# Further Definition of “Swap,” “Security-Based Swap,” and “Security-Based Swap Agreement”; Mixed Swaps; Security-Based Swap Agreement Recordkeeping > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/fr%3A2011-11008 ## Record - **Collection:** Federal Register - **Document type:** Proposed Rule - **Published:** May 23, 2011 - **Citation:** 76 FR 29818 ## Text COMMODITY FUTURES TRADING COMMISSION 17 CFR Part 1 RIN 3038-AD46 SECURITIES AND EXCHANGE COMMISSION 17 CFR Part 240 [Release No. 33-9204; 34-64372; File No. S7-16-11] RIN 3235-AL14 Further Definition of “Swap,” “Security-Based Swap,” and “Security-Based Swap Agreement”; Mixed Swaps; Security-Based Swap Agreement Recordkeeping AGENCIES: Commodity Futures Trading Commission; Securities and Exchange Commission. ACTION: Joint proposed rules; proposed interpretations. SUMMARY: In accordance with section 712(a)(8), section 712(d)(1), sections 712(d)(2)(B) and (C), sections 721(b) and (c), and section 761(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”), the Commodity Futures Trading Commission (“CFTC”) and the Securities and Exchange Commission (“SEC”) (collectively, “Commissions”), in consultation with the Board of Governors of the Federal Reserve System (“Board”), are jointly issuing proposed rules and proposed interpretive guidance under the Commodity Exchange Act (“CEA”) and the Securities Exchange Act of 1934 (“Exchange Act”) to further define the terms “swap,” “security-based swap,” and “security-based swap agreement” (collectively, “Product Definitions”), regarding “mixed swaps,” and governing books and records with respect to “security-based swap agreements.” DATES: Comments should be received on or before July 22, 2011. ADDRESSES: Comments may be submitted, identified by File No. S7-16-11, by any of the following methods: CFTC: • Agency Web site, via its Comments Online process: http://comments.cftc.gov. Follow the instructions for submitting comments through the Web site. • Mail: David A. Stawick, Secretary, Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st Street, NW., Washington, DC 20581. • Hand Delivery/Courier: Same as mail above. • Federal eRulemaking Portal: http://www.regulations.gov. Follow the instructions for submitting comments. Please submit your comments using only one method. “ Product Definitions” must be in the subject field of responses submitted via e-mail, and clearly indicated on written submissions. All comments must be submitted in English, or if not, accompanied by an English translation. Comments will be posted as received to http://www.cftc.gov. You should submit only information that you wish to make available publicly. If you wish the CFTC to consider information that you believe is exempt from disclosure under the Freedom of Information Act, a petition for confidential treatment of the exempt information may be submitted according to the procedures established in section 145.9 of the CFTC's regulations. 1 1 17 CFR 145.9. The CFTC reserves the right, but shall have no obligation, to review, pre-screen, filter, redact, refuse or remove any or all of your submission from www.cftc.gov that it may deem to be inappropriate for publication, including obscene language. All submissions that have been redacted or removed that contain comments on the merits of the rulemaking will be retained in the public comment file and will be considered as required under the Administrative Procedure Act and other applicable laws, and may be accessible under the Freedom of Information Act. SEC Electronic Comments • Use the Commission's Internet comment form ( http://www.sec.gov/rules/proposed.shtml ); • Send an e-mail to rule-comments@sec.gov. Please include File Number S7-16-11 on the subject line; or • Use the Federal eRulemaking Portal ( http://www.regulations.gov ). Follow the instructions for submitting comments. Paper Comments • Send paper comments in triplicate to Elizabeth M. Murphy, Secretary, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549-1090. All submissions should refer to File Number S7-16-11. This file number should be included on the subject line if e-mail is used. To help us process and review your comments more efficiently, please use only one method. The SEC will post all comments on the SEC's Internet Web site ( http://www.sec.gov/rules/proposed.shtml ). Comments are also available for Web site viewing and printing in the SEC's Public Reference Room, 100 F Street, NE., Washington, DC 20549, on official business days between the hours of 10 a.m. and 3 p.m. All comments received will be posted without change; the SEC does not edit personal identifying information from submissions. You should submit only information that you wish to make available publicly. FOR FURTHER INFORMATION CONTACT: CFTC: Julian E. Hammar, Assistant General Counsel, at 202-418-5118, jhammar@cftc.gov, Mark Fajfar, Assistant General Counsel, at 202-418-6636, mfajfar@cftc.gov, or David E. Aron, Counsel, at 202-418-6621, daron@cftc.gov, Office of General Counsel, Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st Street, NW., Washington, DC 20581; SEC: Matthew A. Daigler, Senior Special Counsel, at 202-551-5578, Cristie L. March, Attorney-Adviser, at 202-551-5574, or Leah M. Drennan, Attorney-Adviser, at 202-551-5507, Division of Trading and Markets, or Michael J. Reedich, Special Counsel, or Tamara Brightwell, Senior Special Counsel to the Director, at 202-551-3500, Division of Corporation Finance, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549-7010. SUPPLEMENTARY INFORMATION: The Commissions jointly are proposing new rules and interpretive guidance under the CEA and the Exchange Act relating to the Product Definitions, mixed swaps, and security-based swap agreements. Table of Contents I. Background II. Scope of Definitions of Swap and Security-Based Swap A. Introduction B. Proposed Rules and Interpretive Guidance Regarding Certain Transactions Outside the Scope of the Definitions of the Terms “Swap” and “Security-Based Swap” 1. Insurance Products (a) Types of Insurance Products (b) Providers of Insurance Products 2. The Forward Contract Exclusion (a) Forward Contracts in Nonfinancial Commodities (b) Commodity Options and Commodity Options Embedded in Forward Contracts (c) Security Forwards 3. Consumer and Commercial Agreements, Contracts, and Transactions 4. Loan Participations C. Proposed Rules and Interpretive Guidance Regarding Certain Transactions Within the Scope of the Definitions of the Terms “Swap” and “Security-Based Swap” 1. In General 2. Foreign Exchange Products (a) Foreign Exchange Products Subject to the Secretary's Swap Determination: Foreign Exchange Forwards and Foreign Exchange Swaps (b) Foreign Exchange Products Not Subject to the Secretary's Swap Determination (i) Foreign Currency Options (ii) Non-Deliverable Forward Contracts Involving Foreign Exchange (iii) Currency Swaps and Cross-Currency Swaps 3. Forward Rate Agreements 4. Combinations and Permutations of, or Options on, Swaps and Security-Based Swaps 5. Contracts for Differences D. Certain Interpretive Issues 1. Agreements, Contracts, or Transactions That May Be Called, or Documented Using Form Contracts Typically Used for, Swaps or Security-Based Swaps 2. Transactions in Regional Transmission Organizations and Independent System Operators III. The Relationship Between the Swap Definition and the Security-Based Swap Definition A. Introduction B. Title VII Instruments Based on Interest Rates, Other Monetary Rates, and Yields 1. Title VII Instruments Based on Interest Rates or Other Monetary Rates That Are Swaps 2. Title VII Instruments Based on Yields 3. Title VII Instruments Based on Government Debt Obligations C. Total Return Swaps D. Security-Based Swaps Based on a Single Security or Loan and Single-Name Credit Default Swaps E. Title VII Instruments Based on Futures Contracts F. Use of Certain Terms and Conditions in Title VII Instruments G. The Term “Narrow-Based Security Index” in the Security-Based Swap Definition 1. Introduction 2. Applicability of the Statutory Narrow-Based Security Index Definition and Past Guidance of the Commissions to Title VII Instruments 3. Narrow-Based Security Index Criteria for Index Credit Default Swaps (a) In General (b) Proposed Rules Regarding the Definitions of “Issuers of Securities in a Narrow-Based Security Index” and “Narrow-Based Security Index” for Index Credit Default Swaps (i) Number and Concentration Percentages of Reference Entities or Securities (ii) Public Information Availability Regarding Reference Entities and Securities (iii) Treatment of Indexes Including Reference Entities That Are Issuers of Exempted Securities or Including Exempted Securities 4. Security Indexes 5. Evaluation of Title VII Instruments on Security Indexes That Move From Broad-Based to Narrow-Based or Narrow-Based to Broad-Based (a) In General (b) Title VII Instruments on Security Indexes Traded on Designated Contract Markets, Swap Execution Facilities, Foreign Boards of Trade, Security-Based Swap Execution Facilities, and National Securities Exchanges H. Method of Settlement of Index CDS I. Security-Based Swaps as Securities Under the Exchange Act and Securities Act IV. Mixed Swaps A. Scope of the Category of Mixed Swap B. Regulation of Mixed Swaps 1. Introduction 2. Bilateral Uncleared Mixed Swaps Entered Into by Dually-Registered Dealers or Major Participants 3. Regulatory Treatment for Other Mixed Swaps V. Security-Based Swap Agreements A. Introduction B. Swaps That Are Security-Based Swap Agreements C. Books and Records Requirements for Security-Based Swap Agreements VI. Process for Requesting Interpretations of the Characterization of a Title VII Instrument VII. Anti-Evasion A. CFTC Proposed Anti-Evasion Rules B. SEC Request for Comment Regarding Anti-Evasion VIII. Administrative Law Matters—CEA Revisions IX. Administrative Law Matters—Exchange Act Revisions X. Statutory Basis and Rule Text I. Background On July 21, 2010, President Obama signed the Dodd-Frank Act into law. 2 Title VII of the Dodd-Frank Act 3 (“Title VII”) established a comprehensive new regulatory framework for swaps and security-based swaps. The legislation was enacted, among other reasons, to reduce risk, increase transparency, and promote market integrity within the financial system, including by: (i) Providing for the registration and comprehensive regulation of swap dealers, security-based swap dealers, major swap participants, and major security-based swap participants; (ii) imposing clearing and trade execution requirements on swaps and security-based swaps, subject to certain exceptions; (iii) creating rigorous recordkeeping and real-time reporting regimes; and (iv) enhancing the rulemaking and enforcement authorities of the Commissions with respect to, among others, all registered entities and intermediaries subject to the Commissions' oversight. 2 See Dodd-Frank Wall Street Reform and Consumer Protection Act, Public Law 111-203, 124 Stat. 1376 (2010). The text of the Dodd-Frank Act is available at http://www.cftc.gov/LawRegulation/OTCDERIVATIVES/index.htm. 3 Pursuant to section 701 of the Dodd-Frank Act, Title VII may be cited as the “Wall Street Transparency and Accountability Act of 2010.” Section 712(d)(1) of the Dodd-Frank Act provides that the Commissions, in consultation with the Board, shall jointly further define the terms “swap,” “security-based swap,” and “security-based swap agreement” (“SBSA”). 4 Section 712(a)(8) of the Dodd-Frank Act provides further that the Commissions shall jointly prescribe such regulations regarding “mixed swaps” as may be necessary to carry out the purposes of Title VII. In addition, sections 721(b) and 761(b) of the Dodd-Frank Act provide that the Commissions may adopt rules to further define terms included in subtitles A and B, respectively, of Title VII, and sections 721(c) and 761(b) of the Dodd-Frank Act provide the Commissions with authority to define the terms “swap” and “security-based swap,” as well as the terms “swap dealer,” “major swap participant,” “security-based swap dealer,” and “major security-based swap participant,” to include transactions and entities that have been structured to evade the requirements of subtitles A and B, respectively, of Title VII. 4 In addition, section 719(d)(1)(A) of the Dodd-Frank Act requires the Commissions to conduct a joint study, within 15 months of enactment, to determine whether stable value contracts, as defined in section 719(d)(2) of the Dodd-Frank Act, are encompassed by the swap definition. If the Commissions determine that stable value contracts are encompassed by the swap definition, section 719(d)(1)(B) of the Dodd-Frank Act requires the Commissions jointly to determine whether an exemption for those contracts from the swap definition is appropriate and in the public interest. Section 719(d)(1)(B) also requires the Commissions to issue regulations implementing the determinations made under the required study. Until the effective date of such regulations, the requirements under Title VII do not apply to stable value contracts, and stable value contracts in effect prior to the effective date of such regulations are not considered swaps. See section 719(d) of the Dodd-Frank Act. The Commissions currently are conducting the required joint study and will consider whether to propose any implementing regulations (including, if appropriate, regulations determining that stable value contracts: (i) are not encompassed within the swap definition; or (ii) are encompassed within the definition but are exempt from the swap definition) at the conclusion of that study. Section 712(d)(2)(B) of the Dodd-Frank Act requires the Commissions, in consultation with the Board, to jointly adopt rules governing books and records requirements for SBSAs by persons registered as swap data repositories (“SDRs”) under the CEA, 5 including uniform rules that specify the data elements that shall be collected and maintained by each SDR. 6 Similarly, section 712(d)(2)(C) of the Dodd-Frank Act requires the Commissions, in consultation with the Board, to jointly adopt rules governing books and records for SBSAs, including daily trading records, for swap dealers, major swap participants, security-based swap dealers, and security-based swap participants. 7 5 7 U.S.C. 1 et seq. 6 The CFTC has issued proposed rules regarding SDRs and, separately, swap data recordkeeping and reporting. See Regulations Establishing and Governing the Duties of Swap Dealers and Major Swap Participants, 75 FR 71397, Nov. 23, 2010; Swap Data Recordkeeping and Reporting Requirements, 75 FR 76573, Dec. 8, 2010. The SEC has also issued proposed rules regarding security-based swap data repositories (“SBSDRs”), including rules specifying data collection and maintenance standards for SBSDRs, as well as rules regarding security-based swap data recordkeeping and reporting. See Security-Based Swap Data Repository Registration, Duties, and Core Principles, 75 FR 77306, Dec. 10, 2010; Regulation SBSR—Reporting and Dissemination of Security-Based Swap Information, 75 FR 75208, Dec. 2, 2010. 