requires that the end-user relying on it notify the CFTC how it generally meets its financial obligations associated with uncleared swaps.^[8] Some market participants have asked the CFTC to permit end-users to use a one-time (or periodic) report to satisfy the requirement to notify the CFTC of its election and to clarify that public companies need not receive explicit board approval to enter into each individual swap. Other market concerns relating to the end-user clearing exemption include whether to allow the exemption for small banks and other financial entities having less than $10 billion in assets and the appropriate level of swap dealer responsibility in confirming that its counterparty qualifies for the exemption.

Possibly the most significant point of concern for end-users involves the margin rules that regulators will ultimately propose for uncleared swaps. Under the Act, the capital and margin requirements imposed in connection with uncleared swaps are to reflect the greater risk to the swap dealer or major swap participant and the financial system as a whole arising from such swaps. Corporate end-users and lobbying groups have long argued that they should be exempt from these margin requirements, as such market participants were unrelated to the root cause of the financial crisis.^[9] End-user anxiety persists over this issue, as the immediate liquidity drain of corporate end-users to satisfy even modest margin requirements would be measured in the billions of dollars and could lead to a profound loss of jobs from the United States economy.^[10]

Although the relevant margin rules have not yet been proposed, it appears that regulators are largely in agreement with the corporate end-users on this point. In particular, the Board of Governors of the Federal Reserve (the “Federal Reserve”) (which, as a prudential regulator of bank swap dealers, shares responsibility for drafting the rules) recently indicated that it plans to strongly consider the systemic risk an institution poses in establishing margin rules. Specifically, Federal Reserve Governor Daniel Tarullo testified on February 15^th that the Federal Reserve planned to establish exposure thresholds for margin from non-financial end-users that would be “substantially higher than those for financial market participants.” This would result in a de facto exemption for many non-financial companies, although certain larger end-users would be required to post margin. CFTC Chairman Gensler took an even more accommodating approach, stating that the CFTC view was that the Act’s margin requirements clearly “do not cover nonfinancial end users” and that legislation was not necessary to further clarify the point.

^[1] In a February 8^th letter to the CFTC, SEC and other regulators, several Senators cautioned as follows:

“[W]e hope that your agencies will take the time to implement [the Act] thoughtfully and to pay particularly close attention to the array of unintended consequences that may arise. If the major overhaul of our derivatives market is implemented hastily, agency rulemakings could have negative effects on our economy at a time when we can least afford it.”

Similarly, in a January 26th letter to the CFTC, two Congressmen expressed their concern with the rapid publication of proposed regulations, arguing that “by prioritizing speed over deliberation in writing rules, the CFTC has created an irrational sequence of rule proposals that prevents stakeholders and the public from providing meaningful comments after rules are proposed.” The Congressmen urged that the CFTC elect to voluntarily adhere to Executive Order 12866, issued by President Barack Obama on January 18th, which, among other things, requires that government agencies “propose or adopt a regulation only upon a reasonable determination that its benefits justify its costs.” The executive order does not apply to independent agencies such as the CFTC.

^[2] These requirements include: (i) having a reasonable basis to believe that the special entity has an independent representative that, inter alia, has sufficient knowledge to evaluate each transaction and its risks and (ii) before the initiation of any transaction, disclosing to the special entity in writing the capacity in which the swap dealer or major swap participant is acting.

^[3] For additional information regarding swaps with ERISA plans under the relevant proposed rules, please click here.

^[4] This portion of the Act was driven, at least in part, by claims that excessive speculation in the oil market resulted in a precipitous spike in the price of crude oil to almost $150 per barrel in July 2008.

^[5] The proposed regulations cover nine exempt commodities (i.e., gold, silver, copper, platinum, palladium, crude oil, natural gas, heating oil and gasoline) and 19 agricultural commodities (including, but not limited to, corn, oats, rice, soybeans, wheat, milk, cocoa, coffee, sugar and cotton).

^[6] Under the Act, “real-time public reporting” is defined to mean to report data relating to a swap, including price and volume, as soon as technologically practicable after the time at which the swap has been executed.

^[7] Response of the International Energy Credit Association to the Commodity Futures Trading Commission Notice or Proposed Rule respecting Real-Time Public Reporting of Swap Transaction Data (17 CFR Part 43, RIN 3038-AD08, Federal Register Dec. 7, 2010) pursuant to Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act, dated February 7, 2010.

^[8] Generally, the Act makes it unlawful for any person to engage in a swap that the CFTC determines should be required to be cleared unless that person submits the swap for clearing to a registered or exempt derivatives clearing organization (“DCO”). However, an important exemption to this requirement exists if one counterparty to a swap (i) is not a financial entity, (ii) is using the swap to hedge or mitigate “commercial risk” (as such term will be defined by the CFTC) and (iii) notifies the CFTC how it generally meets its financial obligations associated with uncleared swaps. Notwithstanding this exemption, a party that satisfies these requirements and enters into a swap with a swap dealer or major swap participant may elect to require clearing of the swap and, in any such case, will have the sole right to select the DCO at which the swap will be cleared.