7 The CFTC has issued proposed rules regarding recordkeeping requirements for swap dealers and major swap participants. See Reporting, Recordkeeping, and Daily Trading Records Requirements for Swap Dealers and Major Swap Participants, 75 FR 76666, Dec. 9, 2010. Under the comprehensive framework for regulating swaps and security-based swaps established in Title VII, the CFTC is given regulatory authority over swaps, 8 the SEC is given regulatory authority over security-based swaps, 9 and the Commissions shall jointly prescribe such regulations regarding mixed swaps as may be necessary to carry out the purposes of Title VII. 10 In addition, the SEC is given antifraud authority over, and access to information from, certain CFTC-regulated entities regarding SBSAs, which are a type of swap related to securities over which the CFTC is given regulatory authority. 11 8 Section 721(a) of the Dodd-Frank Act defines the term “swap” by adding section 1a(47) to the CEA, 7 U.S.C. 1a(47). This new swap definition also is cross-referenced in new section 3(a)(69) of the Exchange Act, 15 U.S.C. 78c(a)(69). Citations to provisions of the CEA and the Exchange Act, 15 U.S.C. 78a et seq., in this release refer to the numbering of those provisions after the effective date of Title VII, except as indicated. 9 Section 761(a) of the Dodd-Frank Act defines the term “security-based swap” by adding new section 3(a)(68) to the Exchange Act, 15 U.S.C. 78c(a)(68). This new security-based swap definition also is cross-referenced in new CEA section 1a(42), 7 U.S.C. 1a(42). The Dodd-Frank Act also explicitly includes security-based swaps in the definition of security under the Exchange Act and the Securities Act of 1933 (“Securities Act”), 15 U.S.C. 77a et seq. 10 Section 721(a) of the Dodd-Frank Act describes the category of “mixed swap” by adding new section 1a(47)(D) to the CEA, 7 U.S.C. 1a(47)(D). Section 761(a) of the Dodd-Frank Act also includes the category of “mixed swap” by adding new section 3(a)(68)(D) to the Exchange Act, 15 U.S.C. 78c(68)(D). A mixed swap is defined as a subset of security-based swaps that also are based on the value of 1 or more interest or other rates, currencies, commodities, instruments of indebtedness, indices, quantitative measures, other financial or economic interest or property of any kind (other than a single security or a narrow-based security index), or the occurrence, non-occurrence, or the extent of the occurrence of an event or contingency associated with a potential financial, economic, or commercial consequence (other than the occurrence, non-occurrence, 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). 11 Section 761(a) of the Dodd-Frank Act defines the term “security-based swap agreement” by adding new section 3(a)(78) to the Exchange Act, 15 U.S.C. 78c(a)(78). The CEA includes the definition of “security-based swap agreement” in subparagraph (A)(v) of the swap definition in CEA section 1a(47), 7 U.S.C. 1a(47). The only difference between these definitions is that the definition of SBSA in the Exchange Act specifically excludes security-based swaps ( see section 3(a)(78)(B) of the Exchange Act, 15 U.S.C. 78c(a)(78)(B)), whereas the definition of SBSA in the CEA does not contain a similar exclusion. Instead, under the CEA, the exclusion for security-based swaps is placed in the general exclusions from the swap definition ( see CEA section 1a(47)(B)(x), 7 U.S.C. 1a(47)(B)(x)). Although the statutes are slightly different structurally, the Commissions interpret them to have consistent meaning that the category of security-based swap agreements excludes security-based swaps. To assist the Commissions in further defining the Product Definitions (as well as certain other definitions) and in prescribing regulations regarding mixed swaps as may be necessary to carry out the purposes of Title VII, the Commissions published an advance notice of proposed rulemaking (“ANPR”) in the Federal Register on August 20, 2010. 12 The comment period for the ANPR closed on September 20, 2010. 13 The Commissions received comments addressing the Product Definitions and/or mixed swaps in response to the ANPR, as well as comments in response to the Commissions' informal solicitations, 14 from a wide range of commenters. 12 See Definitions Contained in Title VII of Dodd-Frank Wall Street Reform and Consumer Protection Act, 75 FR 51429, Aug. 20, 2010. The ANPR also solicited comment regarding the definitions of the terms “swap dealer,” “security-based swap dealer,” “major swap participant,” “major security-based swap participant,” and “eligible contract participant.” These definitions are the subject of a separate joint proposed rulemaking by the Commissions. See Further Definition of “Swap Dealer,” “Security-Based Swap Dealer,” “Major Swap Participant,” “Major Security-Based Swap Participant” and “Eligible Contract Participant,” 75 FR 80174, Dec. 21, 2010 (“Entity Definitions”). The Commissions also provided the public with the ability to present their views more generally on implementation of the Dodd-Frank Act through their Web sites, dedicated electronic mailboxes, and meetings with interested parties. See Public Comments on SEC Regulatory Initiatives Under the Dodd-Frank Act/Meetings with SEC Officials located at http://www.sec.gov/spotlight/regreformcomments.shtml; Public Submissions, located at http://comments.cftc.gov/PublicComments/ReleasesWithComments.aspx; External Meetings, located at http://www.cftc.gov/LawRegulation/DoddFrankAct/ExternalMeetings/index.htm. 13 Copies of all comments received by the SEC on the ANPR are available on the SEC's Internet Web site, located at http://www.sec.gov/comments/s7-16-10/s71610.shtml. Comments are also available for Web site viewing and printing in the SEC's Public Reference Room, 100 F Street, NE., Washington, DC 20549, on official business days between the hours of 10 a.m. and 3 p.m. Copies of all comments received by the CFTC on the ANPR are available on the CFTC's Internet Web site, located at http://www.cftc.gov/LawRegulation/DoddFrankAct/OTC_2_Definitions.html. 14 See supra note 12. The Commissions have reviewed the comments received, and the staffs of the Commissions have met with many market participants and other interested parties to discuss the definitions. 15 Moreover, the Commissions' staffs have consulted extensively with each other as required by sections 712(a)(1) and (2) of the Dodd-Frank Act and have consulted with staff of the Board as required by section 712(d) of the Dodd-Frank Act. 15 Information about meetings that CFTC staff have had with outside organizations regarding the implementation of the Dodd-Frank Act is available at http://www.cftc.gov/LawRegulation/DoddFrankAct/ExternalMeetings/index.htm. Information about meetings that SEC staff have had with outside organizations regarding the product definitions is available at http://www.sec.gov/comments/s7-16-10/s71610.shtml#meetings. The views expressed in the comments in response to the ANPR, in response to the Commissions' informal solicitations, and at such meetings are collectively referred to as the views of “commenters.” Based on this review and consultation, the Commissions are proposing interpretive guidance, and in some instances also proposing rules, regarding, among other things: (i) The regulatory treatment of insurance products; (ii) the exclusion of forward contracts from the swap and security-based swap definitions; (iii) the regulatory treatment of certain consumer and commercial contracts; (iv) the regulatory treatment of certain foreign-exchange related and other instruments; (v) swaps and security-based swaps involving interest rates (or other rates) and yields; (vi) total return swaps (“TRS”); (vii) the application of the definition of “narrow-based security index” in distinguishing between certain swaps and security-based swaps, including credit default swaps (“CDS”) and index CDS; and viii) the specification of certain swaps and security-based swaps that are, and are not, mixed swaps. In addition, the Commissions are proposing rules: (i) establishing books and records requirements applicable to SBSAs; (ii) providing a mechanism for requesting the Commissions to interpret whether a particular type of agreement, contract, or transaction (or class of agreements, contracts, or transactions) is a swap, security-based swap, or both ( i.e., a mixed swap); and (iii) providing a mechanism for evaluating the applicability of certain regulatory requirements to particular mixed swaps. Finally, the CFTC is proposing rules to implement the anti-evasion authority provided in the Dodd-Frank Act. The Commissions believe that the proposed rules and interpretive guidance will further the purposes of Title VII. While the Commissions believe that these proposals, if adopted, would appropriately effect the intent of the Dodd-Frank Act, the Commissions are very interested in commenters' views as to whether those purposes have been achieved, and, if not, how to improve these proposals. II. Scope of Definitions of Swap and Security-Based Swap A. Introduction Title VII of the Dodd-Frank Act applies to a wide variety of agreements, contracts, and transactions classified as swaps or security-based swaps. The statute lists these agreements, contracts, and transactions in the definition of the term “swap.” 16 The statutory definition of the term “swap” also has various exclusions, 17 rules of construction, and other provisions for the interpretation of the definition. 18 One of the exclusions to the definition of the term “swap” is for security-based swaps. 19 The term “security-based swap,” in turn, is defined as an agreement, contract, or transaction that is a “swap” (without regard to the exclusion from that definition for security-based swaps) and that also has certain characteristics specified in the statute. 20 Thus, the statutory definition of the term “swap” also determines the scope of agreements, contracts, and transactions that could be security-based swaps. 16 See CEA section 1a(47)(A), 7 U.S.C. 1a(47)(A). This swap definition is also cross-referenced in new section 3(a)(69) of the Exchange Act, 15 U.S.C. 78c(a)(69). 17 See CEA section 1a(47)(B), 7 U.S.C. 1a(47)(B), clauses (i)-(x). 18 See CEA sections 1a(47)(C)-(F), 7 U.S.C. 1a(47)(C)-(F). 19 See CEA section 1a(47)(B)(x), 7 U.S.C. 1a(47)(B)(x). 20 See section 3(a)(68) of the Exchange Act, 15 U.S.C. 78c(a)(68). The statutory definitions of “swap” and “security-based swap” are detailed and comprehensive, and the Commissions believe that extensive “further definition” of the terms by rule is not necessary. Nevertheless, several commenters have stated, 21 and the Commissions agree, that the definitions could be read to include certain types of agreements, contracts, and transactions that previously have not been considered swaps or security-based swaps and that nothing in the legislative history of the Dodd-Frank Act appears to suggest that Congress intended such agreements, contracts, and transactions to be regulated as swaps or security-based swaps under Title VII. The Commissions thus believe that it is important to clarify the treatment under the definitions of certain types of agreements, contracts, and transactions, such as insurance products and certain consumer and commercial contracts. 21 See, e.g., Letter from Edward J. Rosen, Cleary Gottlieb Steen & Hamilton LLP, Sept. 21, 2010 (“Cleary Letter”); Letter from Robert Pickel, Executive Vice President, International Swaps and Derivatives Association, Inc., Sept. 20, 2010 (“ISDA Letter”). In addition, commenters also raised questions regarding, and the Commissions believe that it is important to clarify: (i) The exclusion for forward contracts from the definitions of the terms “swap” and “security-based swap;” and (ii) the status of certain commodity-related products (including various foreign exchange products and forward rate agreements (“FRAs”)) under the definitions of the terms “swap” and “security-based swap.” Finally, the Commissions are providing guidance regarding certain interpretive issues related to the definitions. 22 22 Some commenters raised concerns regarding the treatment of inter-affiliate swaps and security-based swaps. See, e.g., Cleary Letter; Letter from Coalition for Derivatives End Users, Sept. 20, 2010 (“CDEU Letter”); ISDA Letter; Letter from Richard A. Miller, Vice President and Corporate Counsel, Prudential Financial Inc., Sept. 17, 2010; Letter from Richard M. Whiting, The Financial Services Roundtable, Sept. 20, 2010. A few commenters suggested that the Commissions should further define the term “swap” or “security-based swap” to exclude inter-affiliate transactions. See Cleary Letter; CDEU Letter. The Commissions are considering whether inter-affiliate swaps or security-based swaps should be treated differently from other swaps or security-based swaps in the context of the Commissions' other Title VII rulemakings. B. Proposed Rules and Interpretive Guidance Regarding Certain Transactions Outside the Scope of the Definitions of the Terms “Swap” and “Security-Based Swap” 1. Insurance Products A number of commenters expressed concern that the definitions of the terms “swap” and “security-based swap” potentially could include certain types of insurance products 23 because the statutory definition of the term “swap” includes, in part, any agreement, contract, or transaction “that provides for any purchase, sale, payment, or delivery (other than a dividend on an equity security) that is dependent on the occurrence, nonoccurrence, or the extent of the occurrence of an event or contingency associated with a potential financial, economic, or commercial consequence.” 24 The Commissions do not interpret this clause to mean that products historically treated as insurance products should be included within the swap or security-based swap definition. 25 23 See, e.g., Letter from Ernest C. Goodrich, Jr., Managing Director—Legal Department, and Marcelo Riffaud, Managing Director—Legal Department, Deutsche Bank AG, Sept. 20, 2010 (“Deutsche Bank Letter”); Letter from Sean W. McCarthy, Chairman, Association of Financial Guaranty Insurers, Sept. 20, 2010 (“AFGI Letter”); Letter from Robert J. Duke, The Surety & Fidelity Association of America, Sept. 20, 2010 (“SFAA Letter”); Letter from J. Stephen Zielezienski, Senior Vice President & General Counsel, American Insurance Association, Sept. 20, 2010; Letter from Franklin W. Nutter, President, Reinsurance Association of America, Sept. 20, 2010 (“RAA Letter”); Letter from James M. Olsen, Senior Director Accounting and Investment Policy, Property Casualty Insurers Association of America, Sept. 17, 2010; Letter from Jane L. Cline, President, and Therese M. Vaughan, Chief Executive Officer, National Association of Insurance Commissioners, Sept. 20, 2010; Letter from Joseph W. Brown, Chief Executive Officer, MBIA Inc., Sept. 20, 2010 (“MBIA Letter”); Cleary Letter; Letter from White & Case LLP (“White & Case Letter”), Sept. 20, 2010; Letter from Carl B. Wilkerson, Vice President and Chief Counsel, Securities & Litigation, American Council of Life Insurers, Nov. 12, 2010 (“ACLI Letter”); Letter from Stephen E. Roth, James M. Cain, and W. Thomas Conner, Sutherland Asbill & Brennan LLP, for the Committee of Annuity Insurers, Dec. 3, 2010. 24 CEA section 1a(47)(A)(ii), 7 U.S.C. 1a(47)(A)(ii). 25 The Commissions also believe it was not the intent of Congress through the swap and security-based swap definitions to preclude the provision of insurance to individual homeowners and small businesses that purchase property and casualty insurance. See CEA section 2(e), 7 U.S.C. 2(e) and section 6(l) of the Exchange Act, 15 U.S.C. 78f(l) (prohibiting individuals and small businesses that do not meet specified financial thresholds or other conditions from entering into swaps or security-based swaps other than on or subject to the rules of regulated futures and securities exchanges). The Commissions are aware of nothing in Title VII to suggest that Congress intended for insurance products to be regulated as swaps or security-based swaps. Moreover, that swaps and insurance products are subject to different regulatory regimes is reflected in section 722(b) of the Dodd-Frank Act which, in new section 12(h) of the CEA, provides that a swap “shall not be considered to be insurance” and “may not be regulated as an insurance contract under the law of any State.” 26 Accordingly, the Commissions believe that state or Federally regulated insurance products that are provided by state or Federally regulated insurance companies 27 that otherwise could fall within the definitions should not be considered swaps or security-based swaps so long as they satisfy the proposed rules or comport with the related proposed interpretive guidance. 28 At the same time, however, the Commissions are concerned that agreements, contracts, or transactions that are swaps or security-based swaps might be characterized as insurance products to evade the regulatory regime under Title VII of the Dodd-Frank Act. Accordingly, the Commissions are proposing rules and interpretive guidance that would clarify that agreements, contracts, or transactions meeting certain requirements would be considered insurance and not swaps or security-based swaps. 26 7 U.S.C. 16(h). Moreover, other provisions of the Dodd-Frank Act address the status of insurance more directly, and more extensively, than Title VII. For example, Title V of the Dodd-Frank Act requires the newly established Federal Insurance Office to conduct a study and submit a report to Congress, within 18 months of enactment of the Dodd-Frank Act, on the regulation of insurance, including the consideration of Federal insurance regulation. Notably, the Federal Insurance Office's authority under Title V extends primarily to monitoring and information gathering; its ability to promulgate Federal insurance regulation that preempts state insurance regulation is significantly restricted. See section 502 of the Dodd-Frank Act (codified in various sections of 31 U.S.C.). Title X of the Dodd-Frank Act also specifically excludes the business of insurance from regulation by the Bureau of Consumer Financial Protection. See section 1027(m) of the Dodd-Frank Act, 12 U.S.C. 5517(m) (“The [Bureau of Consumer Financial Protection] may not define as a financial product or service, by regulation or otherwise, engaging in the business of insurance.”); section 1027(f) of the Dodd-Frank Act, 12 U.S.C. 5517(f) (excluding persons regulated by a state insurance regulator, except to the extent they are engaged in the offering or provision of consumer financial products or services or otherwise subject to certain consumer laws as set forth in Title X of the Dodd-Frank Act). 27 As discussed above, the establishment of the Federal Insurance Office under Title V of the Dodd-Frank Act suggests that Federal insurance law could be established in the future. The Commissions believe that the proposed rules should, therefore, include a specific reference to Federal insurance law. 28 To the extent an insurance product does not fall within the language of the swap definition by its terms, it would not need to satisfy the requirements under the proposed rules in order to avoid being considered a swap or security-based swap. The proposed rules contain two subparts; the first subpart addresses the agreement, contract, or transaction and the second subpart addresses the entity providing that agreement, contract, or transaction. More specifically, with respect to the former, paragraph (i) of proposed rule 1.3(xxx)(4) under the CEA and paragraph (a) of proposed rule 3a69-1 under the Exchange Act would clarify, as discussed in more detail below, that the terms “swap” and “security-based swap” would not include an agreement, contract, or transaction that, by its terms or by law, as a condition of performance: • Requires the beneficiary of the agreement, contract, or transaction to have an insurable interest that is the subject of the agreement, contract, or transaction and thereby carry the risk of loss with respect to that interest continuously throughout the duration of the agreement, contract, or transaction; • Requires that loss to occur and to be proved, and that any payment or indemnification therefor be limited to the value of the insurable interest; • Is not traded, separately from the insured interest, on an organized market or over-the-counter; and • With respect to financial guaranty insurance only, in the event of payment default or insolvency of the obligor, any acceleration of payments under the policy is at the sole discretion of the insurer. In addition, the second subpart of the proposed rules, in paragraph (ii) of proposed rule 1.3(xxx)(4) under the CEA and paragraph (b) of proposed rule 3a69-1 under the Exchange Act, would require that, in order to be excluded from the swap and security-based swap definitions as an insurance product, the agreement, contract, or transaction must be provided: • By a company that is organized as an insurance company whose primary and predominant business activity is the writing of insurance or the reinsuring of risks underwritten by insurance companies and that is subject to supervision by the insurance commissioner (or similar official or agency) of any state 29 or by the United States or an agency or instrumentality thereof, and such agreement, contract, or transaction is regulated as insurance under the laws of such state or the United States; 29 The term “State” is defined in section 3(a)(16) of the Exchange Act to mean “any State of the United States, the District of Columbia, Puerto Rico, the Virgin Islands, or any other possession of the United States.” 15 U.S.C. 78c(a)(16). The CFTC is proposing to incorporate this definition into proposed rule 1.3(xxx)(4) for purposes of ensuring consistency between the CFTC and SEC rules further defining the term “swap.” • By the United States or any of its agencies or instrumentalities, or pursuant to a statutorily authorized program thereof; or • In the case of reinsurance only, by a person located outside the United States to an insurance company that is eligible under the proposed rules, provided that: (i) such person is not prohibited by any law of any state or of the United States from offering such agreement, contract, or transaction to such an insurance company; (ii) the product to be reinsured meets the requirements under the proposed rules to be an insurance product; and (iii) the total amount reimbursable by all reinsurers for such insurance product cannot exceed the claims or losses paid by the cedant. 30 30 The “cedant” is the insurer writing the risk being ceded or transferred to such person located outside the United States. In order for an agreement, contract, or transaction to qualify as an insurance product that would not be a swap or security-based swap: (i) The agreement, contract, or transaction would have to meet the criteria in the first subpart of the proposed rules and (ii) the person or entity providing the agreement, contract, or transaction would have to meet the criteria in the second subpart of the proposed rules. 31 The fact that an agreement, contract, or transaction qualifies as an insurance product does not exclude it from the swap or security-based swap definitions if it is not provided by a qualifying person or entity, nor does the fact that a product is regulated by an insurance regulator exclude it from the swap or security-based swap definitions if the agreement, contract, or transaction does not satisfy the criteria for insurance set forth in the proposed rules. 32 31 The Commissions note that certain variable life insurance and annuity products are securities and would not be swaps or security-based swaps regardless of whether they met the requirements under the proposed rules. See CEA section 1a(47)(B)(v), 7 U.S.C. 1a(47)(B)(v) (excluding from the definition of “swap” any “agreement, contract, or transaction providing for the purchase or sale of 1 or more securities on a fixed basis that is subject to—(I) the [Securities Act]; and (II) the [Exchange Act]”). See also SEC v. United Benefit Life Ins. Co., 387 U.S. 202 (1967) (holding that a “flexible fund” annuity contract was not entitled to exemption under section 3(a)(8) of the Securities Act, 15 U.S.C. 77c(a)(8), for insurance and annuities); SEC v. Variable Annuity Life Ins. Co., 359 U.S. 65 (1959) (holding that a variable annuity was not entitled to exemption under section 3(a)(8) of the Securities Act, 15 U.S.C. 77c(a)(8), for insurance and annuities). 32 The Commissions note that Title VII provides flexibility to address the facts and circumstances of new products that may be marketed or sold as insurance, for the purpose of determining whether they satisfy the requirements of the proposed rules, through joint interpretations pursuant to section 712(d)(4) of the Dodd-Frank Act. In addition, the Commissions are proposing interpretive guidance to clarify that, independent of paragraph (i) of proposed rule 1.3(xxx)(4) under the CEA and paragraph (a) of proposed rule 3a69-1 under the Exchange Act, certain insurance products do not fall within the swap or security-based swap definitions so long as they are provided in accordance with paragraph (ii) of proposed rule 1.3(xxx)(4) under the CEA and paragraph (b) of proposed rule 3a69-1 under the Exchange Act. (a) Types of Insurance Products 33 33 See supra note 23, regarding comments received addressing this criterion. Paragraph (i) of proposed rule 1.3(xxx)(4) under the CEA and paragraph (a) of proposed rule 3a69-1 under the Exchange Act would set forth four criteria for an agreement, contract, or transaction to be considered insurance. First, the proposed rules would require that the beneficiary have an “insurable interest” underlying the agreement, contract, or transaction at every point in time during the term of the agreement, contract, or transaction for that agreement, contract, or transaction to qualify as insurance. The requirement that the beneficiary be at risk of loss (which could be an adverse financial, economic, or commercial consequence) with respect to the interest that is the subject of the agreement, contract, or transaction at all times throughout the term of the agreement, contract, or transaction would ensure that an insurance contract beneficiary has a stake in the interest on which the agreement, contract, or transaction is written. 34 Similarly, the provision of the proposed rules that would require the beneficiary to have the insurable interest continuously during the term of the agreement, contract, or transaction is designed to ensure that payment on the insurance product is inextricably connected to both the beneficiary and the interest on which the insurance product is written. In contrast to an insurance product, a CDS (which may be a swap or a security-based swap) does not require the purchaser of protection to hold any underlying obligation issued by the reference entity on which the CDS is written. 35 34 Requiring that a beneficiary of an insurance policy have a stake in the interest traditionally has been justified on public policy grounds. For example, a beneficiary that does not have a property right in a building might have an incentive to profit from arson. 35 Standard CDS documentation stipulates that the incurrence or demonstration of a loss may not be made a condition to the payment on the CDS or the performance of any obligation pursuant to the CDS. See, e.g., Int'l Swaps and Derivatives Ass'n, “2003 ISDA Credit Derivatives Definitions,” art. 9.1(b)(i) (2003) (“2003 Definitions) (“[T]he parties will be obligated to perform * * * irrespective of the existence or amount of the parties' credit exposure to a Reference Entity, and Buyer need not suffer any loss nor provide evidence of any loss as a result of the occurrence of a Credit Event.”). Second, the requirement that an actual loss occur and be proved under the proposed rules similarly would ensure that the beneficiary has a stake in the insurable interest that is the subject of the agreement, contract, or transaction. If the beneficiary can demonstrate actual loss, that loss would “trigger” performance by the insurer on the agreement, contract, or transaction such that, by making payment, the insurer is indemnifying the beneficiary for such loss. In addition, limiting any payment or indemnification to the value of the insurable interest aids in distinguishing swaps and security-based swaps (where there is no such limit) from insurance. 36 36 To the extent an insurance product provides for such items as, for example, a rental car for use while the car that is the subject of an automobile insurance policy is being repaired, the Commissions would consider such items as constituting part of the value of the insurable interest. Third, the proposed rules would require that the insurance product not be traded, separately from the insured interest, on an organized market or over-the-counter. With limited exceptions, 37 insurance products traditionally have been neither entered into on or subject to the rules of an organized exchange nor traded in secondary market transactions ( i.e., they are not traded on an organized market or over-the-counter). Whereas swaps and security-based swaps also generally have not been tradable at-will in secondary market transactions ( i.e., on an organized market or over-the-counter) without counterparty consent, the Commissions understand that swaps and security-based swaps are routinely novated or assigned to third parties, usually pursuant to industry standard terms and documents. 