^[9] Indeed, when the Act was still in draft form, Senators Blanche Lincoln and Christopher Dodd clarified in a June 30, 2010 letter that “[t]he [proposed Act] does not authorize the regulators to impose margin on end users, those exempt entities that use swaps to hedge or mitigate commercial risk.”

^[10] The Coalition for Derivatives End-Users issued a study on February 14^th which concluded that the imposition of a three percent (3%) margin requirement on swaps used by Standard & Poor’s 500 companies could cut capital spending by $5.1 to $6.7 billion and result in the loss of between 100,000 to 130,000 jobs. Congressional testimony from corporate end-users also focused on the risk of increased prices of goods and services that could result if margin rules applied to them. In an interesting discourse, following testimony by a representative of MillerCoors LLC in support of a broad end-users exemption from margin rules, one Congressman warned regulators that their rules could affect the price of a six-pack of beer, stating “I think you just got the attention of the American people.” In his sobering response, CFTC Chairman Gary Gensler acknowledged that the CFTC had met with representatives of the brewing company and had reassured them that the CFTC had no intention of imposing margin rules on the company, stating “We’re aware and focused on the cost of a six-pack.”

The Commodity Futures Trading Commission (“CFTC”) and Securities Exchange Commission (“SEC” and, together with the CFTC, the “Commissions”) continue to meet with market participants and industry groups and to publish proposed rules and requests for comment related to the implementation of Title VII of the Dodd-Frank financial reform, titled the “Wall Street Transparency and Accountability Act of 2010” (the “Act”). The Act is generally intended to bring the $615 trillion over-the-counter derivatives market under greater regulation.  The CFTC, which will have primary responsibility for the regulation of “swaps” (as opposed to “security-based swaps,” which will be primarily regulated by the SEC), recently published proposed rules on various topics related to the Act, including: (i) conflicts of interest policies and procedures, registration requirements and governing duties of swap dealers and major swap participants; (ii) matters relating to compliance policies and annual reports for swap dealers and major swap participants; (iii) agricultural swaps; (iv) conflicts of interest requirements for derivatives clearing organizations (“DCOs”), designated contract markets and swap execution facilities; (v) reporting of pre-enactment swaps; (vi) financial resources requirements for DCOs; (vii) the process for review of swaps for mandatory clearing; (viii) the prohibition of market manipulation; (ix) registration of foreign boards of trade; and (x) antidisruptive practices authority.

The Commissions have received numerous comment letters and other input from firms, industry groups and other interested parties in connection with the implementation of the Act.^[1] Included in these is a recommendation by the International Swaps and Derivatives Association, Inc. (“ISDA”) that the Commissions should grant waivers of mandatory clearing under the Act in limited circumstances where bilateral and/or systemic risk would be reduced, such as where a swap that is required to be cleared hedges the market and counterparty risk of a swap that is not able or required to be cleared.  ISDA suggests that, in such circumstances, managing both related transactions on a bilateral basis reduces risk, as the alternative (i.e., clearing one swap through a central clearing facility and managing the other on a bilateral basis) increases risk between the two counterparties as well as in the central clearing facility and the financial system more broadly.  Among other things, ISDA notes that, in granting such limited waivers, the Commissions could put in place reporting requirements and waiver limits to ensure that the use of the waivers is not designed to avoid clearing.

Separately, the Securities Industry and Financial Markets Association (“SIFMA”) sent a comment letter relating to, among other things, the end-user exemption from mandatory clearing in the Act.  An important exemption to clearing exists under the Act if one counterparty to a swap (i) is not a financial entity, (ii) is using the swap to hedge or mitigate “commercial risk” (as such term will be defined by regulators) and (iii) notifies the relevant Commission how it generally meets its financial obligations associated with uncleared swaps.  In its letter, SIFMA proposed that “commercial risk” be defined broadly as “any risk incurred by a non-financial entity in connection with its business.”  In making this recommendation, SIFMA points out that such a definition would be consistent with congressional intent, as reflected in the legislative history, to provide a broad clearing exemption for non-financial entities. It further notes that an exemption limited solely to risks directly related to the production of goods and services, and not also encompassing risks related to financing, would inhibit the ability of end users to enter swaps to decrease risks generated by their commercial activities and, as a result, inhibit their ability to ultimately produce those goods and services.

^[1] Copies of the comment letters submitted with respect to each of thirty rulemaking areas identified by the CFTC may be found here.