38 For the foregoing reasons, the Commissions believe that lack of trading separately from the insured interest is a feature of insurance that is useful in distinguishing insurance from swaps and security-based swaps. 37 See, e.g., “Life Settlements Task Force, Staff Report to the United States Securities and Exchange Commission” (“In an effort to help make the bidding process more efficient and to facilitate trading of policies after the initial settlement occurs, some intermediaries have considered or instituted a trading platform for life settlements.”), available at http://www.sec.gov/news/studies/2010/lifesettlements-report.pdf (July 22, 2010). 38 See, e.g., Int'l Swaps and Derivatives Ass'n, “2005 Novation Protocol,” available at http://www.isda.org/2005novationprot/docs/NovationProtocol.pdf (2005); Int'l Swaps and Derivatives Ass'n, “ISDA Novation Protocol II,” available at http://www.isda.org/isdanovationprotII/docs/NPII.pdf (2005); Int'l Swaps and Derivatives Ass'n, 2003 Definitions, supra note 35, Exhibits E (Novation Agreement) and F (Novation Confirmation). Fourth, the proposed rules would address financial guarantee policies, also known as bond insurance or bond wraps. 39 Although such products can be economically similar to products such as CDS, they have certain key characteristics that distinguish them from swaps and security-based swaps. 40 For example, under a financial guarantee policy, the insurer typically is required to make timely payment of any shortfalls in the payment of scheduled interest to the holders of the underlying guaranteed obligation. Also, for particular bonds that are covered by a financial guarantee policy, the indenture, related documentation, and/or the financial guarantee policy will provide that a default in payment of principal or interest on the underlying bond will not result in acceleration of the obligation of the insurer to make payment of the full amount of principal on the underlying guaranteed obligation unless the insurer, in its sole discretion, opts to make payment of principal prior to the final scheduled maturity date of the underlying guaranteed obligation. Conversely, under a CDS, a protection seller frequently is required to make payment of the relevant settlement amount to the protection buyer upon demand by the protection buyer after any credit event involving the issuer. 41 39 Several commenters expressed concern that the swap and security-based swap definitions could encompass financial guarantee policies. See, e.g., AFGI Letter; Letter from James M. Michener, General Counsel, Assured Guaranty, Dec. 14, 2010 (“Assured Guaranty Letter”); MBIA Letter; Letter from the Committee on Futures and Derivatives Regulation of the New York City Bar Association, Sept. 20, 2010. Financial guarantee policies are used by entities such as municipalities to provide greater assurances to potential purchasers of their bonds and thus reduce their interest costs. See “Report by the United States Securities and Exchange Commission on the Financial Guarantee Market: The Use of the Exemption in section 3(a)(2) of the Securities Act of 1933 for Securities Guaranteed by Banks and the Use of Insurance Policies to Guarantee Debt Securities” (Aug. 28, 1987). 40 See, e.g., AFGI Letter (explaining the differences between financial guaranty policies and CDS); Letter from James M. Michener, General Counsel, Assured Guaranty, Sept. 13, 2010 (noting that the Financial Accounting Standards Board has issued separate guidance on accounting for financial guaranty insurance and CDS); Deutsche Bank Letter (noting that financial guaranty policies require the incurrence of loss for payment, whereas CDS do not). 41 While a CDS requires payment in full on the occurrence of a credit event, the Commissions recognize that there are other financial instruments, such as corporate guarantees of commercial loans and letters of credit supporting payments on loans or debt securities, that allow for acceleration of payment obligations without such guarantees or letters of credit being swaps or security-based swaps. The Commissions do not believe that financial guarantee policies, in general, should be regulated as swaps or security-based swaps. However, because of the close economic similarity of financial guarantee insurance policies guaranteeing payment on debt securities to CDS, the Commissions also are proposing that, in addition to the criteria noted above with respect to insurance generally, financial guarantee policies also would have to satisfy the requirement that they not permit the beneficiary of the policy to accelerate the payment of any principal due on the debt securities. This requirement would further distinguish financial guarantee policies from CDS because, as discussed above, the latter generally requires payment of the relevant settlement amount on the CDS after demand by the protection buyer. The Commissions believe that requiring all of the criteria in paragraph (i) of proposed rule 1.3(xxx)(4) under the CEA and paragraph (a) of proposed rule 3a69-1 under the Exchange Act would help limit the application of the proposed rules to products appropriately regulated as insurance and provide that products appropriately subject to the regulatory regime under Title VII of the Dodd-Frank Act are regulated as swaps or security-based swaps. As a result, the Commissions believe that these requirements would help prevent the proposed rules from being used to circumvent the applicability of the swap and security-based swap regulatory regimes under Title VII. However, the Commissions are considering an additional criterion as well. One ANPR commenter suggested that the proposed rules require that, in order to qualify as insurance that is excluded from the swap definition, payment on an agreement, contract, or transaction not be based on the price, rate, or level of a financial instrument, asset, or interest or any commodity. 42 Such a requirement could help to prevent swaps from being executed in the guise of insurance in order to avoid the regulatory regime established by Title VII. It may ensure that an agreement, contract, or transaction is not treated as insurance if it is used for speculative purposes or to influence prices in derivatives markets. Yet, another ANPR commenter stated that such a requirement for an agreement, contract, or transaction to qualify as insurance rather than a swap “is not consistent with common variable life insurance and variable annuity products, which deliver insurance guarantees that do vary with the performance of specified assets.” 43 42 See Cleary Letter. 43 See ACLI Letter. The Commissions request comment on whether, in order for an agreement, contract, or transaction to be considered insurance pursuant to paragraph (i) of proposed rule 1.3(xxx)(4) under the CEA and paragraph (a) of proposed rule 3a69-1 under the Exchange Act, the Commissions should require that payment not be based on the price, rate, or level of a financial instrument, asset, or interest or any commodity. If so, the Commissions also request comment on whether variable annuity contracts (where the income is subject to tax treatment under section 72 of the Internal Revenue Code) and variable universal life insurance should be excepted from such a requirement. 44 44 26 U.S.C. 72. See also supra note 31. Although the proposed criteria should appropriately identify agreements, contracts, and transactions that should be considered to be insurance, the Commissions also are proposing interpretive guidance that certain enumerated types of insurance products are outside the scope of the statutory definitions of swap and security-based swap under the Dodd-Frank Act. These products are surety bonds, life insurance, health insurance, long-term care insurance, title insurance, property and casualty insurance, and annuity products the income on which is subject to tax treatment under section 72 of the Internal Revenue Code. 45 The Commissions believe that these enumerated insurance products do not bear the characteristics of the transactions that Congress subjected to the regulatory regime for swaps and security-based swaps under the Dodd-Frank Act. 46 As a result, excluding these enumerated insurance products should appropriately place traditional insurance products outside the scope of the swap and security-based swap definitions. Such insurance products, however, would need to be provided in accordance with paragraph (ii) of proposed rule 1.3(xxx)(4) under the CEA and paragraph (b) of proposed rule 3a69-1 under the Exchange Act, as discussed below, and such insurance products would need to be regulated as insurance. 45 Id. 46 The list of enumerated insurance products is generally consistent with the provisions of section 302(c)(2) of the Gramm-Leach-Bliley Act (“GLBA”), 15 U.S.C. 6712(c)(2), which addresses insurance underwriting in national banks. (b) Providers of Insurance Products The second subpart of the proposed rules, in paragraph (ii) of proposed rule 1.3(xxx)(4) under the CEA and paragraph (b) of proposed rule 3a69-1 under the Exchange Act, would require that, in addition to meeting the product requirements discussed above (or being subject to the interpretive guidance regarding enumerated insurance products provided above) the agreement, contract, or transaction be provided by a person or entity that meets certain criteria. Generally, the product would have to be provided by a company that is organized as an insurance company whose primary and predominant business activity is the writing of insurance or the reinsuring of risks underwritten by companies whose insurance business is subject to supervision by the insurance commissioner (or similar official or agency) of any state 47 or by the United States or an agency or instrumentality thereof, and such agreement, contract, or transaction is regulated as insurance under the laws of such state or of the United States. 48 47 See supra note 29, regarding the definition of “State” contained in the proposed rules. 48 This paragraph of the proposed rules is substantially similar to the definition of an insurance company under the Federal securities laws. See section 2(a)(13) of the Securities Act, 15 U.S.C. 77b(a)(13); section 2(a)(17) of the Investment Company Act of 1940, 15 U.S.C. 80a-2(a)(17). These definitions also include reinsurance companies. In order to ensure regulatory consistency, the Commissions believe that it is appropriate to include substantially the same definition of an insurance company as currently exists elsewhere in the Federal securities laws, but the Commissions are requesting comment regarding the role played by a receiver or similar official or any liquidating agent for such insurance company, in its capacity as such, rather than proposing this provision of the insurance company definition. The requirement that the agreement, contract, or transaction be provided by a state or Federally regulated insurance company would help ensure that entities that are not regulated under insurance laws are not able to avoid regulation under Title VII of the Dodd-Frank Act as well. The Commissions believe that this requirement also should help prevent regulatory gaps that otherwise might exist between insurance regulation and the regulation of swaps and security-based swaps. The proposed rules also would require that the agreement, contract, or transaction provided by the insurance company be regulated as insurance under the laws of the state in which it is regulated or the United States. The purpose of this proposed requirement is that an agreement, contract, or transaction that satisfies the other conditions of the proposed rules must be subject to regulatory oversight as an insurance product. As a result of the requirement that an insurance regulator must have determined that the agreement, contract, or transaction being sold is insurance ( i.e., because state insurance regulators are banned from regulating swaps as insurance), 49 the Commissions believe that this condition would help prevent products that are swaps or security-based swaps from being characterized as insurance products in order to evade the regulatory regime under Title VII of the Dodd-Frank Act. 49 See section 722(b) of the Dodd-Frank Act. The Commissions also believe that it is appropriate to exclude insurance that is issued by the United States or any of its agencies or instrumentalities, or pursuant to a statutorily authorized program thereof, from regulation as swaps or security-based swaps. Such insurance would include, for example, Federal insurance of savings in banks, savings associations, and credit unions; catastrophic crop insurance; flood insurance; Federal insurance of certain pension obligations; and terrorism risk insurance. Accordingly, the proposed rules would provide that products meeting the criteria discussed above that are required for an agreement, contract, or transaction to qualify as insurance are excluded from the swap and security-based swap definitions if they are provided by the Federal government or pursuant to a statutorily authorized program thereof. Finally, the Commissions believe that where an agreement, contract, or transaction qualifies as insurance excluded from the swap and security-based swap definitions, the lawful reinsurance of that agreement, contract, or transaction similarly should be excluded. Such reinsurance would be excluded from the definitions even if the reinsurer is located abroad and is not state or Federally regulated. Accordingly, the proposed rules would provide that an agreement, contract, or transaction of reinsurance would be excluded from the swap and security-based swap definitions if it is provided by a person located outside the United States, if such person is not prohibited by any law of any state or the United States from offering such reinsurance to a state or Federally regulated insurance company, so long as the product to be reinsured meets the requirements under the proposed rules to be an insurance product, and the total amount reimbursable by all reinsurers for such insurance product cannot exceed the claims or losses paid by the cedant. The proposed rules would cover only an agreement, contract, or transaction by an insurance company and would not affect the characterization of the asset that is being insured. For example, if an agreement, contract, or transaction insures or guarantees the payment on a security, the security would remain subject to all applicable securities laws. The guarantee agreement, contract, or transaction, however, would not be regulated as a swap or security-based swap if it meets all of the requirements of the proposed rules. 50 50 The guarantee agreement, contract, or transaction, however, could itself be a security that is subject to the Federal securities laws.” See, e.g., section 2(a)(1) of the Securities Act, 15 U.S.C. 77b(a)(1) (including in the statutory definition of “security” a guarantee of a security). One commenter has stated that monoline insurance companies (also called financial guarantors) continue to guarantee payments under interest rate swaps related to municipal debt. 51 The CFTC believes that an insurance “wrap” of a swap may not be sufficiently different from the underlying swap to suggest that Congress intended the former to fall outside the definition of the term “swap” in Title VII. 51 See Letter from Bruce E. Stern, Chairman, Association of Financial Guaranty Insurers Government Affairs Committee, Feb. 18, 2011, at 11-12 (“[F]inancial guarantors have often guaranteed, through the issuance of a financial guaranty insurance policy, the obligations of unaffiliated parties under swaps with other unaffiliated parties. These insurance policies typically cover obligations of municipalities under interest rate or basis swaps relating to bonds issued by municipalities or in connection with asset backed securities.”). The SEC, however, believes that, where an agreement, contract, or transaction is a security-based swap, the insurance of that security-based swap should not be regulated pursuant to Title VII, provided that the insurance meets the proposed requirements discussed above. 52 52 See supra note 32. The Commissions request comment on this issue generally, and also on the particular questions set forth in the Request for Comment section below. The Commissions also are considering whether the issuer of such insurance (or guarantee) in respect of swaps or security-based swaps entered into by an affiliate or third party could be considered to be a major swap participant or major security-based swap participant. The Commissions have requested comment in the proposing release for the definitions of the terms “major swap participant” and “major security-based swap participant”. 53 53 See proposed Entity Definitions, supra note 12. Request for Comment 1. The Commissions request comment on all aspects of proposed rule 1.3(xxx)(4) under the CEA and proposed rule 3a69-1 under the Exchange Act and the interpretive guidance in this section. 2. Do the proposed criteria for identifying an agreement, contract, or transaction that would not fall within the swap or security-based swap definitions appropriately encompass insurance and reinsurance products? If not, what types of insurance or reinsurance products are not encompassed, and why? 3. Are there certain products that are commonly known as swaps or security-based swaps, or that more appropriately should be considered swaps or security-based swaps, that could satisfy the criteria in proposed rule 1.3(xxx)(4) under the CEA and proposed rule 3a69-1 under the Exchange Act? 4. Is the proposed requirement that the beneficiary of an agreement, contract, or transaction have an insurable interest that is the subject of the agreement, contract, or transaction, and thereby carry the risk of loss with respect to that interest continuously throughout the duration of the agreement, contract, or transaction in order for the agreement, contract, or transaction not to fall within the swap or security-based swap definition, an effective criterion in determining whether a product is insurance? Why or why not? 5. Is the proposed requirement that loss occur and be proved, and that any payment or indemnification therefor be limited to the value of the insurable interest, in order for an agreement, contract, or transaction not to fall within the swap or security-based swap definition, an effective criterion in determining whether a product is insurance? Why or why not? Is the requirement that any payment or indemnification for proved loss be limited to the value of the insurable interest consistent with conventional insurance analysis across a broad range of products (including traditional property and casualty products)? Are there particular products where such a limitation would not be appropriate? If so, please provide a detailed description of such products and why such a limitation would not be appropriate. 6. Is the proposed requirement that the agreement, contract, or transaction is not traded, separately from the insured interest, on an organized market or over-the-counter, an effective criterion in determining whether a product is insurance? Why or why not? 7. Should the Commissions add, as a requirement for an insurance agreement, contract, or transaction to not be characterized as a swap, that the agreement, contract, or transaction not be based on the price, rate, or level of a financial instrument, asset, or interest or any commodity? Would such a requirement be an effective criterion in distinguishing insurance from swaps and security-based swaps? Why or why not? If so, should the Commissions add any carve outs from the requirement, such as, for example, variable universal life insurance, or annuity contracts where the income is subject to tax treatment under section 72 of the Internal Revenue Code? Why or why not? Would such a requirement help preclude the use of the proposed rules for products that are swaps or security-based swaps? Why or why not? Would such a requirement preclude the use of the proposed rules for products that currently are insurance? If so, what insurance products would be precluded by such a requirement, and how? How are insurance payments determined today? 8. Is the proposed requirement that, with respect to financial guaranty insurance, in the event of payment default or insolvency of the obligor, any acceleration of payments under the policy be at the sole discretion of the insurer an effective criterion in determining whether a financial guaranty policy is insurance that does not fall within the swap or security-based swap definition? Why or why not? 9. Does the interpretive guidance proposed in this section appropriately identify certain enumerated insurance products as traditional insurance products that would not fall within the swap or security-based swap definition if the provider of the product satisfies the requirements of the proposed rules? Why or why not? Is the interpretive guidance proposed in this section sufficient? Why or why not? Are there additional types of traditional insurance that should be similarly enumerated? If so, which ones and why? Could the exclusion of any of the enumerated insurance products serve to exclude products that should be regulated as swaps or security-based swaps? If so, which ones and why? Should the enumerated insurance products be required to be provided in accordance with paragraph (ii) of proposed rule 1.3(xxx)(4) under the CEA and paragraph (b) of proposed rule 3a69-1 under the Exchange Act? Why or why not? If not, please provide a detailed explanation of the insurance products that should not be subject to these requirements. Are there insurance products currently offered that do not meet these criteria? If so, please provide details regarding such products and their providers. 10. The Commissions are proposing guidance that certain enumerated types of insurance products, including property and casualty insurance, are outside the scope of the statutory definitions of the terms “swap” and “security-based swap” under the Dodd-Frank Act. The Commissions request comment generally as to the proposed guidance regarding property and casualty insurance. The CFTC also requests comment on whether the products specified in section 302(c)(2) of the GLBA, which names certain insurance products, including private passenger or commercial automobile, homeowners, mortgage, commercial multiperil, general liability, professional liability, workers' compensation, fire and allied lines, farm owners multiperil, aircraft, fidelity, surety, medical malpractice, ocean marine, inland marine, and boiler and machinery insurance, should be considered traditional property and casualty insurance. Why or why not? If so, please provide an explanation of the product and how it differs from transactions that should be subject to the swap regulatory regime of the Dodd-Frank Act. The SEC also requests comment on whether the products specified in section 302(c)(2) of the GLBA should be enumerated in the Commissions' proposed guidance regarding property and casualty insurance as outside of the scope of the swap and security-based swap definitions? Are there other categories of traditional property and casualty insurance that should be specifically enumerated? If so, please provide a detailed description of such other categories of property and casualty insurance that should be specifically identified, and why. If there are certain types of property and casualty insurance that fall within the swap definition, will that affect the ability of persons, including consumers and businesses, to protect their properties against losses? If so, please provide a detailed explanation. 11. Are there situations in which an insurance product may be assigned to another party that are not addressed by the criteria in proposed rule 1.3(xxx)(4) under the CEA and proposed rule 3a69-1 under the Exchange Act? Is additional clarification necessary to address such situations? If so, what clarification? 12. Is the proposed requirement that the agreement, contract, or transaction be provided by a company that is organized as an insurance company whose primary and predominant business activity is the writing of insurance or the reinsuring of risks underwritten by insurance companies and that is subject to supervision by the insurance commissioner (or similar official or agency) of any state, as defined in section 3(a)(16) of the Exchange Act, or by the United States or an agency or instrumentality thereof, and that the agreement, contract, or transaction be regulated as insurance under the laws of such state or of the United States, an effective criterion in determining whether an agreement, contract, or transaction falls within the swap or security-based swap definition? Does it sufficiently preclude the use of the proposed rules by unregulated entities? Why or why not? Does it sufficiently prevent evasion of the requirements of Title VII with respect to agreements, contracts, or transactions that are swaps or security-based swaps? Why or why not? 13. Are there circumstances under which a receiver or similar official or any liquidating agency for a state or Federally regulated insurance company, acting in its capacity as such, would be providing insurance rather than administering an insurance product that is provided by an insurance company? Please provide a detailed explanation of any such circumstances. If there are such circumstances, should the proposed rules include a provision that an agreement, contract, or transaction that satisfies the criteria of insurance but that is provided by a receiver or similar official or any liquidating agency for a state or Federally regulated insurance company, in its capacity as such, qualify as insurance that is excluded from the swap and security-based swap definition? Why or why not? 14. Do the proposed rules appropriately treat an agreement, contract, or transaction that satisfies the criteria of insurance but that is provided by the United States or any of its agencies or instrumentalities, or pursuant to a statutorily authorized program thereof, as insurance that is excluded from the swap and security-based swap definition? Why or why not? Are there other types of government-issued insurance products that are not covered by paragraph (ii) of proposed rule 1.3(xxx)(4) under the CEA and paragraph (b) of proposed rule 3a69-1 under the Exchange Act? Do states or state agencies or instrumentalities provide insurance products? Should the proposed requirement also include a provision that the agreement, contract, or transaction can be provided by any state or any of its agencies or instrumentalities, or pursuant to a statutorily authorized program thereof? Why or why not? 15. Do the proposed rules appropriately treat reinsurance by a person located outside the United States of a product meeting the requirements for insurance under the proposed rules, so long as the total amount reimbursable by all of the reinsurers for such insurance product cannot exceed the claims or losses paid by the cedant, as insurance excluded from the swap and security-based swap definitions if such person is not prohibited by any law of any state or of the United States from offering such reinsurance to a state or Federally regulated insurance company? Do these provisions of the proposed rules sufficiently prevent evasion of the requirements of Title VII with respect to agreements, contracts, or transactions that are swaps or security-based swaps? Why or why not? 16. Are there additional criteria for identifying contracts, agreements, or transactions that are insurance and not swaps or security-based swaps that the Commissions should consider? Please provide detailed information and empirical data, to the extent possible, supporting any suggested criteria. 17. Should the proposed rules relating to insurance include a provision related to whether a product is recognized at fair value on an ongoing basis with changes in fair value reflected in earnings under U.S. generally accepted accounting principles? If so, what specific challenges may be encountered in light of the proposed Accounting Standards Update “Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities,” issued by the Financial Accounting Standards Board (“FASB”) on May 26, 2010? Is recognizing a product at fair value on an ongoing basis (with changes in fair value reflected in earnings) inconsistent with treating such a product as insurance rather than a swap or security-based swap? Why or why not? Please provide examples of specific products and their correct accounting treatment under U.S. generally accepted accounting principles. 18. Where an agreement, contract, or transaction falls within the swap definition, should insurance of that agreement, contract, or transaction also be included in the swap definition? Why or why not? Is the insurance wrap of a swap sufficiently different (economically or otherwise) from the swap that is insured? Why or why not? Would the regulation of such swap “wraps” as swaps impose costs on or otherwise impact the underlying cash markets ( e.g., the ability to issue, and cost of issuing, municipal debt)? Please quantify to the extent possible. Would treating such “wraps” as insurance falling outside the swap definition frustrate or undermine Title VII's objectives in regulating the swap markets in any way? Why or why not? Please provide empirical data and analysis to the extent possible. 19. Where an agreement, contract, or transaction falls within the security-based swap definition, should the insurance of that agreement, contract, or transaction also be included in the security-based swap definition? Why or why not? Would the regulation of insurance on a security-based swap as a security-based swap under Title VII impose costs or otherwise impact the underlying cash markets ( e.g., the ability to issue, and cost of issuing, municipal debt)? Please quantify to the extent possible. Would regulating such products as insurance rather than as security-based swaps frustrate or undermine Title VII's objectives in regulating the security-based swap and swap markets? Why or why not? Please provide a detailed explanation and empirical data to the extent possible. 20. Should the proposed rules include a provision similar to section 302(c)(1) of the GLBA 54 that would provide that any product regulated as insurance before July 21, 2010 (the date the Dodd-Frank Act was signed into law) and provided in accordance with paragraph (ii) of proposed rule 1.3(xxx)(4) under the CEA and paragraph (b) of proposed rule 3a69-1 would be considered insurance and not fall within the swap definition? Why or why not? Should different criteria apply to products regulated as insurance before July 21, 2010? Why or why not? If so, please provide a detailed description of what different criteria should apply. 54 15 U.S.C. 6712(c)(1). 21. The Commissions understand that swap guarantees may be offered by non-insurance companies. Should the Commissions provide guidance as to whether swap or security-based swap guarantees (that are not guarantees or insurance policies offered by insurance companies discussed above) should be considered swaps or security-based swaps? Why or why not? 2. The Forward Contract Exclusion The definitions of the terms “swap” and “security-based swap” do not include forward contracts. They exclude “any sale of a nonfinancial commodity or security for deferred shipment or delivery, so long as the transaction is intended to be physically settled”. 55 Commenters have requested guidance from the Commissions regarding the scope of this exclusion. The Commissions believe it is appropriate to provide guidance to market participants regarding the applicability of the exclusion from the definitions of swap and security-based swap for forward contracts with respect to nonfinancial commodities 56 and securities. 55 CEA section 1a(47)(B)(ii), 7 U.S.C. 1a(47)(B)(ii). 56 The discussion in subsections (a) and (b) of this section applies solely to the exclusion of nonfinancial commodity forwards from the swap definition in the Dodd-Frank Act. (a) Forward Contracts in Nonfinancial Commodities The wording of the forward contract exclusion from the swap definition with respect to nonfinancial commodities is similar, but not identical, to the forward contract exclusion from the definition of “future delivery” in the CEA, which excludes “any sale of any cash commodity for deferred shipment or delivery”. 57 Several ANPR commenters expressed the view that, with respect to nonfinancial commodities, the forward contract exclusion from the swap definition should be interpreted in the same manner as the CFTC has interpreted the forward contract exclusion from the term “future delivery” and, in particular, that the CFTC's “Brent Interpretation” 58 should apply to “book out” transactions for purposes of the forward exclusion from the swap definition. 59 The CFTC believes that clarification of the scope of the forward contract exclusion from the swap definition with respect to nonfinancial commodities is appropriate. 60 57 CEA section 1a(27), 7 U.S.C. 1a(27). The CEA does not define the term “futures contract.” Rather, the CEA refers to a futures contract as a “contract of sale of a commodity for future delivery.” See, e.g., CEA section 2(a)(1)(A), 7 U.S.C. 2(a)(1)(A) (providing the CFTC with exclusive jurisdiction over “contracts of sale of a commodity for future delivery” (other than security futures) traded or executed on, among other things, a designated contract market (“DCM”)); CEA section 4(a), 7 U.S.C. 6(a) (a “contract for the purchase or sale of a commodity for future delivery” other than a contract made on an exchange located outside the United States must be conducted on or subject to the rules of, among other things, a DCM). Accordingly, by excluding forward contracts from the CEA's definition of the term “future delivery,” the CEA provides that a forward contract is not a contract of sale of a commodity for future delivery and, hence, not a futures contract. 58 Statutory Interpretation Concerning Forward Transactions, 55 FR 39188, Sept. 25, 1990 (“Brent Interpretation”). 59 See Letter from Joanne T. Medero, Managing Director, BlackRock, Sept. 20, 2010 (“BlackRock Letter”), Letter from Matt Schatzman, Senior Vice President, Energy Marketing, BG Americas and Global LNC, Sept. 20, 2010 (“BG Letter”); Cleary Letter; Letter from Edward W. Gallagher, President, Dairy Risk Management Services, a division of Dairy Farmers of America, Inc., Sept. 20, 2010 (“DFA Letter”); Letter from Eric Dennison, Sr. Vice President and General Counsel, Stephanie Miller, Assistant General Counsel—Commodities, and Bill Hellinghausen, Director of Regulatory Affairs, EDF Trading North America, LLC, Sept. 20, 2010 (“EDF Letter”); Richard F. McMahon, Jr., Executive Director, Edison Electric Institute, Sept. 20, 2010 (“EEI Letter”); Letter from John M. Damgard, President, Futures Industry Association, Sept. 20, 2010 (“FIA Letter”); Letter from Richard Ostrander, Managing Director and Counsel, Morgan Stanley, Sept. 20, 2010 (“Morgan Stanley Letter”); Letter of Michael Greenberger, JD, Law School Professor, University of Maryland School of Law, Sept. 20, 2010 (“University of Maryland Letter”); R. Michael Sweeney, Jr., Mark W. Menezes, and David T. McIndoe, Hunton & Williams, LLP, on behalf of the Working Group of Commercial Energy Firms, Sept, 20, 2010 (“WGCEF Letter”); Letter from Paul H. Stebbins, Chairman and Chief Executive Officer, World Fuel Services Corporation, Sept. 17, 2010 (“World Fuel Letter”). 60 As discussed in part II.D.1 below, the terminology and documentation used by the parties are not dispositive of whether a particular agreement, contract, or transaction is a swap or security-based swap under the CEA or Exchange Act. Thus, if an agreement, contract, or transaction with respect to a nonfinancial commodity qualifies for the forward exclusion from the swap definition, it would not be a swap even if the parties refer to it as a swap or document it using an industry standard form agreement that is typically used for swaps. Conversely, such an agreement, contract, or transaction that does not qualify for the forward exclusion from the swap definition would not be excluded even if the parties refer to it as a forward contract. Forward contracts with respect to nonfinancial commodities are commercial merchandising transactions. The primary purpose of the contract is to transfer ownership of the commodity and not to transfer solely its price risk. The CFTC has noted: The underlying postulate of the [forward] exclusion is that the [CEA's] regulatory scheme for futures trading simply should not apply to private commercial merchandising transactions which create enforceable obligations to deliver but in which delivery is deferred for reasons of commercial convenience or necessity. 61 61 Brent Interpretation, supra note 58, at 39190. The CFTC has reiterated this view in more recent adjudicative orders. See, e.g., In re Grain Land Coop., [2003-2004 Transfer Binder] Comm. Fut. L. Rep. (CCH) ¶ 29,636 (CFTC Nov. 25, 2003); In re Competitive Strategies for Agric., Ltd., [2003-2004 Transfer Binder] Comm. Fut. L. Rep. (CCH) ¶ 29,635 (CFTC Nov. 25, 2003). Courts have expressed this view as well. See, e.g., Salomon Forex, Inc. v. Tauber, 8 F.3d 966, 971 (4th Cir. 1993) (“[C]ash forwards are generally individually negotiated sales * * * in which actual delivery of the commodity is anticipated, but is deferred for reasons of commercial convenience or necessity.”); CFTC v. Int'l Fin. Serv. (N.Y.), 323 F. Supp. 2d 482, 495 (S.D.N.Y. 2004). See also CFTC v. Co Petro Mktg. Grp., Inc., 680 F.2d 573, 579-580 (9th Cir. 1982); CFTC v. Noble Metals Int'l, Inc., 67 F.3d 766, 772-773 (9th Cir. 1995; CFTC v. Am. Metal Exch. Corp., 693 F. Supp. 168, 192 (D.N.J. 1988); CFTC v. Morgan, Harris & Scott, Ltd., 484 F. Supp. 669, 675 (S.D.N.Y. 1979) (forward contract exclusion does not apply to speculative transactions in which delivery obligations can be extinguished under the terms of the contract or avoided for reasons other than commercial convenience or necessity). The CFTC believes that the forward contract exclusion in the Dodd-Frank Act with respect to nonfinancial commodities should be read consistently with this established, historical understanding that a forward contract is a commercial merchandising transaction. Many commenters discussed the issue of whether the requirement in the Dodd-Frank Act that a transaction be “intended to be physically settled” in order to qualify for the forward exclusion from the swap definition with respect to nonfinancial commodities reflects a change in the standard for determining whether a transaction is a forward contract. 62 Because a forward contract is a commercial merchandising transaction, intent to deliver historically has been an element of the CFTC's analysis of whether a particular contract is a forward contract. 63 In assessing the parties' expectations or intent regarding delivery, the CFTC consistently has applied a “facts and circumstances” test. 64 Therefore, the CFTC reads the “intended to be physically settled” language in the swap definition with respect to nonfinancial commodities to reflect a directive that intent to deliver a physical commodity be a part of the analysis of whether a given contract is a forward contract or a swap, just as it is a part of the CFTC's analysis of whether a given contract is a forward contract or a futures contract. 62 See, e.g., BG Letter (forward exclusion for swaps should be consistent with the forward exclusion from futures); BlackRock Letter (the CFTC should interpret “intended to be physically settled” consistently with existing CFTC principles, including book outs); DFA Letter (forward exclusion for swaps should be interpreted consistently with the CFTC's prior forward contract interpretations and precedent, including forwards requiring delivery but including embedded options); EDF Letter (forward exclusion from the definition of swap should be construed in a consistent manner with the forward exclusion under the CEA); EEI Letter (forward exclusion from swap definition should be interpreted consistently with the forward exclusion from futures); FIA Letter (the Commissions should, through rulemaking or interpretation, provide that the “intent” standard in the forward exclusion with respect to swaps will be interpreted the same as the existing forward exclusion with respect to futures); Morgan Stanley Letter (the forward exclusion from the swap definition should be interpreted consistently with the forward exclusion from futures); University of Maryland Letter (forward exclusion from swap definition intended to be consistent with the forward exclusion from futures); WGCEF Letter (physical delivery forwards should be distinguished from swaps under standards identical to those used in forwards vs. futures); World Fuel Letter (forward exclusion for swaps should be interpreted in a manner consistent with the forward exclusion from futures). 63 As recently as October 25, 2010, the CFTC observed in In re Wright that “it is well-established that the intent to make or take delivery is the critical factor in determining whether a contract qualifies as a forward.” In re Wright, CFTC Docket No. 97-02, 2010 WL 4388247 at *3 (CFTC Oct. 25, 2010) ( citing In re Stovall, et al., [1977-1980 Transfer Binder] Comm. Fut. L. Rep. (CCH) 20,941 (CFTC Dec. 6, 1979); Brent Interpretation, supra note 58). In Wright, the CFTC noted that “[i]n distinguishing futures from forwards, the [CFTC] and the courts have assessed the transaction as a whole with a critical eye toward its underlying purpose. Such an assessment entails a review of the overall effect of the transaction as well as a determination as to what the parties intended.” Id. at *3 ( quoting Policy Statement Concerning Swap Transactions, 54 FR 30694, July 21, 1989 (“Swap Policy Statement”) (citations and internal quotations omitted). 64 In its recent decision in In re Wright, the CFTC applied its facts and circumstances test in an administrative enforcement action involving hedge-to-arrive contracts for corn, and observed that “[o]ur views of the appropriateness of a multi-factor analysis remain unchanged.” Wright, supra note 63, n.13. The CFTC let stand the administrative law judge's conclusion that the hedge-to-arrive contracts at issue in the case were forward contracts. Id. at **5-6. See also Grain Land, supra note 61; Competitive Strategies for Agric., supra note 61. Commenters also requested clarification of the treatment of one type of forward contract—“book-out” transactions—in the context of the forward exclusion from the swap definition with respect to nonfinancial commodities. The issue of book-outs first arose in 1990 in the Brent Interpretation 65 because the parties to the crude oil contracts in that case could individually negotiate cancellation agreements, or “book-outs,” with other parties. 66 In describing these transactions, the CFTC stated: 65 See Brent Interpretation, supra note 58. The CFTC issued the Brent Interpretation in response to a Federal court decision that held that certain 15-day Brent system crude oil contracts were illegal off-exchange futures contracts. See Transnor (Bermuda) Ltd. v. BP N. Am. Petroleum, 738 F. Supp. 1472 (S.D.N.Y. 1990). The Brent Interpretation provided clarification that the 15-day Brent system crude oil contracts were forward contracts that were excluded from the CEA definition of “future delivery,” and thus were not futures contracts. See Brent Interpretation, supra note 58. 66 The Brent Interpretation described these “book-outs” as follows: “In the course of entering into 15-day contracts for delivery of a cargo during a particular month, situations often arise in which two counterparties have multiple, offsetting positions with each other. These situations arise as a result of the effectuation of multiple, independent commercial transactions. In such circumstances, rather than requiring the effectuation of redundant deliveries and the assumption of the credit, delivery and related risks attendant thereto, the parties may, but are not obligated to and may elect not to, terminate their contracts and forego such deliveries and instead negotiate payment-of-differences pursuant to a separate, individually negotiated cancellation agreement referred to as a `book-out.' Similarly, situations regularly arise when participants find themselves selling and purchasing oil more than once in the delivery chain for a particular cargo. The participants comprising these `circles' or `loops' will frequently attempt to negotiate separate cancellation agreements among themselves for the same reasons and with the same effect described above.” Brent Interpretation, supra note 58, at 39190. It is noteworthy that while such [book-out] agreements may extinguish a party's delivery obligation, they are separate, individually negotiated, new agreements, there is no obligation or arrangement to enter into such agreements, they are not provided for by the terms of the contracts as initially entered into, and any party that is in a position in a distribution chain that provides for the opportunity to book-out with another party or parties in the chain is nevertheless entitled to require delivery of the commodity to be made through it, as required under the contracts. 67 67 Id. at 39192. Thus, in the scenario at issue in the Brent Interpretation, the contracts created a binding obligation to make or take delivery without providing any right to offset, cancel, or settle on a payment-of-differences basis. The “parties enter[ed] into such contracts with the recognition that they may be required to make or take delivery.” 68 68 Id. at 39189. On these facts, the Brent Interpretation concluded that the contracts were forward contracts, not futures contracts: Under these circumstances, the [CFTC] is of the view that transactions of this type which are entered into between commercial participants in connection with their business, which create specific delivery obligations that impose substantial economic risks of a commercial nature to these participants, but which may involve, in certain circumstances, string or chain deliveries of the type described * * * are within the scope of the [forward contract] exclusion from the [CFTC's] regulatory jurisdiction. 69 69 Id. at 39192. Although the CFTC did not expressly discuss intent to deliver, the Brent Interpretation concluded that transactions retained their character as commercial merchandising transactions, notwithstanding the practice of terminating commercial parties' delivery obligations through “book-outs” as described. At any point in the chain, one of the parties could refuse to enter into a new contract to book-out the transaction and, instead, insist upon delivery pursuant to the parties' obligations under their contract. The CFTC believes that the principles underlying the Brent Interpretation similarly should apply to the forward exclusion from the swap definition with respect to nonfinancial commodities. To summarize, then, the CFTC believes that: (i) The forward contract exclusion from the swap definition with respect to nonfinancial commodities should be interpreted in a manner that is consistent with the CFTC's historical interpretation of the forward contract exclusion from the definition of the term “future delivery”; (ii) intent to deliver is an essential element of a forward contract excluded from both the swap and future delivery definitions, and such intent in both instances should be evaluated based on the CFTC's established multi-factor approach; and (iii) book-out transactions in nonfinancial commodities that meet the requirements specified in the Brent Interpretation, and that are effectuated through a subsequent, separately-negotiated agreement, should qualify for the forward exclusion from the swap definition. 70 70 This interpretive guidance is consistent with legislative history. See 156 Cong. Rec. H5247 (June 30, 2010) (colloquy between U.S. House Committee on Agriculture Chairman Collin Peterson and Representative Leonard Boswell during the debate on the Conference Report for the Dodd-Frank Act, in which Chairman Peterson stated: “Excluding physical forward contracts, including book-outs, is consistent with the CFTC's longstanding view that physical forward contracts in which the parties later agree to book-out their delivery obligations for commercial convenience are excluded from its jurisdiction. Nothing in this legislation changes that result with respect to commercial forward contracts.”). See also 156 Cong. Rec. H5248-49 (June 30, 2010) (introducing into the record a letter authored by Senator Blanche Lincoln, Chairman of the U.S. Senate Committee on Agriculture, Nutrition and Forestry, and Christopher Dodd, Chairman U.S. Senate Committee on Banking, Housing, and Urban Affairs, stating that the CFTC is encouraged “to clarify through rulemaking that the exclusion from the definition of swap for `any sale of a nonfinancial commodity or security for deferred shipment or delivery, so long as the transaction is intended to be physically settled' is intended to be consistent with the forward contract exclusion that is currently in the [CEA] and the CFTC's established policy and orders on this subject, including situations where commercial parties agree to `book-out' their physical delivery obligations under a forward contract.”). As noted above, the Brent Interpretation applies to “commercial participants in connection with their business.” 71 Market participants that regularly make or take delivery of the referenced commodity (in the case of the Brent Interpretation, a tanker full of Brent oil) in the ordinary course of their business meet that standard. Such entities qualify for the forward exclusion from both the future delivery and swap definitions for their forward transactions under the Brent Interpretation even if they enter a subsequent transaction to “book out” the forward contract rather than make or take delivery. Intent to make or take delivery can be inferred from the binding delivery obligation for the referenced commodity in the contract and the fact that the parties to the contract do, in fact, regularly make or take delivery of the referenced commodity in the contract in the ordinary course of their business. 71 See Brent Interpretation, supra note 58, at 39192. Some commenters to the ANPR requested clarification with regard to the application of the CFTC's 1993 order exempting certain energy contracts from regulation under the CEA (the “Energy Exemption”) 72 after enactment of the Dodd-Frank Act. 73 The Energy Exemption extended the Brent Interpretation regarding the forward contract exclusion from the term “future delivery” to energy commodities other than oil. The CFTC believes that the book-out provisions of the Brent Interpretation similarly should apply to the forward contract exclusion from the swap definition for nonfinancial commodities besides oil. Further, the CFTC also is proposing interpretive guidance herein that the Brent Interpretation with respect to the application of the forward contract exclusion from the term “future delivery” in the context of book-out transactions applies not just to oil, but to all nonfinancial commodities. The CFTC, therefore, is proposing to withdraw the Energy Exemption, while retaining and extending through this interpretive guidance the Brent Interpretation regarding book-outs under the forward contract exclusion with respect to nonfinancial commodities. 74 72 Exemption for Certain Contracts Involving Energy Products, 58 FR 21286, Apr. 20, 1993. The Energy Exemption generally applies to certain energy contracts: (i) Entered into by persons reasonably believed to be within a specified class of commercial and governmental entities; (ii) that are bilateral contracts between two parties acting as principals; (iii) the material economic terms of which are subject to individual negotiation by the parties; and (iv) that impose binding obligations on the parties to make and receive delivery of the underlying commodity, with no right of either party to effect a cash settlement of their obligations without the consent of the other party (except pursuant to a bona fide termination right such as default). Like the Brent Interpretation, the Energy Exemption provides that the parties can enter into a subsequent book-out settlement of the obligation in a manner other than by physical delivery of the commodity specified in the contract. Id. at 21294. 73 See, e.g., WGCEF letter. The CFTC issued the Energy Exemption shortly after Congress had provided the CFTC with exemptive authority pursuant to CEA section 4(c), 7 U.S.C. 6(c), in section 502 of the Futures Trading Practices Act of 1992, Public Law 102-546, 106 Stat. 3590 (1993). 74 To avoid any uncertainty, the CFTC also notes that the Dodd-Frank Act supersedes the Swap Policy Statement. The CFTC is aware that some commenters have suggested that the Commissions should exercise their authority to further define the term “eligible contract participant” to encompass the “line of business” provision of the Swap Policy Statement. See Swap Policy Statement, supra note 63, at 30696-30697. The Commissions will address these comments in their joint final rulemaking with respect to the Entity Definitions. See supra note 12. (b) Commodity Options and Commodity Options Embedded in Forward Contracts Some commenters responding to the ANPR requested clarification regarding the status of commodity options under the swap definition. 75 Questions also were raised regarding options embedded in forward contracts, i.e., whether a forward contract with respect to a nonfinancial commodity that contains an embedded option can still qualify for the forward contract exclusion from the swap definition. 76 75 See, e.g., World Fuel Letter (exclusion for commercial options set forth in CFTC Regulation 32.4 should also be an exclusion from the swap definition). 76 See, e.g., Letter from Patrick Kelly, Policy Advisor, API, Sept. 20, 2010 (“API Letter”), EEI Letter; Letter from Daniel S.M. Dolan, VP, Policy Research & Communications, Electric Power Supply Association, Sept. 20, 2010 (“EPSA Letter”) (physically settled options should be included in the forward exclusion from the swap definition); DFA Letter; ISDA Letter. One commenter suggested that the CFTC should apply to each contract with an enforceable delivery obligation a rebuttable presumption of intent to deliver, even if an option to cash settle is included in that contract. See WGCEF Letter. The statutory swap definition explicitly provides that commodity options are swaps. 77 Accordingly, the CFTC recently proposed revisions to its existing options rules in parts 32 and 33 of its regulations with respect to the treatment of commodity options under the Dodd-Frank Act, and requested public comment on those proposed revisions. 78 The question of the application of the forward exclusion from the swap definition with respect to nonfinancial commodities, where commodity options are embedded in forward contracts (including embedded options to cash settle such contracts), is similar to that arising under the CEA's existing forward contract exclusion from the definition of the term “future delivery.” The CFTC's Office of General Counsel addressed forward contracts that contained embedded options in a 1985 interpretive statement (“1985 Interpretation”), 79 which the CFTC recently adhered to in its adjudicatory Order in the Wright case. 80 While both were issued prior to the effective date of the Dodd-Frank Act, the CFTC believes that it would be appropriate to apply this guidance to the treatment of forward contracts in nonfinancial commodities that contain embedded options under the Dodd-Frank Act. 77 7 U.S.C. 1a(47)(A)(i). Options on securities and certain options on foreign currency are excluded from the swap definition by CEA sections 1a(47)(B)(iii) and (iv), respectively. 7 U.S.C. 1a(47)(B)(iii) and (iv). These options are not subject to the Commissions' proposed guidance in this section. 78 See Commodity Options and Agricultural Swaps, 76 FR 6095, Feb. 3, 2011. 79 See Characteristics Distinguishing Cash and Forward Contracts and “Trade” Options, 50 FR 39656, Sept. 30, 1985. 80 Wright, supra note 63. In Wright, the CFTC described the 1985 Interpretation and stated that the CFTC traditionally has engaged in a two-step analysis of “embedded options” in which the first step focuses on whether the option operates on the price or the delivery term of the forward contract and the second step focuses on secondary trading. 81 The CFTC believes that these same principles can be applied with respect to the forward contract exclusion from the swap definition for nonfinancial commodities in the Dodd-Frank Act, too. That is, a forward contract that contains an embedded commodity option or options 82 would be considered an excluded nonfinancial commodity forward contract (and not a swap) if the embedded option(s): (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, so that the predominant feature of the contract is actual delivery; and (iii) cannot be severed and marketed separately from the overall forward contract in which they are embedded. 83 Conversely, where the embedded commodity option(s) render delivery optional, the predominant feature of the contract cannot be actual delivery and, therefore, the embedded option(s) to not deliver preclude treatment of the contract as a forward contract for a nonfinancial commodity. The CFTC would look to the specific facts and circumstances of the transaction as a whole to evaluate whether any embedded optionality operates on the price or delivery term of the contract, and whether an embedded commodity option is marketed or traded separately from the underlying contract, to determine whether that transaction qualifies for the forward contract exclusion from the swap definition for nonfinancial commodities. 84 The CFTC believes that such an approach would help prevent commodity options that should fall within the swap definition from qualifying for the forward contract exclusion for nonfinancial commodities instead. 81 Id. at n.5. In Wright, the CFTC affirmed the Administrative Law Judge's holding that an option embedded in a hedge-to-arrive contract did not violate CFTC rules regarding the sale of agricultural trade options. The CFTC first concluded that the puts at issue operated to adjust the forward price and did not render the farmer's overall obligation to make delivery optional. Then, turning to the next step of the analysis, the CFTC explained that “the put and [hedge-to-arrive contract] operated as a single contract, and in most cases were issued simultaneously * * *. We do not find that any put was severed from its forward or that either of [the put or the hedge-to-arrive contract] was traded separately from the other. We hold that in these circumstances, no freestanding option came into being. * * *” Id. at *7. 82 The CFTC believes that “options” in the plural would include, for example, a situation in which the embedded optionality involves option combinations, such as costless collars, that operate on the price term of the agreement, contract, or transaction. 83 See Wright, supra note 63, at **6-7. 84 This facts and circumstances approach to determining whether a particular embedded option takes a transaction out of the forward contract exclusion for nonfinancial commodities is consistent with the CFTC's historical approach to determining whether a particular embedded option takes a transaction out of the forward contract exclusion from the CEA definition of the term “future delivery.” See Wright, supra note 63, at *5 (“As we have held since Stovall, the nature of a contract involves a multi-factor analysis . * * *”). (c) Security Forwards 85 85 The discussion above regarding the exclusion from the swap definition for forward contracts on nonfinancial commodities does not apply to the exclusion from the swap and security-based swap definitions for security forwards or to the distinction between security forwards and security futures products. No commenters sought clarification of the exclusion from the swap and security-based swap definitions for the “sale of a nonfinancial commodity or security for deferred shipment or delivery, so long as the transaction is intended to be physically settled,” in the context of most sales of securities for deferred shipment or delivery; however, some commenters sought clarification of this exclusion in the context of mortgage securitizations. 86 The Commissions believe it is appropriate to address how the exclusions from the definitions of swap and security-based swap apply to security forwards and other purchases and sales of securities. 86 Specifically, commenters requested clarification that the swap and security-based swap definitions do not include buying and selling mortgages and forward trading of agency ( i.e., Federal Home Loan Mortgage Corporation (“Freddie Mac”), Federal National Mortgage Association (“Fannie Mae”), and Government National Mortgage Association (“Ginnie Mae”) mortgage-backed securities (“MBS”) in the “To-Be-Announced” (“TBA”) market in order to provide the certainty needed to avoid unnecessary disruption of the securitization market. See Letter from Stephen H. McElhennon, Vice President & Deputy General Counsel, Fannie Mae, Sept. 20, 2010 (“Fannie Mae Letter”); Letter from Lisa M. Ledbetter, Freddie Mac, Sept. 20, 2010. The Dodd-Frank Act excludes purchases and sales of securities from the definitions of swap and security-based swap in a number of different clauses. 87 Under these exclusions, purchases and sales of securities on a fixed or contingent basis 88 and sales of securities for deferred shipment or delivery that are intended to be physically delivered 89 are explicitly excluded from the definitions of swap and security-based swap. 90 The exclusion from the definitions of swap and security-based swap of a sale of a security for deferred shipment or delivery involves an agreement to purchase securities, or groups or indexes of securities, at a future date at a certain price. 87 See CEA sections 1a(47)(B)(ii), (v), and (vi), 7 U.S.C. 1a(47)(B)(ii), (v), and (vi). 88 See CEA section 1a(47)(B)(v), 7 U.S.C. 1a(47)(B)(v) (excluding from the swap and security-based swap definitions “any agreement, contract, or transaction providing for the purchase or sale of 1 or more securities on a fixed basis that is subject to [the Securities Act and Exchange Act]”); CEA section 1a(47)(B)(vi), 7 U.S.C. 1a(47)(B)(vi) (excluding from the swap and security-based swap definitions “any agreement, contract, or transaction providing for the purchase or sale of 1 or more securities on a contingent basis that is subject to [the Securities Act and Exchange Act], unless the agreement, contract, or transaction predicates the purchase or sale on the occurrence of a bona fide contingency that might reasonably be expected to affect or be affected by the creditworthiness of a party other than a party to the agreement, contract, or transaction”). 89 See CEA section 1a(47)(B)(ii), 7 U.S.C. 1a(47)(B)(ii). 90 The Commissions note that calling an agreement, contract, or transaction a swap or security-based swap does not determine its status. See discussion supra part II.D.1. As with other purchases and sales of securities, security forwards are excluded from the definitions of swap and security-based swap. The sale of the security in this case occurs at the time the forward contract is entered into with the performance of the contract deferred or delayed. If such agreement, contract, or transaction is intended to be physically settled, the Commissions believe it would be within the security forward exclusion and therefore outside the swap and security-based swap definitions. 91 Moreover, as a purchase or sale of a security, the Commissions believe it also would be within the exclusions for the purchase or sale of one or more securities on a fixed basis (or, depending on its terms, a contingent basis) and, therefore, outside the swap and security-based swap definitions. 92 91 See CEA section 1a(47)(B)(ii), 7 U.S.C. 1a(47)(B)(ii). 92 See CEA sections 1a(47)(B)(v) and (vi), 7 U.S.C. 1a(47)(B)(v) and (vi). As noted above, commenters requested specific guidance in the context of forward sales of MBS that are guaranteed or sold by Fannie Mae, Freddie Mac, and Ginnie Mae and the mortgages underlying such MBS. MBS guaranteed or sold by Fannie Mae, Freddie Mac and Ginnie Mae are eligible to be sold in the TBA market, which is essentially a forward or delayed delivery market. 93 The TBA market has been described as one that “allows mortgage lenders essentially to sell the loans they intend to fund even before the loans are closed.” 94 In the TBA market, the lender enters into a forward contract to sell MBS and agrees to deliver MBS on the settlement date in the future. The specific MBS that will be delivered in the future may not yet be created at the time the forward contract is entered into. 95 The Commissions believe that such forward sales of MBS in the TBA market would fall within the exclusion for sales of securities on a deferred settlement or delivery basis even though the precise MBS are not in existence at the time the forward MBS sale is entered into. 96 Moreover, as the purchase or sale of a security, the Commissions believe such forward sales of MBS in the TBA market would fall within the exclusions for the purchase or sale of one or more securities on a fixed basis (or, depending on its terms, a contingent basis) and therefore outside the swap and security-based swap definitions. 97 93 Task Force on Mortgage-Backed Securities Disclosure, “Staff Report: Enhancing Disclosure in the Mortgage-Backed Securities Markets,” part II.E.2 (Jan. 2003). 94 Id. 95 Id. 96 See CEA section 1a(47)(B)(ii), 7 U.S.C. 1a(47)(B)(ii). 97 See CEA sections 1a(47)(B)(v) and (vi), 7 U.S.C. 1a(47)(B)(v) and (vi). Request for Comment 22. The Commissions request comment on all aspects of the proposed interpretive guidance set forth in this section regarding the forward contract exclusion from the swap and security-based swap definitions with respect to nonfinancial commodities and securities. 23. Is the proposed interpretive guidance set forth in this section sufficient with respect to the application of the forward contract exclusion from the swap definition with respect to nonfinancial commodities? If not, what changes should be made? Commenters also are invited to comment on whether the application of the Brent Interpretation generally, and its conclusions regarding book-outs in particular, is appropriate to the forward exclusion from the swap definition with respect to nonfinancial commodities. Would it permit transactions that should be subject to the swap regulatory regime to fall outside of the Dodd-Frank Act? 24. Is it appropriate, in light of the Dodd-Frank Act, for the CFTC to withdraw the Energy Exemption while concurrently retaining the Brent Interpretation, and extending it to the forward contract exclusion from the definition of “future delivery” and the swap definition, for book-out transactions in all nonfinancial commodities? Why or why not? Is the conclusion that the Dodd-Frank Act supersedes the Swap Policy Statement appropriate? Why or why not? 25. Are there any provisions of the Energy Exemption or Swap Policy Statement that the Commissions should consider incorporating into the definitions rulemakings (other than the request already submitted by some commenters in response to the proposed Entity Definitions that the “line of business” provision of the Swap Policy Statement be incorporated into the definition of the term “eligible contract participant” (“ECP”))? If so, please explain in detail how such provisions are consistent with the requirements of the Dodd-Frank Act and would not permit transactions that should be subject to the swap regulatory regime to fall outside of the Dodd-Frank Act. 26. How frequently do book-out transactions of the type described in the Brent Interpretation occur with respect to nonfinancial commodities? Please provide descriptions of any such transactions, and data with respect to their frequency. Are there any nonfinancial commodities or transactions to which the Brent Interpretation should not apply, either with respect to the forward contract exclusion from the definition of “future delivery” or the forward contract exclusion from the swap definition, or both? Why or why not? 27. Should a minimum contract size for a transaction in a nonfinancial commodity ( e.g., a tanker full of Brent oil) be required in order for the transaction to qualify as a forward contract under the Brent Interpretation with respect to the future delivery and swap definitions? Why or why not? If so, what standards should apply to determine such a minimum contract size? Should the Brent Interpretation for nonfinancial commodities with respect to the future delivery and swap definitions be limited to market participants that meet certain requirements? Why or why not? If so, does the “eligible commercial entity” definition in CEA section 1a(17) 98 provide an appropriate requirement? Why or why not? What other requirements, if any, should be imposed? 98 7 U.S.C. 1a(17). 28. How often, and to what extent, do entities that do not regularly make or take delivery of the commodity in the ordinary course of their business engage in transactions that should qualify as forward contracts? Should such contracts qualify for the safe harbor provided by the Brent Interpretation? Why or why not? If so, how can it be demonstrated that the primary purpose of such transaction is to acquire or sell the physical commodity? Would including these transactions in the scope of the Brent Interpretation permit transactions that should be subject to the swap regulatory regime to fall outside of the Dodd-Frank Act? If so, could this concern be addressed by imposing conditions in order to qualify for the forward exclusion? What conditions, if any, would be appropriate? 29. Are “ring” or “daisy chain” markets for forward contracts, such as the 15-day Brent market, primarily used for commercial merchandising, or do they serve other purposes such as price discovery or risk management? Please explain in detail. 30. Should contracts in nonfinancial commodities that may qualify as forward contracts be permitted to trade on registered trading platforms such as DCMs or swap execution facilities (“SEFs”)? If so, are additional guidance or rules necessary to determine whether contracts traded on such platforms are excluded from the CEA definition of “future delivery” and/or the swap definition? If so, please describe in detail such markets and explain what further guidance or rules would be appropriate? Should conditions be imposed with respect to the nature of the market participants or the percentage of transactions that must result in delivery over a specified measurement period, or both? If so, what conditions would be appropriate? 31. Should the Commissions provide guidance regarding the scope of the term “nonfinancial commodity” in the forward contract exclusion from the swap definition? If so, how and where should the Commissions draw the line between financial and nonfinancial commodities? 32. Should the forward contract exclusion from the swap definition apply to environmental commodities such as emissions allowances, carbon offsets/credits, or renewable energy certificates? If so, please describe these commodities, and explain how transactions can be physically settled where the commodity lacks a physical existence (or lacks a physical existence other than on paper)? Would application of the forward contract exclusion to such environmental commodities permit transactions that should be subject to the swap regulatory regime to fall outside the Dodd-Frank Act? 33. Are there other factors that should be considered in determining how to characterize forward contracts with embedded options with respect to nonfinancial commodities? If so, what factors should be considered? Do provisions in forward contracts with respect to nonfinancial commodities other than delivery and price contain embedded optionality? How do such provisions operate? Please provide a detailed analysis regarding how such provisions should be analyzed under the Dodd-Frank Act. 34. Is the analysis of forward contracts with embedded options in the 1985 Interpretation and the CFTC's Wright decision appropriately applied to transactions entered into after the effective date of the Dodd-Frank Act? Why or why not? If not, how should the analysis be modified? 35. How would the proposed interpretive guidance set forth in this section affect full requirements contracts, capacity contracts, reserve sharing agreements, tolling agreements, energy management agreements, and ancillary services? Do these agreements, contracts, or transactions have optionality as to delivery? If so, should they—or any other agreement, contract, or transaction in a nonfinancial commodity that has optionality as to delivery—be excluded from the swap definition? If so, please provide a detailed analysis of such agreements, contracts, or transactions and how they can be distinguished from options that are to be regulated as swaps pursuant to the Dodd-Frank Act. To what extent are any such agreements, contracts, or transactions in the electric industry regulated by the Federal Energy Regulatory Commission (“FERC”), State regulatory authorities, regional transmission organizations (“RTOs”), independent system operators (“ISOs”) or market monitoring units associated with RTOs or ISOs? 36. Is there any issue with respect to the treatment of commodity options that the Commissions have not addressed and that should be addressed a [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A2011-11008. Public record. Not legal advice.